September 3, 2013 – TMT Portfolio Updates: Walking the Topline

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 Sell side analysts love to back end load estimates for the companies that they favor, pushing sales acceleration and margin expansion into the back half or even into the next fiscal year. As we approach 3Q earnings, we thought it useful to identify the large cap TMT stocks where the next 4 quarter estimates were the most disengaged from the revenue and gross margin trends of the past 8 quarters. Overall the TMT components of the S&P have underperformed the broader index by 6.2% YTD, perhaps indicative of an 8 quarter trend showing slight sales deceleration and gross margin declines. In contrast, consensus forecasts assume a reversal of both trends. Looking at forecasts vs. historical trend for individual companies, NFLX, VIAB, INTC, and ADBE stand out as non-cyclicals having unusually positive inflection points embedded in consensus, while WDC, INTU, WDAY and ATVI are have the sharpest downward departures from trend. We note that AAPL has delivered the steepest sales deceleration and is forecast for the second most abrupt reacceleration in the sample. Turning to our model portfolios, the large cap portfolio outperformed the TMT components of the S&P500 by 720bp over the past 3 months, while the small cap model outperformed its analogous benchmark by 370bp. We are adding S and CCI in replacement for WPP and NVDA in the large cap model, and PAY, VALU and MKTO to the small cap in lieu of FIRE, WBSN and FIO.

Backend loaded estimates raise risk in 2H. Analysts love to push sales acceleration and margin improvement out to quarters in the back half and to the following year, hoping their favorite companies will beat the easier estimates upfront and set up the aggressive future projections as plausible. As such, downward revisions and quarterly misses are more likely in the back half of the fiscal year. We set up a screen to assess the risk of overly aggressive forward estimates in 67 TMT stocks with market caps above $10B. Using the last 8 quarters to assess trends in YoY sales growth and gross margins, we then analyzed the variation of the next four quarter estimates against those trends. Companies with estimates considerably above trend, and in particular, implying an inflection point reversing a previously downward slope could carry unusual risk of disappointments.

Large cap TMT growing at 7.6% annual pace. Over the past 8 quarters, our universe grew at an average 7.6% CAGR, with CCI showing the greatest acceleration and AAPL the sharpest deceleration. Analyst expectations show a substantial bias toward mean regression, with projected inflection points common, particularly for companies with the most pronounced deceleration trends. This is understandable in the cyclical technology names – e.g. MU, AMAT, XLNX, and TXN– that have been in an obvious downtrend over the past two years. With those stocks, we find several others – HPQ, ORCL, IBM, DELL, XRX, and CHTR – that have less obvious cases for a reversal of trend. At the top of the list, removing stocks affected by large acquisitions, are names projected to fall off of accelerating sales trends – e.g. Intuit, Crown Castle, Activision, etc.

59% of 67 TMT large caps have seen declining gross margins. Excepting companies like GOOG, where large deals hit margins during the past 8 quarters, media stocks have seen the worst margin deterioration with TV, CHTR, and CBS all in the bottom 5. Considering the trends vs. consensus expectations, analysts are apparently expecting a serious downturn in payroll processing margins, with ADP 1st and PAYX 8th. Likewise, the recovery in disk drive profitability has not impressed the sell side, which places STX and WDC with the 3rd and 4th margin declines vs. trend. Meanwhile, consensus is far more bullish on media, expecting big margin upside for TV, CBS and VIAB vs. trend. Cyclicals MU and SNDK are getting the same benefit of the doubt.

Big expectations can be hard to live up to. Considering both sales growth and margin expectations against trend, the bar has been set very high for VIAB, INTC, ADBE, AAPL and NTAP, all of whom must reverse well established trends to meet consensus over the next 4 quarters. The other stocks in the bottom 10 are cyclicals (MU, AMAT, TXN and GLW) with reasonable expectation of an upturn, and NFLX, which has skewed trend lines due to a period of hypergrowth at the beginning of the 8 quarter period. At the other extreme, the 5 companies deemed likely to fall the furthest off of recent performance by analysts are WDC, ATVI, INTU, DISC.A, and VZ. Of these, we see WDC as a clear winner, even in the face of sell side skepticism.

Our large cap model portfolio performance has been strong. On an equal weight basis, our large cap model portfolio outperformed the S&P 500 by over 1000bp driven by the successes of companies like Netflix, Workday, NetSuite, and NVIDIA. In re-evaluating the portfolio, we are removing WPP because of recent merger activity in the advertising subsector and risk in the scalability of advertising services. We are also removing NVIDIA because of concerns over momentum of design wins and failure to penetrate a popular handset. We are instead adding Crown Castle as a result of our fundamentals screen and its positioning in wireless. Also, given the prospect of renewed rivalry in the wireless market and attractive spectrum assets for fixed wireless broadband, we are adding Sprint.

Our small cap model portfolio performance has been strong. Small TMT investing is inherently difficult given some of the most exciting opportunities have been co-opted by the platforms or remain in private hands in hopes of an IPO at a large cap valuation. Even so in this backdrop, our model portfolio outperformed the small cap S&P 600 benchmark by 1420bp and returning 28.1% since the last model portfolio update in April. Performance was driven by several companies with returns north of 45%: Web.com (+78.8%), Websense (+70.7%), Applied Micro Circuits (+65.0%), Sourcefire (+48.0%) and K12 (+47.8%). Also, because two of these companies were acquired: Sourcefire and Websense, we are adding Verifone and Valuclick to the small cap model portfolio. Thematically, Verifone is well positioned for POS devices that accept mobile payments. Also, Valuclick is one of the few publicly traded online advertising pureplays. We are also replacing Fusion-io with Marketo, a SaaS provider in the marketing space that IPOed in May.

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