TMT: The Longs and Shorts of it
SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak
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January 5, 2016
TMT: The Longs and Shorts of it
Our large cap long and short portfolios are comprised of 15 stocks each, and while we are comfortable with the overall prospects for each, we are often asked for our highest conviction names. On the long side, we believe that GOOGL, MSFT, and TWTR have soft expectations, reasonable valuations and specific catalysts to take them higher early in 2016. On the short side, we see ORCL, JNPR and IPG as particularly challenged, with clear potential negative catalysts, difficult consensus targets, and unrealistic valuations.
Exh 1: The SSR Large Cap LONG TMT Model Portfolio
GOOGL – Alphabet had a banner year, rallying 50% in the back half of 2015 after sitting in a holding pattern for the prior 18 months. We believe that this momentum can carry forward into 2016. First, sales growth, adjusting for FX, has begun to reaccelerate, despite investors’ concerns that the paradigm shift to mobile platforms would hamstring the company’s dominant search advertising franchise. We see several reasons for this. YouTube is breaking out as a mobile platform, taking market share with triple digit growth in video views and better than 50% growth in ad sales. This is poorly appreciated by investors due to Alphabet’s secrecy and Facebook’s promotion of its own video ad efforts. Search is proving more resilient on mobile, as Google uses deep links to index in-app content and enables Android users to execute search from within an app via Now on Tap. Discovery remains as knotty a problem when the information is locked into apps as when it is on web sites. Meanwhile, the linear TV advertising model is deteriorating before our eyes, with digital the obvious beneficiary. Note that Google, Facebook and Twitter currently capture nearly 60% of US mobile ad spending.
Exh 2: Key Operating and Valuation Metrics – GOOGL
Second, we believe catalysts abound for Alphabet (Exhibit 2). The company has reportedly been in serious discussions with a number of automakers around its market leading autonomous vehicle technology, raising the profile of an initiative that could challenge Uber and give Google a leg up in the local delivery competition with Amazon. The high profile hire of Diane Greene, the founder of VMWare, to drive Alphabet’s thus-far disappointing IaaS business could also yield fruit. With a year under her belt, CFO Ruth Porat could institute a dividend and draw in a new class of investors. At the same time, consensus expectations are eminently beatable, and the current valuation does not reflect the growth and cash flow of which Alphabet is capable. We expect a 4Q15 beat to set a strong tone for 2016, with near term upside to $900.
Exh 3: Key Operating and Valuation Metrics – MSFT
MSFT – Microsoft surprised skeptical investors with strong results in 2015, beating EPS estimates by an average of 13% over the first three quarters, and spurring a tidy 19% gain for the year, all of it coming in the back half. Still, expectations for CY16 – low single digit growth in sales and EPS – look very beatable, and the valuation, adjusted for the company’s cash hoard, is pedestrian for a company with Microsoft’s business momentum. (Exhibit 3). Our proprietary framework, which assesses the long term and short term components of valuation, shows Microsoft well below average on both expected cash flow growth and implied terminal value, placing it in the Death Watch category with such notables as Yahoo, Intel, Cisco, and Oracle, despite its clearly superior position in the cloud and prospects for accelerating growth.
Microsoft just announced that 200M devices are now running Windows 10, just 5 month after release, a faster rate of adoption than any prior Windows release. Moreover, 40% of Windows 10 activations occurred post-Thanksgiving, a sign that holiday sales of Microsoft powered products were strong. This portends well for 2QFY16 results and speaks well for the potential for an enterprise upgrade cycle in the year ahead. It also establishes a strong base for Microsoft’s cloud applications, in particular, Office 365 to piggyback on Windows 10 growth. The stunning success of Azure, which is growing at a triple digit pace and gaining share in pursuit of IaaS market leader Amazon Web Services, will continue in 2016 adding upside to both top- and bottom-line growth. We believe Azure is a business with the potential to grow to hundreds of billions in revenue. A 30% breakout to better than $70 is possible on strong December and March earnings, with a bright future in the cloud beyond that.
TWTR – Unlike Alphabet and Microsoft, Twitter had a horrible 2015, ending the year down more than 40% after running up 35% in the first quarter. This is despite growing its full year revenues at a roughly 60% pace into the face of fierce FX headwinds, and turning in earnings that were more than double expectations. Twitter is the third largest player in mobile advertising, behind Google and Facebook, it is the fastest growing mobile ad platform of the top 10, and is separating itself cleanly from the number 4 player Yahoo. It has extremely valuable interest signals for its registered user base and an exceptionally powerful and flexible native format for advertisers. Why then the sell off?
The culprit was stagnant monthly active users (MAUs), a Facebook metric of engagement chosen by management for the roadshow, adopted by investors as their primary yardstick for evaluating the company, and, unfortunately, poorly suited to assessing the business as it has evolved. Like Google’s YouTube (and unlike Facebook), Twitter has more users viewing its content without logging in than it has registered MAUs – its monthly unique visitor log tops 900M. While Twitter is likely stuck with the MAU metric, there is reason to believe that it can reaccelerate its registered users. First, Twitter has greatly improved the onboarding process for new users – shortcutting the cumbersome timeline customization process. Second, a partnership deal with Google is finally in full swing, with Tweets now showing high in search results and driving new traffic to the Twitter site where they can be enticed to register. Third, marketing activities around the core service and the new user friendly “Moments” digest have begun.
At the same time, Twitter has also begun to monetize its unlogged-in visitors – serving advertising based on the topics and tweeters for which the user searches. While such ads are unlikely to fetch prices as high as those served to registered users, for whom Twitter maintains a trove of interest data, the sheer volume potential could add significantly to potential sales. Moreover, Twitter has also launched adjunct apps for short form videos (Vine) and ad hoc live video streams (Periscope) which have gained significant audiences – these too will be monetized. Despite its strong record of monetization and massive total audience (including unlogged-in users), Twitter’s market cap sits well below the private valuation of the largely unmonetized Snapchat, which boasts fewer MAUs than Twitter and no unlogged visitors.
