Get the latest content first

FANGA – Is that all there is?

Theo Maas – Portfolio Manager Arnhem Global SMA’s

If you get your news solely from the AFR, you would think that there are just five investable stocks outside Australia: Facebook, Amazon, Netflix, Google (or Alphabet) and Apple. We call them the FANGA stocks (an extension of throwing in Apple to the widely used FANG acronym). As you can see in the chart below, four of them have had a spectacular run in the last two years, averaging 91% between them. With that run, they added US$600bn of market cap, and with a combined market cap of US$2 trillion, are now larger than the GDP of Italy while only marginally behind that of the UK.

FANGA Share Price Performance Since December 2014
fanga-1
Performance of the five FANGA stocks in percentage terms from 31/12/14 to 18/11/16
Source: Arnhem Investment Management, Capital IQ

We don’t believe that this run will continue and have only one of the five, namely Alphabet, in our Global SMA portfolios. Before I explain the reasons why, I would like to address the tech ‘mini wreck’ in the last two weeks, or in the other words – discuss the Donald in the room. In my view, there is ‘Good Donald’ and there is ‘Bad Donald’ with regards to the FANGA stocks. Good Donald means lower company tax rates, foreign cash repatriation with no or low tax impact and significant infrastructure spending (ignoring the adverse budget effects here!). Bad Donald means trade wars, import duties and a reversal of outsourcing to low cost countries. All of these issues will potentially have a big impact on the operations of the five FANGA stocks. Furthermore, CEO’s like Amazon’s Jeff Bezos (who actually owns the very anti-Trump newspaper The Washington Post) and Apple’s Tim Cook have openly been very critical of the President-elect.

Let me take you through my views on all five of the stocks which we will do by first discussing the relevant industry issues, then company issues and finally the valuation of the stock. Let’s start with the one FANGA stock that we do like: Alphabet or The Artist formerly known as Google.

Alphabet

Alphabet is involved in various industries which are all based on online advertising. The main business is Search-based advertising which is the crown jewel, as they dominate this industry. A question I always ask clients is “Do you know anyone that uses Bing?” The big growth area is video-based advertising which is done through YouTube. Alphabet bought YouTube for US$1.6bn in 2006, which was considered outrageous as YouTube was only 18 months old at the time, but it turned out to be one of the best acquisitions in corporate history as it is now worth roughly $150bn on most analysts’ numbers. As the average time spend on YouTube goes up, and those of you with teenagers can relate to this, the value of YouTube as an advertising platform also goes up.

The next growth area is Mobile, which impacts all assets of Alphabet. More and more internet traffic is generated on smartphones and tablets (typically 60-70% for most sites). While the growth is there, it does bring new challenges as old advertising models (like banners) that worked on the PC do not work on a small screen.

The only fast growing advertising area that Alphabet has missed completely (and not for a lack of trying) is Social Media. Their Google+ effort has been miserable. Facebook has run with it and is now dominating this space. Unless Alphabet acquires its way in, this will remain a weak spot. The problem is that buying a company like Snap (the makers of Snapchat) is not going to be cheap.

If we turn to company analysis it is clear that 90% of revenues comes from advertising. They do have however, a long list of potential winners which are classified under a division called Other Bets. The one Bet that has the most potential in my view is Google Cloud, which does the same as Amazon Web Services and Microsoft Azure, i.e. offering cloud-based services to corporate customers. Google has a similar infrastructure footprint as Amazon and Microsoft and there is no reason why they cannot win significant market share in this space.

Alphabet has been profitable from day one and there has never been a sense of urgency to lower the cost and focus the efforts on the most profitable ventures. Alphabet’s new CFO has done a lot of good work in cleaning up the cost structure of Google and I expect more efficiencies to follow.

Alphabet is trading around a P/E multiple of 20x, but given the organic growth of +20% they have shown in recent quarters, there is plenty of upside in my view. If you look at the EPS growth profile over the last 10 years in the chart below, you can see that they can demonstrate stellar performance in both growth and consistency.

