TMT Model Portfolio Update: The Skeptics Guide
SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak
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May 28, 2015
TMT Model Portfolio Update: The Skeptics Guide
We assessed the valuations of 188 large cap TMT stocks, using our proprietary framework, which separates EV into near term and long term components. Graphed on these axes, the names fall into quadrants with interesting implications for trading. Historically, “Dream” stocks, with strong expectations both short and long term have tended to outperform, while performance by the other quadrants has been mixed. This quarter, we are taking a closer look at the “skepticism” quadrant – i.e. stocks with above average expected 5-yr cash flow growth, but with implicit 5th yr terminal values representing <80% of the total EV. Skepticism stocks are fighting narratives of long term risk that does not preclude strong near term result. While performance in recent quarters has been strong, these companies still must deliver evidence sufficient to change investor biases beyond meeting immediate expectations. This quarter, there are 42 skepticism stocks – semiconductor names are the most prevalent, followed by enterprise software, Internet and hardware. Of these stocks, we believe that GOOG and GRUB have particular potential to change their investor narrative and break out, and have included them in our large cap model portfolio. Both large cap and small cap model portfolios performed well over the past quarter, beating the tech elements of their respective benchmarks by 90 and 120bp respectively. We are removing AAPL and FIS from our large cap portfolio, adding DIS and ADBE. In our small cap portfolio, we are replacing QLYS and OPWR with TNET and VEEV.
- “Dream” stocks have outperformed. Applying our framework, which separates EV into short term and long term components, shows that over the past three years, Dream stocks, with strong near term consensus expectations and implied terminal values, tended to outperform. The other three categories have been volatile, with the Skepticism sector (ST strong/LT weak) largely outperforming and Comeback (LT strong/ST weak) sector underperforming over the past 18 months. The Death Watch cohort has been particularly volatile, with spectacular appreciation in 2013 offsetting otherwise poor performance. This is due to the influence of a handful of stocks – AAPL, AVGO, BRCM, CSCO and EA – which delivered unexpected gains after residing in the quadrant during that time.
- Skepticism gaining momentum. Based on 12 month returns, the Skepticism quadrant has gone from being a poor bet, prior to mid-2013, to being a relatively good one. These stocks typically must counter negative investor narratives before they can rerate. Today, 16 of 42 Skepticism names are semiconductor vendors, with 3 more from semi cap equipment and fab services, arguably, suggesting that investors are looking past a near term cyclical peak. 12 companies are in enterprise SW and services, most selling on-premises solutions at risk to the cloud. ADBE and ADSK stand out as on their way to a SaaS future. Consumer internet names are also well represented – GRUB, YELP, PCLN, P, and GRPN joining GOOG, the company that is often cited as the primary threat to the others in the category.
- GOOG stands out as the opportunity in the quadrant. Despite expectations for 20% annual cash flow growth over the next 5 yrs., less than 2/3rds of GOOG’s EV is in its terminal value, putting in the bottom 20% of the large cap TNT universe. A narrative suggesting that the company’s search franchise is seriously threatened by mobile apps has gained hold with investors, miring it in the Skepticism quadrant for every period of our analyses. We believe GOOG’s coming initiatives to orchestrate value in mobile commerce and its emerging strength in IaaS hosting can counter the bearish story and catalyze a rerating, while the likelihood of continued growth in the near term protects to the downside.
- ADBE and ADSK are intriguing. In our recent work on SaaS application software, we noted that ADBE and ADSK had proactively moved to cloud-focused strategies that exploit falling prices for IaaS hosting from AMZN, MSFT and GOOG. The appearance of both stocks in the Skepticism quadrant suggests that investors have not yet embraced the new narrative, pricing them with obviously cloud threatened SW players such as VMW and RHT. Similarly, we believe food delivery leader GRUB has a far more defensible position vs. feared future competition from Uber, AMZN and GOOG, than do other consumer Internet names in Skepticism, such as YELP, PCLN, P, and GRPN.
