Snap has a rock bottom valuation of 4 P/S and the stock has not traded here in the entirety of its public market history.
In fact, this is nearly 50% lower than the March 2020 Covid low when it traded at 7 P/S. The Covid March low matches the previous low from Q4 2018.
I believe Snap is oversold and we hope to capture this opportunity.
Q2 2022 Earnings
As long as the FED is raising rates, then the primary reason to close a position will be due to a company’s declining cash profile and/or declining margins. Snap provided a shocking report on the bottom line in Q2 and we had no choice but to exit and regroup.
We covered this briefly here when we said: “The other negative to Snap’s report included more losses on the bottom line. Free cash flow is at ($147) million in the most recent quarter. Adjusted EBITDA fell from +$117 million to +$7 million. GAAP net losses went from ($152) million to ($422) million.”
Some of this is driven by the company’s generous stock-based compensation which totaled $1.2 billion over the trailing twelve months, or about $300 million per quarter. That’s 50% of the company’s gross profit.
There was a $500 million stock repurchase announcement in July with 3% of outstanding shares purchased as of August 31. This helps to offset SBC dilution.
However, there is new information regarding Snap’s bottom line as of August 31 and September 6th:
In August, Snap announced a 20% reduction in work force and will reduce operating expenses through restructuring its products to cut back on Other Bets, such as drones and Originals.
This will result in a $500 million operating expense reduction relative to Q2 2022 which includes $50 million from content costs and $450 million from personnel and opex cost reductions. Of the total $110 to $175 million in transition costs, the majority will be reflected in Q3 2022 with $95 million to $135 million incurred as an adjusted operating expense.
Snap stated this will result in “adjusted EBITDA and positive free cash flow at current revenue levels” which will “drive meaningful operating leverage when revenue growth accelerates.”
One week later, there was an additional leaked memo on September 6th where the CEO stated his 2023 goals are for $6 billion in revenue, adjusted EBITDA above $1.5B and free cash flow above $1 billion. This would represent 20% growth on the top line. The memo also pointed toward 30% growth in DAU to 450M, up from the 352M the company reported last quarter.
My interpretation is that DAU will outpace revenue growth because DAU growth will come from Rest of World where users are monetized at a lower rate than North America and Europe. This has been the trend over the past year in Snap’s key metrics.
Of the $6 billion in estimated revenue for 2023, Snapchat+ will contribute $350 million in revenue next year. The premium subscription currently has 1 million subscribers and is expected to reach 4 million by the end of 2022.
Following the announcement, analyst Mark Mahaney stated he is modeling an EBITDA margin of 17% for FY2023 up from 9% in FY2022.
“Evercore ISI analyst Mark Mahaney raised the firm's price target on Snap to $17 from $14 and keeps an In Line rating on the shares as he is "modestly increasing" his FY22-FY23 revenue estimates and also raising his EBITDA estimates following the company's intra-quarter update on August 31. He is now modeling a meaningful EBITDA margin expansion to 17% next year from his estimate of 9% margin in FY22, driven by cost reduction initiatives and scaling of the business, Mahaney noted.”
Morgan Stanley is in line with Mark Mahaney with a 9% margin this year to $670 million and $919 million for FY2023.
“Morgan Stanley analyst Brian Nowak raised the firm's price target on Snap to $10 from $8 following Snap's recent better than expected August ad update and announcement of a $500M cost reduction plan. Nowak has raised his FY22 and FY23 revenue estimates by 9% and EBITDA forecasts to $670M and $919M, respectively, but keeps an Underweight rating citing low near-term visibility and still-high execution risk.”
That would put Snap back on track for a H2 profile similar to 2021 for adjusted EBITDA of about $118 million in Q3 and $229 million in Q4. I’m basing this off 2021 when Q4 was roughly 2X the profitability of Q3.
Perhaps most importantly, if Snap does achieve the $6 billion, then Mark Mahaney is modeling $1 billion in adjusted EBITDA. In 2021, Snap had adjusted EBITDA of $617 million. If we go with $1 billion conservatively and $1.5 billion for a high estimate per the leaked memo, then this will be 1.5X-2X adjusted EBITDA in 2023 compared to 2021.
Overall, there has been a rapid turnaround in 30-day analyst EPS revisions that show Snap as the leading stock in the tech universe for 72K% change on the bottom line for FY2022.
What this means is that instead of Snap reporting ($0.09) EPS, the company is now expected to report $0.05 EPS.
The estimates for FY2023 are at $0.33 EPS, up from $0.16 EPS for FY2023 consensus before the announcement.
Regarding free cash flow, to put this in perspective, the company had negative FCF of negative ($147) million last quarter. The company will now be positive $1 billion in FCF for FY2023 compared to FCF of $126 million in FY2021. That’s a 8X improvement in two years. Assuming this happens, Snap is guiding for a remarkable turnaround in the cash profile of the company — which is the reason we are attracted to the stock once again.
Notably, it was not only Netflix’s entry into CTV ads that made the stock attractive in July/August, but the improving free cash flow guide from 2022 to 2023.
When the headcount reduction was announced, the CEO also disclosed that Snap was losing two of its top ad executives to Netflix. This is seen as a negative yet we are also keen on the Netflix opportunity and imagine the executives see what we see, which is global streaming juggernaut + CTV ads = (likely) a new trajectory.
The CTV ad opportunity is our top trend in media but we also like Snap at this valuation (both things are true). Snap’s audience is especially interesting for advertisers, but ultimately, product takes a back seat when there is a hawkish Fed. As we are seeing with MongoDB, the cash margin is too critical right now to move from a positive FCF to a negative FCF.
Revenue Growth and DAUs:
In a rising rate environment where cash is rerated with each Fed announcement, the bottom line is arguably more important than the top line (within reason). If Snap had not provided a significant improvement to the bottom line, then we would not be re-evaluating the stock.
Regarding the top line, Snap stated in the Investor Update on August 31st that “quarter to date” they are tracking 8% revenue growth for Q3.
What the CEO said in the September 6th memo regarding inflation and how he looks at revenue growth is important so I’ve pasted it verbatim here:
“In this inflationary environment, we need to adjust the way that we think about our revenue growth. With the U.S. Consumer Price Index at 8.5% growth year-over-year in July, and our Q3 QTD nominal revenue growth rate disclosed on August 31st at 8%, our revenue is growing -0.5% in real terms.
In short, if we are growing revenue below the rate of inflation, our business is actually shrinking. Meta’s revenue, in real terms, shrunk by nearly 10% in Q2, while our Q2 revenue grew approximately 4% in real terms. As we think about our revenue goals for next year, we need to consider the rate of inflation and factor it into our ambitions.
Our goal for 2023 is $6 billion in revenue, of which we will generate $5.65 billion of advertising revenue, and $350 million of revenue from Snapchat+.
Assuming that $5.65 billion of advertising revenue represents approximately 20% growth year-over-year, and assuming an 8% inflation rate, we would be generating approximately 12% year-over-year inflation-adjusted advertising revenue growth.
That’s a far cry from the 50%+ year-over-year average annual revenue growth we’ve generated over the past five years, but we believe it’s an appropriate goal in this environment. If we can generate $6 billion in revenue in 2023, we should be able to generate at least $1.5 billion in Adj. EBITDA and $1 billion of free cash flow.”
I believe the market has not moved much on this news because it requires a Q3 report and a Q4 guide to show if there’s any near-term acceleration from the paltry 8% growth. Essentially, the market will be looking for a sign that September was stronger than August. There is risk it September won’t be stronger than August and/or Q4 won’t be stronger than Q3, yet I/O Fund is subjectively comfortable with the risk as I believe the 4 P/S valuation is pricing in the worst case scenario.
