The TMT Model Portfolio: 15 Well Positioned Stocks and a few more

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


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August 24, 2018

The TMT Model Portfolio: 15 Well Positioned Stocks and a few more

Our 15-stock model portfolio has delivered outstanding performance vs. the S&P 500 and vs. the tech components of that index over the past 3 months, 6 months and full year. It is designed to feature leading companies well exposed to the major technology vectors that we believe are remaking the TMT landscape – Enterprise Cloud, AI, 5G, Blockchain, Digital Media, and E-commerce. While we normally use our quarterly update to make changes to the portfolio, we believe all our names are well positioned to outperform vs. achievable expectations in coming months. We believe even relative laggards – NFLX (-4.1% since May), IBM (+3.0%), and NOW (+3.6%) – whose 2Q18 reports yielded concern rather than enthusiasm, are likely to surprise positively in coming quarters, driven by factors that we have detailed in our prior research. As such, we are letting the portfolio ride as currently constituted, and using this update to review several stocks that we had included previously and removed. These names – WDAY, TMUS, ADBE, MLNX, TWTR, CCI, STX, and DATA – were replaced largely to make room for new constituents for which we had more enthusiasm but are still exemplars of our main investment themes. All have performed well since they were removed and remain strong options for inclusion in the future.

  • Our model portfolio performed particularly well in this period. Continuing our 2018 hot streak, the portfolio beat the S&P500 by 838bp since the last update in May and topped the tech components of the S&P by 844bp. Newly added AYX was the big winner, up 63.7%, but KEYS, GOOGL, AMZN, QCOM, ZEN, and CRM were all up double digits. NFLX (-4.1%), IBM (+3.0%), and NOW (+3.6) were the obvious laggards, majority hit by negative reaction to 2Q18 results or guidance, but these stocks remain well positioned against the major opportunities being created by the emerging Cloud/AI era of tech, and we expect significant future upside. As such, we are holding our portfolio as is.
  • Portfolio composition has evolved in its six years. 51 different companies have been part of our 15-stock portfolio over the past seven years. Early on, we tried to keep a stricter subsector balance, resulting in relatively poor performance, but over the past few years, a strong thematic emphasis has accompanied outstanding performance vs. both the market and our benchmark. We believe that the next decade of TMT will be driven by six major change vectors – Enterprise Cloud, AI, 5G, Blockchain, Digital Media, and E-commerce – and all 15 stocks provide significant exposure. The average holding time for the current constituents is 28 months, and only one stock – GOOGL – has been in the portfolio since inception (two other inaugural choices – QCOM and CRM – have returned after having been removed for a time, MSFT was added on the very first update in 2011).
  • Several recently removed stocks have continued to outperform. With just 15 slots in the portfolio, adding a new name requires removing an incumbent constituent. Often, we still see significant potential in the stock being removed but simply prefer its replacement or see benefit in greater portfolio diversity or reduced volatility. To that end, we are reviewing 8 of the 12 stocks that have been replaced over the past two years – WDAY, TMUS, ADBE, MLNX, TWTR, CCI, STX and DATA. On average, these names have slightly underperformed their replacements in the portfolio but have outperformed the market since they were removed. We would strongly consider the stocks on the list were we to replace one of the current constituents.
  • WDAY- SaaS HR application leader WDAY came out of the portfolio in May 2018 to make room for AYX. We still see it as a clear category leader in the Enterprise Cloud, but its success makes growth a bit harder and acquisition a bit less likely than smaller names, like AYX.
  • TMUS- TMUS had a 42-week run in our portfolio, but we took it out this past February, as we believe the impending acquisition of S will delay 5G deployment, temper strategic moves and distract investors. Still, the stock has been on a tear of late, and we expect a surprisingly easy approval to catalyze strong appreciation in 2019. Long term, we believe a combined TMUS/S can harvest market share from VZ/T and make mobile 5G broadband a viable alternative to fixed residential broadband.
  • ADBE- At one point, 1/3 of our portfolio was SaaS Enterprise Cloud stocks. ADBE, which had been a stalwart for us for nearly 3 years, was removed in December 2017 to add CIEN. Since, it has outperformed its replacement by 2563bp. Looking ahead, ADBE is on the right side of enterprise’s shift to the cloud and has an underrated AI capability, but it is now big enough to make its growth harder to sustain and we like MSFT and CRM better.
  • MLNX- MLNX makes switching/interface chips for hyperscale data centers, a key building block for Enterprise Cloud, AI, and Blockchain. While we are very bullish on capex in that sector, the volatility of MLNX was difficult, and we replaced it in July 2017 in favor of KEYS. While we have been delighted with KEYS performance, MLNX is up 65% since we removed it.
  • TWTR- TWTR is a unique platform for real-time information distribution with an effective competitive moat and an excellent context for delivering engagement for digital advertising. We removed it last April amidst heavy investor skepticism, but our decision to replace it with IBM was short-sighted. We see TWTR as an undervalued alternative to GOOGL and FB in Digital Media, with surprising AI strength.
  • CCI- We held wireless tower REIT CCI in the portfolio for 43 months, removing it in December 2016. We saw CCI as widely appreciated by investors and saw more upside in CRM, which has outperformed it 80% to 15% over the past 19 months. Still, we expect a faster and more aggressive 5G roll-out to pick up steam in 2019 with the likely approval of TMUS-S, so the timing may be right for CCI.
  • STX- Either STX or its rival WDC was in our portfolio from June 2012, to May 2016, when we took out STX in favor of MLNX. We got tired of waiting for Enterprise Cloud datacenter demand to outweigh the deteriorating PC market, but, of course, in the 27 months since we removed STX, it has risen more than 190%. Consensus expects a cyclical downturn, but we are much more optimistic.
  • DATA- We lost faith with Enterprise Cloud analytics application player DATA in 2Q16 after a sharp sell off on fears of a MSFT threat. That threat has not really materialized, and DATA has more than doubled since we removed it. Sales are now accelerating, and its SaaS analytics platform makes it an interesting M&A candidate (CRM? GOOGL?).

