Month: February 2019

Facebook Stock: Too Good to Be True

Posted on by io-fund

Facebook has financial statements that Wall Street dreams are made of. Profit margins are at 40 percent, free cash flow outperforms due to low capex, and annual growth exceeds 20 percent year-over-year. In fact, FB posted 35 percent growth this past year with lots of runway to go. Meanwhile many of its FAANG peers struggle with high capex (Netflix) and diminishing growth (Apple).

To put it simply, Facebook’s cash flow and profit margins are not only some of the best in the S&P 500, but the best in the world. The ad dollar machine has incredible inertia and advertisers simply can’t turn away.  If you are looking at the income statements, then you have every reason to go all-in on this company.

The more insidious issue at hand is that Facebook is posting meteoric growth of 35% year-over-year in the middle of a tech slump, yet the stock price does not reflect the growth. The current earnings should have caused a rally, instead Facebook is at a PE ratio of 19 while posting better growth than Netflix with a PE ratio of 150, Google at 24 and Microsoft at 23.

In fact, Facebook is growing faster than 95% of the S&P 500 with margins higher than 90% of the S&P, but Facebook stock is hovering at post-Cambridge Analytics levels. If financials and free cash flow “never lie,” then this stock should be at $240 right now (well past the stock price it was when posting $40 billion annual revenue)

In April, I published “Facebook’s Challenges are Much Bigger than Cambridge Analytica.” You’d have to go back in a time machine to remember all of the stock investors insisting Cambridge Analytica was “priced into the stock” and Facebook would be the bull story everyone was betting on. Before the Q2 Facebook stock plunge, I insisted that the GDPR was a much bigger deal than investors realized and I broke down the various ways Facebook illegally (in the EU) takes data from users and non-users outside of Facebook. (Jeffrey Gundlach, the Bond God, may have stated the stock would be hurt by regulations, but he most certainly couldn’t explain why revenue would be affected or why investors should care. Likewise, Citron said Facebook was a long-term short, but has now reversed their recommendation to a buy with a fairly sensational report about Facebook being evil, which drove the price down making it a great opportunity – again, not explaining much in the way of the business model).

The goal of this article is to break down the risk of Facebook stock for any investor who wants to know. I realize a large majority of Facebook investors may not want to know, because, well, numbers don’t lie.

First-party data vs. Third-party data

Data extraction that is done inside the apps of FB, Instagram and Whatsapp is fair use and legal. You’ve given consent to use these apps, and how they use your data, within reason, is within the realm of a first-party relationship. This is very similar to how you engage with every company who you provide information to.

For the rest of this article, we are placing those applications aside. They are not at risk. What is at risk is that Facebook collects data from millions of applications and websites it does not own. This is called third-party data because you are not a party to the customer relationship in order to collect the data. As of May 25th, the European Union made this illegal in those geos.

Take a look at your smartphone right now. Facebook is collecting data from your applications through software called Audience Network. If you have 25 apps on your phone, Facebook’s software is tracking you inside 12 of those applications, for example. (Again, we are not talking about Facebook-owned apps – these are not apps owned by Facebook).

The GDPR is concerned with tracking that occurs outside of a first-party relationship, and Facebook’s revenue will be affected when third-party data collection is cut off.

Don’t believe me? You don’t have to. Facebook has stated they expect single digit losses and they list the GDPR and data regulation as a risk in their SEC filings. The window of opportunity here, if you like to bet against Facebook (like I did and will again), is that Facebook investors are walking towards a mirage of uninterrupted returns. They, again, think Facebook’s problems are in the rear view, and that these privacy issues are within Facebook’s domain, such as FB, Instagram and Whatsapp. Perhaps more concerning, is that investors don’t have a means of determining how third-party sites (that Facebook does not own) contributes to the $55 billion in revenue.

Germany is Hot on the Trail

Despite all of the investigations on privacy this past year, regulators and the press struggle to organize the issues into one clear thesis. Are we worried that Facebook is leaking data to profiling agencies like Cambridge Analytica? Is Facebook politically motivated and censoring posts or is this a free platform for people to express their ideas? Or what about the pixel we keep hearing about? Or that Facebook should censor what teenagers post? What was that thing about George Soros and Sheryl Sandberg? It’s a complete mess.

The FTC is unlikely to understand how a software development kit (SDK) works and what kind of device signals SDKs can extract, and why that threatens privacy[1]. The FTC is still reacting to fairly insignificant data leaks and the accusations of political brainwashing (this is what the FTC is likely to fine Facebook for). It clouds the actual practices that lie beneath, and it’s unintelligible as to why Facebook investors should care about any of this.