We need DAU to remain strong, but judging by the CEO’s comments, that shouldn’t be a problem as the company provided the forecast of 35% growth over the next 18 months when the CEO said in the memo the goal was to: “Increase Daily Active Users to 450 million in Q4 ’23.” This is up from 352 million DAU in Q2.
Risks:
Snap’s management has struggled to provide accurate guidance in H2 2021 and H1 2022. This twelve-month period has seen (40%) drops in price and +58% gains in price in one day.
This is a volatile stock particularly because management’s guidance has been wrong. We have to take that into consideration when relying on management’s guidance for H2 2022 and FY2023. Morgan Stanley called it “execution risk” when referring to CEO Spiegel’s inability to guide correctly and navigate the many headwinds his company faces.
However, institutional analysts agree with the bottom line and the improvements that $500 million reduction in opex will lead to, including those that are underweight, so that’s helpful. The 8% revenue growth seems reasonable and not an over-promise compared to the 50% revenue growth that had been provided in 2021.
There is a risk that DAU misses as the 35% growth over 18 months is a strong guide.
The stock based compensation is high and viewed as a negative in this macro environment. This weighs on GAAP operating margin.
Conclusion:
Our decision to look for an entry is based on the stronger bottom line, the anticipated full 8X growth in FCF over two years coupled with a rock bottom valuation.
“It’s the Economy, Stupid,” is a famous line about focusing a political campaign on one central focus. It was used by Clinton during a recession when George Bush was out of touch on what Americans were experiencing during 1992.
Management teams over the last 24 hours are saying it’s the economy and it’s out of our control. I used that headline because there is one central focus right now and its probably time to set nuances and other explanations aside.
Today, it was announced that GDP declined for two quarters in a row, which technically puts us in a recession. This happened around the same time that three management teams said ad spend on their platforms was paused (Meta, Snap last week, Roku). Not only did ad spend halt suddenly in Q2 but it has not gotten better one month into the third quarter.
What do Roku, Snap and Shopify have in common? They are ad-tech and e-commerce related but otherwise there’s not much in common product-wise. Snap and Roku have little to no overlap in advertisers or audience being mobile vs CTV ads and Roku has zero effects from Apple’s iOS changes. In fact, one thing that bothers me about Roku’s report is we now know that Snap’s Q3 miss was not due to the Ukraine war or Apple’s IDFA changes. We also know that Shopify’s margins are not worsening due to the fulfillment center or something management did. We also now know that tough Q2 Covid comps are not the issue or else the guidance would have been strong.
The common thread across these management teams is that the economy is greatly affecting them and there’s no way to manage this except to cut headcount and muscle through it. What they are also saying is that a recovery is not on the horizon at this time.
Roku actually had surprising account growth of 1.8 million — higher than Q2 of last year. Snap also grew 18% despite tough audience growth comps. Shopify believes their Merchant growth in the second half will accelerate from the first half. Yet, this is not translating to more revenue, and in all cases, is translating to more losses on the bottom line.
This is because we are in a recession.
There’s no reason to discuss the nuances of the products, the management teams, or too many details if we are in the midst of a fierce, macro headwind that is not letting up. We know macro is challenging but the headlines want to make it about the actual company.
“Tiktok is taking too much market share.” Well, Snap had strong user growth of 18% and this will be the highest across all media by the time the reports come in. In a normal economy, dollars follow eyeballs. “Roku faces too much competition” – well, the company added 1.8 million active accounts in a quarter when juggernaut Netflix was negative roughly 1 million this quarter. Netflix’s guide next quarter is for 1 million, so Roku’s Q2 is two times Netflix’s Q3 guide right now. All around, the evidence is not there it’s a competitive issue.
I’m not going to elaborate on product because it’s in the rear seat right now and the economy is in the driver’s seat.
Here’s the question — will these three companies be the only ones to discuss broad economic headwinds that they’re not able to overcome evidenced by flat to negative revenue growth and worsening margins?
Our analysis on SHOP and ROKU is fairly similar which is that Q2 was a miss on the top line and management in both cases said Q3 is faring worse than Q2 in terms of revenue at this time. In addition to the top line issues, the losses on the bottom line are increasing.
I’ve pulled out quotes about what was said in terms of a potential recovery (it’s not going to be a Q3 rebound and Q4 is in question). It’s easy to fall into black and white thinking (one stock is bad because it’s down right now and another stock is good because it’s up right now), but I think something broader is going on.
The earnings calls over the past 24 hours have been nearly identical in tone and statements:
Here is Meta from Q2 call:
“That said, we seem to have entered an economic downturn that will have a broad impact on the digital advertising business. And it's always hard to predict how deep or how long these cycles will be, but I'd say that the situation seems worse than it did a quarter ago.”but I'd say that the situation seems worse than it did a quarter ago.”
Meta also said this:
“Now of course, the third challenge that we're facing here is the macro economy. And we can't control the timing of when things will bounce back, but I'll note that periods like this are when marketers reevaluate their budgets and are even more focused on finding the highest-performing advertising. And in the last recession, we invested in our ads business through the downturn and came out stronger on the other side, and I'm focused on making sure that we do the same today.”but I'll note that periods like this are when marketers reevaluate their budgets and are even more focused on finding the highest-performing advertising. And in the last recession, we invested in our ads business through the downturn and came out stronger on the other side, and I'm focused on making sure that we do the same today.”
I was encouraged by Big Tech’s earnings but now it’s looking like Google and Microsoft are simply more defensible.
With that said, we are likely to reconsider quite a few of our positions — not because a product is weak or a conviction of ours is gone for good. It’s because management teams across the board are saying that Q3 is worse than Q2 right now and as tech investors we’re not going to ignore that message.
Shopify:
I want to pull out only a few numbers for easy comparison:
This means Shopify’s revenue is essentially flat across a six-month period. There is year-over-year growth, but sequentially, it’s not moving much.
Here are the operating margins:
The adjusted operating loss for the second quarter of 2022 was $41.8 million, or 3% of revenue, compared with adjusted operating income of $236.8 million or 21% of revenue in the second quarter of 2021.
I was earnestly hoping for a bottom on these margins, but management said the opposite:
“Factoring in these expectations, we expect to generate an adjusted operating loss for the second half of 2022 with Q3 adjusted operating loss, excluding severance costs expected to materially increase over Q2.”we expect to generate an adjusted operating loss for the second half of 2022 with Q3 adjusted operating loss, excluding severance costs expected to materially increase over Q2.”
“As we significantly decelerate operating expense growth into Q4 and with Q4's higher seasonal GMV and revenue, we expect an adjusted operating loss in Q4 that is significantly smaller than in Q3, but larger than in Q2.”, we expect an adjusted operating loss in Q4 that is significantly smaller than in Q3, but larger than in Q2.”
Net margin is a bit of a mess for Shopify because they have investments in Affirm, Global-E and Slivergate. The unrealized losses are at $1.2 billion this quarter and were at $1.5 billion last quarter. However, adjusted net losses were at $38.5 million compared to income of $285 million last quarter. The company missed on EPS with expected adjusted EPS of $0.03 versus ($0.03) EPS reported.
Stock Based Compensation increased from $151 million in H1 2021 to $257 million in H1 2022. The company stated that SBC plus payroll taxes is at $750 million for the full year.
In the call, an analyst asked if the company was planning on exceeding the $1 billion investment that was already discussed in regard to Shopify Fulfillment Network and the CFO said there are no plans to expand that amount at this time.
Comments on the Economy:
“While the macro environment exited tough COVID year-over-year comps in mid-Q2, consumer spend on services and in-person shopping remained high and persistent inflation at 40-year highs dampened online sales globally. In the face of rapidly escalating prices for essential goods and energy, consumers have been favoring discount retailers and reducing their spend on other goods categories.”consumers have been favoring discount retailers and reducing their spend on other goods categories.”
