TMT: The Good, the Bad and the MEH
SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak
FOR IMPORTANT DISCLOSURES 203.901.1633 /.1634
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December 11, 2013
TMT: The Good, the Bad and the MEH
We recently published research (“TMT: How the Mighty Can Fall”) detailing the trajectory of companies and market sectors that have been overtaken by innovation. Threats to incumbents typically take 4-6 years from the appearance of alternatives until real impact shows in financial results. However, once begun, the deterioration proceeds faster and more forcefully than most investors expect. We have screened the universe of U.S. TMT companies with market caps in excess of $10B, judging exposure to threatened business areas and ability to exploit the innovations that are reshaping the sector. Exposure is measured by sales in the affected areas, weighing near term threats more heavily than those further away. Positioning is assessed subjectively, looking at the scope of new paradigm initiatives at each company and judging their relative ability to execute. Of the 80 companies, 26 fall into the attractive” little exposure/well positioned” quadrant, while another 29 suffer from the converse – in both cases, the implications are obvious. 12 companies boast strong positioning against opportunity, but must cope with deterioration from threatened business areas. We judge these by their commitment to the new paradigm and by their ability to mitigate near term threats, balanced by market expectations. The final 13 companies are neither particularly threatened nor well positioned. These typically compete in focused subsectors, such as defense or manufacturing systems, and the business drivers may be idiosyncratic. We are adjusting our large cap model portfolio – removing N, which we believe may be vulnerable to more nimble SaaS competitors with more modern architecture, and adding TWTR.
- Leadership in TMT is changing with an innovation-driven paradigm shift. We recently wrote about the destructive effect of paradigm shifts in TMT on previously vibrant market segments. The waves of change are typically slow to develop – 4-6 years from appearance to effect – but almost universally devastating to the companies in their path in the 1-3 years after impact. We believe that waves of destruction, driven by mobile user platforms, cloud data processing, and wireless broadband, will threaten entire business segments ranging from consumer PCs and traditional cell phones in the immediate term, to areas like enterprise data center technology, channelized TV, fixed broadband, and credit cards in the future.
- Many large cap TMT bellwethers face big threats to their current revenues. We have identified 15 different businesses that we expect to face disruption, and have broken them in to 4 buckets based on how quickly we expect to see impact on sales and profits for incumbents. Parsing the current revenues of 80 large cap TMT companies into these buckets, and applying a discount to those with more distant threats, we have scored each stock for its exposure to the paradigm shift. Companies like HPQ or IBM, with clear and present danger, score poorly, while cloud economy leaders, like GOOG or FB have essentially no exposure.
- Investments in the new paradigm have had varying degrees of effectiveness. We rated the same 80 companies based on their positioning for emerging opportunities and on our assessment of their ability to execute. For example, many traditional IT vendors have stepped up activity in delivering cloud-based services, but remain constrained by their need to sustain dying architectures and by their insufficient skill sets. Such players – such as ORCL or IBM – may have reasonable position but questionable execution. This is consistent with history, as incumbent vendors have typically failed in attempts to shift into a disruptive technology.
- Companies in the “little exposure/strong position” quadrant are obvious winners. The companies without exposure to threatened business areas and deemed likely to succeed in the new paradigm are poised to lead the next era of TMT, with stocks like GOOG and QCOM at the positive extreme of the quadrant. Conversely, companies that are highly exposed and poorly positioned – such as HPQ, ORCL or cable MSOs – represent serious long term risk, even if sales and cash flows are robust today.
- Players that are both well positioned and threatened may be interesting. Value may be best mined from the threatened but well positioned quadrant in companies where threats have been more apparent to investors than their future prospects. Companies like MSFT and STX fall into this category. In contrast, companies where positioning has overshadowed future risks may be overvalued. SaaS pioneers CRM and N, both currently tied to expensive relational data bases and sub-scale dedicated infrastructure, are examples.
- Unthreatened, poorly positioned companies are mostly idiosyncratic. Interestingly, few companies are both unthreatened and poorly positioned for future opportunity. Those that fall into the quadrant tend to be focused industrial electronics players that may face risks farther in the future should new paradigm approaches – e.g. “the Internet of things” – spread into unexpected arenas.