- The Large Cap Model Portfolio beat its benchmarks and its time to remove AAPL. Our Large Cap Portfolio was up 210bp since our last update on Feb 23, 61bp above the tech components of the S&P500. NFLX, DATA, TMUS, AMZN and MSFT were particularly strong performers, offsetting disappointing performance from TWTR, WDAY, WDC and CCI. We are removing AAPL, which has appreciated nearly 24% since we added it last October. While we expect another blow out for June, the blasé reaction to the big upside surprise in March earnings suggests that investors are already fixated on the extraordinarily difficult compare that the company faces in December. We are also removing FIS to avoid confusion with our Financials franchise. This should not be construed as a change of heart on the stock.
- Adding DIS and ADBE. DIS has delivered exceptional execution in developing content and managing its parks division. With a well-planned slate of movies, TV programming, and consumer products tied to tent-pole franchises like Marvel, StarWars, Pixar, and Frozen, we believe its current position in the Dream quadrant is well justified. ADBE, as mentioned above, has reinvented itself as a leader in SaaS subscription software and is well-positioned to defend and extend its leadership in the cloud era.
- The Small Cap Model Portfolio returned to strong performance. Our Small Cap Portfolio was up 380bp from February, vs. a 130bp rise in the S&P 600 and a 240bp increase in its tech components. OLED, RENT, and HUBS contributed to the outperformance. The latter two names were also recent additions in February. On the flipside, we saw sharp declines in OPWR, QLYS, and SMCI. We are removing OPWR and QLYS, both of which screened poorly in our recent research on SaaS application software, which assessed 43 SaaS names based on the potential of their applications, the efficiency of their operations, and the flexibility of their infrastructure approach. In their place, we are adding two stocks that screened well on all three of the criteria in our research framework – TNET and VEEV. We note that portfolio constituent HUBS also excelled on all three criteria.
The SSR TMT Heatmap
TMT stocks cannot be trusted to regress to the mean – expensive stocks often get more expensive, while cheap stocks get cheaper, and, occasionally, die. As such, valuation is a dangerous tool for tech investors, but ignoring it entirely can be dangerous as well. We use a framework that breaks valuation into two axes – one showing the 5-yr free cash flow growth estimated by consensus, and the other measuring the percentage of the enterprise value represented by the present value of the 5th year terminal value, once the value of those 5-yrs of forecast cash flows have been subtracted. In the framework, our universe of 188 large cap TMT stocks fall into quadrants, each with clear implications for investment.
Tracking performance by quadrant since the end of 2012, “Dream” stocks with strong expectations for both near and long terms have delivered the best and most consistent performance, with cohort constituents up an average of 360bp in the following year with just one quarter of underperformance. “Death Watch” stocks have also outperformed above average, driven by the extraordinary performance of constituent AAPL during late 2013. Outside of that period or excluding AAPL, Death Watch stocks have significantly underperformed. “Comeback” stocks, with weak near term expectations but substantial implied terminal values, performed very well at the beginning of our range of analysis but have fallen steadily since 2Q13. In contrast, “Skepticism” stocks, with expectations for strong near term growth but weak terminal values, have had the opposite trajectory, starting poorly but showing good performance in more recent quarters.
This quarter, we are taking a closer look at the Skepticism quadrant. 14 of the 44 constituents are chip vendors, with another 3 semi cap equipment and fab services players as well. Several of these – e.g. AVGO, SWKS, SYNA and BRCM – appear tied to concerns that the global smartphone market may be approaching saturation. We are not quite so worried, and have included SYNA in our small cap model portfolio. Another 12 are enterprise software players. We like ADBE based on its strong early embrace of the SaaS subscription model, and are adding ADBE to our large cap model portfolio. Finally, 7 Skepticism stocks are consumer Internet stocks. Curiously, the main knock on PCLN, TRIP, YELP, P, GRPN and GRUB appears to be the threat from big Internet players like GOOG, which also finds itself in the Skepticism quadrant based on fears that its Search franchise is at risk to the apps provided by those same players. We are inclined to favor the dominant GOOG, although we believe GRUB’s app business is protected by its investment in its physical operations, and have included it in our small cap portfolio.
