TMT: Portfolio Update – Sooner, or Later?

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak


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July 24, 2014

TMT: Portfolio Update – Sooner, or Later?

We sorted a universe of 67 large cap TMT stocks based on the 5-year cash flow growth projected by consensus, and the percentage of EV represented by the implied 5th year terminal value. Arrayed on these axes, the companies fall into 4 distinct quartiles: 1) Fast growing, high terminal value “Dream Stocks”, where investors are betting on long-term leadership; 2) Fast growing, low terminal value “Skepticism Stocks”, where investors expect current luster to fade; 3) Slow growing, high terminal value “Comeback Stocks”, where investors believe set-backs are temporary; and 4) Slow growing, low terminal value “Death Watch Stocks”, where investors have little faith in long-term viability. With our firm belief in thematic TMT investing, the majority of our large cap model portfolio is squarely in category 1, where stocks like NFLX, AMZN, and TWTR are expected to grow into their valuations. MSFT and STX are our “Death Watch” representatives – we believe both will deliver substantial future growth not reflected in their valuations. Names like AAPL, INTC and portfolio pick QCOM inhabit quadrant 2 – this quartile can be intriguing IF results and news flow can break the deep investor skepticism over their long-term sustainability. We are most negative about the “Comeback Stocks”, generally erstwhile leaders like IBM and HPQ, where the modest enthusiasm seems misplaced and the risk skewed to the downside. However, we are adding FIS from group 2 to the portfolio, replacing IACI, as we believe mobile payments could drive significant near term upside. In small cap, we are adding RKUS, and FUEL, replacing the recently acquired OPEN and the volatile 3D printing name XONE.

  • TMT valuations reflect expectations driven by themes. Valuation metrics have been poor predictors of TMT performance – expensive stocks often grow into their valuations, while cheap ones often get cheaper or fail. Still, in the context of a thematic investing approach, valuation can shed insight into the sentiment behind individual names. We built a model to sort a universe of 70 large cap TMT stocks based on consensus 5-year cash flow projections and the percentage of enterprise value represented by the 5th year terminal value implied by the current share price, metrics intended to represent the short term and long term growth expectations of the market.
  • “Dream Stocks” must keep investors believing. We have labeled the quadrant characterized by high growth expectations for both the short and long term as “Dream Stocks”. These are the companies that are believed to be the long term leaders in the emerging cloud/mobile era – names like GOOG, NFLX, AMZN, FB, CRM, and WDAY reside here. Typically, investments in this category work, as long as that belief of long-term dominance remains intact. Unexpected signs of competitive rivalry or other business model deterioration are treated far more harshly than short term sales or EPS fluctuations. While these stocks are maddening to value investors, they are analogous to DELL, CSCO, MSFT, and INTC during the heyday of the PC era. Half of our large cap model portfolio comes from this category.
  • “Death Watch” stocks must overcome deep investor biases. The “Death Watch” quadrant is the group of stocks with low expectations in both the short and long term. These companies are often value traps with little prospect for reversing decelerating earnings. Today, the “Death Watch” includes PC era leaders like ORCL, EMC, and CSCO, where we largely concur with the negative implications of their valuations. However, the “Death Watch” also includes stocks, like MSFT, STX, and WDC, where neither short term nor long term expectations reflect the real growth potential. If we are correct, these names could show significant appreciation as results belie the market bias.
  • Investors do not believe that “Skepticism Stocks” can sustain near term momentum. Stocks that sport strong consensus short term FCF growth, but modest terminal values reflect low investor confidence that current success can be sustained. This quadrant contains stalwarts like AAPL, INTC, VMW, GLW, and EBAY. In each case, the size of the company, the emergence of disruptive competitors, and the lack of compelling new paradigm growth narratives tempers investor enthusiasm. These stocks may continue to underperform their near term performance unless they can reestablish their growth bona fides with new product initiatives and/or substantial upside revenue surprises. Otherwise, strong results by these companies may go unrewarded, much as MSFT remained “cheap” during its post-Gates decade of slow growth and high cash flows. Our pick from this group is QCOM, which we believe can extend outside of its high end smartphone chipset stronghold.
  • “Comeback Stocks” often reflect unwarranted investor optimism. The 4th category holds stocks with dismal short term expectations but high implied long-term value. Here we find a smattering of cyclical, like LLTC, TXN and AMAT, where a substantial future turnabout is sensible, but also old-line IT names, like IBM, HPQ, XRX, ADP and PAYX, where recovery is a substantial stretch. These stocks are amongst the most vulnerable in the TMT universe, as unless near term cash flows can surprise significantly to the upside, it is almost certain that the implicit long term expectations will have to contract. Eventually, we expect most to be excellent candidates for short side investments. We currently have no stocks from this quadrant in our model portfolio.
  • Adjusting our model portfolios. Performance in the large cap portfolio was poor for the past 3 months, driven by the significant downturn in internet stocks, such as TWTR and DATA, which didn’t really reverse until later in the quarter. We are removing IACI, which is losing relevance as an acquisition target, in favor of FIS, which we believe is ideally placed to profit from the early rise of mobile payments programs. In contrast, our small cap portfolio performed well in the quarter, driven by OPEN, SYNA and XONE. We are replacing OPEN, which recently agreed to acquisition by PCLN, and XONE, which has been extremely volatile. We are adding RKUS, which stands to benefit from accelerating demand for public WiFi, and FUEL, an intriguing ad tech company that uses big data to facilitate programmatic ad buying.

