Ten Investable Things that We Think Will Happen in 2019

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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January 2, 2019

Ten Investable Things that We Think Will Happen in 2019

Another year, another set of predictions. Our 2018 predictions turned out well – six solid A’s, two B’s and a couple of clunkers (QCOM fought off AVGO but didn’t resolve things with AAPL, and IBM technically delivered growth, but we won’t take credit). Our 3 top long picks featured two home runs – ZEN (+71%) and KEYS (+47%) – along with ho-hum GOOGL (-3%). Of our shorts, T (-22%) and AAPL (-7%) were on target, AVGO (-2%) was less so. For the full year, our model portfolio performance was quite good, up 24.7% and beating the S&P500 by 3172bp and the tech components of the index by 2767bp. With that, we offer ten new predictions for 2019, all driven by our conviction that TMT has entered a new paradigmatic era driven by hyperscale cloud computing, AI and 5G.

  • Growth tech recovers and outperforms the broader market. Progress on global trade and less hawkish monetary policy stem the wrenching volatility of 4Q18. Cloud franchises and SaaS software, with little exposure to China and strong business momentum, will thrive. Chip stocks will be mixed – cloud data center, telecom and automotive will be strong markets, but smartphones will be weak. All in, we expect the tech benchmark to slightly beat the S&P and for tech growth stocks, including those in our model portfolio, to outperform by more than 300bp.
  • AWS and GCP moves up the SW stack via M&A, Azure gains 500bp of share. Cloud hosts are increasingly concerned that infrastructure-as-a-service (IaaS) will be increasingly commoditized by sophisticated platform software and SaaS applications. We expect AMZN and GOOGL to address this via acquisition, targeting platform plays and anchoring SaaS franchises, perhaps considering mega-deals like AMZN-VMW or GOOGL-CRM. Meanwhile, we see MSFT, already well integrated up the stack, gaining 500bp of share on market leader AWS.
  • Cloud CAPEX tops expectations with 30% growth. Vigorous competition will drive strong growth in cloud service revenues, which will in turn, drive CAPEX. After increasing their investment by 50% in 2018, we believe hyperscale datacenter spending will easily top expectations for ~20% growth in 2019. Within this, we believe the ongoing shift toward AI processing will favor GPUs and FPGAs over CPUs, and that competition for CPUs will become more formidable.
  • Merged TMUS/S announces aggressive 5G plans. The tea leaves are pointing toward a 1H completion of the TMUS/S merger. We expect the combined entity to announce very aggressive 5G investment plans, pointing toward national service coverage by 2020 and competitive residential broadband plans in high opportunity markets. We expect this to spur higher spending by VZ, T and the cable industry.
  • The EU acts against FB, AAPL and AMZN. To date, GOOGL has been the EU’s favorite whipping boy, assessing nearly $8B in fines and demanding changes to its shopping service and the terms it demands from Android OEMs. Even with the likely 2Q19 departure of current Competition Commissioner Margarethe Vestager, we expect the EU to continue the aggressive pursuit of mega-cap US tech companies. Judgments against FB on privacy, AAPL on service bundling and AMZN for favoring its own products vs. its 3rd party marketplace and for domination in e-books seem likely, with multi-billion-dollar fines and disruptive remedies attached.
  • AI speaker installed base nearly doubles, smartphone revenues decline. Industry analyst Canalys estimates that the total installed base of AI-assistant enabled home speakers hit 100M in 2018, up from ~45M in 2017. While Canalys expects deceleration to 70% growth in 2018, we expect the ongoing battle between AMZN and GOOGL to keep the sales pace brisk. We believe that the installed base will top 190M for 2019, with low prices and new AI-driven functions fueling continued consumer enthusiasm.
  • NFLX tops 165M subs before DIS launches its competing service. The 4th quarter swoon hammered NFLX, which lost more than a third of its value despite posting a big surprise in subscribers and profits in October. While exposure to shaky developing markets is a concern, much of the negative news flow pointed to a future threat from DIS (and other media companies, like T and CMSCA) as a major risk. We believe this perspective underestimates the difficulties these companies will face in entering the streaming market and the substantial lead that NFLX has built. We believe that NFLX will add more than 25M new subscribers before DIS will claim the first for its new services.
  • Waymo announces new markets, GM/Cruise pushes its launch to 2020. GOOGL’s Waymo just made its 2018 target for launching commercial robo-taxi service in Phoenix. A new safety officer coincided with the return of emergency drivers to the vehicles, but beyond some grousing over the very conservative driving style, the launch appears to be a success. With mapping and testing underway in Austin, Atlanta, SF/Silicon Valley, and Kirkland, we expect Waymo to announce planned service beyond Phoenix in 2019. Meanwhile, GM’s Cruise had promised its own launch in SF for 2019. Given technical and business system challenges, we believe the plan will have to shift to 2020 or even 2021.
  • Financial services and healthcare are the new battlegrounds for Internet giants. AMZN has bee quietly edging into financial services, already offering loans to marketplace merchants and prepaid/credit cards for consumers. We expect it to announce consumer checking in concert with a bank partner in 2019. GOOGL will likely follow, expanding on its Google Pay platform to offer cash back credit and prepaid accounts. AMZN will continue its disruption of the US pharmacy biz, attacking out-of-pocket drug spending and signing new corporate partners for its planned employee health program. AAPL will push HARD on health applications for its Watch, prompting GOOGL and its OEMs to follow. AI applications for healthcare will move from proof-of-concept to clinical practice.
  • Our best picks for the year. Long: NFLX – Beaten up on misplaced fears of DIS, we expect upside surprises to drive significant outperformance; TMUS – Completing the S merger will bring big cost synergies and a push to lead in 5G; NTNX – Enterprises need platform-layer solutions to enable hybrid-cloud and multi-cloud operations, plus NTNX is a prime acquisition candidate. Short: ORCL – We are NOT believers that the 2QFY19 surprise indicates a rosy future; BKNG – New name, new symbol, but still vulnerable to disintermediation and very exposed to China; DBX – cloud storage is a commodity waiting to happen and the top cloud hosts have huge cost advantage.