Not to fault the FTC. Since I wrote my article in April, hundreds of journalists have covered Facebook’s privacy issues, and not one reporter has clearly described how Facebook’s software extracts data across billions of users the company doesn’t have a relationship with, and why this is illegal in the EU as of May 25th, 2018.

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Germany, however, is hot on Facebook’s trail. Last month, I read an article that spelled out exactly how and why Facebook’s business models are at risk. If you’re an investor in Facebook, you’ll want to read it and follow what Germany is doing. As the article pointed out, Facebook is collecting data off-site from millions of applications and websites it doesn’t own, and Germany most certainly doesn’t want its citizens tracked by a company in the United States with this software.

Therefore, the approaching FTC fine for political issues or fake news is a red herring. The important regulations to watch are from the European Union as their concerns will have the greatest impact on Facebook’s revenue, which I believe is unsustainable in the current regulatory environment.

What is Audience Network and the Pixel Worth?

Hopefully, Facebook bulls have stopped reading the article by this point as they definitely will not want to hear the specifics on how much revenue is generated from the third-party data that Facebook doesn’t have consent to collect. (If bulls are still reading this article, I am sure to hear about it in the comments).

A few stats:

  • Facebook’s “third-party website and application” revenue is not in their SEC filing. Google clearly discloses this and the company makes $17 billion per year off third-party sites. (I think the fact FB didn’t break out this line item is a bit misleading, but that’s up to the SEC and anyone who experienced losses from Facebook stock to determine).
  • The official statistic I have in my research is that Facebook’s software is in approximately 40% of the mobile applications on the market. That exceeds Google’s third-party reach on mobile and would be about 2 million iOS and Android apps. If you look collectively at these 2 million applications, all of the 3-4 billion smartphones in the world today will have at least 1 of these 2 million applications installed.
  • Facebook Audience Network directly monetizes over 2 billion users (off-Facebook and off-Instagram) yet collects data on approximately 3-4 billion users. The value of this exceeds the value of Instagram (which has 1 billion users).
  • The data from the software informs the entire ad machine for higher average revenue per user. (Lookalike modeling is somewhat complicated but that’s the easiest way I can describe it within this article). I wrote about lookalike modeling a few years back. You can read about it here.
  • In 2016, Facebook executives warned of ad load issues. This means that the Facebook properties of FB and IG can only handle so many ads as there is finite inventory. The majority of the revenue made past this date would have relied on the Audience Network 2 million app-reach.

I put the value of Audience Network and third-party data at $20 billion in annual revenue. This is conservative considering Google makes $17 billion and when comparing apples to apples, mobile is worth much more than desktop (mobile can extract location, text/SMS and app activity across the device). You could probably add about $5 billion in brand reputation issues, as well, if/when third-party revenue is cut off. In addition, Facebook has added about $35 billion in revenue since the warning of ad load issues [2] in 2016, and at the time, Audience Network was stating massive user growth of over 1 billion users. Assuming half of this came from the new software with a reach 3-4 billion people is, again, conservative.

Is Facebook still a great stock at $30 billion annual revenue? Yes, in fact, I think it’s priced pretty close for a company with those financials. The adjusted expectations of the market could cause a shock for a year or two, but in the long-run, a $30 billion in annual revenue with low capex is still a solid business.

Takeaway: If you’re one of my readers who is invested in Facebook, keep a close eye on the EU and don’t get a false sense of confidence if the FTC clouds the press with fines for fake news or political ads while Germany and the EU pursues the software that collects third-party data.

The timing of this is probably 2020-2021, maybe even 2022 for all of the third-party data collection to be regulated. My prediction is that 2019 will be the year the European Union cuts off the third-party software and the United States may catch up during the election year or shortly thereafter. I’m watching the EU closely for a put option now. If they go forward, I’ll enter a short position again (as I did when the GDPR went into effect end of May 2018 and was rewarded for that courage).

[1] For reference purposes, an SDK has the capability to track every activity performed on the smartphone across ten device signals and sensors. They track everything you click, say or text inside the apps, and they can track your location whether you are inside the application with the SDK or not.

[2] Ad loads refer to the limited amount of ads social media feeds can show. For instance, one social media user may see a ratio of one ad per seven posts, which restricts the number of ads Facebook can serve within its own properties of Facebook and Instagram, creating finite limitations.

Best Bet for Tech Stocks in 2019? Secular IaaS.

Posted on by io-fund

If ever there was a growth story in the next 2-3 years, especially during potential economic uncertainty, then infrastructure-as-a-service (IaaS) is it. This past week, Amazon’s IaaS offering, AWS, reported sales growth of 45% from $5.11 billion to $7.43 billion, with operating income increasing 61% to $2.18 billion up from $1.35 billion. Microsoft’s IaaS offering, Azure, was up 76 percent (same as last quarter) reaching $4 billion in revenue. Microsoft’s overall commercial cloud computing revenue which includes software grew 48 percent to $9 billion. If both companies continue on this trajectory in 2019, then Microsoft will narrow its gap from 3:1 to 2:1 with Amazon.