TMT Valuation: Believing is Seeing

Winning in technology is about innovation, and winning in tech investing is about imagination – what will the future be like and what companies are best positioned to profit from the journey there? Investors’ dreams of the future are embedded in the valuations of tech stocks, and as long as those dreams are alive, valuation is almost meaningless. CEOs, like AMZN’s Jeff Bezos and GOOG’s Larry Page, seem to understand this implicitly, taking far greater care to support the mythos of their future domination than they do to deliver reliable quarterly earnings. Dreams can be nightmares as well. Once written off by investors, companies perceived as future losers have a very hard time changing the accepted narrative. We have attempted to model this phenomenon by separating out the short term performance and long term potential elements implicit in the share prices of a universe of 72 large cap TMT stocks. On one axis, we plot the 5 year CAGR of consensus free cash flow estimates, and on the other, we plot the percentage of enterprise value (EV) represented by the implicit 5th year terminal value left after subtracting the NPV of those explicitly forecasted cash flows.

The companies, plotted against those axes, fall out into four fairly distinct quadrants. In the upper right, characterized by strong forecast growth and a substantial terminal value, are the “Dream Stocks”. The companies that you would expect to be here are here – NFLX, AMZN, FB, GOOG, CRM, WDAY and others. Here, valuations are resilient as long as the narrative of future domination remains viable. The lower left corner is the “Death Watch” list, companies where investors expect little near term cash flow growth, with little hope of long term success. A number of old-paradigm IT companies live here – CA, ORCL, EMC, CSCO, MSFT, etc. – along with a handful of beaten down cyclicals. Stocks in this category can escape by proving the near term consensus trajectory wrong, something we believe MSFT is in the process of doing. Escape is more difficult for stocks in the south-east corner. The “Skepticism Stocks”, such as AAPL, VMW, QCOM, INTC, and GLW, are expected to deliver strong near term results, but investors have no faith that they can sustain them. Even if names in this category beat expectations now, they must also change the narrative for the future. Conversely, the “Comeback Kids” in the north-west are getting the benefit of the doubt. Bad performance today, by stocks like IBM, HPQ, TXN and ADP, is somewhat overlooked against perhaps overly sunny expectations of future value. While valuations here may be somewhat resilient, we view the risks as overwhelmingly to the downside.