It’s Prediction Time

We had a great 2018 – even considering the slap-down that played out over the last 3 months. Our model portfolio – 15 large cap stocks with a few adjustments over the course of the year – outperformed both the S&P500 and the tech components of that index, delivering +24.7% absolute performance. Our January predictions played out similarly well – 6 As, 2 Bs, and 2 Cs.

Our grade A predictions? GOOGL did indeed launch its commercial robocab service in Phoenix, albeit with just a couple of weeks left in 2018. AAPL did miss iPhone shipment estimates, compounding the damage by ending the quarterly release of unit sales, and culminating in a messy pre-announcement for Q1FY19. The reversal of Net Neutrality regulations had no noticeable effect, as predicted, despite the hew and cry from the tech press. US TV viewership and ad sales were as bad as we thought they would be – and it won’t get any better in 2019 either. AMZN has caught up with WMT in terms of GMV and will pass it in 2019. Our 2018 long (ZEN, KEYS and GOOGL) and short (AAPL, T, and AVGO) were on target.

The Bs: US carrier capex did NOT rise 8% – the TMUS/S merger approval stalled spending to just 3%. MSFT’s Azure and GOOGL’s GCP made progress against AMZN’s AWS, just not the big moves we were expecting. The Cs: QCOM did fend of AVGO as predicted but did not resolve its dispute with AAPL, leaving its shares back in the doghouse with investors. Technically, IBM did, in fact, deliver its first full year sales growth in 5 years, as we had forecast. Still, the 0.70% growth was aided by currency and the stock is still widely mistrusted, so we are not going to give ourselves credit for this one.