“Consistent with this, we are taking actions to recalibrate our investment spending to build for long-term success. We are keenly aware of what's happening around us. We anticipate that inflation and the continued softness in consumer spending on goods will persist through the remainder of the year. Throughout the organization, our teams are mindful of the macro environment and have been rigorously evaluating and adjusting our spending priorities. And we have taken this time to also make adjustments to ensure we have an efficient, productive and highly motivated team.”We anticipate that inflation and the continued softness in consumer spending on goods will persist through the remainder of the year. Throughout the organization, our teams are mindful of the macro environment and have been rigorously evaluating and adjusting our spending priorities. And we have taken this time to also make adjustments to ensure we have an efficient, productive and highly motivated team.”
“We expect 2022 will be different, more of a transition year in which e-commerce is largely reset to the pre-COVID trend line and is now pressured by persistent high inflation.”more of a transition year in which e-commerce is largely reset to the pre-COVID trend line and is now pressured by persistent high inflation.”
“Our financial outlook for the rest of 2022, which includes the impact of Deliverr and our new compensation system, assumes that higher inflation will persist for the foreseeable future and, combined with rising interest rates, will pressure consumers' wallets for purchases of goods.”assumes that higher inflation will persist for the foreseeable future and, combined with rising interest rates, will pressure consumers' wallets for purchases of goods.”
Note: Microsoft said FX headwinds are expected to ease Jan-June of next year.
Roku:
Roku’s current quarter came in strong all things considered. The problem is the Q3 guide is a substantial miss of $200 million with management guiding for 3% growth to $700 million compared to $902 million expected.
This is surprising given the company had secured $500 million last year and secured $1 billion in the current upfront season in committed ad spend. What Roku calls the scatter market, or ad spend that can be turned on/off, is what is weighing on the current guide.
The company missed on gross profit for a guide of $395 million and reported gross profit of $355 million.
The company reported operating losses of ($110.5) million and net income losses of ($112) million.
Adjusted EBITDA also went negative to ($12.1) million so that’s weighing on the report. The guide is for ($190) million in net losses and Adjusted EBITDA of ($75) million.
So, not only has Roku firmly been in negative territory on their margins but these losses are increasing for Q3. The player gross margin weighs on this, which we knew would happen and this is not a deterrent as we want the audience growth that has come from keeping player prices low. However, the slowing revenue growth puts pressure on these margins and that’s not something management prepped investors for.
Roku also pulled full year guidance which I can’t recall has happened in the past.
The first analyst had the same question I have – where did this dramatic pullback in ad spend come from?
Cory CarpenterCory Carpenter
Hey, thanks for the question. Hoping you could expand a bit on what you're seeing in the ad market. It sounds like you saw a pretty dramatic, broad based pullback, but any color on when you started to see the market turn or what verticals perhaps were most impacted would be helpful. Thank you.It sounds like you saw a pretty dramatic, broad based pullback, but any color on when you started to see the market turn or what verticals perhaps were most impacted would be helpful. Thank you.
Anthony WoodAnthony Wood
Hey Cory. This is Anthony, I'll take that and then turn it over to Steve to add some more color. So, at a high level, of course we are seeing advertisers worried about a possible recession, and so we're seeing them reduce their spend in places that are easy for them to turn off and turn back on. So for example, the scatter market which is, an important source of ad revenue for Roku is an easy market for advertisers to turn off and turn back on, and so that's one of the big factors we're seeing from the macroeconomic environment and that's impacting the growth rate in the short term.So, at a high level, of course we are seeing advertisers worried about a possible recession, and so we're seeing them reduce their spend in places that are easy for them to turn off and turn back on. So for example, the scatter market which is, an important source of ad revenue for Roku is an easy market for advertisers to turn off and turn back on, and so that's one of the big factors we're seeing from the macroeconomic environment and that's impacting the growth rate in the short term.
Steven LoudenSteven Louden
Yeah. Just adding some color on the advertiser pullback in the scatter market overall. Certainly that was a significant factor in the quarter in progress as the quarter went on, but an advertiser perception survey noted that almost half of advertisers in Q2 made pauses on their ad TV spend on TV streaming, which was similar to the amount that passed on digital video and traditional TV.but an advertiser perception survey noted that almost half of advertisers in Q2 made pauses on their ad TV spend on TV streaming, which was similar to the amount that passed on digital video and traditional TV.
So this is definitely a broad scale, significant pullback that that happened within the quarter itself and one that's pretty similar to other historical times of a degree of uncertainty or advertisers worried about impending economic downturns. For example, at the start of the pandemic, this is very similar to when a lot of advertisers paused or greatly detailed their spend and then once they got a better handle on which way the world was going, they added those budgets back.So this is definitely a broad scale, significant pullback that that happened within the quarter itself and one that's pretty similar to other historical times of a degree of uncertainty or advertisers worried about impending economic downturns. For example, at the start of the pandemic, this is very similar to when a lot of advertisers paused or greatly detailed their spend and then once they got a better handle on which way the world was going, they added those budgets back.
Additional Comments on the Economy:
“In Q2, we saw a significant slowdown in TV advertising spend due to the macroeconomic environment, which is pressuring Roku's platform business growth in the short term.”
“The current economic state is causing TV advertisers to pause and reconsider spend, which is painful in the short term, but it also causes them to seek greater efficiency and ROI, which will benefit Roku in the mid and long term. This reminds us of when advertisers pause spend during the 2008 recession, but it became a catalyst that accelerated the shift of ad spend from print publishing to digital.”The current economic state is causing TV advertisers to pause and reconsider spend, which is painful in the short term, but it also causes them to seek greater efficiency and ROI, which will benefit Roku in the mid and long term. This reminds us of when advertisers pause spend during the 2008 recession, but it became a catalyst that accelerated the shift of ad spend from print publishing to digital.”
“Going forward, we expect reduced consumer discretionary spend to pressure Roku TV and player unit sets.”
“As we look ahead to the third quarter, we are facing an increasingly difficult and uncertain environment. Recessionary fear, inflationary pressures, rising interest rates and ongoing supply chain issues will continue to impact both consumers and advertisers. We believe consumers are going to continue to moderate discretionary spend and the ad scatter market will remain pressure.”We believe consumers are going to continue to moderate discretionary spend and the ad scatter market will remain pressure.”
“Our player margins will continue to be pressured as we insulate consumers from cost increases caused by ongoing headwinds from supply chain disruptions and inflationary pressures.”
“Given the volatility and uncertainty of the current macroeconomic environment, we are withdrawing our previous full year revenue growth outlook for 2022. Our outlook has always been based on our assessments of both our business and the broader macroeconomic environment and at this point we feel that there is too much macro uncertainty for us to provide a full year outlook.”
Here is a quote from Snap’s earnings report where the company said the same as Roku and also why digital ads can often be more forward-looking than other areas that are slower to respond to economic pressures:
“You alluded to this in your question in terms of it making — when it turns — it's easier to turn on. It's definitely easier to turn off. So as companies are reevaluating their priorities and their cost structure, they are looking at things like digital ad spend. It's easy to pause, reevaluate and move forward there. So those same tools and services that make it easy to ramp up, make it easy to ramp down. And we know that our advertising partners are facing significant uncertainty, and we talked about that a few times. So I'll focus on the others.”So as companies are reevaluating their priorities and their cost structure, they are looking at things like digital ad spend. It's easy to pause, reevaluate and move forward there. So those same tools and services that make it easy to ramp up, make it easy to ramp down. And we know that our advertising partners are facing significant uncertainty, and we talked about that a few times. So I'll focus on the others.”
This is a longer quote that has increasing importance in terms of when the slowdown occurred.
“And then beginning — later in Q4 and certainly through the first half of this year, we've seen macroeconomic challenges have built. While there have been lingering supply chain and labor supply issues impacting certain segments that began during the pandemic, more recently, we've seen the impact of persistently high inflation, then rising interest rates and rising geopolitical risks associated with the war in Ukraine. Those macro headwinds have disrupted many of the industry segments that have been most critical to the growing demand for advertising solutions over prior years.