Our large cap model portfolio leans heavily to “Dream Stocks”, with 8 of 15 names in the quadrant. 3 of our picks are on “Death Watch” – we believe MSFT, STX and JDSU are all positioned to surprise against modest near term expectations. 2 more are “Skepticism Stocks” – QCOM and IACI struggle against perceptions that their currently strong businesses are vulnerable in the more distant future. The last 2 picks, S and CCI, do not easily fit into this framework, as their physical assets contribute a substantial and difficult to estimate portion of future value. The performance of this portfolio was poor over the past 3 months, owing to the tail end of a disastrous period for cloud-related stocks that appears to have finally reversed. Given reduced faith that IACI can monetize its cloud franchises, we are replacing it with FIS, which is well positioned to profit from growth in mobile payments. Our small cap portfolio performed very well this quarter. We are replacing OPEN (which was acquired) and XONE, with carrier-class WiFi equipment maker RKUS and ad tech company FUEL.

It Just Doesn’t Matter, It Just Doesn’t Matter

In a previous lifetime, we had access to a top notch quantitative analysis team with comprehensive back tested model. While the predictive performance of this model against most sectors of the economy was excellent, it was consistently poor for tech stocks, despite many attempts to adjust it. Very few metrics, whether value-oriented or momentum-oriented, showed significant correlation to future performance, and those factors that did have correlation, had low levels of explanatory power and tended to change from period to period. Valuation tools were particularly frustrating – if anything, tech stocks worked slightly counter to classic mean reversion, expensive stocks had a slight tendency to get more expensive and cheap stocks would get cheaper, but without enough predictive significance to drive a quantitative investment strategy. Momentum was dangerous – it would work until it didn’t, with frequent, dramatic inflection points that the model couldn’t predict. This experience, spread over more than a decade, has given us strong conviction in the primacy of thematic investing in TMT.

History supports a thematic approach. During the PC era, top performers Dell, Intel, Microsoft, Cisco, and Oracle were perpetually expensive, growing into their valuations and then some. Of course, the late ‘90’s saw hype around these and other, less established, tech stocks push to unsustainable heights. However, pure valuation-based and momentum-based analyses were useless in identifying the collapse of the bubble. The few that were able to anticipate the inflection point did so with thematic tools – telecommunication carriers had insufficient capital to continue financing their investment in network build-outs, triggering a domino effect of canceled orders, catastrophic quarterly disappointments, and share price collapse across the TMT landscape. In the aftermath of the 2001 recession, only investors with a firm vision of the coming future were prescient enough to buy Apple, Google, Amazon, or, all of which have been expensive against consensus expectations all of the way up.

At this point, thematic investing behavior is almost innate. Amazon CEO Jeff Bezos has the luxury of investing his company’s potential profits back into the business to expand rapidly, enter new markets and develop new products without significant pressure to deliver short term EPS. Facebook and Google operate with similar halos. As long as the dream of future domination remains alive in the minds of investors, perceived future winners have a long leash. Meanwhile, companies that are perceived as losing relevance in the future are given no benefit of the doubt. For these players, even strong financial results are nitpicked for signs of potential future weakness. The CEOs of companies like Microsoft, Qualcomm, and even Apple must feel some frustration over their second class treatment by the market.

The Dream is Still Alive

We have created a framework for sorting stocks based on the short term and long term expectations of the market. For each of a universe 72 large cap TMT stocks, we calculated the 5-year CAGR of free cash flows expected by consensus estimates – where 5 year consensus forecasts were not available, we estimated the missing years based on the trajectory of the data at hand. We then calculated the 5th year terminal value that was implied by the current share price by subtracting the net present value of those forecasted cash flows from enterprise value (essentially, market cap + current liabilities – cash & investments), discounting cash holdings to reflect future tax liabilities and capital inefficiency. The remainder, expressed in present day dollars, and taken as a percentage of the enterprise value, represents the portion of the current valuation related to long-term franchise value. We then plotted the companies on axes representing the near-term FCF CAGR and the terminal value percentage of total EV. The size of the bubble is the current percentage cash flow margins. The collected plot is not particularly linear, with the various companies spreading out from a mean of roughly 11% 5-year FCF CAGR and 65% of value represented in the fifth year terminal value (Exhibit 1).

