TMT: 1Q 2015 Earnings Rundown
SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak
FOR IMPORTANT DISCLOSURES 203.901.1633 /.1634
psagawa@ / firstname.lastname@example.org
May 5, 2015
TMT: 1Q 2015 Earnings Rundown
Two main themes surprised us during 1Q15. First, advertisers are showing caution at a particularly eventful moment in the evolution of mobile commerce, and second, the enterprise transition to the cloud is playing out even faster and more profitably than we had anticipated. The first trend contributed to serious stumbles at TWTR, LNKD, YELP and YHOO, and did no favors for GOOG and FB, both of which have traded sideways after FX affected revenue misses. The second trend pleased AMZN and MSFT investors, both of which delivered big upside in cloud sales and margins. The data center IT players threatened by the shift to the cloud – IBM, EMC and others – largely disappointed as we thought, but have not been punished by the market. Finally, we jumped the gun on QCOM, which acknowledged that a rebound is still a few quarters away. Most of the rest of 1Q, including AAPL and NFLX’s blowouts, played according to our expectations.
- FX headwinds affected nearly everyone in 1Q 2015. The effect of the strong dollar was likely much stronger than what was embedded in estimates, delivering a 640bp hit to sales on average. Investors largely shrugged this off, and the hit will likely be less painful next Q.
- Advertisers are more cautious on mobile than expected. Most ad driven internet names missed sales, caused in part by those FX headwinds, but also by a noticeable drag in mobile ad spending. FB and GOOG largely shrugged it off, but TWTR took it on the chin, noting that ad buyers were skittish on new formats and that a new buyer friendly pricing scheme hit 1Q sales. We remain extremely bullish on the long term future of mobile ads, but note that we may have been ahead of ourselves this Q.
- Webscale data center operations make big $. Shockingly, fast growing AWS is AMZN’s most profitable business, even after huge price cuts in 2014. MSFT also saw huge growth from its cloud software efforts, while GOOG’s well hidden IaaS business is likely riding the same wave. Traditional IT names IBM and EMC disappointed against modest expectations, implying a sharper than expected transition to the cloud and good news for SaaS application players, most of whom have yet to report.
- Smartphone growth shows interesting contrasts. Investors yawned at AAPL’s blowout, already nervous over the impossible compares coming for FY16. However, AAPL suppliers ARMH and SWKS got some love. QCOM got a beat down after lowering guidance – the benefits of a China resolution and the new Kryo processor architecture won’t help until next FY.
- Wireless rivalry continues. With a price war in full effect, TMUS took 1M postpaid phone adds at the expense of T and VZ, which will continue to see margin pressure. Despite T/VZ seeing strong non-phone device adds, they are starting to lose postpaid phone subs. Expect this to continue.
- E-commerce is a tale of two cities. While AMZN saw strong growth in a weak FX environment, EBAY’s beat came as a surprise driven by PayPal. With the core EBAY business struggling and PayPal under threat from a host of mobile payments solutions, our outlook is negative.
The SSR TMT Heatmap
With most TMT 1Q15 results in the books, the themes that we discussed in our preview note several weeks back (see http://www.ssrllc.com/wp-content/uploads//ftr/15.04.20-1Q15-Earnings-Preview.pdf) largely played out as expected with few notable exceptions. We were surprised by a hiccup in digital advertising which damped the torrid growth pace a bit, and took a particular hit out of TWTR, which must answer questions about the credibility of its management team. We also jumped the gun on QCOM, which we see as being extraordinarily undervalued, but which cautioned investors that the benefits from the resolution of its Chinese antitrust investigation and from the coming delivery of its new Kryo processor architecture are still at least two quarters away. There was also a significant positive surprise, as AMZN revealed that its AWS IaaS cloud hosting business was larger and FAR more profitable than we had surmised. Combined with MSFT’s upside cloud surprise and universal disappointment from traditional IT suppliers, this is a strong indication that the exodus from private enterprise data centers to AMZN, MSFT’s and GOOG’s public clouds is well under way.