We're seeing these various headwinds put pressure on the earnings of a wide variety of companies, and this is directly impacting the demand for advertising. Specifically, advertising spending, in particular, auction-driven direct response advertising is among the very few line items in a company's cost structure that they can reduce immediately in response to pressure on their top line or their input costs. As a result, as many industries and verticals have come under top line or input cost pressure, advertising spending has been amongst the first areas impacted.”We're seeing these various headwinds put pressure on the earnings of a wide variety of companies, and this is directly impacting the demand for advertising. Specifically, advertising spending, in particular, auction-driven direct response advertising is among the very few line items in a company's cost structure that they can reduce immediately in response to pressure on their top line or their input costs. As a result, as many industries and verticals have come under top line or input cost pressure, advertising spending has been amongst the first areas impacted.”
If you recall, Snap also reported a flat Q3 along with Meta and now Roku – with a specific mention of the slowdown happening in the last 90 days.
Conclusion:
I wanted to connect the dots here because two days ago, it looked like Snap was a turbulent product with a management team that had become hard to rely upon.
If you recall, analysts had slated a Q3 rebound and Q4 rebound for many ad-tech stocks while being wary of Snap’s ability to overcome Apple’s changes. Shopify was similar to ad-tech with consensus of 26% growth for Q3 and 29% growth for Q4. Those estimates have been lowered since this morning.
Some investors will want to make this a Snap problem, a Roku problem, a Shopify problem and a Meta problem (side note: Meta might have a product specific problem ….).
You can see what I’m getting at – how many companies does it take to have slowing growth before it stops being about the company and instead is seen as a problem with the economy? The issue with the current earnings reports is this was not slowing growth; it was halted growth.I very much want this to be an insulated case but there’s at least a 50/50 chance that the abrupt pause in digital ad spend will translate to more companies and industries as we move along.
Note from Knox: If we continue to receive broad confirmation of the developing thesis, expect us to strategically raise cash while in the current bounce. I’ve been providing daily levels and targets, which we will continue to use if we see a larger bear market rally as the most likely outcome over the coming weeks-months.
Positioning changes we are considering:
Reducing our Roku position to 3% range and we will buy back in when we see evidence of a rebound
It’s likely we close Twilio before earnings
It’s likely we close Asana before earnings
We may close Magnite as it’s tough to foresee this company doing well given the issues across ad spend
Across cloud, Snowflake has exposure to discretionary spending and we might reduce our position here. We would likely wait for Datadog to come in although SNOW had more exposure last quarter
We will put this money into the companies that show strength given tough macro and we will revisit our thesis on any closed or heavily trimmed positions once the economy bounces back. I’m aware it’s natural to want to make this about a company or a product or “Covid winners,” but we are not in consensus with this.
To complicate matters, the market is forward looking so Knox’s technicals are likely to front run fundamentals on a recovery. This means the market will start buying again before management teams provide strong earnings reports.
We want to be very careful with this decision and will wait for technical triggers to act. If we do get the signal to raise cash, we will buy/re-enter when a renewed uptrend begins, and our hedge signal is flashing all-clear.
We saw with Shopify that this environment is not going to allow management slide by and not provide formal guidance. Shopify has not provided guidance for some time yet was penalized last quarter (23%) for continuing this pattern.
Snap did provide this in their investment letter:
“As we look toward Q3, we are pleased with the momentum we have observed in our community, and we estimate that DAU will be approximately 360 million in Q3. Thus far in Q3, revenue is approximately flat on a year-over-year basis.”
The story has changed since we first entered the stock, and that’s the #1 reason to close a position. You may recall, Snap was free cash flow positive last year +$223 million FCF in FY2021 and had provided 50% revenue guidance for the next few years during their Analyst Day. Q4 earnings was a blowout in terms of positive surprise to the upside – the stock gained 58% in one day. But Q1 was a slight disappointment with some complicated earnings call discussions over ads being paused during the Ukraine situation. You can read my write-up here. That Q1 earnings report caused us to cut the position in half from 6% to 3%. Due to Snap losing 50% of its value since Q1 earnings, that puts our position at roughly 1.5% when we close it tomorrow.
If this was due to tough Q2 comps, then it could have been forgiven if the company provided a strong guide. The guide was anything but strong. When Snap opens tomorrow, it will join other ad-tech companies such as Unity with its YTD losses. The goal is to find which one of these ad-tech stocks will lead us out of this rout and it’s not going to be Snap anytime soon. Unity now looks comparatively better, which is why earnings season requires flexibility as new information comes in daily.
The more important topic discussed on the call was that Snap stated they lack visibility because advertisers can turn on/off ads with very little friction. This affected other ad-tech stocks because investors are concerned it means Q3 will be weaker than expected on ad spend.
The other negative to Snap’s report included more losses on the bottom line. Free cash flow is at ($147) million in the most recent quarter. Adjusted EBITDA fell from +$117 million to +$7 million. GAAP net losses went from ($152) million to ($422) million.
The positive was Snap’s audience growth. The company is likely to report the highest audience growth this quarter across all media – including streaming media and social media — with 18% growth in DAUs to 347 million. The guide for Q3 on DAUs was also strong at 17.6% growth from 306M to 360M DAUs.
We are laser focused on finding the ad-tech stocks that can emerge as leaders right now and our plan is to move quickly to build those positions and consequently cut any that under perform. You can expect to see Knox’s Sell Alert come through sometime soon.
Eyeing Netflix: Q2 Earnings
Netflix is trading at a 10-year historic low valuation, which means this is an opportune time to discuss the pros and cons of this stock should there be upside potential.
The lagging discussion on Netflix is that there was a subscriber decline in Q1 of 200,000, excluding Russia and a subscriber decline of 970,000 in Q2. While critics believe this is due to saturation, it’s much more likely the decline is coming from a pull forward due to Covid as all media stocks – both streaming and social media – demonstrated outsized audience growth through Q2 2021. Therefore, Netflix is lapping some tough quarters for audience growth comps.
Netflix management was clear that this quarter was “less bad” as they hinted the company is not exactly celebrating the results. The company technically returns to growth next quarter for subscribers with a guide of 1 million, yet this is a marked decline from the 4.4 million in the year ago quarter. As discussed, due to the overall impact across many media stocks from shelter-in-place, it would be hasty to believe there’s something inherently wrong with an individual company when the entire media industry was affected. It’s better to hold those conclusions until H2 2022 through H1 2023 after giving it a full year after tough Covid comps have cleared. Ultimately, media is very seasonal, and we should have a nice glimpse as to which companies emerge stronger by Q4 2022, as this is the strongest quarter seasonally.
With that said, there is already evidence that Netflix is taking more market share than its peers. In fact, Nielsen is raising Netflix’s market share for engagement to 7.7% from 6.6%, which puts Netflix in the lead over any other competing subscription service. This is due to high-quality content such as Stranger Things 4, which reported 1.3 billion hours streamed.
Advertising is not a 1:1 on users, rather Netflix’s revenue growth following the ad tier will be determined by engagement. Today, Netflix has more engagement with 220 million users than YouTube with 2 billion users. That’s key to the equation here.
Advertisers are also likely to pay a high premium for Netflix’s Hollywood-level content. It’s not only the 100 million people sharing passwords that illustrates what the uptake could be for a lower-priced tier, it’s also the high level of engagement the company’s content garners that could make for a nice equation for industry-leading ARPU due to demand from exclusive advertisers coupled with the supply, or premium content, that Netflix offers.
Due to FX headwinds, Netflix missed on revenue in the most recent quarter at 9% revenue growth compared to 9.7% expected. However, on a constant currency basis, revenue growth was 13%. The same was true for Netflix’s guide, it was a miss due to FX headwind at 4.7% for the upcoming Q3 quarter, yet on a constant currency basis, it is a 12% guide on revenue and a beat in that regard.