2018 CLOUD IAAS REVENUES
$26 billion AWS
$10 billion MS

UPDATED PROJECTED 2019 if growth continues at current rate
$16 billion MS
$30 billion AWS

Amazon, Microsoft and Google Revenue Trend Chart

Note: I’ve written quite a bit of analysis over the last few months about the duopoly between Microsoft and Amazon. To quickly summarize, my first analysis discussed the strategic acquisition of Github. My second analysis discussed the great efforts Microsoft has put into become a serious bidder for the Pentagon contract.my first analysis discussed the strategic acquisition of Github. My second analysis discussed the great efforts Microsoft has put into become a serious bidder for the Pentagon contract.

Truly, there is plenty of green field for both players. The investment window for the IaaS market is far from over as it took twelve years for the IaaS market to reach $40 billion and it will take only three years to double to $80 million – and this figure is on the low end of estimates.

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Here are a few of the projections for this space from various analysts:

  • Amazon’s Cloud Business could reach $71 billion by 2022 with a valuation of $350 Billion (source Jefferies – which tends to be more bullish on AWS than MS).
  • Microsoft’s Cloud Business Could Be Bigger Than Windows by 2021 with $26.4 billion in revenue in 2021 fiscal year vs. $20.3 billion from Windows (source: Keybanc – most estimates on MS are low, which is why there’s still a growth story here)
  • Global cloud IT market will triple between 2015 and 2020 with IaaS being the segment with the largest growth of 27% compared to SaaS growth of 18% (source: Bain and also SoftwareStrategistBlog.com)

Global IT Revenue Chart Growth source: Bain Analysis

IaaS Cloud is Secular

On a micro-level, the tech industry is in a state of transition. Mobile is hitting saturation, social media faces privacy regulations, chip makers are getting hurt in the trade war, and meanwhile, 5G, artificial intelligence, and autonomous vehicles are too nascent to see returns in the near term. This is one reason I continue to hammer on IaaS as a safe, secular bet. Companies are going through a major transition right now by transferring work loads into the cloud.

As these transitions take place, IaaS will be as essential to companies as food, gas and cigarettes are to consumers. The company that has transferred to the cloud cannot exist without budgeting for this operating expense. Meanwhile, the companies who have not transferred to the cloud risk losing on competitive advantages such as artificial intelligence, machine learning, and scaling quickly through server virtualization.

As it currently stands, IaaS is Amazon’s largest revenue segment and Microsoft’s fastest growing revenue segment – although there is plenty of addressable market left for both players. Amazon’s capex spending (which includes all capex; not AWS specific) was at $14 billion in 2018 while Microsoft reported capex of $12 billion. One major drawback is that these are not pure play IaaS stocks which introduces risk from other revenue segments. You can read my follow up analysis on 6 pure play cloud stocks here.6 pure play cloud stocks here.

Pure Play Tech Stocks to Benefit from IaaS Growth

Posted on by io-fund

This is the second article in a 2-part series. The first article “Best Bet for Growth Stocks in 2019? Secular IaaS.” can be accessed here.This is the second article in a 2-part series. The first article “Best Bet for Growth Stocks in 2019? Secular IaaS.” can be accessed here.here.

One reason for Microsoft’s success with growth rates of 76% in the last two quarters is the company’s hybrid approach. This approach helps customers keep their most sensitive data on their own servers while sending workloads that have advantages as  cloud apps, such as real-time data analytics, to Azure. This, in turn, has caused Amazon to chase Microsoft with recent efforts to improve its hybrid solutions.

The Department of Defense is a perfect example of an entity that would want to keep its most secure data with on-premise servers while leveraging the cloud for artificial intelligence and machine learning. Fortune 500 companies with substantial IP are another example of who would require on-premise security.

Understanding hybrid is key because it gives transparency into how companies with big budgets think and how they evaluate the cloud. Security is clearly a concern as on-premise servers continue to be in demand as a counterpart to the public and private cloud. Therefore, small to mid-cap companies which help to make the cloud more secure have room for near-term growth.

Additionally, the strengths and benefits of the public and private cloud include mining data more efficiently and improving accuracy and also productivity. Therefore, any small to mid-cap companies that assist with data insights or improved work flows will have room for near-term growth. For example, SalesForce is a major growth story that came from improving both the accuracy of sales targets and productivity of sales teams.