Alphabet P/E and EPS, Nov 2006 to Nov2016
fanga-2
Alphabet forward P/E (left hand scale) and EPS (right hand scale) from Nov 2006 to Nov 2016
Source: Arnhem Investment Management, Capital IQ

Apple

My view on Apple is more controversial and is based on the old saying that a great company does not always equal a great stock. I spend 20% of my salary on Apple products, but I just can’t get myself to buy their shares.
Ever since the demise of Nokia, the smartphone industry has been very competitive. While the usual suspects like Apple, Samsung, LG and Sony continue to battle, they have been joined by a long list of Chinese players like Huawei, Oppo and Xiaome. It is clear that Apple (who uses proprietary IOS operating system) has been losing share versus the rest who are predominantly on Alphabet’s operating system Android. In that battle, the likes of Symbian (mostly Nokia), Blackberry and Microsoft have almost disappeared.

Furthermore, the replacement cycles of smartphones have continued to lengthen. Bluntly put, consumers have not felt the need to replace their phone every year when the new model comes out. The reason is simple: there is not a lot of new innovation; yes it is a little faster and yes the camera is marginally better, but does that really convince you to part with upwards of $1,000 to buy the new one? The answer is resoundingly no.

If we look at company level, it is clear that Apple is now completely dependent (60%-70%) on the iPhone. Ever since they launched it in 2007, it has transformed the company into the US$600bn giant it now is. The problem, as we just discussed, is that this industry is going ex-growth and Apple is losing share in that market environment.

So what’s next? While, the iPad changed the dynamics for a few years, it is now showing similar declines. PC’s and notebooks are a niche business for Apple these days and the new release of the overpriced MacBook Pro will not help. New products like the Apple Watch have been little more than a rounding error and despite all the talk about Cars and TV’s, there is little evidence of any imminent products. The bulls on the stock will talk about iCloud or Services, but it is clear to me that Apple is little more than a me-too in this area and competition is brutal from the likes of Amazon, Microsoft, Google and Spotify.

One of the big question marks is what they will do with their cash. While they have become more active in buying back shares and handing out a bigger dividend (the yield is just above 2%), the $250bn of cash that sits on the balance sheet goes a long way. They have traditionally shied away from acquisitions and the biggest they have done was Beats at $3bn, so it is unlikely that they will change their M&A strategy. The biggest challenge they have is that the majority of cash is held overseas and we will need a big drop in the tax rate to bring this back home. Maybe Trump can help out?

Apple is now trading at a P/E of 12x and the problem is that the consensus numbers are still too optimistic. We have seen a 10% decline in EPS this fiscal year and that trend looks likely to continue based on the new iPhone 7 sales, yet to hit the market. So in all likelihood, we are looking at a classic value trap scenario in my view.

Apple P/E and EPS, Nov 2006 to Nov2016
fanga-3
Apple forward P/E (left hand scale) and EPS (right hand scale) from Nov 2006 to Nov 2016
Source: Arnhem Investment Management, Capital IQ

Amazon

My view on Amazon is more mixed. I really like the Amazon Web Services business, yet less excited about the retail business whilst being worried about the market’s assumptions hereon.

Let me explain.

It is clear that Internet Retail is very competitive, with low barriers to entry though only a handful of companies actually make a profitable business out of it. Even Amazon after 20 years and with dominating market share struggles to get more than a 3% profit margin. This industry will continue to grow though as e-commerce penetration is still well below 10% in most markets.

The most attractive industry for Amazon is the Cloud services market, where Amazon Web Services or AWS dominates. The demand for data (driven by the likes of Netflix and software-as-a-service companies like Salesforce) is accelerating and drives demand for more datacentre computer power and storage. It is a very profitable market, but requires a lot of initial capex which makes the barriers to entry high.

In terms of Amazon as a company I would say: if only I could buy AWS separately! AWS is unfortunately only 10% of sales and 25% of profitability, so you need to be positive on the majority of the traditional Amazon retail business. And this is where the issues start. Amazon has a long track record of either pulling the growth or the margin lever, but have never been able to combine the two. The one positive driver is the Prime subscription based model, where we see that Prime customers spend more than twice as much as other customers.

The 10-year EPS profile in the graph below shows the volatility of the Amazon business model and as a consequence the P/E multiple has been all over the place; it is still a healthy 100x as I write. Amazon has a huge following among the sell-side analysts in the US who have a track record of being too optimistic with EPS forecasts.
And yes, if someone asks, I do believe that Amazon will launch in Australia next year and that they will be very disruptive for the existing bricks-and-mortar retailers.

Amazon P/E and EPS, Nov 2006 to Nov2016
fanga-4
Amazon forward P/E (left hand scale) and EPS (right hand scale) from Nov 2006 to Nov 2016
Source: Arnhem Investment Management, Capital IQ

Facebook

Facebook is one I am trying to like (pun intended) and the multiple contraction helps, but I continue to have concerns about the long term monetisation potential of its user base.