Not surprisingly, the operating margin was also affected by the strong dollar at 20% in the current quarter and 16% for Q3. The strong dollar led to a slightly better EPS as Netflix saw a $305 million unrealized gain from F/X remeasurement on Euro debt.
The most important line item for Netflix is the company’s cash flow. Looking back, this has been troublesome for Netflix as the company lost $3.3 billion in cash in 2019 as it built up its original content pipeline. However, the company is on an entirely new trajectory with $1 billion in free cash flow expected this year and “substantial” free cash flow in 2023, per Netflix management.
The new and improved trajectory in free cash flow won’t change the company’s debt levels anytime soon. Netflix is firmly setting expectations for $10 to $15 billion in debt into the foreseeable future. This is necessary to continue to hold its place as the top media company in terms of revenue and engagement. Gross debt stands at $14.3 billion, when accounting for $5.8 billion in cash, net debt is at $8.5 billion. The company has been able to improve its cash content spend-to-content amortization ratio from 1.6X to 1.4X in 2021 and an expected 1.2-1.3X in 2022.
Netflix has a few new paths to monetization and to re-accelerate subscriber growth. The company is rolling out a new password-sharing plan and is also now partnered with Microsoft on ads to roll out in 2023. More time than not, cross-selling results in higher revenue where someone who would normally churn can now be monetized through ads. Likewise, viewers who can try out Netflix may decide to upgrade to remove ads. Ultimately, the move towards ads also helps Netflix to be more recession-proof in the event households decide to cut costs.
Risks:
We do not see the current soft subscriber numbers as a sign of saturation. Netflix has risen in market share over the past year. Instead, soft subscriber numbers are a result of the pull forward nearly all media companies experienced from Covid. We fully expect Netflix will return to normal subscriber growth due to the catalysts listed above.
Instead, the primary risk for Netflix is its debt in a rising rate environment. This may depress the company’s valuation more than its ad-tech peers who have strong cash flow and little to no debt during tougher macro conditions. Netflix cannot temper this debt if it intends to compete against other subscription streaming services and also the many broadcast networks that have migrated to streaming.
There is also execution risk with a pivot from subscription-only to also including the ad tier. We view the Netflix management team as perhaps the most capable in the industry of pulling off this pivot as they have consistently broken ground in areas much more challenging than introducing ads. In addition to this, CTV ads can monetize at $40 ARPU and we believe Netflix content will set a new record on ARPU. With that said, even if the execution risk is lower than it would be with other management teams, Netflix is likely to fetch a higher valuation after its proven the ad tier will be successful – ETA of H2 2023.
What to Watch: Price Action for Netflix Stock
By: Knox Ridley
The big picture question to ask is – has NFLX put in THE bottom? There are 3 scenarios that could unfold from the current price range, that would help us manage risk around this question:
Red: If NFLX breaks below $185, the odds favor one more low, which would be targeting the $147-$115 region. If this happens, it greatly reduces the odds that NFLX will see new highs in the next growth cycle.
Orange: The current swing up breaks above $250. If this happens, the odds favor a push into the $340-$405 region. If this scenario is playing out, we would see the uptrend stall in this region in a bear market rally. The same lower price targets would hold in this scenario.
Green: If any renewed uptrend can break above $405, the odds will shift towards a move to all-time highs.
Netflix bottomed in May while the rest of the market went on to make a new low. More times than not, stocks that bottom first, tend to lead into the next uptrend. This is a show of strength worth monitoring.
We only have 3 waves down from the 2021 high. This may not seem significant, but it is. If this 3-wave move down turns into 5 waves down (red scenario), the odds that we push deep into the orange range are low before the next leg down.
The Relative Strength Index (RSI) has reclaimed a significant level. Note the blue arrow on the RSI around 57. This was the spot where price topped just before the waterfall moment happened in this bear market. The fact that the recent push higher has reclaimed this level is a show of strength and an early sign that green/orange is likely playing out.
Conclusion: The odds favor a push into the $340-$405 region. As long as the next dip holds $185, the more aggressive play would be to buy into that dip. A safer play would be to wait for the breakout above $250.
Please Note: We have not forgotten about Unity as perhaps a better choice to re-allocate Snap’s position. The stock needs to breakout first.
Apple Inc. (NASDAQ:AAPL) became the most valuable company in the world through creating and dominating the smart phone/mobile microtrend. As the majority of the global community went from zero smart phones to it becoming a necessity in their lives, Apple became the most valuable company in the world. However, like all trends, eventually it reaches the point of saturation. Instead of hypergrowth, we see competitors fight over existing customers on lower cost goods as revenue growth moves into a more consistent yet slower rate of change.
Apple epitomizes what it means to be both a good value stock and a good tech stock with its strong margins, outsized cash flows, stable balance sheet, and a loyal base of customers supporting the brand.
Apple has been very consistent with its margins and cash flows. The company's operating margin of 30.82% and the net profit margin of 25.71% are excellent, while most tech companies are currently struggling with the bottom line. It also has an outstanding free cash flow margin of 26.37%. The company has also been shareholder-friendly since it consistently repurchases shares.
We have not owned Apple because it is simply not involved in any of the new tech microtrends that will likely give us the next Google (GOOG, GOOGL), Apple, or Amazon (AMZN). However, this does not mean that Apple does not deserve a place within a portfolio.
Apple is an outsized beneficiary to passive investing. For those that do not want to pick stocks, and instead just own the index, Apple takes up the largest portion of this money. For example, if you don't want to own tech companies and instead want simply exposure through Technology Select Sector SPDR ETF (XLK), 23.47% of that money goes to Apple.
In regards to the S&P 500, which is the most passively owned index through various mutual funds and ETFs, Apple currently takes up 6.85% of the weighting in the S&P 500, and therefore gets 6.85% of funds going into the S&P 500. This is more than UnitedHealth Group, Berkshire Hathaway (BRK.A, BRK.B), Johnson & Johnson (JNJ), Nvidia (NVDA), and Exxon (XOM) combined!
Because of how its history of share buybacks, healthy Free Cash Flow, and its very large market cap, it remains a darling within institutional funds that are managing billions. In fact, as of June 30th, 16.07 billion shares outstanding are owned by institutions. This means that roughly 98% of all shares outstanding are owned by institutions.
Even though it is not in the forefront of AI, Machine Learning, Cloud or Big Data, it is uniquely setup to capture an outsized portion of passive investors' funds as well as institutional funds. Therefore, it is difficult to imagine the broad markets making new highs without Apple.
Technically, Apple has exhibited a level of relative strength in this bounce that is what you want to see in confirming a broad market trend reversal. It has reclaimed the $145 resistance level, which is a key supply zone to take back. Whether it will hold it is the question?
The fact that Apple has reclaimed the $145 level is a show of strength, regardless of the weakness in the momentum. If the other FAANGs were showing the level of strength APPL is right now by reclaiming key resistance levels, that would be encouraging that a meaningful low is underway. However, we are just not seeing that right now.
Google
We recently wrote about how Google (Alphabet) is our second favorite FAANG. In a cookie-less world due to Apple's notable change to its IDFA, owners of 1st party data, like Google, are setting themselves up to further dominate. This catalyst, coupled with its positioning within the AI microtrend, is the reason why it reserves a position within our portfolio.
Sign up for I/O Fund's free newsletter with gains of up to 403% – Click hereSign up for I/O Fund's free newsletter with gains of up to 403% – Click hereClick here
This also lines up with the technical chart on a long-term basis. Google is the healthiest chart amongst the FAANGs, as it is comfortably above its critical support zone at $1800. As long as any additional weakness is seen here, above this critical support suggests that GOOGL is one of the FAANGs that is likely to make a new high.