Our predictions for 2019 are listed above. All of them reflect our belief that we are a few years into a generational transition from a world of constrained datacenter resources, modular software development and inadequate networking capacity to one with practically limitless hyperscale datacenter resources, AI-based holistically developed software, and ample wireless bandwidth. The resilience of growth tech, the transition to the cloud, the scale advantages of cloud-based services, the power and flexibility of AI-based software, and the performance of 5G wireless all proceed from this ongoing paradigm change.

Our best picks for 2019 also reflect this perspective. Investors are doubting NFLX, concerned that deteriorating emerging markets and future competition from DIS (and others) will stall its torrid growth. We see this as an opportunity – NFLX has a huge lead and momentum, while the growing pains for competitors will be greater than most assume. We expect the TMUS/S merger to get approval early in 2018. Management will hit the ground running gaining synergies and exploiting spectrum advantage to lead in 5G. Finally, a main barrier for enterprises moving to the cloud is platform software to allow them to manage a hybrid public/private and multi-cloud solution set. NTNX has a strong cloud middleware solution that will attract both customers and potential suitors.

On the flipside, our short picks contain companies disadvantaged by the new era. ORCL just posted an upside surprise but offers solutions on the wrong side of the paradigm shift and its own customers hate it. BKNG is well loved, but it is making a big risky bet on China and could see AMZN competing in the travel market. Finally, DBX has filled a niche for consumers and small business, but competition in cloud storage is growing fierce and the big cloud hosts have huge cost advantages. 2019 could be disappointing for all three names.

The Crazy Year That Was

We were quite optimistic heading into 2018. The growth tech that we favor in our model portfolio was on a roll. Our predictions for the year were bullish on cloud adoption, AI development, and 5G investment, while pessimistic for traditional media, traditional telecom and Apple. More than half of the predictions were spot on, while just two turned out to be duds for investors (Exhibit 1). To review:

1. Google Launches Commercial Robocab Service- This one came in just under the deadline, when Waymo began offering commercial rides to a limited area of Phoenix in early December. Despite a little bit of skeptical press, mostly highlighting the safety-first caution that still sees lengthy waits for intersections to clear on left hand turns. Deborah Hersman, the former head of the National Transportation Safety Board, joined the team in late November as the Chief Safety Officer, immediately returning safety drivers back to vehicles that had been operating in full autonomous mode prior to the service launch. Alphabet’s self-driving subsidiary remains years ahead of its rivals in its technology, its market testing and its budding ecosystem. We gave ourselves an A.

2. Apple Misses FY18 iPhone Unit Shipments – Yep, that happened. The overall global smartphone market declined in units, as replacement cycles lengthened in a nearly saturated market. Only one segment, low end phones priced below $100, saw growth – too bad for Apple, which competes exclusively in the $600+ ultra-premium segment. Year two in the company’s test of price elasticity was a full-on failure, tacitly acknowledged when management announced on the fiscal year end conference call that they would no longer offer unit shipment details in future quarters, and explicitly demonstrated by the pre-announcement on January 2. The stock lost more than a quarter of its peak market cap, ending the year 11% lower than it started. This was an A+

3. US Carrier CAPEX Rises 8% – This one was wrong, but in our defense, we expected TMUS and S to lead the way on 5G investment. Instead, the two carriers announced their intention to merge and backed off spending while the deal was reviewed by regulators. We still think the spending surge is coming, once the combination is approved. Actual spending growth was 3%, which was still higher than consensus expectations, so we are giving ourselves a B.

4. Net Neutrality Repeal Will Have Little Effect – If you can remember the tech headlines in the first few months of 2018, many were wringing their hands over the impact of Republican control of the FCC. In particular, the pending repeal of Net Neutrality rules set by the commission was a Silicon Valley bugbear. We thought it was much ado about nothing, and we were right. The carriers were too cowed by the scrutiny to really step up to abusing their market power absent the old rules. Another A+.

5. US TV Viewership and Ad Sales Continue to Slide – And then some. Viewership numbers for linear TV are dismal – the latest Nielsen Total Audience Report (which we think understates the problem) saw every demographic but 65+ seniors watching meaningfully less TV than the year before. eMarketer called full year US TV ad sales down mid-year, and nasty ratings surprises in the fall season hardly made up for it. Every TV media company, save for Discovery, saw its stock lose ground to the broader market in 2018. We’ll take another A+.