Our Thematic Approach

We have published our 15-stock TMT Large Cap Model Portfolio on a roughly quarterly basis for more than seven years. For most of that time, its intention has been to exemplify our thematic research, providing specific investment ideas likely to be advantaged by the changes that we see happening in the TMT landscape. With that context, the portfolio has been very successful, outperforming the S&P 500 by 14519 bp over the past 5 years, 9082 bp over the past two and 3773 bp over the past 12 months. Performance vs. a benchmark of the tech components of the S&P 500 has also been excellent, up 5457bp over 5 years, 4633 bp over 2 years and 2338 bp in the past year.

The most recent 3-month period was one of our best, outperforming the benchmark by 844 bp and the broader market by 838 bp. Newly added Alteryx was the biggest contributor, up more than 63.7% since we added it in May, but the outperformance was broad based, with 8 of 15 stocks rising double digits in the period. Netflix, Service Now, and IBM were the only stocks not to beat the S&P 500, with Netflix the sole constituent to decline in the quarter.

Exh 1: SSR TMT Model Portfolio Performance Since Last Update

Our ongoing investment hypothesis is that we are several years into a generational paradigm shift in the technology landscape, driven primarily by new capabilities and economics afforded by hyperscale datacenter architecture, artificial intelligence (machine learning) software techniques, and advances in wireless networking. Historically, new paradigms (like the PC/Ethernet era that preceded the current environment) have an arc – a period of revolution as the new approach challenges the old, followed by a period of consolidation where the emerging paradigm thrives, then a period of stagnation when the limitations of the

Exh 2: SSR TMT Model Portfolio Historical Performance for 5 Years

Exh 3: SSR TMT Model Portfolio Performance Since Last Update

paradigm become constraints that spur creation of a new one. We believe that we are currently in the middle phase of a Cloud/AI paradigm, and that the companies that best exploit its broad adoption will prosper.