- We are adding Twitter to our model portfolio. While our timing is unfortunate, given the past week’s run up in the share price of TWTR, we are adding it to our model portfolio for three main reasons: 1. TWTR is exceptionally well positioned to prosper from the cloud era, with sustainable leadership in the delivery of increasingly valuable “real time” information; 2) Expectations for coming quarters are easily beatable given new revenue initiatives in play; and 3) Valuation is reasonable given the likelihood of future growth and profitability. To make room for TWTR, we are removing N, which recently turned down after a long run of outperformance. We believe that new competitors, exploiting the cost, performance and flexibility advantages of public cloud platforms such as AMZN and GOOG, will begin to pressure early SaaS leaders like N and CRM, which rely on older vintage architecture.
Catch a Wave and You’re Living on Top of the World
Two weeks ago, we published a piece (TMT: How the Mighty Can Fall:
) that detailed the history of market segments felled by TMT paradigm shifts over the past 30 years. In this piece we assessed the trajectory of more than a dozen business areas from the moment that innovation-enabled alternatives first hit the market, through the time that the competitive effects of those alternatives began to show in the sales and profits of the incumbents, onto the subsequent deterioration of the market. In this, the pattern was clear: the time between the appearance and impact of the threat was most typically 4-6 years and the downturn in profits was sharp – down 30-50% in the first 3 years. We believe new waves of change are coming, driven by the rise of app-based mobile user platforms, cloud-based data processing architectures, and wireless broadband networks, that will disrupt and destroy current business segments in the same way that mini-computers, paging networks, and newspaper advertising have been washed over.
We have evaluated 80 large cap TMT companies as to their exposure to disruptive innovation, and to their ability to benefit from change with new paradigm business initiatives. Exposure was measured by parsing each company’s sales into buckets based on the estimated proximity of threats from innovation – categories under immediate threat, like non-smart cell phones or consumer PCs, were weighed at 100%, while categories with longer term threats, such as enterprise data center hardware (75%), fixed residential broadband service (50%), or credit card networks (25%), were assigned lower weights. Similarly, we subjectively assessed each of the companies both for the prominence of their new paradigm initiatives and for their ability to execute against them to yield a 1-10 score for positioning.
Plotting the 80 stocks by both exposure and positioning is revealing. Companies scoring well on both factors are the obvious winners, with GOOG, AMZN and QCOM leading the way with top scores on both axes. Altogether, there are 26 companies that fit into that upper right quadrant. In contrast, the lower left quadrant – high exposure and poor positioning – contains the obvious losers. Most traditional IT bellwethers and TV distribution system operators are here. For companies with both high exposure and strong positioning, valuation is key – are investors underplaying the risk or reward? MSFT and STX, barely under the line on exposure and sporting better than 6% FCF yields, look attractive, while DISH, which gets a bump on positioning for its spectrum holdings but offers a 0.8% FCF yield, does not. Stocks in the not exposed and not well positioned for change quadrant, such as TEL, XRX, or FIS, are largely focused on vertical solutions or commodity components. The investment case for these companies will be idiosyncratic.
In keeping with these assessments, we are removing N from our large cap model portfolio, which underperformed its benchmark by 1500bp during the past 3 months. We see old-line SaaS vendors, tied to traditional RDBS software infrastructure, as long term vulnerable to emerging competitors that leverage the superior unstructured cloud architecture. While this impact is still years away, current valuations raise our level of concern. We are adding TWTR in its place, which we believe is poised to exceed near term expectations. We are also adjusting our small cap portfolio, which underperformed by 1090bp, removing MRIN and K12, and adding XONE and GTAT.
They Kill Horses, Don’t They?
We recently published a lengthy report (
) that reviewed 14 different industries that were badly disrupted by the innovations of the PC era. This era, stretching from the early ‘80’s until a few years ago, was the result of a comprehensive TMT paradigm shift, catalyzed by the contemporaneous emergence of PC and cell phone technologies, along with the dramatic Reagan-era deregulation of the U.S. telecommunications and cable TV industries. The technology sea-change loosed new product and service concepts that washed over entrenched business models in waves, destroying market segments ranging from minicomputers, sales of which declined precipitously after the advent of clustered PC-based servers in the late ‘80’s, to newspaper advertising, which plummeted after peaking in 2006, the victim of internet-based advertising vehicles.