However, over the next month, it appears that Google is tracing a bear flag pattern. This is a common pattern that we see in 4th waves, which suggests we need one more wave to complete the 5 wave pattern in Google's drawdown.
Netflix
NFLX is another FAANG that we believe has a higher probability of making a new high in the next growth cycle than most believe. While market was focused on NFLX reporting a subscriber miss of 200,000, it failed to recognize that NFLX is on track to monetize around 100 million new subscribers who are sneaking onto the platform through shared passwords. We wrote about this extensively in a recently report, and as a result has entered into our matrix of potential positions to own going into the next growth cycle.
We believe NFLX is undervalued based on where this monetization will take its revenue in the coming quarters, and this is showing up in the chart on a long-term basis. However, over the next month, Netflix looks to be tracing a bear pennant pattern/triangle pattern. These are common in 4th waves, suggesting one more push lower to complete the drawdown.
Microsoft
Microsoft (MSFT) is one of the FAAMGs that we believe will continue to exhibit dominance into future tech trends. It is one of the leaders in the on-going cloud trend, and is also setting itself up to lead in edge computing and machine learning. We believe Microsoft has multiple catalysts to maintain its growth, which is why we own it within our portfolio.
We think Microsoft is the best risk/reward mega-cap tech stock due to its firm foundation in the cloud and its diversified cloud products. It's also positioned for outsized growth due to its exposure to secular tailwinds such as Artificial Intelligence (AI), Machine Learning (ML), and the build out of the 5G network edge. We think Microsoft will take a substantial share of these markets at the infrastructure level due to its relationships with the Fortune 500 and Global Fortune 2000.
The company's business relationships with Fortune 500 companies, brand image, and wide user base are the moats that will help the company drive revenues in the hybrid cloud, machine learning, and artificial intelligence segments. Microsoft Azure is used by more than 95% of the Fortune 500 companies, which shows the company's dominance across enterprises.
This is also present within the long-term chart of Microsoft, as it is another FAANG that has a high probability of making a new high in the next growth cycle. As long as it critical support holds at $215, this will remain our primary outlook. However, like the rest of the FAANGs, it looks like it is setting up for one more push lower before we can start looking up.
Amazon
Amazon also looks ready to break the $101.50 support zone in what looks like a 4th wave top. The RSI continues to fail under the key bear market resistance at 57. We also have a confirmed Negative RSI Reversal Signal, which is when the RSI makes a higher high while price makes a lower high. This is happening well underneath the bear market resistance of 57 on the RSI. The odds favor one more push lower.
Meta
Meta Platforms (META) is the one stock within the FAANGs that has a high probability of not seeing new highs in the next growth cycle. Fundamentally, the effects of Apple's changes to IDFA has finally caught up with META. We have been warning about this shift in META since early 2020. In short, Audience Network is what allowed META to become the advertising behemoth that it is. Not only was META capturing 1st party data through Facebook, but Audience Network allowed it to capture a large portion of 3rd party data.
Sign up for I/O Fund's free newsletter with gains of up to 403% – Click hereSign up for I/O Fund's free newsletter with gains of up to 403% – Click hereClick here
We had also said back in 2018 that we think Audience Network contributed $5 Billion to $10 Billion in ad revenue (the third-party data ad exchange FB uses). Three years later, that's what Facebook stated in their February 2nd earrings call – "we believe the impact of iOS overall as a headwind on our business in 2022 is on the order of $10 billion."
Simply put, the metaverse is simply not big enough to fill this revenue gap. This is showing up in the chart of META. For one, we have a confirmed 5 wave drop from the all-time high. For one, note how the 3rd wave, which is the most powerful move in a trend, happened on peak volume and peak momentum. This is because traders/investors realized that they are on the wrong side of the herd. They sell at any price, creating an intense moment of sentiment. The 5th waves are always on weaker volume and momentum, which is what we are seeing. Here, the shorts always press their luck, exhausting sellers for this move down.
Why this is significant is that the only corrective pattern that starts with 5 waves down is a Zig-Zag pattern. This is 5 waves down, a 3 wave retrace that fails around half way, then another 5 wave pattern down to new lows. If accurate, the next growth cycle will have META making a move back towards $225-$275 before failing.
For this to invalidate, META must reclaim the $330 resistance zone. This is unlikely due to the fundamental problems META now faces.
In conclusion, there are simply too many divergences between Apple's strength and the rest of the FAANGs to signal a meaningful low is in. I think the odds are high that we at least attempt a double bottom, if not a push towards 3500 SPX before we can start looking up. I do believe that if we do see a push to new lows, it will likely be the 5th wave in this correction. So, it should be on weaker momentum and less volume than prior moves. If so, we will continue to add to beaten down tech stocks that primed to become the next FAANGs.
Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.
This article was originally published on Forbes on Jul 6, 2022,12:24pm EDTForbes on Jul 6, 2022,12:24pm EDT
Growth has been hit hard this year, particularly the technology sector, yet Apple has been an exception as Apple’s stock has positive 1-year returns of 2% and YTD the company has outperformed the Nasdaq and all other FAANG stocks.
Apple epitomizes what it means to be both a good value stock and a good tech stock with its strong margins, outsized cash flows, stable balance sheet, and a loyal base of customers supporting the brand. Apple has not only outperformed FAANG stocks over a one-year period but is also leading when we compare it over five years.
Apple’s return of 513% during the five-year period from January 01, 2017 to December 31, 2021 is also higher than tech giant Microsoft’s return of 441%.
Apple is Tech’s Best Value Stock
Apple has been very consistent with its margins and cash flows. The company’s operating margin of 30.82% and the net profit margin of 25.71% are excellent, while most tech companies are currently struggling with the bottom line. It also has an outstanding free cash flow margin of 26.37%. The company has also been shareholder-friendly since it consistently repurchases shares.
While comparing to other popular value stocks like Walmart, Apple is trading at a slightly higher forward P/E ratio of 23 compared to Walmart’s 19. However, the company’s net profit margin of 25.71% is very good compared to Walmart’s 1.45%. Similarly, Apple has an excellent free cash flow margin of 26.37% compared to Walmart's negative free cash flow margin of -5.15%.
This helps illustrate why Apple’s stock has held up well as investors are able to participate in the most cash efficient company of all time while also participating in the company’s future innovation cycle.
Sign up for I/O Fund's free newsletter with gains of up to 403% -Click hereSign up for I/O Fund's free newsletter with gains of up to 403% -Click hereClick here
Apple’s recent results
Apple’s revenue in the recent quarter grew by 9% year-over-year to $97.3 billion. The company’s revenues beat Wall Street analysts estimates by 3.5%.
iPhone sales increased by 5% to $50.6 billion and 8% to $122.2 billion for the H1 fiscal year 2022 ending September. iPhone sales face a tough comparable, as in the previous year, sales grew 66% in Q2 FY2021 and by 34% in 1H FY2021. According to data from Counterpoint Technology Market Research, the overall average selling price of the iPhone increased 14% YoY to $825 in 2021.
Luca Maestri, CFO, said in the earnings call, “Tim has mentioned a number of times the iPhone 13 family is having a really strong year. We — when we look at top-selling smartphones around the world, we've had pretty incredible results during the March quarter. The top six models in the United States are iPhones, the top four in Japan, the top five in Australia, five of the top six in urban China and so on and so forth. So, the iPhone 13 has been truly a global success.”
The strong demand for M1-powered Macs helped drive growth of 15% to $10.4 billion in the recent quarter despite supply constraints. The company also mentioned that the last 7 quarters were the company’s “best seven quarters ever for [the] Mac.”
The company released the new M1 Ultra in March. The M1 Ultra connects the die of two M1 Max chips to create a system on a chip (SoC) to offer 128GB of high-bandwidth and low-latency unified memory to offer peak performance from high-performance and high-efficiency cores in the M1 Ultra’s CPU. The GPU offers optimal graphics memory for GPU-intensive workloads and the Neural Engine runs up to 22 trillion operations per second.