In this context, we look for model portfolio constituents that will benefit from six major change vectors that proceed from the generational sea change: Enterprise Cloud, AI, 5G, Blockchain, Digital Media, and E-commerce. We have written extensively on all these topics, and a list of links can be found in exhibit 4.

Exh 4: SSR TMT Model Portfolio Tracks Key TMT Vectors

TMT Vectors Summary Favored Companies Highlighted Past Work
Enterprise Cloud Shift of traditional on-premise hosting to shared public or hybrid cloud infrastructure, driven by tremendous cost benefits; Replacing packaged software model with dynamic cloud deployed SaaS Cloud Hosts: GOOGL, AMZN, MSFT, IBM
Hardware: MLNX, STX
AI Risk Management: Catalyzing Banking’s Move to the Cloud

15 Stock TMT Model Portfolio: Winning Enterprise Cloud and Betting on Self-Service Analytics

AI, Blockchain and the Cloud: Banks in the New Technology Era

Artificial Intelligence AI infused software winning enterprise and consumer applications, driving demand for specialized hardware for processing needs Cloud Hosts: GOOGL, MSFT, AMZN, IBM
Other AI Products: FB, CRM, TWTR
Hardware: NVDA, XLNX
AI Assistants: The New UI Paradigm that will End the OS/App Era

AI, Blockchain and the Cloud: Banks in the New Technology Era

Self-Driving Cars: Waymo and GM are FAR ahead of Uber…And Everyone Else

AI: Sizing the Market – Big, Bigger and Biggest

AI Assistants: The Next User Interface Paradigm

5G Wireless Carriers challenging market hegemony midst eroding dominance of US wireless duopoly; Aggressive 5G capex spend benefitting suppliers Testing and Measurement: KEYS
Optical: CIEN,
Tower: CCI
Switching: MLNX
5G Test Equipment: Adding KEYS to Our Model Portfolio

5G: Rising Global Carrier Competition to Drive Capex

5G: Hyperscale + AI + 5G = Sea Change

A 5G Wireless Primer: The Final Ingredient for the Next Era of TMT

Blockchain Design and development of bespoke blockchain solutions Consultants and Consortium: IBM, ACN, MSFT Banks, Payments and Blockchain: Right Idea, Wrong Tool

Commercial Blockchain: Objects May Be Further Away Than They Appear

Digital Media Linear TV has peaked, TV ad spend has stalled. Digital native streamers and social platforms emerging advantaged Streaming: NFLX, AMZN, GOOGL,
Social: FB, TWTR
The End of TV: Media Strains to Adapt to the Streaming Era;

The War on TV: The Attack of the Boxes

War on TV: Streaming is Coming

War on TV: The Biggest Pipe Will NOT Win

TMT: The Advertising Revolution Will Not Be Televised

E-Commerce E-commerce gaining more share of US retail spend; Development in consumer technology threaten traditional retail models Commerce: AMZN, GOOGL, FB The Future of Shopping

Ten Investible Things that We Think Will Happen in 2018

No Changes

Ordinarily, we use our quarterly portfolio updates to make changes to its composition, but at this time, we are comfortable with the stocks that we have included. We are not inclined to make changes just for the sake of change – our average holding time for the current 15 constituents is 34 months. In lieu of a portfolio change, and associated verbiage justifying it, we will use this note to review several stocks that we have removed from the portfolio over the past two years. While we have replaced a few stocks for which our opinion had materially soured and others that had been acquired, many of the removals were made simply to adjust the balance of the portfolio or to make room for a new name that we liked even better. Some of these stocks remain very attractive investments, well tied to the factors driving change in the landscape.