Exh 1: SSR’s TMT Valuation Framework

We then examined the companies inhabiting each of the four quadrants of the graph. The upper right hand section – companies carrying expectations of better than 11% annual cash flow growth and with implicit terminal values that were more than 65% of their EV – contains the “Dream Stocks” (Exhibit 2-3). These 18 companies are richly valued, even in comparison to their strong projected near term growth. Amongst the group are such luminaries as Amazon, Google, Facebook,, and ARM, alongside well regarded cloud/internet names like LinkedIn, WorkDay, Priceline, TripAdviser, Adobe and Autodesk, and fast growing up-and-comers like Twitter and Tableau. We note that payments processing specialist Fidelity National (FIS), which our Financials colleague Howard Mason has identified as the company best positioned to benefit from growth in mobile payments, is also in this quadrant. Interestingly, mixed signal semiconductor vendor NXP, semiconductor capital equipment leader Applied Materials and content delivery network operator Akamai make it into this quadrant, albeit near its lowest thresholds. Equinix is an outlier due to a terminal value greater than its enterprise value, due to the enduring value of its substantial fixed assets, which are not reflected in EV. We are skeptical that Equinix is likely retain business value in a future IT world that we expect to be dominated by a small handful of massive public cloud operators.

Exh 2: SSR’s TMT Valuation Framework CHARTThe Dream Stocks

“Dream Stocks” get the benefit of the doubt, and can weather near term setbacks as long as the market remains convinced of the long-run narrative of domination. For these stocks, sales growth is far more important than margins to investors and sloppy quarters are quickly forgiven in the face of new product introductions and confident forward statements. Most of them will probably grow into their valuations – at least eventually.

Exh 3: SSR’s TMT Valuation Framework TABLE – “The Dream Stocks”

Death Watch

Opposite the dream stocks, in the lower left hand corner of the graph, is the “Death Watch” quadrant (Exhibit 4-5). Here, stocks are expected to underperform on 5 year cash flow growth and carry a vote of “no confidence” in the form of a smaller than average implicit terminal value. At the center of the 16 names in the group is a gaggle of former enterprise IT darlings – Microsoft, Oracle, Cisco, EMC, Checkpoint, Computer Associates and NetApp. Clustered near the upper thresholds are Red Hat, Accenture, JDSU, Broadcom, Electronic Arts and Seagate. To the left, with poor expected near term cash flows but nearly average implicit terminal values, are three traditionally cyclical stocks – SanDisk, KLAC and Western Digital – that are more likely on “Downcycle Watch” than on “Death Watch”.

Stocks in this group have the advantage of low expectations, and to the extent that they can deliver near term surprises against consensus, excellent performance is possible without fundamental changes in investors’ long term perceptions of their positioning. We also note that investor perceptions may be wrong. We are enthusiastic about Microsoft’s long term potential as a provider of enterprise cloud hosting and SaaS applications, and see the market skepticism, borne of more than a decade of strategic meandering, as a substantial opportunity. We have included Microsoft as a constituent of our large cap model portfolio for the past 2 ½ years. We also have included JDSU, which we believe can prosper with future investment cycles for optical networking infrastructure and with its network testing equipment business.

Exh 4: SSR’s TMT Valuation Framework CHART – “Death Watch”

Exh 5: SSR’s TMT Valuation Framework TABLE – “Death Watch”

Skepticism Bordering on Cynicism

Stocks with expectations for strong near term growth but low implicit terminal values are in a difficult position. These “Skepticism Stocks” may deliver upside sales growth, fat margins and EPS beats, but until investors stop expecting the sky to fall at some point down the line, results will be raked over for signs of encroaching weakness and any negative news flow will be amplified, even as positive news flow is ignored. Sitting in this category are 19 companies, most of them former market darlings that have had a bit of a fall from grace (Exhibits 6-7). To the far right of the quadrant, with expected cash flow growth more than double the universe average but carrying paltry implicit terminal values, are Qualcomm, Corning and Avago. Each was viewed as an early winner from the emerging mobile era – Qualcomm raked in the royalties and dominated smartphone chipsets, Corning made all of the glass going into those smartphones, and Avago had a contract for radio chips in the iPhone. Alas, investors no longer believe that any of that is going to last.