FX Headwinds. The strong dollar weakened the value of non-US operations as the Euro, British Pound and Japanese Yen hit decade lows against the dollar. The appreciating dollar hit corporate earnings to the tune of 3-6% in 4Q14 and continued to have a strong impact in 1Q15 averaging a 640bp headwind for major names including AAPL, AMZN, GOOGL, FB, and MSFT. Hedging programs weren’t enough to offset currency losses. The Euro, which is a substantial portion of most tech companies’ FX exposure is down -7.5% against the dollar YTD, while the British Pound along with Canadian and Australian Dollars are down about -3 to -5%. The Japanese Yen saw a steep decline at the end of last year, but has remained flat since the beginning of the year. The Chinese Yuan, of course, has a floating peg to the dollar. The Euro has seen some reversal in its declines over the past couple of weeks, but remains well below last quarter’s levels. Given the steep decline of some currencies over the past two quarters, FX should be less of an issue in the coming quarter.
Digital Ad Growth. Digital ad growth continued this quarter, just not as strong as we expected given the results reported by GOOGL, FB, and TWTR, which posted ad revenue gains of 11%, 47%, and 72% respectively. All were hit by currency, but GOOG and TWTR had issues with some ad products. GOOG would have had an increase in cost per click had it not been for skippable YouTube ads, while TWTR faced challenges with advertiser acceptance of its premium priced direct response products. TWTR, which saw its stock plummet nearly 20% after its announcement, also indicated it had raised the bar of what constitutes an engagement or click, and no longer monetizes some brand interactions such as retweets. TWTR management is shifting strategy to get compensated for actions tied to specific campaign goals. This unexpected move brought in lower than expected revenue and led to a downward guidance revision.
Globally, digital advertising now represents just over 25% of a $525B measured media advertising market. We believe digital’s addressable market, which includes other non-measured media spend such as promotions, couponing, direct mail, marketing services, etc to be over $1.5T. This would bring current share of digital advertising to under 10%, which we believe still has a very long runway to grow. This idiosyncratic growth in digital and mobile advertising will certainly continue, giving a boost to companies that best engage users. Despite their hiccups this quarter, we remain bullish on the mobile ad leaders, GOOG, FB, and TWTR, while the future is murky for subscale online ad players such as Yahoo, AOL and others that have declining reach and engagement.
Enterprise IT Moves to the Cloud. AMZN surprised well to the upside when it delivered its first ever break out of the AWS business, impressing investors at the level of un-Amazon profitability. AWS made some $265M in profit on $1.57B in revenue and will likely surpass $1B in profit and $7B in revenue for the year. We believe that public cloud infrastructure and cloud-based application software will slowly consume the more than $3T in global data center spending, with a substantial deflationary impact on overall IT budgets but a massive opportunity for market leaders in IaaS and SaaS.
Webscale public cloud services like AWS have huge cost and performance advantages vs. private data centers based on several factors: 1) Use of commodity components vs. value-added configured systems; 2) Extraordinary power efficiency; 3) Much higher utilization; 4) Higher system availability; 5) Superior backup and redundancy; 6) Flexibility, scalability, power and convenience; 7) Substantial economies of scale. These attributes and a 50-75% cost advantage vs. in-house enterprise data centers have given AMZN, GOOGL, and MSFT, which employ cutting edge data center design, sophisticated software, and massive scale, a significant advantage over an enterprise’s in-house computing capabilities. With cloud pricing dropping at roughly 30%/yr, the gap is widening adversely affecting vendors of traditional enterprise IT hardware used in corporate data centers.
Aside from AMZN, the other cloud infrastructure players didn’t break out their cloud Infrastructure-as-a-Service (IaaS) operations. MSFT revealed that its overall commercial cloud business continued to grow briskly at 106% YoY and noted that Azure customer usage more than doubled. GOOG didn’t offer any hints about its enterprise cloud business, which was buried in the “other” revenue bucket along with Google Play, Chromecast, Chromebooks, and Nexus, which collectively grew 23% YoY. AMZN’s margin disclosure despite the aggressive price competition suggests there is money to be made here, and we expect the three to vigorously continue competing to draw more enterprise cloud customers. This is unequivocally bad for old paradigm hardware and software makers, the likes of IBM, Cisco, Hewlett Packard, EMC, and Oracle. Differentiated SaaS application players, like Salesforce, Workday, Tableau, Splunk, Proofpoint, Zendesk and others, should also show strength in market that is gathering steam.
