TMT: 1Q16 Earnings – It Ain’t 2014 Anymore

sagawa

1Q16 earning season confirmed several business trends. Ad driven businesses showed strong. Smartphone and PC sales were weak. The enterprise migration to the cloud continued apace, while traditional IT suppliers struggled. AMZN sharply accelerated its e-commerce sales in a tough retail environment, while sustaining profitability. We had written our concerns for the OTA and GDS travel businesses (http://www.ssrllc.com/publication/otas-wanna-get-away/) – 1Q16 results were mixed, with recent consolidation playing more smoothly than we expected. We expect the security market to shake out in 2016 – 1Q was a start, with a few beats and a few more sharp disappointments. Against this backdrop, our long model portfolio slightly underperformed, with STX the big loser. We are removing it and DATA, and adding MLNX and LNKD. Our short model portfolio had more pronounced underperformance, due to ill-advised bets against linear TV. We are pulling shorts on CBS, CHTR and IPG, replacing them with HPE, DISH and NUAN.

US advertising is red hot. TV execs are basking in strong 1Q16 results, driven by the unusual presidential campaign, which added direct ad spending and boosted news ratings, while tightening the scatter market for other advertisers.  Nearly every media company not named Viacom turned in strong TV revenues, despite continued deterioration in the size and quality of their core audiences. CBS CEO Moonves crowed that his 12% organic growth represented market share recovery from digital rivals, but FB blew out earnings with 58% ad growth and GOOGL posted 23% growth, after TAC and FX. With audiences shifting their attention online, particularly in the most coveted demographics, we expect a serious snapback in media ad sales in 2017, once the campaign and Olympics are over. Meanwhile, everyone can enjoy the rising tide.

Devices are ice cold. Industry analysts Gartner and IDC set the stage by lowering their PC forecasts ahead of the quarter results. It should have been no surprise that many PC linked names – HPQ, INTC, STX, WDC, etc. – missed estimates. MSFT is a bit of a mixed story – it suffered on PCs, but delivered stellar cloud results. Smartphones also disappointed, with AAPL’s big miss the main story. We expect global replacement rates to continue to lengthen (http://www.ssrllc.com/publication/smartphones-mobile-maturity/), and see little to no market growth going forward beyond the very low priced segment.

The cloud is rising. AMZN’s AWS and MSFT’s Azure continue to take swaths of share in IaaS, growing 64% and 120% respectively in 1Q16. SaaS companies are also showing well again. Many, including CRM, have yet to report, but a few that have – LNKD, NOW, SHOP, ZEN, and others – delivered strong results. Two others, OPWR and TXTR, were acquired by ORCL in the quarter, another indication of the attractiveness of the group.

AMZN is killing it. We were concerned that consensus forecasts of 1Q16 sales acceleration off of a blistering 28.2% YoY pace despite a weak overall retail environment, and beat on EPS to boot. AWS got many of the headlines, but AMZN’s e-tail business is doubling the growth of the online market from the leadership position. Increasingly, e-commerce looks like a rout.

OTA consolidation is working. We remain cautious on the OTAs and GDSs, as the tepid economy, increasing resolve of hoteliers and airlines, and the rise of new competitors (i.e. AirBnB) are obvious threats to the high growth expectations and fat margins in the group. 1Q16 showed little impact from these factors, as the benefits of recent consolidation played earlier and stronger than we expected. We remain concerned for 2H16 and beyond (http://www.ssrllc.com/publication/otas-wanna-get-away/).

Security shakeout playing out. Security earnings were mixed with CHPT, SYMC, FEYE and VRSN off on misses or weak guidance, and CYBR and FTNT moving up on surprises. Generally, hardware vendors have underperformed software. As we wrote in February, we expect overall demand to weaken with basic security commoditized and more advanced solutions blocked by IT department limitations and threatened by the cloud. (http://www.ssrllc.com/publication/cybersecurity-trust-no-one/) Still, we see opportunity for a small number of differentiated leaders, such as PANW, CYBR and ANET, to prosper.

Old line IT value trap. In an echo of 2014, traditional IT names – i.e. IBM, HPE, HPQ, INTC, CSCO, ORCL, and others – had been strong performers through March. Earning season seems to have clipped their wings, as reports from the group, thus far, have been disappointing. Given clear evidence of an accelerating move to the cloud by their enterprise customers, we do not expect the trajectory for these companies to improve.

Pulling DATA and STX from our model portfolio. Since our last update in early March, model portfolio constituent STX has dropped 44%, holding overall portfolio appreciation to 1.2% against a 1.6% gain in the tech components of the S&P500. While we still see believe cloud storage will one day more than offset declining sales to PC and storage system OEMs, we now see the inflection point as more than a year away, prompting us to remove STX. We are also removing DATA – we believe that the recent sharp deceleration in license revenue is most likely driven by competitive inroads by MSFT’s PowerBI product. If so, we believe the growth narrative for the stock could be broken. In their place, we are adding HR SaaS player LNKD, which looks to be recovering from its Jan. tumbler, and MLNX, which we believe is well positioned to exploit a cloud-driven shift to white box networking.

Too early to short TV. The performance of our short model portfolio continues to be poor, underperforming the bench mark by 390bp since March. The biggest flaw in the portfolio has been our concentrated bet against linear TV, which as noted above, has dramatically outperformed. While we believe media will indeed suffer a significant downturn, the raucous presidential campaign will run until the first Tuesday in November. We will wait until then to return CBS, CHTR, and IPG to the portfolio. In their place, we will add HPE (The 1Q16 growth which sparked a 40% run in March is unsustainable), DISH (It is growing less likely that it will be able to fully monetize its spectrum assets) and NUAN (Deep learning platforms from GOOGL, MSFT and others will threaten its voice and image recognition businesses).

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