Apple announced the M2-powered Mac at WWDC in June, offering a faster CPU, a more powerful GPU and also a faster Neural Engine. The upcoming release will also offer 50% more memory bandwidth and a larger cache with 25% more transistors on the second generation 5nm SoC design.
Services revenue grew by 17% to $19.8 billion. As the company’s installed base of active Apple devices increased, more revenue funnels to increase the company’s services business. The company has also witnessed increased customer engagement with 825 million paid subscriptions at the end of the March quarter, up 25% YoY.
Management is also looking to tap enterprise subscription revenue as the vast majority of its revenue comes from consumers. It has launched enterprise subscription services called Apple Business Essentials in the United States for small and medium-sized businesses, which is aimed to provide support to employee device management and iCloud Storage.
Luca Maestri, said in the earnings call, “Obviously, we sell Apple Care to enterprises already today. But we know enterprise in general as a market is a very interesting market for us and we're putting a lot of effort and focus on it and we believe we have really good opportunities to grow.”
The company has managed to maintain good margins. The gross margin was 43.75% compared to 42.51% in the same period last year. The company’s services business has a higher gross margin of 72.6%, while the product gross margin was 36.4%.
The operating profits were $29.98 billion with an operating profit margin of 30.82%, compared to $27.50 billion with an operating profit margin of 30.70%. Net income was $25 billion or $1.52 per share compared to $23.6 billion or $1.40 per share. The net profit margin was 25.7% compared to 26.4% in the same period last year.
The company has good operating cash flows. In the recent quarter, it reported 28.2 billion of operating cash flows. The company has a stable balance sheet with cash and marketable securities of $193 billion and debt of $120 billion, with a net cash position that comes to $73 billion. The company returned $27 billion to shareholders through dividends of $3.6 billion and share repurchases of $22.9 billion.
The company’s share buyback strategy was appreciated by one of the analysts in the earnings call. To a question on why the company is not looking for acquisitions instead of only buying back the stock. Tim Cook replied, “We're always looking and we continue to look. But we would only acquire something that were strategic. We acquire a lot of smaller companies today and we'll continue to do that for IP and for great talent. And — but we don't discount doing something larger either if the opportunity presents itself. And so — but I don't want to go through my list with you on the phone, but we're always looking.”
Looking forward
iPhone sales account for the majority of its revenues (accounted for 52% of the total sales in the recent quarter), which helped the company reach record FY 2021 revenues of $365.82 billion, a YoY growth of 33%.
Wall Street analysts expect revenue to grow by only 7.7% this year and 5.4% in the next year. For next quarter, analysts are expecting revenue to grow by 1.53%. Management had mentioned in the earnings call that supply chain issues, and silicon shortages will negatively impact the company’s revenues in the June quarter.
“We believe our year-over-year revenue performance during the June quarter will be impacted by a number of factors. Supply constraints caused by COVID-related disruptions and industry-wide silicon shortages are impacting our ability to meet customer demand for our products. We expect these constraints to be in the range of $4 billion to $8 billion which is substantially larger than what we experienced during the March quarter.”
However, from the recent data, some analysts are pointing to wins in China. UBS analyst David Vogt said, “During May, overall smartphone shipments in China decreased ~9% YoY despite an easy comp last year (May 2021 down ~31% YoY). However, on a month-to-month basis, shipments were up ~16% as data suggests Covid lockdowns and supply chain shortages on the margin are abating, consistent with our recent checks. More importantly, we estimate iPhone shipments increased ~13% YoY and ~155% month-over-month as Apple took material share, consistent with our checks.”
Sign up for I/O Fund's free newsletter with gains of up to 403% -Click hereSign up for I/O Fund's free newsletter with gains of up to 403% -Click hereClick here
How does it compare to FAANG companies?
The company’s operating margin of 30.82% is the highest among the FAANG companies. Meta’s operating margin of 30.54% comes second and Amazon has the lowest operating margin of 3.15%.
Meta Platforms has the highest net profit margin of 26.75% among the FAANG stocks. It is followed by Apple with a net profit margin of 25.71%.
Apple stock is currently trading at a forward P/E ratio of 23. The stock is reasonably valued when compared to other FAANG stocks. Meta Platforms is the cheapest among the FAANG stocks. However, the company has a history of problems like privacy issues and the company’s loss of advertisement revenues due to Apple’s IDFA changes. You can read our analysis here on Facebook as to why the company continues to face headwinds to its core business model.
Apple has a high free cash flow margin of 26.37% and is ranked second behind Meta Platform’s free cash flow margin of 30.94% and significantly higher than the Amazon’s negative free cash flow margin of -15.24%.
Risks to consider:
Apple’s revenue growth has been decelerating. FY 2021 was an exception as revenue grew by 33%. However, growth in the FY 2020 was 5.5% and in the FY 2019, revenue fell by 2%. According to the Wall Street analysts revenue is expected to grow 7.7% in this fiscal year ending September 2022.
Morgan Stanley analyst Katy Huberty lowered the company’s price target to $185 from $195 and kept an Overweight rating on the shares. The analyst said, “High-end consumer spending intentions are beginning to deteriorate, as the stock market is down 22% year-to-date, consumer confidence is at a 10-year low, and inflation is at 40 year highs.” She further added, “The risks of a pullback at even the high-end consumer space are rising, and that a majority of survey respondents expect to reduce spending in the next six months due to inflationary pressures.”
In addition to the macro risks mentioned above, it’s worth noting that Apple’s revenue growth deceleration in 2019 also occurred when the US Consumer Price Index was at 1.71% in September 2019 compared to the current 8.6% in May 2022. It’s worth noting that Apple’s revenue deceleration occurred when inflation was low. We covered the deceleration in 2019 as we believe it was due to broad-level saturation across the mobile industry with Covid creating an anomaly in terms of demand for personal electronics.
Conclusion:
We recently covered Apple in a webinar where we discussed the two leading FAANGs in terms of sizable catalysts on the horizon that will help them to remain on the Top 5 for World’s Most Valuable Companies. Apple was not one of the two FAANGs discussed as the company does not a massive catalyst on the horizon like two of its peers —- yet this is entirely irrelevant to value investors. Thus, the stock has outperformed in an environment when value stocks are favored.
Apple has a great lineup of products with a loyal customer base supporting its valuable brand IP. The company’s margins and strong operating cash flows have positioned the company to overcome the global uncertainty. Notably, the company’s revenue growth is slowing down, and as growth investors, the stock does not fit our investment profile despite its considerable strength as a value stock.
Royston Roche, Equity Analyst at the I/O Fund, contributed to this article.
Micron reported Q2 results that beat estimates and guided for Q3 sales and earnings growth above expectations. However, Micron’s share are off 9% post-earnings, which may be due to commentary around soft demand in China, slowing PC sales and concerns that Micron may be nearing the top of the cycle. We believe that these concerns are temporary, and that Micron is structurally becoming a less cyclical company, which deserves a premium multiple. I discuss the company’s latest results and why we believe the recent sell-off is overdone in more detail below.
Micron’s Q2 FY2022 Beat Expectations and Guidance Was Above Consensus
Micron reported Q2 FY2022 results on March 30th, and sales increased 1% QoQ to $7.8 billion driven by a 4% sequential rise in NAND sales, which accounted for ~25% of total revenues. NAND sales also increased 19% YoY and management expects NAND sales to increase by ~30% YoY for the year. Demand for NAND is being driven by Micron’s new 176-layer NAND technology, which represented the majority of Micron’s NAND shipments. We explained the importance of 176-layer NAND here, stating that Micron has significantly increased memory capacity and is a leader in this technology, allowing the company to capture more market share.