6. Qualcomm Fights Off Broadcom and Settles with Apple- Technically, we go the first part right, with an assist from the President, Qualcomm did fight off Broadcom. Still, this is immaterial to QCOM

Exh 1: SSR TMT 2018 Predictions Scorecard

investors who are still suffering from the ongoing soap opera with Apple. The lost royalties killed FY18 results and left the stock drifting aimlessly. We still believe that Qualcomm holds the stronger hand, and is better in the courtroom, but it’s taking much longer than we predicted. Look for a big splash in 2H19, but for now, give us a C.

7. Microsoft and Alphabet Make Big Moves Against Amazon Web Services – Microsoft’s Azure IaaS platform nearly doubled the growth of market leader Amazon Web Services. It acquired open source repository GitHub for $7.5B, strengthening its position with developers and signaling its intention to extend far beyond its base of existing infrastructure software customers. Alphabet’s Google Cloud Platform expanded its partnership with Salesforce and outgrew AWS, but it remains a distant #3. Our grade? B+.

8. Amazon’s Gross Merchandize Volume Catches Walmart by 4Q18 – The final numbers aren’t in yet, but we’re ready to make the call. Amazon will be the largest US-based retailer in 2019. This was inevitable but hidden by Amazon’s practice of reporting only the fees earned from 3rd party sales. With GMV growth of more than 35% and ongoing incursion into new categories, such as grocery, pharmacy and B2B, we expect Amazon to quickly extend its lead. This prediction merits an A.

9. IBM Delivers Full Year Sales Growth – IBM did deliver 0.70% sales growth, helped by a mainframe upgrade cycle and currency tailwinds. Still, coming off a disappointing 3Q18, we are loath to take credit. We still think Big Blue is likely to find its legs and get some benefit from its AI and blockchain investments, but it may take a while. We’ll take our C and move on.

10. Our Top Picks for 2018 – Two of our three top longs were homeruns. Zendesk appreciated more than 70% for the year, despite taking a licking during the recent market swoon. Keysight was also a champ, up 47% for the year as carriers and equipment makers invested in 5G test gear ahead of the 2019 roll out. Alphabet, down 3% for the year, was roughly a market performer. As for our shorts, AT&T fumbled its way to a 22% full-year decline and Apple’s late swoon wiped away its 2018 gains and then some, finishing 7% off. AVGO bounced back from its Qualcomm disappointment and beat the market with a 2% decline. Overall, we’ll take another A.

Drumroll Please … Our 2019 Predictions

  1. Growth tech recovers and outperforms the broader market – We looked at this in our most recent model portfolio piece (http://www.ssrllc.com/publication/model-portfolio-is-it-safe/). Over the last 28 years, and with the notable exception of the Internet Bubble 2001 recession, tech has outperformed the broader market after significant downturns. On average, tech has rebounded from a trough back to its previous peak in 38% more time than it took to fall (Exhibit 2, 3, 4). This is 645bp faster than the broader market. Furthermore, the tech premium vs. the S&P500 has fallen from 10x to 3x since October. Finally, growth tech is relatively less vulnerable to the biggest risk factors in the market – China, interest rates, and emerging market growth. We believe that we’ve seen the bottom and that growth tech will lead the way back. This will be positive for all the companies in our model portfolio (Exhibit 5).