Overall, our large cap portfolio outperformed its benchmark by 61bp in the quarter, led by NFLX, DATA, TMUS, AMZN and MSFT, which more than offset TWTR, WDC and CCI. We are removing AAPL, as we believe that anticipation of the gravely difficult compares coming for FY15 has begun to burden the stock. We are also removing FIS, as we are deferring comment on the stock to our Financials Analyst. In their place, we are adding DIS, which we believe has established a content roadmap with extraordinary promise, and ADBE, for the reasons mentioned above.
Our small cap portfolio also outperformed, beating the tech elements of the S&P600 by 141bp. OLED, RENT, and HUBS were notable performers. We are replacing OPWR and QLYS, both of which performed poorly in the quarter and were ranked poorly by our SaaS screening framework introduced in our recent note (http://www.ssrllc.com/wp-content/uploads//ftr/15.05.15-SaaS-Eating-the-World.pdf). In their place, we are adding TNET and VEEB, which rated strongly in all three or the criteria in our model.
Exh 1: SSR’s ST/LT Quadrant Valuation Framework
The Skeptics, The Dreamers and Me
We introduced our proprietary ST/LT valuation framework nearly a year ago as a tool to assess the short and long term expectations embedded in the market enterprise values of individual companies (Exhibit 1). This framework uses the free cash flow growth estimated by consensus as the “ST” axis, then subtracts the present value of those cash flows from enterprise value to establish an implied 5th year terminal value. The second “LT” axis is the percentage of EV represented by this implied terminal value.
The framework is used to evaluate a universe of 188 TMT companies with market caps in excess of $3B. Setting the axes to the median value for each of the “ST” and “LT” metrics then establishes quadrants that we have named “Dream Stocks”, “Skepticism Stocks”, “Comeback Stocks” and “Death Watch Stocks”. Those names reflect the balance of LT and ST optimism in each quadrant – Dream Stocks are expected to deliver growth for as far as the eye can see. Skepticism Stocks are expected to perform well in the near term, but lose their luster down the line. Comeback Stocks will be excused their near term performance as long as belief in a long term recovery can be sustained. Death Watch stocks are not expected to deliver in either the short term or the long term (Exhibit 2).
Exh 2: SSR ST/LT Framework – Universe of 188 TMT companies
Retroactively applying this framework back to mid-2012 and tracking the forward performance of the stocks in each quadrant over time reveals some interesting patterns. We were not surprised to see the Dream stock quadrant with the strongest performance. Dream stocks, the constituents changing quarter to quarter, have returned an average of 358bp above the overall universe in the first 12 months (Exhibit 3). This outperformance was a bit inconsistent, with above average returns from 5 of 8 quarters offsetting lower than average returns in the other three.
Surprisingly, the Death Watch was the second highest performing quadrant, returning 193bp above median on average (Exhibit 4). This outperformance was driven by extraordinarily strong returns from the cohorts beginning in the 3rd and 4th quarters of 2013, and reflecting a period of excellent performance in the second half of 2014. Some of this can be attributed to the September launch of the iPhone 6, as AAPL and smartphone component suppliers AVGO, BRCM and SWKS all delivered spectacular performance during that time frame.
The Comeback Kids delivered the poorest performance, missing the median by an average of 291 bp, with just three quarters above the line. The performance spiked for the 1Q13 cohort and has been down hard of late, with the most recent two groups underperforming by more than 750 bp. In contrast, the Skepticism quadrant, which also has shown poorly against median on average, has the profile of very, very poor returns from the cohorts of 2Q12 to 1Q13, but strong to neutral returns ever since.
Exh 3: TMT Quadrant Relative Performance – 12 Months after Analysis
Exh 4: TMT Quadrant Performance – Average Relative Performance 2Q12-1Q14
Changing the Story
In our February update, we focused on the stocks of the Death Watch (Exhibit 5). This time we are taking a closer look at the Skepticism quadrant. As noted above, this quadrant has underperformed the median by an average of 246 bp over the 8 quarters of our analysis, but has delivered better returns of late. We see these stocks as having broken narratives – analysts continue to project strong growth over the next five years, but investors do not want to give them credit for growth beyond that point and may be expressing skepticism over the achievability of estimates in the near term as well. Companies in this predicament must change the story.