Workday (Enterprise Cloud)

Workday, a SaaS-based enterprise resource planning software maker with leading modules for human resources, planning and finance, had been a part of our model portfolio April 2013 until the recent update in May 2018 when we decided to exclude it to make room for Alteryx. We still like the company – it has a great product addressing a wide market opportunity supported by strong management – but its success has raised expectations and its valuation reduces the potential for a take-out at a premium. Alteryx, a much smaller company amidst better than 50% growth, has a much greater potential surprise (Exhibit 5).

Exh 5: WDAY returns relative to replacement AYX after dropping from Portfolio

Nonetheless, Workday remains an interesting investment (Exhibit 6). The enterprise shift to the cloud has shown accelerating demand for SaaS application offerings and Workday is a category leader. Management estimates its addressable market at well over $75B, growing at over 15% YoY as the company reaps market share to drive its 30%+ annual growth. Workday is known for excellent customer satisfaction ratings and invests aggressively in product innovation, adding supplemental modules for easy cross deployment to existing customers.

Exh 6: Key Operating and Valuation Metrics – WDAY

Workday now boasts of a total 2,100 customers, with over 175 companies from Fortune 500 using their human resource software. Financial management software is used by over 450 companies in total – 45% growth within a year. Operating losses in the most recent quarter were at $71.3M, or negative 11% of revenues compared with negative 12.5% of revenue a year ago – bringing it a step closer to profitability. Big ticket clients such as Walmart use Workday tools to touch 2M+ employees giving the platforms wide range of data assets to build on and an ultimate test in cloud scalability.

With heavy expectations built in all SaaS growth names, there is some inherent volatility risk for shareholders in case of any signs of imperfect results yet with continued product innovation, strong customer relationships, steady growth rate and a likelihood of SaaS industry-wide consolidation, we remain confident of Workday’s outperformance in the long run and believe the stock is a great choice to play the SaaS growth narrative into the remainder of this decade.

T-Mobile (5G)

We had held TMUS in the portfolio for more than 3 and a half years before removing it this past February. Its aggressive “Uncarrier” strategy has been very effective in drawing market share from a market-leading duopoly (VZ and T) whose 5%-ish dividend yields made it prohibitive to confront T-Mobile, and from the dumpster fire that is Sprint. T-Mobile lowered prices, eliminated long-term service contracts, while offering free international roaming, contract buyouts from other carriers, free data for streaming media services, and unlimited usage packages, attacking the most critical pain points for its rivals’ customers. Verizon and AT&T, still clinging to decreasingly meaningful coverage metrics as their primary marketing message, while T-Mobile touts advantages on price, speed, local availability and network congestion.

Over its 42-month tenure in our portfolio, T-Mobile was up 108.2% but all of that during its first 30 months. In the year prior to its removal, TMUS lost more than 1900 bp vs. the S&P, as investors began to see limits in its longer-term growth potential (Exhibit 7). We removed the stock from the portfolio shortly after it announced its plans to merge with Sprint, surmising that the deal would put a hold on 5G investment and competitive initiatives and that investors would take a skeptical stance on the potential for success given the DoJ’s opposition to AT&T’s acquisition of Time Warner.

Exh 7: TMUS returns relative to replacement ZEN after dropping from Portfolio

A few months later, our position is softening. Comments from the DoJ acknowledging that maintaining 4 national carriers rather than 3 is not necessarily in service to better competition for consumers raise hopes of approval. We also note that a speedy close to the deal would hasten the combined carrier’s 5G network build-out, in alignment with the administration’s apparent goal for the US to lead in the next generation of wireless. American consumers could benefit from more muscular and aggressive competition from a combined T-Mobile/Sprint. We believe the merged carrier would have the spectrum resources to offer unlimited 5G broadband with price/performance to pressure residential fixed-line operators, a further boon. T-Mobile shareholders would benefit from both enhanced growth and from substantial cost synergies resulting from combining operations.