What we know is that Social Media is the fastest growing segment in advertising, although it is coming off a low base. The market is concentrated and M&A activity, like Facebook buying Whatsapp and Instagram, has made it even more so. The newcomers are players like soon to be IPO-ed Snap (of Snapchat) and Chinese players like Tencent and Alibaba, who so far have struggled to get any traction outside of Asia.

The fundamental problem I have with the industry is how can you monetise your customer base (by either letting them pay for stuff or forcing them to watch more ads) without losing them. We know that social media customers are a fickle bunch, as I am sure you all remember MySpace. Given that this phenomenon is new, we are basically flying in the dark. I do feel that the sell side community is too optimistic about companies charging for stuff that has always been free, especially to a generation that has come to expect that most things in life are free.

Facebook has done a brilliant job so far in acquiring their customer base organically and at the same time eliminated every potential competitor by buying them. And while ad revenue is growing, the question is how far can they take this and whether the customer base of Instagram and especially Whatsapp is willing to pay up or get bombarded with ads. I do note that Facebook is facing more scrutiny around its censorship, its function as a ‘news’ hub and its recent mistakes in billing clients.

The market is certainly pricing in a significant step up in revenue per user, which I struggle to see. We have, however, seen a significant derating of the multiple of the stock (it is below 30x now) as can be seen in the chart below, so we will get to a point where these risks are priced in. We’re not there yet though.

Facebook P/E and EPS, Nov 2006 to Nov2016

fanga-5
Facebook forward P/E (left hand scale) and EPS (right hand scale) from May 2012 to Nov 2016
Source: Arnhem Investment Management, Capital IQ

Netflix

The final FANGA stock is my least favourite: Netflix. A combination of rising content costs, net neutrality issues and revenue per customer expectations steers me well clear of it.

The Streaming Video on Demand (or SVOD) industry has come out of nowhere in recent years and is taking the world by storm. Most countries have seen at least 3 players compete for market share and the question is whether SVOD has had an impact on other forms of TV as well. While the jury is still out, it is clear that consumers have started ‘cutting or shaving cords’, i.e. cancelling or downgrading their Pay TV packages.

The biggest threat to the industry is the price of content. Given there are now more players, those with deep pockets like Netflix and Amazon are bidding for rights to this content. This has seen the price of this content rise significantly, as evidenced by the main sports rights, like the English Premier League or NBA Basketball. Besides sports, original content is the other driver to differentiate yourself, which is not cheap either. Netflix for example spent US$100m on the first season of House of Cards (Kevin Spacey got US$30m of that by the way!).

What is a threat is the fact that the SVOD industry has had a freeride so far in terms of infrastructure. While every telco in the world has felt the ‘Netflix’ effect, i.e. significant increases in data downloads, Netflix is not the one paying for this. This is partly driven by something called ‘net neutrality’ that most governments around the world subscribe to. In other words, telcos are not allowed to discriminate between network traffic and therefore not allowed to charge more for a Netflix stream. The arrival of President-elect Trump, who is an opponent of net neutrality, may change things somewhat with the consequence that the SVOD industry may have to pay a share of the necessary infrastructure.

Netflix has done an excellent job in growing its customer base around the world, yet it is bleeding cash outside the US due to a combination of scale and rising content costs. Meanwhile, the competition is not sitting still and players like Amazon Prime, Hulu and potentially Google and Apple are coming.

Netflix has had a spotty financial track record as can be seen by the 10 year EPS graph below. Consequently, the multiple has also been very volatile.

Netflix P/E and EPS, Nov 2006 to Nov2016
fanga-6
Netflix forward P/E (left hand scale) and EPS (right hand scale) from Nov 2006 to Nov 2016
Source: Arnhem Investment Management, Capital IQ


This article has been prepared by Arnhem Investment Management Pty Limited ABN 17 129 606 775, AFSL 332484. It pays no regard to the specific investment objectives, financial position or particular needs of any specific recipient. You should seek your own professional advice in relation to any financial product referred to. You should also obtain the product disclosure statement relating to any financial product referred to and consider the statement before making any decision about whether to acquire the financial product. This article, including the information contained herein, may only be copied, reproduced, republished, or posted if done so in whole with original disclaimer included. © Arnhem Investment Management, 2016