Exh 2: S&P 500 and Tech Components Rebound Stats after major sell-offs

Exh 3: S&P 500 and Tech Components Peak-to-Trough drop during major sell-offs

Exh 4: S&P Tech Components recovered much faster than S&P 500 broader index post major sell-offs

Exh 5: SSR TMT 15 Stock Long-only Model Portfolio

2. AWS and GCP moves up the SW stack via M&A, Azure gains 500bp of share – Infrastructure-as-a-Service (IaaS), the business of hosting commercial computing on cloud-based hyperscale datacenters has evolved to a three-horse race in most western markets (http://www.ssrllc.com/publication/cloud-software-a-long-journey-with-three-layers/). Amazon’s AWS is currently well in the lead – it established the market years ahead of its rivals and dominates with the web-based businesses and development organizations that made up most of the demand in the first decade of web hosting (Exhibit 6). Still, demand in the next era is increasingly from traditional enterprises with the need to balance in-house resources with multiple cloud-based hosts. This will likely pressure price for cloud computing and storage at the infrastructure level, forcing AWS to look up the stack to platform functions and applications to generate more value added. The same is true for Google Compute Platform (GCP) and we expect both companies to look to acquisitions and partnerships to bulk up their offerings. As a side note, we see VM Ware as an ideal partner for AWS and Salesforce for GCP, but we aren’t going to go that far out on a limb and predict deals in 2019. Meanwhile, Microsoft’s Azure is buttressed by its parent’s strong platform and application franchises, and by its trusted relationships with traditional enterprise IT. We think Azure can close the market share gap vs. AWS by at least 500bp, continuing to grow at nearly twice the rate as its rival (Exhibit 7).

Exh 6: Cloud Infrastructure Services Market Share, Q3 2018

Exh 7: MSFT Azure Cloud Historical Quarterly Growth Rates, 1Q17 – 3Q18

On that trajectory, we expect Microsoft to take the lead by 2022. We see this as positive for MSFT and for potential M&A candidates – CRM, VMW, NTNX, PVTL, NOW, AYX, ZEN, and many others.

3. Cloud CAPEX tops expectations with 30%+ growth – In 2018, the major hyperscale datacenter operators – led by Amazon, Microsoft, Alphabet, Facebook, and Alibaba – collectively grew CAPEX by more than 50%, according to Synergy Research (Exhibit 8). Consensus expectations for 2019 spending by these companies forecast a sharp deceleration to ~20% spending growth. Given the booming demand for public cloud hosting as the inexorable exodus of enterprising computing plays out and the internal internet franchises operated by these companies, we believe these projections are far too conservative (LINK). We look for better than 30% spending growth, reflecting the substantial opportunity for the cloud hosts (i.e. MSFT, AMZN, GOOGL), with significant implications for their suppliers – NVDA, XLNX, MLNX, and others will strongly benefit.

4. Merged TMUS/S announces aggressive 5G plans – First, we expect the DoJ and FCC to approve the combination of the number 3 and 4 US wireless carriers, perhaps as early as 1Q19. Second, we expect the combined company to lay out a comprehensive plan to capture substantial cost synergies and step up competitive pressure on market leaders Verizon and AT&T. A big piece of these plans will be a major acceleration in 5G network investment. With substantial spectrum advantage, the new network will spur price cuts and service enhancement, with explicit intention to attack residential broadband service in addition to traditional wireless. This will spur Verizon and AT&T to pick up the pace on their own deployments. This scenario will be good for T-Mobile and Sprint and bad for the market leading duopoly and the cable industry (Exhibit 9). It will also be a boon to wireless telecom suppliers.

Exh 8: Cloud Capex Spending and Growth Rates, 2014 – 2019

Exh 9: Consensus Estimate for US Carrier Capex and Annual Growth rates

We remain bullish on test equipment (KEYS, NATI, Anritsu) and optical backhaul (CIEN). ERIC and NOK will see revenue acceleration (although, previous build cycles have been mixed for these suppliers). We will also begin to see demand for later cycle plays, like small cells (COMM).