However, while we wait, competition has slowed – T-Mobile is taking share at a slower pace and 5G investment plans are far more cautious than we would expect post-merger. We believe Verizon and AT&T are also damping their own 5G deployment plans in the absence of a much more aggressive move from T-Mobile (Exhibit 8). If we are right, and deal approval is more likely, and sooner, than is commonly thought, an investment in the “Uncarrier” could prove attractive (Exhibit 9). Even in a best-case scenario, it would seem unlikely to get resolution before 1Q19, but stranger things have happened.

Exh 8: Consensus Estimates of US Carrier Capex Spending

Exh 9: Key Operating and Valuation Metrics – TMUS

Adobe (Enterprise Cloud):

We held Adobe in the portfolio from May 2015 until December 2017 recognizing the successful transition of its packaged software business into a SaaS model and stock gained 135.5% during that time. Adobe is primarily known for its creative and marketing software suites and has managed to consistently grow revenue at a better than 20% YoY (Exhibit 10). The core business is divided into two segments: Digital Media, which includes creative tools and Adobe document cloud offerings, makes up over 70% of the revenues and grew at a 22% rate in the most recent quarter. The other segment is the Adobe Experience Cloud, which covers end to end digital marketing solutions with a cloud hosted content management, execution and tracking tool, makes up remainder of the revenue and is growing at 18% Y/Y. Approximately 89% of the 2Q18 revenues were from recurring sources, testifying for high customer retention and subscription renewal rates.

Adobe has a well differentiated suite of creative software with few competitors in its core segments. The Digital Media and creative segment competes with other giants like Apple, Microsoft, Autodesk and several other non-public freemium SaaS products although none of which sell time tested products backed with age old sales relationships and that primarily has been Adobe’s moat. Timely and strategic acquisitions over the years have helped the company stay on top of the latest fad in its space and has helped build a loyal ecosystem of designers and creatives. For Digital Marketing segment, the company finds no direct competition with the big players but sees some risk from analytics tracking and measurement solutions

Exh 10: Key Operating and Valuation Metrics – ADBE

offered by Google, IBM, Salesforce etc. and a range of other ad-tech names. Industry surveys repeatedly place Adobe at the top of the race though.

While Adobe is undoubtedly excellent, with strong AI talent, a powerful cloud-based platform, solid customer relationships and well-regarded management, it has also grown very large. Its $125B market cap makes it an unlikely M&A target – it is a more likely buyer than seller. This, and an uncomfortable overweight in SaaS stocks, led us to replace Adobe with Ciena earlier this year (Exhibit 11). That trade-off has been a net loser for us, as Adobe has since churned out quarterly beats.

Exh 11: ADBE returns relative to replacement CIEN after dropping from Portfolio

MLNX (Enterprise Cloud, 5G)

We briefly held Israeli interconnect chip maker Mellanox – a pure-play for the rise of software defined networking (SDN) in hyperscale datacenters – in our model portfolio from May 2016 to July 2017, finally choosing to replace it with 5G testing equipment maker KEYS after suffering from wrenching volatility in what was then a thinly traded stock (Exhibit 12). Our timing could hardly have been worse. We had been right about Mellanox in the first place. The stock popped the following quarter and is up more than 80% in the last year on consistent top line outperformance.

Mellanox makes InfiniBand and Ethernet switching and interface chips, which are staples in high performance computing environments. It also offers end to end SDN solutions. In traditional networking, there are three basic functions of a switch implemented in firmware right on each switching device. The Data Plane handles the actual switching of the data packets, the Control Plane communicates with other switching devices to adjust to network conditions, and the Management Plane enables administration of the network. Software defined network allows implementation of the control and management planes entirely in code, thus enabling the network to be managed centrally without hardware level reconfigurations. Switches, focusing only on data plane tasks, are simpler, shifting the key performance factor from the ability to manage complex tasks to pure speed. This approach is ideal for networked hyperscale datacenters, which typically have large but predictable data flows. Mellanox is the industry leader in 25G+ high speed adapter market size, with over 65% market share in the category and received windfalls from soaring hyperscale

Exh 12:MLNX returns relative to replacement KEYS after dropping from Portfolio