Exh 6: SSR’s TMT Valuation Framework CHART – “Skepticism Stocks”

The rest of the companies are clustered between 12 and 20% expected annual cash flow growth. Leading this group is Apple, which deserves comment on its own. Despite its obvious and unprecedented success, Apple is not accorded the same long term valuation premium as its apparent peers – like Google, Amazon or Facebook. We believe this is explained by three factors: First, Apple continues to reiterate its commitment to a narrow market focus on high margin integrated devices sold at significant price premiums. The addressable market for Apple’s most important product category – the iPhone – has shown clear signs of approaching saturation while its second most important product category – the iPad – has begun declining in sales as much lower priced competitors take control of the tablet market. Without real evidence of new product initiatives with potential to buttress the slowing growth of the iPhone and replace the declining sales of iPads, top line growth estimates have become an article of faith. Second, Apple’s extraordinary margins and rising capex leave it little room to grow cash flows without top line expansion. Third, Apple has shown very little interest in distributing its mountainous cash holdings, most of which are held overseas with presumably hefty tax penalties for repatriation. Nominally $150B and ostensibly more than 25% of its market cap, we believe the market is placing a serious implicit discount on this asset.

Exh 7: SSR’s TMT Valuation Framework TABLE – “Skepticism Stocks”

The other stocks in the category include a roster of fallen investor favorites – Intel, VMWare, EBay, Garmin, Expedia, Citrix, Nvidia, Symantec and Juniper – and a handful of more successful cyclicals – Lam Research, Analog Devices, Xylinx and Altera. It also includes IAC corporation, which has been in our model portfolio since September 2011. We believe the quality of IAC’s online franchises has deteriorated with the rise of mobile apps and no longer believe that it is a likely candidate for acquisition. As such, we will remove it from the portfolio going forward.

The Comeback Kids

Then there are the stocks where the consensus expects weak near term results, but where the implicit terminal value is nonetheless high (Exhibits 8-9). These 18 “Comeback Stocks” are widely spread across the quadrant, with old-line technology firms – IBM, HP, Xerox, Texas Instrument, Automatic Data Processing, Paychex, Amphenol, TE Connectivity and Motorola Solutions – well represented. Investors may believe they see something in the future of these companies that justifies raising them above the “Death Watch”. The other names in the group are fairly idiosyncratic. Crown Castle is here because its substantial real estate holdings skew its terminal value unnaturally high. Yahoo is here because of its unrealized investment in Alibaba. Activision is a hits driven video game publisher with some of the most valuable franchise properties in the industry – this intangible asset may also skew valuation high. Alliance Data Systems, already at the quadrant’s upper threshold for near term growth, is in the consumer loyalty program game – a business and skill set presumed to be gaining in importance as retail paradigms shift. Finally, Fiserv is in the electronic payments business, and while we believe it is not as well positioned as its rival FIS, it presumably will also have significant value 5 years out, once a shift to mobile payments has begun to play out in earnest.

There is real risk in the Comeback Stocks. In particular, we see nothing in the activities, assets or character of the old-line technology names to lead us to believe that they will mount the recovery implicit in their relatively rich terminal values. Given the valuation, the risks are asymmetrically negative. This is the place to go hunting shorts.

Exh 8: SSR’s TMT Valuation Framework CHART – “Comeback Kids”

Exh 9: SSR’s TMT Valuation Framework TABLE – “Comeback Kids”

The Large Cap Model Portfolio

Our large cap model portfolio had a second consecutive poor showing during the past quarter after a long stretch of significant outperformance, delivering just 4.6% appreciation since April against the 12.4% appreciation of the tech components of the S&P 500 (Exhibit 10). The primary cause was the ongoing weakness in cloud-related stocks, i.e. Twitter, Tableau, IAC and WorkDay, which comprise a large piece of our 15 stock portfolio. We believe that the investor concerns for the sector have faded and that strong 2Q14 growth can drive significant recovery. Our semiconductor constituents – ARM, JDSU and Qualcomm also faired relatively poorly.