Exh 1: Previous TMT Paradigm Shift Casualties
The businesses in question were a disparate lot – technology platforms, telecommunications services, and media formats amongst them – but all shared a common trajectory. Threats, as they appeared, were not taken seriously by incumbent executives, armed with encouraging sales reports and confident in their ability to respond to the alternative technical approach should risks become more apparent. Typically, the period between the introduction of a viable alternative product based on new paradigm technology and impact on incumbent businesses was 4-6 years, occasionally stretching as long as 10 (Exhibit 1). Gloomy prognostications were taken as alarmist, and the stocks of the companies in harm’s way tended to perform well for some time – usually taken as an affirmation that the threats were not to be taken seriously.
However, once the new paradigm alternatives gained traction, the impact came hard and fast. Minicomputer king DEC’s quarterly earnings hit an all-time high in 3Q88 – three years later, it was making losses, and a decade later, it was absorbed into Compaq for less than a third its peak valuation. Wireless pager production peaked in 1995 at nearly 40 million units, but had fallen more than 50% by 1998 as the top paging operators, PageNet and Mobile Media went bankrupt. Nextel had nearly 19M subs in 2005, a year before its acquisition by Sprint. By 2008, the number was less than 14M in a rapidly growing market, as cellular operators mimicked the “killer” push-to-talk functionality, and Sprint wrote off nearly all of its investment. The “Big 4” broadcast TV networks lost 25% of their prime time audience to cable nets between 1993 and 1996, and only held on by buying and launching their own cable nets. Dial-up ISPs went from 95% of internet access in 2000 to less than 25% in 2006, with the rise of broadband crushing the newly merged AOL-TimeWarner in the process. Telco landlines went from more than 95% of U.S. residential telephony in 2000 to less than 45% ten years later, as cable operators aggressively played for telephone market share and younger consumers decided to go wireless only. Circuit-based office telephones system sales dropped from nearly 47 million lines in 1999 to less than 8 million in 2006, as IP network alternatives ripped through the market. Sales of circuit switch equipment for public telephone networks followed suit, dropping in half from 2000 to 2001 and trending further down from there. Newspaper advertising sales fell by more than half between 2006 and 2009. Yellow Pages ad revenues were off 40% between 2007 and 2011. CD sales dropped 50% between 2004 and 2009. U.S. bookstore revenues fell 25% between 2008 and 2011, and a third of the nation’s travel agency locations closed between 1998 and 2004.
Exh 2: Waves of Innovation in TMT, 1980 – Present
In all of these cases, executives in the threatened industry and the media and analysts that followed them failed to appreciate the gravity of the threat until it was, likely, too late. Often, investors figured it out a bit earlier, but even then, the time between the appearance of the threat and its impact on share price was long in coming (Exhibit 2). Moreover, the damage done to the incumbent players was very often fatal, with many multi-billion dollar market cap companies coming to bankruptcy or to unfavorable M&A deals. Few of the leaders in the threatened businesses ever managed to adapt to the changing technology and re-establish their leadership – IBM and HP spring to mind, and the broadcast TV nets that diversified into cable.
What Goes Around, Comes Around
The recent struggles of the traditional cell phone manufacturers are evidence that a new set of destructive waves have begun – this time, the sea-change paradigm shift is driven by the rise of app-focused mobile user platforms, distributed cloud data center architecture, and wireless broadband. With the rise of new paradigm smart phones, Ericsson, Palm, Motorola, and Nokia have all been taken out of the business for huge discounts from their one-time market values. Blackberry, which stubbornly insisted on going it alone, looks likely to pay the ultimate price for its hubris, and erstwhile market stalwarts HTC and LG are showing disturbing signs as well. Meanwhile, PC makers, like Dell and HP, are suffering from a sharp downturn in the consumer market – Gartner has adjusted its global PC unit forecast downward for 12 consecutive quarters – as mobile platform-based tablets render the traditional Wintel standard increasingly obsolete in the home. Similarly, we expect PC era peripherals, and in particular, printers, to suffer accordingly (Exhibit 3).