Smartphone Growth Continues. Smartphone growth still has some runway as AAPL and QCOM delivered better than expected results. AAPL easily shattered expectations on iPhone 6 as the upgrade cycle continues and the company sees success in new markets like China. Meanwhile QCOM was punished for a downward guidance revision on some device socket loss and pending licensing agreements in China after it settled with the country’s anti-monopoly authority.
We project high-end smartphone unit growth will be in the low single digits over the next 5 years, in part because of the artificially high 2014-15 volumes associated with early upgrades to the iPhone 6. Demand for premium tier phones is fairly consistent in developed markets with replacement cycles driven by subsidies. Low end models will grow at a robust 12-14%, with average prices for the segment edging ever lower as viable sub $50 products begin to drive demand. Collectively, this points to overall ASP’s dipping at a 4-5% CAGR, yielding market sales growth of 4-5% annually through 2019. Given AAPL’s enormously successful upgrade cycle with the iPhone 5, the company will have a tough compare come next year as high end phones mature becoming a replacement driven business. We continue to view QCOM as the big winner in in smartphones as it gets a royalty for nearly every 4G LTE device shipped.
TMUS Eats Everyone’s Lunch.Wireless rivalry in the US continues to work in TMUS’ favor as the company added 1.3M postpaid net subscribers including some 1.2M phones, largely at the expense of T and VZ whose earnings reports were cryptic when it came to disclosing their net smartphone post-paid adds. T threw out a lot of numbers. It saw 441,000 net postpaid adds (including devices) and 1.2M net wireless adds total, which included 700K new tablets and 700K Connected cars for a net total of 945K device adds. The company mentioned it added some 500K postpaid smartphone subs, but the figure also includes feature phone migrations and its not clear what the real postpaid net add number is. VZ was a bit more open, reporting 247K net new smartphones driven by prepaid, while losing 183K postpaid phone subs. Sprint, which only announced results this morning reported 1.2M net adds along with postpaid phone losses of 201K. Sprint is still effectively the number three player with 29.6M postpaid users versus TMUS’ 28.3, but we don’t expect the status quo will last long with TMUS likely to take more share in the current quarter. Also, expect T and VZ margins to shrink as they lower prices to compete and stem sub defections.
The Results are In
Apple handily beat on every metric as we expected reporting it sold some 61.17M iPhones against consensus expectations of 57.3M. The company shattered records for Greater China delivering 71% growth in the region and likely sold more iPhones there than in the US during the quarter. An increased mix of iPhone 6 and 6 Plus drove ASPs to $659 per device, up $62 YoY even in the face of currency headwinds, but down sequentially. Using this and other data points disclosed during the call, it’s possible to triangulate iPhone mix and penetration of sales to existing users. Based on the disclosed ASP, we estimate iPhone 6/6 Plus represent 60-65% of iPhone unit sales. With Tim Cook disclosing some 20% of the iPhone user base has upgraded to the iPhone 6 / 6 Plus, it’s likely 79% of those iPhone 6s sold went to upgrades, while the 86% of the existing base of iPhone 6 users are upgrades. Sure the iPhone helped the company add 150bp in margin to 40.8%, but the high rate of upgrades should be worrisome come next year when the next version of the iPhone will be up against these numbers. With the company divulging little about the Watch, CFO Luca Maestri noted margins for the wearable will be lower than the company average. This comes as a surprise to us as we would have expected higher margins for the Watch. Modeling for the next quarter, we would expect margins to be flat and the opportunity for another blowout seems lower. This is beginning to smell like the top for Apple and as we approach its WWDC event in June, emphasis will shift to what they can do next year. With the blockbuster iPhone 6 release in the books, it will be a hard act to follow and the company will be up against the mother of all compares come 1FQ 2016.