We are making two changes to the Large Cap Model Portfolio (Exhibit 11). First, we are swapping JDSU to the small cap portfolio, in light of its current valuation below our $3B threshold, in exchange for VeriFone Systems, which has appreciated above that same level. Second, we are dropping IAC and replacing it with Fidelity National Information Services (FIS). FIS is in agreement with the retail merchant consortium MCX to process mobile payments made on the system, and is well positioned to provide similar services to other would-be payments players. As mobile payments gains traction with merchants and consumers, FIS is an obvious beneficiary and the top pick of our financials analyst Howard Mason.

Exh 10: SSR Large Cap TMT Model Portfolio – Before Reconstitution

Exh 11: SSR Large Cap TMT Model Portfolio – Reconstituted

The Small Cap Model Portfolio.

In contrast, the small cap portfolio performed well during the past three months, up 6.5%, 130bp better than the tech components of the S&P600 benchmark (Exhibit 12). The performance was aided by the acquisition of Open Table by Priceline, the recovery of consumer 3D printer maker ExOne from a sharp decline in the previous quarter, and by the strong appreciation of mobile device component vendors OmniVision and Synaptics. As we noted above, we are trading VeriFone to the large cap portfolio in exchange for JDSU in recognition of these stocks passing our $3B market cap threshold in opposite directions. OpenTable must be removed as a result of the acquisition and we are dropping ExOne, due to ebbing faith in the near term potential for consumer 3D printers. In their place, we are adding commercial WiFi gear maker Ruckus Wireless, which will benefit greatly from aggressive WiFi roll out plans from Google, Comcast and the FCC, and ad tech leader Rocket Fuel, which is well positioned to exploit the paradigm shift toward digital advertising (Exhibit 13).

Exh 12: SSR Small Cap TMT Model Portfolio – Before Reconstitution

Exh 13: SSR Small Cap TMT Model Portfolio – Reconstituted

Appendix: Model Portfolio Addition Business Descriptions
FIS (also dba Fidelity National Information Services)
FIS is a dedicated banking and payments technology company. The company was historically part of Equifax and spun off in 2001 to form a company called Certegy. In 2005, the company was acquired by a business unit of Fidelity National Financial and spun off as Fidelity National Information Services, which later became FIS. The company offers services to approximately 14,000 institutions in 100 countries. Its Financial Solutions Group provides comprehensive services and software to serve the technology, processing and outsourcing needs of financial institution customers. The Payment Solutions Group provides a set of software and services for the electronic funds transfer (EFT), card processing, item processing, bill payment, and government payments processing needs of the company’s customers.

Ruckus Wireless
Ruckus Wireless was founded in 2004 and provides carrier-class Wi-Fi solutions. The company’s solutions, which are called Smart Wi-Fi, are used by service providers and enterprises to solve network capacity and coverage challenges associated with the traffic and number of users and client devices on wireless networks. The company sells its products to a range of service providers and enterprises selling its products to approximately 33,000 end-customers worldwide. The company has a portfolio of approximately 90 patents awarded by the United States Patent and Trademark Office and other patent offices worldwide. The company went public in November 2012.

Rocket Fuel
Rocket Fuel was founded in 2008 by a group of former Yahoo employees. It provides a programmatic media buying platform that uses artificial intelligence, big data, and predictive analytics for autonomous real time bidding on digital media impressions. The platform evaluates numerous data points to score and predict the likelihood consumers will respond to digital ads and then bids on impressions to reach those customers. As of December 2013, the company had 1,224 active customers, including major advertisers. Its advertiser base span various sectors, such as automotive, cable, computer manufacturing, education, finance and insurance, health care, hospitality and food services, retail and telecommunications. The company cooperates with the likes of Google, Facebook, and Yahoo, but competes with AOL and MSN. The company went public in September 2013.

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