Exh 3: PC Unit Shipment Forecast Revisions – 4Q09-3Q13
Other business categories under ongoing pressure from this TMT paradigm shift include wireline telecommunications, print media, and enterprise servers (Exhibit 4). The relatively recent downturn in server sales has been chalked up, by many, to the dismal global economy, reasoning that harks back to those that expected mini-computer demand to sharply rebound from the 1990 recession. With cloud-based alternatives, such as Amazon Web Services, Microsoft Azure and Google Compute Engine, growing rapidly as their price/performance advantage widens vs. internal data center investment, we believe optimism is misplaced.
The shift of enterprise processing from private data centers built with value-added servers from the likes of HP and IBM to cloud operators with massive distributed data centers based on proprietary software and commodity parts points to likely future weakness in other enterprise IT categories. Demand for data center hardware, such as storage systems or networking equipment, while still growing, has been decelerating on a trajectory that portends declining sales not far in the future. Similarly, infrastructure software, such as relational database systems or virtualization hypervisors, are not well suited to a public-cloud dominated architecture and will see serious threats from unstructured solutions from cloud-based operators. IT managers have been reticent to renew their commitments to these software products, as evidenced by slowing new license activity (Exhibit 5). Traditional enterprise application software is also at risk from new paradigm solutions run in the cloud and sold as subscription. We expect all of this to come to a head within the next year or two.
Exh 4: Enterprise Server Shipments by Price Band– 2010-2013
Exh 5: Universe of Enterprise Application Software – Suitability for the Cloud by Application and Current Spending on Cloud
At the same time that enterprise IT vendors face pressure from the cloud, we expect channelized video system operators and advertising-driven TV networks to begin showing the effects of streaming video competition sooner rather than later. As we have written (see The War on TV series
), television viewership peaked and has begun to recede in the last four years (Exhibit 6). While TV advertising has remained robust despite the shrinking audience, the same circumstances held for newspapers a decade ago (Exhibit 7). We expect the TV ad market to roll over in the next year or two. Similarly, cord cutting is starting to gain momentum after fits and starts over the past few years and the total number of pay TV subscribers has begun to fall despite steady increases in the total number of US households. At the same time, network fee demands on MSOs are growing more aggressive in light of the looming weakness in advertising. This is ominous for cable and satellite operators as the quality and variety of on-line streaming video available as an alternative continues to improve at a quickening pace. These effects should also play out in the next 18-24 months.
Exh 6: US TV Households and Average Daily Viewing
Further down the line – say 2-4 years out – we expect disruption to another set of businesses. Traditional enterprise desktop PCs and point-of-sale hardware should turn downward for good. As the cloud market rewards the cost and performance advantages of architectural leadership and scale, we expect many smaller competitors to suffer, such as subscale IaaS players and SaaS application pioneers with systems built atop dead-end relational data base infrastructure software. The same is true of mobile device app developers, many of which will be squeezed out by the manifest destiny of the companies controlling the user platforms – Google, Apple, Microsoft, and, perhaps, Amazon. In a similar timeframe, we also believe that wireless broadband networks will be fast enough, reliable enough and cheap enough to compete successfully for residential broadband, beginning a subscriber exodus to echo the wireless-only telephone phenomenon of the past decade and wrecking the cable industry’s “ace in the hole” for replacing lost video revenues with higher broadband prices.
Exh 7: Annual Newspaper Advertising Spend versus Circulation, 1950-2012
Finally, before the end of the decade, we believe that payments solutions based in the cloud will begin to bypass credit card networks for security and settlement, cutting out a substantial part of transaction costs and opening the door to a more creative set of consumer banking and finance services. We also expect Amazon and its e-commerce brethren to push delivery windows to an hour or less, raising the threat to grocery stores and other delay sensitive retail businesses. Continued developments in machine learning and falling prices for wireless broadband should also enable deeper cloud-application incursion into a wider range of consumer services, including health care and education.
We have collated these businesses threatened by the new paradigm into four categories, based on the timing by which we believe they will be affected by change. The first bucket, essentially businesses already under assault, is assigned a full 100% weighting. The second bucket, deemed likely to see a material downturn within the next 2 years, is given a 75% weighting. Similarly, the third bucket – 2-4 years out – gets a 50% weight and the fourth bucket – expected to hit by decade end – gets 25% (Exhibit 8). We applied these screens to 80 U.S. based TMT companies with market capitalization in excess of $10 billion, making judgments as to the percentages of their revenues that accrue to each of the buckets and applying the appropriate weighting to reach a score for their exposure. We then parsed the scores across a 1-10 scale.