Google missed the quarter largely on currency headwinds which took a $795M bite out of topline revenue despite an aggressive hedging program the company touted during last quarter’s call. Paid clicks were up 13%, just shy of expectations and cost per click was down -7%. Despite the miss, the market reacted positively sending the stock up after the announcement. Google noted that its own site CPCs would have trended into positive territory were it not for YouTube’s Trueview skippable ads, which collect a smaller fee per impression when skipped. Also, traffic acquisition costs continue to decline as Google sees more traffic from its own products. TAC is at a two year low of 21.6% of ad revenue. Other revenues, which include devices like Nexus, Chromebooks, and Google’s cloud services were up 23% YoY and now make up just over 10% of revenue. The call had no mention of the company’s recent European regulatory hurdles or the cloud business. With CFO Patrick Pichette leaving after this quarter, we believe his successor Ruth Porat may bring to management a more shareholder friendly perspective and be very likely to introduce a dividend or share buyback program. Despite the FX miss, GOOGL’s business shows a lot of strength and continues to be one of our top picks.
Amazon delivered a strong topline beat sending the stock well over its 52 week highs after the announcement. The topline beat came despite some $1.3B in FX pain and weak international growth even in constant currency terms. The big news with this quarter was AMZN finally breaking out its cloud business. While 50% revenue growth YoY in the context of a cloud service price war is impressive, the company also disclosed AWS profitability is $265M on $1.57B in revenues, a very un-Bezos 17%. With a $6B run rate, AWS also brings in over $1B in profit on an annualized basis, which is a positive surprise for investors and demonstrates the promised of cloud services. During the call, the company also assured investors that computing infrastructure costs were allocated between AWS and the e-commerce businesses, affirming the AWS margin contribution is real. Net shipping costs were unchanged from the previous quarter at 4.8%, and might not go much lower given the company is nearly a year into its Prime price increase. Other than that AMZN continues to be very cryptic in disclosing information of interest to investors such as the number of Prime subs. AMZN appears to be firing on all cylinders and continues to be one of our top 2015 picks.
Microsoft delivered a healthy beat despite some FX exposure and a lull in the Windows upgrade cycle. The company’s cloud business continues to grow in the triple digits and Office 365 is up to 50M active monthly users while some 50 trillion objects are stored in Azure. Surface continued to impress with 44% growth to $713M and ad revenue from Bing search was up 21%. FX also had a major impact on the business as revenue would have been up 9% and gross margin 4% greater, though MSFT got some FX benefits as restructuring costs associated with its European Nokia helped grow operating income and EPS 4% and 7% respectively. Windows OEM revenues were down 19% for Pro and 26% for non-pro, while commercial volume licensing revenue was down 2%. With Windows 10 due to bow this summer, we have more reason to be optimistic MSFT will benefit from the upgrade cycle in the latter two calendar quarter of the year. Now is a good time to buy the stock ahead of the upgrade.
Facebook missed its consensus top line target due to FX pressures. 51% of the company’s revenue is from overseas, with just over half of that coming from the weakened Eurozone. Facebook indicated revenues would have been 7% better QoQ and 10% YoY had it not been for the stronger dollar. Aside from FX headwinds, everything else would have pointed to a blowout quarter. Engagement as measured by Daily over Monthly Active users is at an all-time high of 65%, mobile now makes up for 73% of revenue, up from 59% last year and nearly nothing when the company IPOed three years ago. Daily actives are now up to 936M users and monthlies up to 1.44B. Also mentioned during the call were some remarks that illustrate more runway to go with FB’s largest marketing clients not spending even 5% of their ad budgets on Facebook. On the cost front, OPEX was up 83%, R&D up 133%, and SBC up 156% YoY as the company continues to integrate its Oculus, Whatsapp, and LiveRail acquisitions while also investing in its next generation platform, internet.org, and artificial intelligence. FB’s SBC expenses continued to be high relative to previous quarters at 20% of revenue, prior to 4Q14 SBC hovered at 11-12% of revenue. We continue to like the stock and the earnings weakness presents a buying opportunity.
