TMT: Paradigm Change Trumps Economic Risk

sagawa

The late August correction hit TMT leaders hard, partially overshadowing 2Q15 numbers that evidenced the technology driven paradigm shifts that are transforming sectors across the economy and concentrating value toward TMT early movers with the necessary skills, assets, and scale to take advantage. Key themes: 1) Pay TV audience losses and flagging ad sales, NFLX’s subscriber growth, and strong ad sales at GOOG, FB and TWTR are all effects of the shift from linear TV to on-demand streaming and digital advertising. 2) AMZN and MSFT’s extraordinary cloud growth, the ongoing success of SaaS apps (e.g. CRM, WDAY, DATA), and weak data center spending (IBM, HPQ, EMC, ORCL, etc.) show the enterprise exodus to the cloud underway. 3) E-commerce continues to erode brick-and-mortar – AMZN reaccelerated its US sales, outgrowing top traditional merchants by a factor of 10, while EBAY executed its split with PYPL amidst swirls of hype around m-payments. 4) In devices, AAPL’s monster iPhone numbers decelerated as tough compares loomed and the Apple Watch turned out to have modest appeal – this hit both AAPL and its suppliers. Meanwhile, indigenous vendors Huawei and Xiaomi have reclaimed leadership in the Chinese smartphone market and seem poised to expend internationally. 5) Finally, TMUS is delivering double digit sales growth, harvesting market share from its competitors VZ and T, which cannot match TMUS for fear of killing margins on its best customers, and S, which continues to struggle in execution. Conclusion: Generational sea change is a powerful force, and the companies driving it forward – GOOG, FB, AMZN, MSFT, and NFLX in particular – are positioned to prosper even in a worst-case economic scenario.

High Multiple Does Not Necessarily Mean High Risk. The TMT sector is in the midst of a generational sea change that positions the leading innovators to concentrate value from traditional businesses across the entire economy. These companies, including the “FANGs” – FB, AMZN, NFLX, and GOOG – are perceived by some investors as part of a new tech bubble, leaving them to take a bigger than average hit from the recent market correction. Given the massive size of the opportunities that these companies target, the huge advantages that they gain from scale, skills and moving early, and the deflationary nature of their products and services, we believe these high flyers will prove MORE resilient to economic downturns than the rest of the economy.

The War on TV.  The deterioration of linear TV has been playing out for years (http://www.ssrllc.com/2013/06/june-12-2013-the-war-on-tv-the-attack-of-the-boxes/ The War on TV), but gloomy results and a few blunt comments from media executives finally shook investors from their torpor and media stocks from relative highs. Despite management happy talk minimizing long term implications, the trajectory is frightening and we see valuations as still optimistic. Meanwhile, NFLX is down nearly 20% from the correction, badly underperforming despite the previous enthusiasm over its strong 2Q15 sub growth. We are not nervous about possible new competitors, including AAPL, and see the current depressed price as a significant buying opportunity. With TV ad revenues decelerating into declines, GOOG, FB and TWTR all posted strong ad revenue growth. This is no coincidence, as ad buyers continue to grow more comfortable with online metrics even as they lose confidence in the reach, efficacy and value of TV.

Enterprise Cloud Exodus. AWS 2Q15 sales up 80% YoY. MSFT cloud revenues up 98% vs. 2014. GOOG’s cloud is reportedly delivering 60% annual growth. CRM is growing 2x%. WDAY sales are up 47%. Meanwhile, HPQ sales are down –8.1%, IBM –13.4%, and ORCL -5.4%. Once favored EMC has decelerated to just 2% growth on an obvious trajectory toward declines. The same is true for CSCO, save for a bump in non-core businesses curiously coinciding with the CEO transition. We see the large majority of traditional IT names as value traps, with the exception of MSFT.

E-commerce is harder than it looks. For all of the talk of “click and mortar” and “omnichannel”, few traditional merchants have successfully turned the corner. AMZN turned up the heat in 2Q, accelerating to 26% growth in its primary e-tail segment. While the top 10 US retailers grew sales an average of 1.8% in 2Q15, US online sales are growing at an estimated 16% clip and AMZN is taking market share. Bellwether WMT saw its 2Q15 sales flat YoY with its multibillion dollar e-commerce initiative decelerating to just 15% growth and less than 13.7% of the sales volume of AMZN. We believe most retailers are seriously underestimating the obstacles to their digital success. Meanwhile, EBAY successfully spun out PYPL, freeing itself to fix its marketplace biz and spruce itself up for sale.

AAPL and the mother of all compares. The iPhone 6 temporarily juiced high end smartphone demand, drawing a lot of upgrade demand forward while also winning share with consumers with a preference for bigger screens.  CEO Tim Cook’s Monday morning email to Jim Cramer stopped the rout in AAPL shares, attesting to continued strong sales in China during July and August, but the big risk is obviously still ahead of it. Meanwhile, Huawei and Xiaomi jumped ahead of AAPL in China and have significant ambitions outside the home market. We expect Chinese brands to take considerable global smartphone share going forward.

TMUS harvesting subs from below. TMUS delivered 11% growth in wireless sales for 2Q15. All other.US carriers posted declines, as TMUS’s low prices and subscriber friendly “Uncarrier” initiatives allowed it to grab post-paid subscribers while market leaders VZ and T held the line to protect ARPUs and margins. We expect this dynamic to continue to play out to TMUS benefit, with S too encumbered with its crazy quilt network and ongoing poor execution to play spoiler.

Staying the Course. Our large cap model portfolio continues to outperform, topping the TMT elements of the S&P500 by 381 bp over the past 3 months. Amongst the portfolio constituents are the companies that we believe that are best positioned to dominate the future post-sea-change landscape – GOOG, FB, AMZN, NFLX, MSFT, TMUS, QCOM, and ARM. DATA, WDAY, ADBE and TWTR are unique cloud franchises, well positioned going forward. DIS, WDC and CCI are not necessarily advantaged by paradigm change, but have near term tailwinds that support their inclusion in the portfolio. We note that our change themed small cap model portfolio has performed very poorly, we believe owing to the concentration of value in those themes toward scale players. Given this, we intend to adjust our strategy to a more value oriented approach with our next update.

Please see our published research page for the full note.

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