We believe that Twitter will significantly exceed expectations for both sales and earnings in 2016 (Exhibit 4). Importantly, we also expect upside surprise in MAUs and success in monetizing unlogged-in users as significant catalysts to rerate the stock much higher. We believe that Twitter could more than double for 2016, with a strong move likely during the first half of the year.
Exh 4: Key Operating and Valuation Metrics – TWTR
Exh 5: The SSR Large Cap SHORT TMT Model Portfolio
ORCL – Oracle bounced around in 2015, finishing down roughly 15% after setting a 10-year high in December of 2014. Still, CEO Larry Ellison has to be thankful that his company hasn’t been treated more harshly, given that it has missed 10 of its last 12 quarters on declining sales and earnings. Analysts have set the bar high, expecting reversals to growth in both revenues and profits. Investors are hanging in – Oracle shares trade at a 17x trailing P/E and a 13x multiple of those optimistic forward estimates. Meanwhile, just over 1% of the float is short.
We think it gets much worse in 2016. Oracle’s hype for its own cloud offerings is behind those rosy growth forecasts, but evidence suggests that it may not be faring all that well. Media reports suggest that Oracle’s cloud revenues, still less than 6% of total sales, are padded by cloud services bundled with license renewals or force sold as a part of the dreaded annual audit true-ups in which Oracle exacts penalties from customers deemed to have used its software more than allowed by its contract terms. Even without considering these allegations, Oracle’s IaaS hosting business was stagnant over the past 12 months, while Amazon and Microsoft have each posted better than 75% growth.
Other old school IT behemoths, like IBM, and Hewlett Packard, have suffered mightily for their inability to adapt to the future. Oracle, through slick talk and its usual flurry of acquisitions, has not yet been held accountable (Exhibit 6). We believe there is 30% downside in the shares to $25 or lower, with likely quarterly disappointments juxtaposed against the successes of Amazon and Microsoft catalysts to erode support for the stock.
Exh 6: Key Operating and Valuation Metrics – ORCL
JNPR – On December 17, 2015, Juniper announced that it had discovered unauthorized code inserted into its security firewall software that could allow hackers administrative access to its routers, and thus, the networks and systems of its customers. This is an example of an integrity breech, which can render typical enterprise security solutions, which emphasize encryption and intrusion detection, ineffective. We believe that private enterprise networks relying on commercial security software are inherently vulnerable to this sort of failure due to insufficient policy measures to protect the many entry points to a typical network, the wide availability of the technology, and the sophistication of the potential threats. We believe that proprietary security solutions employed by the top cloud hosts (Amazon, Microsoft, Google) are dramatically less vulnerable to threat and monitored with much greater technical sophistication than is possible on a private enterprise network. We believe that this is becoming better understood amongst IT professionals, and that enthusiasm for expensive commercial solutions, like those sold by Juniper, will suffer. Indeed, security companies did begin to miss consensus expectations for superlative growth, with FireEye’s 2Q15 disappointment a negative catalyst for many of the stocks in the group (Exhibit 7).
Exh 7: Key Operating and Valuation Metrics – JNPR
However, Juniper did not join the sell-off, continuing on to establish a four year high in October. Even after the December announcement and the subsequent FBI investigation, the stock traded off just 10%. Despite paltry 1.3% annual sales growth over the past three years, analysts are projecting sales to accelerate to 4.5% growth in 2016, with a 35% increase in EPS. Just 2.3% of the company’s shares have been sold short. Historically, shares have been volatile, with the recent peak of $44 in early 2011 followed by a trough of less than $17 in mid-2013. We believe the overhang of an FBI investigation could be a significant drag on sales completion in 1H16, and that a miss against sunny expectations is likely. We believe a disappointment would be punished harshly, with a downside risk below $20.
IPG – The Interpublic Group of Companies is trading just off of its 10-year high, up nearly 7-fold from its post-crash bottom, trading at a healthy 18.3x forward earnings estimates and a 1.5x PEG ratio. This seems a robust valuation for a stock expected to grow its top-line at 0.9% and bottom-line 10.8% in 2016, in what has typically been a quadrennial peak year for US advertising spending. Moreover, analysts expect the next three years to be sunnier than the last three, with the annual sales growth projected to accelerate from 2.4% since 2013, to 3.1% through 2018.
We see storm clouds ahead. Linear TV viewing is deteriorating, as consumers are abruptly shifting their viewing toward streaming programs, leaving poor ratings and PayTV subscriber declines in their wake. This is unequivocally bad for TV ad spending, historically the lifeblood of ad agencies. While election and Olympic year spending will cushion the blow, we still believe expectations for 2016 TV media ad revenues are overly aggressive with potential for doubly painful drop in 2017, putting the whole value chain at risk. In this context, the market enthusiasm for Interpublic appears misplaced (Exhibit 8).
Moreover, the rise of digital media has further implications for the traditional agencies. YouTube, the largest and fastest growing outlet for online video advertising, sells its spots through an automated auction process with no specific agency fee. The same is true for Twitter. Facebook, playing catch-up to YouTube, does offer a 15% agency fee, but we would be surprised to see this maintained once the company is satisfied with its share of streaming video ads. We believe that poor TV ratings will deteriorate further by May’s network Upfront presentations, an obvious negative catalyst for network owners, ad agencies and other dependent businesses. We have included CBS and Nielsen in our 15 stock large cap short model portfolio, but are focusing on IPG as the most vulnerable in a downside scenario.
Exh 8: Key Operating and Valuation Metrics – IPG