Exh 8: Revenue Exposure Methodology
At the low end of the scale are companies with businesses predominantly in the first and second buckets, including names like News Corp, Sirius, Oracle, and Dish. On the other extreme are the champions of the new paradigm – companies like Qualcomm, Google, Facebook, Amazon, LinkedIn and Twitter. In between, companies range across the spectrum with some possible surprises. Microsoft is less exposed than many think, since the large majority of Windows license revenues are from the enterprise. The same is true of the disk drive makers Seagate and Western Digital, which have substantial sales into enterprise storage applications that should be robust even as that market shifts from systems OEMs to cloud data center operators. On the flip side, data center IT vendors and channelized TV distributors are likely more at risk than many investors assume.
Right Place, Right Time
We also rated each of the 80 companies for their likely ability to prosper from the new markets being created by the paradigm shift. Half of the 10 point rating is assigned on the basis of relevant initiatives directed at these opportunities and the other half based on our perception of the company’s ability to execute successfully. Here there is significant credit for having reached a critical mass and having infrastructure, platform or skill base assets already well established. Again at the high end are leaders like Google, Amazon, and Qualcomm, with smaller players like Twitter, and LinkedIn, along with well-armed incumbents like Microsoft, Sprint and the tower companies, a step back. Bringing up the rear on positioning are the increasingly sad HP and a trio of video MSOs. Relative to many investors, we are less enthusiastic on the positioning of both Apple and Facebook, both of which, we believe, face significant execution challenges that will force each out of its historical modus operandi. We are also much more optimistic on Microsoft, which we believe has developed a substantial competitive asset in its Azure cloud infrastructure.
Exh 9: Top 80 TMT Companies Plotted by Positioning for New Opportunities and Exposure to the Old Paradigm
Hail to the Victors
Plotting the 80 companies in our universe by their exposure and positioning, 26 of them fall in the “less exposed, better positioned” quadrant (Exhibit 9). These companies are the best equipped to prosper from the shift to the new TMT paradigm, although those placed higher and to the left are obviously better placed than those closer to the center. The most attractively placed companies are obvious mobile internet stalwarts, Google, Amazon, and Qualcomm, with Twitter, LinkedIn, Crown Castle, SBA and Sprint just behind. We have graphed the relative positioning of the companies in exhibit 9, with the size of each company bubble indicative of free cash flow yield, the financial metric that has historically been the best indicator of relative performance for TMT stocks (Exhibit 10).
At the other extreme are 29 stocks that suffer from both high exposure and poor positioning. The worst placed companies in the sample are media and media distribution companies – News Corp., Time Warner Cable, and Sirius – with data center IT vendors Oracle, Hewlett Packard and Computer Associates, and Pay TV MSOs Direct TV, and Charter just behind. These companies are facing near term threats to revenues without obvious sources of growth from new paradigm initiatives (Exhibit 11).
Exh 10: Quadrant I – Less Exposed, Better Positioned
Exh 11: Quadrant III – Highly Exposed, Poorly Positioned
Exh 12: Quadrant II – Highly Exposed, Well Positioned
High Risk, High Reward
12 stocks fall into the “highly exposed, yet well positioned” quadrant, perhaps surprisingly including notables like Disney, Intel, and Salesforce.com (Exhibit 12). For each of these companies, investors must weigh the relative risks and rewards against the richness of the valuation. For example, Salesforce.com has substantial momentum in selling its SaaS delivered CRM, HR and other enterprise applications, but faces a future architecture transition away from the inflexible Oracle RDBS and subscale data center infrastructure that currently support the business. Similarly, Intel enjoys process leadership in high performance, low power semiconductor manufacturing, but remains tied to a processor design standard that is highly exposed to PC obsolescence and poorly positioned for the mobile device and cloud data center applications that will generate future demand.