Exh 5: SSR’s ST/LT Framework CHART – “Death Watch”
Stocks move in our framework. Analyst revisions raise or lower projected growth rates and move stocks right or left on our short term expectations axis. Share price changes isolated from these revisions shift the implied terminal value and move the stocks up or down on the long term axis. The medians also shift quarter to quarter, and stocks near a boundary may find themselves changing categories without much movement in their own estimates or share prices.
Investors in Skepticism Stocks are looking for a move up to Dream Stock status. However, with analyst expectations already fairly rich, near term results may not be sufficient to inspire a re-rating. Indeed, in the short sample of our analysis, few companies have moved from Skepticism to Dream and stayed there. Subjectively assessing the stocks that have historically populated this category, the ticket up and out is a change in narrative. This may well be difficult to achieve over a short period of time. Still, the appreciation that comes from delivering better than average earnings growth may be enough to tide an investor over until a big payoff from multiple expansion.
The Skepticism Roster
There are 44 current constituents in the Skepticism quadrant (Exhibit 6-7). 14 of these are semiconductor companies, with Avago, Micron, Analog Devices, Broadcom and being the biggest of these. (N.B. BRCM just accepted an acquisition offer from AVGO). Some of this is tied to an ongoing narrative of a slowing global market for smartphones – Avago, Broadcom, ADI, Skyworks, and Synaptics are largely dependent on personal devices. We see this concern as a bit overblown – low end smartphones and other connected devices offer new avenues for growth – and include Synaptics in our small cap model portfolio. Another source of skepticism is the traditional cyclicality of the semiconductor market, which suggests that investors may be looking past a near term peak. We note that there are another 3 constituents that sell semiconductor capital equipment or provide services to semiconductor fabs – these would also seem evidence of post-peak valuations.
Exh 6: SSR’s ST/LT Framework CHART – “Skepticism Stocks”
Exh 7: SSR’s ST/LT Framework TABLE – “Skepticism Stocks”
Enterprise software and services contributes another 13 of the 42 constituents, including big names like VMWare, Cognizant, and RedHat. While we too are skeptical for traditional packaged software vendors – see our recent note (http://www.ssrllc.com/wp-content/uploads//ftr/15.05.15-SaaS-Eating-the-World.pdf) – ADBE stands out as a company that has successfully positioned itself with SaaS cloud subscription models running on low cost IaaS hosts. We are adding ADBE to our large cap model portfolio with this note.
The other big category in Skepticism is the consumer Internet. This subgroup evinces a curious case of dueling narratives. On one hand, Priceline, TripAdvisor, Yelp, Pandora, Groupon, and GrubHub are battling the perception that their basic business models are at risk to the big internet platforms, i.e. Google, Apple, Amazon and Facebook. On the other hand, Google is battling the opposite bugbear, that its powerful search franchise might be at risk from the mobile apps provided by the likes of Priceline, Yelp, Pandora, Groupon and GrubHub. We are more sympathetic to the first perspective, but note that GrubHub’s business model combines physical distribution and providing order management for tens of thousands of restaurants with its consumer food delivery application, yielding a far more substantial moat than the other companies in this mini-grouping. We continue to keep GrubHub in our small cap model portfolio.
Google is a charter member of the Skepticism club, having resided in the quadrant in every quarter since June 2012. Given consensus expectations for 20% annual free cash flow growth over the next 5 years, the generally gloomy long term outlook embedded in the company’s enterprise value is easy to overlook, but given the company’s extraordinary assets, we believe that future is far, far brighter than its valuation implies. We will save a more detailed dive into Google’s initiatives and assets for future research, but we see the company’s towering leadership in data center infrastructure and business analytics as a trump card in mobile commerce and enterprise data hosting initiatives that target hundreds of billions of dollars in directly addressable revenue. Weak long term positioning indeed.
The Large Cap Model Portfolio
Performance in the large cap portfolio was excellent in the quarter, delivering 2.1% appreciation since February 23, and beating the tech components of the S&P500 by 61bp over that time period. The top performers were NFLX, DATA, TMUS and AMZN, all of which rose more than 12% in the quarter, offsetting poor performance by TWTR, WDC and WDAY, all down double digits (Exhibit 8).