Below are a few of the more popular stocks in the cloud space. Although it is my belief some of these are overbought, and will have to prove themselves if we do go through a bear market, it most certainly doesn’t hurt to have them on the radar and to look for the right entry point.

  • Okta and Zscaler are both in cloud cybersecurity. Okta is in the identity and access management market which secures access to APIs, provides single sign-on, and prevents data breaches by protecting identity credentials through multi-factor authorization.

Zscaler is a “zero trust security architecture” that verifies identification and access. Currently, most companies use a virtual private network (VPN) as a security architecture and Zscaler improves on this by leveraging the cloud rather than physical or virtual appliances.

 Risks: One of the greatest risks to these companies is the ongoing competition in cybersecurity. Cybersecurity, in general, is a hard space to create a competitive moat.  In Okta’s case, the tech giants can duplicate the majority of these services. An acquisition, especially talent based, would be a good outcome for Okta. In Zscaler’s case, a competitor could come in and create a pricing war. I also noticed recently that insiders of Zscaler have been selling their stock – one at $2.1 million in stock and another at $4.5 million. 

  • Twilio is a common household name in the San Francisco and Silicon Valley area due to a well-run developer evangelism team. This company was heavily promoted at every developer conference over the last 10 years and you can bet that most of its revenue comes from a very loyal fan base. Twilio’s cloud products are voice-based and SMS/text messaging based, as well as other communication functions through APIs. The translation here is that you can essentially make phone calls and send text messages in the cloud, for instance, like when you call or text through Lyft’s ride share app. Developer-led technologies with strong adoption and loyalty are hard for competitors to shake. In fact, it’s one of the primary key metrics I look for when making tech stock buys.

Risk: There could be a point where artificial intelligence begins to eat into Twilio’s market share. Any manual requests by users or communication done through texting, for instance, will be replaced with highly accurate voice commands. We will speak what we want rather than type what we want. Google, Amazon and Apple are quickly building this out, and the accuracy will be nearly perfect. You can read more on my analysis about the rise of AI assistants here. Twilio has clearly had amazing returns of 335%, so if you got in early, you’re high-flying right now. 

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  • Slack is also a common household name in the San Francisco and Silicon Valley area, and the 8 million subscriber base in 2018 includes 50% global teams in Europe and Asia. Slack is a collaboration hub for work that lets you communicate across multiple team members without having to create long and confusing email threads. There are many productivity features such as sharing files, making calls in-app, and having separate work spaces and threads. Programmers were especially fond of Slack in the beginning and now it’s caught fire across all departments. In fact, I’m currently logged into Slack as I type this communicating with my team.

Risk: Slack filed for an IPO this week, actually. The company is choosing to do a direct listing which introduces risk as the founders and VCs don’t have to wait to cash out of the shares they sell. For obvious reasons, it’s better to have the founding team be in the same sink-or-swim boat as its stock investors (if you don’t believe your company will have returns over the next 6 months, why should I?). Direct listings for buzzy tech IPOs are relatively new, and I’m still a bit weary of them. That point aside, Slack does have serious potential for growth.

  • Veeva is disrupting the pharmaceutical and life sciences industries by assisting with sales and operations while meeting health industry regulations. Veeva has a history of being an outlier with no competition to speak of, and is one of the rare companies that was already profitable when it made its public offering in 2013. Today, Veeva is close to securing the fifth spot for a cloud software company to reach $1 billion in revenue. If Veeva does hit TAM, an exit strategy could be a solid acquisition for deep pocketed Walgreens, CVS or Amazon who has big ambitions to get into pharmaceuticals.

Risk: The major risk to Veeva is the current valuation and total addressable market as they are targeting a specific industry. With a PE ratio hovering around 100 and price to sales of 19, this stock is priced to perfection. Quite a few tech stocks that came of age during the bull streak (for Veeva this was 2013) may have an awakening ahead of them. If there is a good entry point, Veeva’s revenue growth will continue with analysts projecting revenue to “reach just over $2 billion by fiscal 2024.” As an individual investor, I have to make sure the first $1 billion in revenue is priced right with a fair valuation or the second billion in revenue (projected to be five years from now) won’t matter for my returns. 

  • Workday is a cloud platform that increases productivity across HR and finance. This is done through machine learning, analytics and real-time reporting through a cloud platform. Products include financial management and human capital management. Workday is a large cap company and is ranked as the 27th largest internet company by revenue and is one of the first five cloud software companies to achieve $1 billion in revenue.

Risks: Similar to Veeva, Workday came of age during a raging bull market in 2012 and its valuations reflect this. It saw an 83% increase the day of its public filing and went on a tear in 2017/2018. The 52-week low is $107 and its current price is $186. With a price to sales ratio of 15, and no P/E ratio to speak of, I think we will see a better entry point than where it currently stands.