From this grouping, we are most intrigued by the disk drive manufacturers Seagate and Western Digital. The exposure of these companies to the decline of the PC is well understood by investors and embedded in share prices to the tune of nearly double digit free cash flow yields. At the same time, robust demand for disk drives from cloud-based data centers is expected to return the industry to sustainable growth within the next 12 to 18 months, while a consolidation from 5 global competitors to 3 tempers the fierce global rivalry that has constrained industry profitability in the past. For investors with an even greater risk appetite, Dish Networks may be poised to join the fray of the newly contentious wireless carrier market, already roiled by aggressive moves by Sprint and T-Mobile USA. Dish’s spectrum holdings could prove to be very valuable, particularly if they can be augmented by additional licenses through auction, partnership or M&A. Still, the execution risk is very high and its primary video MSO business is clearly threatened.
Exh 13: Quadrant IV – Less Exposed, Not Well Positioned
Outside the Fire
13 stocks in our universe fall appear to be neither overly threatened nor particularly positioned against emerging opportunities (Exhibit 13). Three of these, MA, FIS and FISV, are part of the current credit card dominated payments arena, where we see significant threats but believe them to be relatively distant. The other three, TXN, APH and TEL, are makers of industrial and commodity components that are essentially orthogonal to the industry paradigm shift. Only if the end markets for these components – automotive, defense, manufacturing automation, etc. – are disrupted will these companies suffer. Investment in these names is contingent on threats remaining well outside the investment horizon and in one’s belief in the idiosyncratic markets that they serve.
Our large cap model portfolio has enjoyed exceptional performance, gaining 160 bp vs. the TMT components of the S&P500 over the past 3 months, and 2640 bp upside vs. the benchmark YTD. This has been driven by strong performance from new paradigm bellwethers Google, Amazon, Microsoft and Qualcomm, all of which have outperformed the benchmark, and by Seagate, Netflix, and Sprint, which led performance in the most recent quarter (Exhibit 14).
We are adding Twitter to the portfolio. We came to this conclusion well before the recent 25% run in the share price over the past week, and have decided to continue with the decision rather than wait for a potentially more advantageous opportunity. While the stock may certainly retrace some gains after such a sharp upward move, we remain believers for 3 main reasons: 1. Twitter is exceptionally well positioned to prosper from the cloud era, with sustainable leadership in the delivery of increasingly valuable “real time” information; 2) Expectations for coming quarters are easily beatable given new revenue initiatives in play; and 3) Valuation is reasonable given the likelihood of future growth and profitability. To make room for Twitter, we are removing NetSuite, which recently turned down after a long run of outperformance. We believe that new competitors, exploiting the cost, performance and flexibility advantages of public cloud platforms such as Amazon, Google, and Microsoft, will begin to pressure early SaaS leaders like NetSuite and Salesforce.com, which rely on older vintage architecture.
Exh 14: SSR Large Cap TMT Model Portfolio – Performance since 9/3/2013
Small Cap Struggles
In contrast to our Large Cap Model portfolio, our Small Cap Portfolio continues to struggle (Exhibit 15). As we have indicated in the past, our thesis of value concentration toward big consumer platforms and web-scale cloud operators leaves relatively less room for smaller players to thrive. Moreover, the dearth of TMT IPOs over the past 5 years has left many interesting new companies private. Some of our constituents have been notable performers – PAY, SYNA, and ENTG all outperformed the tech components of the S&P600 small cap index by 1230 bp for the past 3 months. However, the dramatic downturns of stocks like Marin Software and K12 has driven the relative underperformance. We are removing both of these stocks, and adding 3D printing company ExOneCo and solar/LED cap equipment supplier GT Advanced Technologies to the portfolio in their place.
Exh 15: SSR Small Cap TMT Model Portfolio – Performance since 9/3/2013
Note: Revenue exposure scored as an inverse of revenue exposure divided by 0.9 times 10 for a score of 1-10, higher score means less exposure to old paradigm. Quadrants determined by medians, e.g. median Exposure is 7.2 and median positioning is 6. Source: Capital IQ, Company Filings, SSR Analysis
SSR Large and Small Cap Model Portfolios after Update
Note: Shaded Companies reflect new additions. NetSuite removed from large cap model portfolio, Marin Software and K12 removed from small cap model portfolio