Exh 10: Summary of EU action against US big tech in last 10 years

5. The EU acts against FB, AAPL and AMZN – The EU hit Alphabet with nearly $8B in fines in 2018, while also requiring the company to rework their Google Shopping and Android businesses to accommodate commission directives not to favor their own services in shopping services and to no longer require Android licensees to bundle Google applications (Exhibit 10). These rulings were onerous, and while they will be appealed to EU courts and may win, they disrupted strategic plans for the company’s business in Europe. While Apple and Amazon have been hit by tax judgments, they have not yet been taken to the woodshed for their own business practices, which appear to similarly run afoul of the EU’s activist Competition Commission’s ethos. Facebook, which faced clear but toothless rebukes from governments on both sides of the Atlantic in 2018, could see more concrete (and costly) sanctions from the EU in 2019. The outspoken Commissioner for Competition, Denmark’s Margarethe Vestager, is unlikely to be reappointed by her home country and will very likely leave by mid-year, but there is no indication that a successor would be any more conciliatory to the US tech giants. We expect Facebook, Apple and Amazon to all see fines and demands for changes to the business practices in the EU during 2019.

Exh 11: Global Smart Speaker Installed Base Forecast, 2018 – 2022

6. AI speaker installed base nearly doubles, smartphone revenues decline – In 2018, the great AI speaker landgrab picked up pace, with Amazon and Google slashing prices on Echoes and Home Hubs and launching splashy national advertising campaigns. In this environment, the worldwide installed base of these products boomed from less than 50 million to more than 100 million, according to the market research firm Canalys (Exhibit 11). In the second half, Google followed Amazon’s lead with a touchscreen equipped model that enabled a whole new set of user applications. Meanwhile, Apple is lagging with its relatively expensive and under-featured audio focused smart speaker and Facebook recently launched its video-calling oriented (and frankly, scary from a privacy perspective) Portal. We expect the momentum to continue in 2019 – Amazon and Alphabet see big synergies with their core franchises, are making big strides in the performance and functionality of their AI assistants, and gaining buy-in from huge ecosystems of home automation partners. In this context, shipments should stay on the steep part of the adoption curve – we think the installed base will close in on 200M worldwide. Ultimately, we believe AI assistants will displace the entire “app economy” (http://www.ssrllc.com/publication/ai-assistants-the-new-ui-paradigm-that-will-end-the-osapp-era/). Meanwhile, the maturation of the smartphone will continue to play out. Unit shipments will decline, and industry revenues will be down even more. All of this is good for GOOGL, AMZN, and their home automation partners, and bad for the whole smartphone ecosystem – e.g. AAPL, Samsung, QCOM, SWKS, Foxconn, and others.

Exh 12: Netflix Quarterly Subscribers in Millions, 1Q12 – 3Q18

7. NFLX tops 165M subs before DIS launches its competing service – Netflix put up extraordinary 3Q18 numbers, beating EPS estimates $0.89 to the $0.61 consensus and more importantly, topping subscriber addition forecasts of ~5M by nearly 40%. It also projected an upside surprise for 4Q on accelerating sales and subscriber growth (Exhibit 12). So why was the stock down 26% in 4Q, underperforming its FANG compatriots. It seems that the dominant narrative around the stock has changed from “Netflix is killing traditional media” to “Traditional media is on the way to kill Netflix” (Exhibit 13). We think this dramatically underestimates the difficulties that TV media, including Disney, will have in shifting to the streaming model (http://www.ssrllc.com/publication/the-end-of-tv-media-strains-to-adapt-to-the-streaming-era/). The rights to much of Disney’s recent theatrical library has already been licensed to other platforms, including Netflix and AT&T’s Turner, which owns the rights to the initial 6 films in the Star Wars canon. Hyped new content based on the Marvel and Star Wars universes has not yet begun production. Moreover, marketing the new Disney+ service will be a massive undertaking. We do not expect a service launch until nearly the end of 2019. Meanwhile, Netflix is clicking on all cylinders. Guidance for 9.4M new subs would bring the total to nearly 145M at year end, up 27M YoY. We expect Netflix to match that in 2019, riding strong momentum in every region. By the time Disney+ launches, likely in mid-4Q, we expect Netflix to have already surpassed the 165M sub mark, on its way to well

Exh 13: Consensus growth estimates for NFLX present a conservative outlook