This quarter, we are removing two stocks: AAPL and FIS. The decision to remove Apple comes with the stock sitting just off of its all-time high, but after a quarter where the stock appreciated just 2% after delivering a resounding upside surprise to both sales and earnings, with a corresponding round of analyst upward revisions and upgrades. Investors believe that dominant Apple, which has paradoxically resided in the Death Watch quadrant for most of the past three years, will not be able to keep up the pace much longer. While the overwhelming success of the iPhone 6 and 6 plus, introduced in September 2015, has bloodied bearish portfolios for the past 9 months, the one year anniversary of that blockbuster introduction looms. We believe that Apple’s huge 4QCY14 saw substantial early upgrading that borrowed future sales to current customers forward. If so, this would make it a nearly impossible comparison for this year’s expected new models to top. We believe investors have already begun looking ahead to the holiday quarter, and begun their exodus. We don’t want to be in the stock as this plays out.
Exh 8: SSR Large Cap TMT Model Portfolio – Before Reconstitution
FIS is a case of parochial custody. Our financials analyst has staked his claim to those financial tech stocks on the far border of TMT. We are happy to cede responsibility and are removing FIS from our model portfolio as a result.
In their place, we are adding DIS and ADBE (Exhibit 9). Disney has been on a tear, up 35% YoY and 70% over 2 years. We will jump on the bandwagon here, based on the impressive roadmap of entertainment content that the company has planned and an exceptional record of execution, particularly in the studio and theme parks businesses. We remain negative on the future of TV advertising, but believe that the overall strength driven by the Marvel, StarWars, Pixar, Frozen, and traditional Disney franchises will be more than enough to maintain a trajectory of outperformance.
We have noted our interest in Adobe previously in this piece, and believe that it can deliver continued strong growth well into the future. It has also been an excellent stock – up 35% YoY and more than 85% over two years – but given its positioning in the Skepticism quadrant, double digit growth and expectations of significant margin expansion, we don’t see it as expensive. Moreover, its successful adoption of the SaaS model and strong play in content management make it an intriguing acquisition play for less well positioned software players.
Exh 9: SSR Large Cap TMT Model Portfolio – Reconstituted
The Small Cap Model Portfolio
Performance in the small cap portfolio was also excellent, up 3.8% since February, vs. 2.4% appreciation for the tech elements of the S&P600 small cap index (Exhibit 10). Better than double digit appreciation by OLED, RENT, HUBS and SYNA offset double digit declines by OPWR, QLYS, and SMCI. Recently, we published a detailed analysis of SaaS enterprise application vendors (http://www.ssrllc.com/wp-content/uploads//ftr/15.05.15-SaaS-Eating-the-World.pdf), evaluating them on their application quality, operating efficiency and use of capital. In this analysis, two of our small cap constituents, OPWR and QLYS, rated poorly. We are removing them this quarter.
In their place, we are adding two companies that screened well according to our framework, TNET and VEEV (Exhibit 11). TriNet Group provides cloud base HR services to small and medium sized businesses, including brokering various forms of business insurance (e.g. Workers Comp) as part of the package. It is growing at a better than 22% pace and trades at a modest 18x forward P/E. Veeva Systems provides a cloud-based CRM system for pharmaceutical and other life sciences companies to manage their sales to physicians and other health care providers. It is growing at nearly 40% and sports net margins of 13%.
Exh 10: SSR Small Cap TMT Model Portfolio – Before Reconstitution
Exh 11: SSR Small Cap TMT Model Portfolio – Reconstituted
Appendix 1: SSR’s ST/LT Framework CHART – “The Dream Stocks”
Appendix 2: SSR’s ST/LT Framework CHART – “Comeback Kids”
Appendix 3: SSR’s ST/LT Framework TABLE – “The Dream Stocks”
Appendix 4: SSR’s ST/LT Framework TABLE – “Comeback Kids”
Appendix 5: SSR’s ST/LT Framework TABLE – “Death Watch”
Appendix 6: TMT Quadrant Performance – 3 Months after Analysis
Appendix 7: TMT Quadrant Performance – 6 Months after Analysis
Appendix 8: TMT Quadrant Performance – 9 Months after Analysis