Though Twitter’s results were leaked shortly before the close, ironically appearing on an earnings aggregator Twitter feed, the quarter was disappointing for investors. The quarter was unusually strong for user growth metrics typically downplayed by management: MAUs were up to 302M and 308M if including SMS fast followers. Monetization though was weaker than expected. TWTR’s previous quarters have been marked by the reverse: weaker than expected user growth and strong monetization. Ad revenue growth decelerated to 72% YoY after nearly two years of triple digit growth. Data Licensing & Other was up 95% YoY. The company cited weakness in uptake in its direct response products as well as higher pricing in the auction process than marketers were willing to pay. Also, the company refined what constitutes a “click” in direct response and the result is lower click through rates and revenue for TWTR. In addition to revised sales guidance, expected SBC expenses were revised upward. Along with earnings, TWTR also announced its acquisition of TellApart, an ad-tech company focused on direct response. Given the lower than expected performance of TWTR, this earnings report could threaten Dick Costolo’s job and perhaps attract some activist investors to push for TWTR’s acquisition by a bigger platform. The prospect of either a management change or acquisition by a larger player should offer investors some comfort.
QCOM delivered a solid quarter with China regulatory issues somewhat behind it, but issued weaker than expected guidance on share loss to Apple and its socket loss for the latest Samsung Galaxy S6 handsets. QCOM provides the modem for Apple’s iPhone 6 and 6+, but processors bring in more revenue. Though QCOM will still provide modems for multimode 3G CDMA and 4G LTE devices on networks such as Verizon and Sprint, the company is guiding lower for the year, taking FY15 revenue guidance down by $1-$1.3B to $25-27B. With QCOM moving fabrication of its latest Kryo-based proprietary Snapdragon 820 chips to Samsung foundries, a future Samsung Galaxy design win is possible. On the licensing side of the business, the company mentioned its China resolution fall out will still linger with QCOM in the midst of renewing contracts with Chinese licensees and still sees some shortfall in reported device sales booked for its royalties. Still the company saw higher than expected reported device sales for 2014 indicating traction. Aside from some near term bumps related to the QCT or chip business, no other company is as well positioned as QCOM in mobile and wireless and we remain bullish on the name.
NFLX bore the brunt of FX headwinds with EPS missing expectations by 31 cents, otherwise it would have beat expectations by 8 cents in constant currency. International markets are becoming more important for CEO Reed Hastings, who ambitiously announced last quarter that he expects to roll out the service to 200 countries by the end of 2016. The company crushed on sub numbers which came in greater than expected, ending Q1 with 41.4 million subscribers in the U.S. and 20.88 million in the rest of the world. Netflix had guided for for 40.91 million and 20.53 million, in the US and international respectively. Instead, it added 4.9 million, beating its guidance by 840K subs. Netflix also announced that it streamed 10 billion hours of content during the quarter. It reported 5.1B hours last year and nearly doubled aggregate viewing. The better than expected sub growth combined with impressive engagement metrics propelled the stock to all time highs. Despite competitive streaming/Internet TV offerings from HBO, Dish, and Amazon, Netflix’s service has become well-differentiated on original content. NFLX has a lot more runway with its high profile international expansion strategy. Added to that it has possible future monetization levers that include video on demand, live programming, and advertising. We continue to favor the stock and maintain it in our model portfolio.
EBay delivered an upside surprise with PayPal a bright spot, as revenue jumped 14 percent year over year, 17% on an FX neutral basis as the company realized benefits from a hedging program. PayPal transaction volumes climbed 18 percent as it added 3.6 million active accounts in the quarter. PayPal deepened engagement with transactions per active account increasing to 23 in the quarter and monetization per active account increasing to $49. FX was a weak spot with marketplaces revenue down 4% to $2.07B. In the U.S., Gross Merchandise Volume (GMV) was up 2%, while International volume was down 4%, producing $2.1 billion in revenue. Our outlook remains negative on both companies once they are separated even after the company agreed to a five year deal guaranteeing PayPal an 80% portion of eBay transaction volume. The core eBay marketplaces business is showing signs of struggles, and PayPal is threatened by a host of mobile payments solutions from new entrants and existing players.