Importantly, the strength in NAND should also be a tailwind for Lam Research, which sells the etching equipment necessary to build the layers for 176-layer NAND. In our latest update on Lam Research, we explained that “the key reason we think Lam could fare better than its peers is because as 3D layers increase, capital intensity also increases. The process does not scale linearly, instead it’s non-linear because it takes longer than 2X to etch a stack that is 2X high and requires more complex etch and deposition equipment”. With Micron guiding for $12 billion in Capex this year and plans for $150 billion in capacity expansions over time, we should expect Lam Research to see strong demand for etching equipment going forward.
Micron’s NAND prices also benefitted from the contamination of ~8% of the global supply of NAND. In February, memory peer Western Digital disclosed that there was a contamination event at two of its Japanese JV facilities, which resulted in 6.5 exabytes of NAND memory being contaminated. Likely benefitting from this event, Micron’s Q2 NAND prices rose ~4% QoQ, driving much of the topline growth as volumes were flat. As shown below, Micron has outperformed relative to Western Digital YTD, however, both companies have underperformed the broader market in 2022. I outline a few reasons for this in more detail below, which we believe are only temporary.
Similar to NAND, DRAM sales increased 2% QoQ and were up 29% YoY to $6 billion, or 73% of total sales. DRAM volumes increased but were offset with a decline in ASPs. Strong demand in datacenter drove the increase in DRAM sales. For example, Micron’s largest segment, Compute and Networking, grew sales 31% YoY to $4 billion, driven by a 60% YoY rise in data center sales which were “supported by robust demand across our DRAM and SSD portfolio” (Q2 call, 03/30/22). DRAM sales benefitted from Micron’s leading 1-alpha technology which is increasingly being adopted in the memory-intensive cloud environment. During the Q2 call, CEO Sanjay Mehrotra stated that DRAM sales will continue to ramp into 2023 when he said that “We have broadened the qualifications for our 1-alpha DRAM products and are well positioned to support the data center DDR5 transition driven by new CPU platforms, which are targeted to begin ramping later this calendar year and gain momentum in 2023”.
Following the strength in cloud sales, Storage sales increased 38% YoY to $1 billion as SSDs continue to replace HDDs, while Embedded sales increased 37% YoY driven by strength in automotive. A blemish was weakness in Mobile sales, which increased just 4% YoY to $1.9 billion. While the rollout of 5G phones will lead to a ramp in memory content per phone, there may be demand headwinds on the horizon. For instance, Apple cut its forecast of 5G iPhone shipments by ~20%. I discuss this in more detail below.
Continuing down the income statement, gross margin increased by 2,100 bps YoY and 100 bps QoQ to 47%, benefitting from higher NAND margins and the ramp in 1-alpha DRAM and 176-layer NAND technologies, which reduces costs as it scales. Management noted on the Q2 call that most of the efficiency benefits have been realized, and that margin expansion from the ramp is largely behind the firm. Furthermore, YoY gross margin comps were impacted by a one-time $300 million charge taken last year when Micron switched to FIFO accounting.
The strength in gross margin flowed down to operating profit, which increased 118% YoY to $2.7 billion. The dramatic rise in profitability was driven by higher selling prices and cost reductions from the ramp in new technologies outlined above. However, Micron has historically been a cyclical industry, and there may be concerns that Micron is nearing the top of the cycle. This may explain the recent sell-off in Micron’s sales, yet we believe that Micron is becoming structurally less cyclical and that its multiple will rebound once this is clearly evident in future results (discussed in more detail below).
Finally, GAAP earnings per share were $2.00 while non-GAAP EPS was $2.14, which beat estimates by $0.16. Non-GAAP EPS increased 118% YoY and the strength in EPS growth should continue going forward. For instance, Micron will benefit from a lower tax as Idaho’s governor signed a new tax law on March 16th, 2022 that will reduce Micron’s taxable income (Micron is HQ in Idaho). The CHIPS act may also be a tailwind to earnings as the US government looks to incentivize reshoring of manufacturing capacity.
As of the end of the quarter, Micron had $12 billion in cash and equivalents and free cash flow was over $1 billion during the quarter. Management stated that they expect free cash flow generation will be “substantially higher” over the next two quarters relative to H1 2022. Micron intends to use ~50% of its free cash flow to buy back its stock and pay dividends to shareholders. Since 2019, Micron has reduced its share count by an aggregate 113 million, or by 9%. With Micron guiding for record sales and profits in FY2022, cashflow generation should be significant, which will support more buybacks in the future.
Looking forward, management expects Q3 sales to grow 18% YoY to $8.7 billion, which beat initial topline estimates by 6%. Management stated that they are “tracking ahead” of their initial guide set in Q1 for FY2022 and that demand remains strong, but noted during the Q2 call that “there are some pockets where semiconductor shortages have not improved as fast as we had expected, and these shortages are likely to continue into calendar year 2023”. Nonetheless, Q3 adjusted EPS is expected to grow 14% QoQ to $2.46, which beat initial estimates by 9%.
Potential Risks are only temporary
As discussed above, Micron reported strong top and bottom-line results, guided above consensus and expects to be report record sales and earnings in FY2022. However, despite this, Micron has underperformed in 2022 and is off ~9% since announcing FQ2 results. This may be due to a couple developments: 1) softness in mobile and PC sales and in China, 2) and concerns that Micron may be nearing the top of the cycle.
In regards to the first point, during the Q2 call management stated that “We see some weakness in the China market as the local economy slows, smartphone market share shifts and some customers take a more prudent approach to inventory management.” CEO Mehrotra added that he expects PC unit growth will be “flattish”. These comments may have contributed to a post-ER sell-off, and it is notable that AMD is also off following the Micron Q2 print, likely due to its exposure to PC sales. However, management added further color that enterprise PC sales are expected to be strong in the near term, which are more content rich in terms of DRAM and NAND content, which should offset this pressure.
Moreover, 5G phone sales are just now starting to ramp, but the timing of this ramp remains unknown. As mentioned above, Apple has reportedly cut its production forecasts for its first 5G phone by ~20%. While this may be a near-term headwind, it is inconsequential in the long term. This is because 5G phones will inevitably take share from 4G going forward, and 5G phone DRAM content is 50% higher than 4G, while NAND content is >100%.We expect mobile will be a tailwind going forward, despite the near term uncertainty in the pace of the ramp.
Finally, a trend that is typical with highly cyclical companies is that investors tend to reduce exposure when earnings are high due to concerns that the company may be nearing the top of the cycle. Historically, Micron has been a highly cyclical company with periods of oversupply and rapidly declining prices. However, with more demand drivers coming from data centers/cloud and automotive, memory demand is no longer dependent on the short-cycle PC market.
During the Q2 call, CEO Mehrotra explained that over 75% of its quarterly volume are under long-term agreements (LTA) that go out beyond four quarters or more, up from less than 25% in prior years. CEO Mehrotra added that all of the company’s large customers are now under LTAs, which helps improve demand visibility and reduces uncertainty. An increase in LTAs significantly reduces the cyclicality of Micron’s business.
Moreover, new trends on the horizon further smooth demand for memory, reducing Micron’s dependence on the short-cycle PC market. For example, CEO Mehrotra stated that “new EVs are becoming like data center on wheels, and we expect over 100 new EV models to launch worldwide in this calendar year alone”. The memory content in higher end EVs is 15x higher than the average car, which further reduces the cyclical nature of Micron’s business.
As shown below, Micron trades at a 9x PE multiple, which is below where it was trading in 2017 and well below its multiple in 2020 and 2021. We believe that the market remains in a “wait and see” mode until Micron can prove that it is less cyclical. If Micron can prove that it is less cyclical going forward, we should expect a re-rating of its multiple going forward. A trend that supports this is the reduction in finished goods, which declined QoQ despite the softness in China, PC and mobile. A build in finished goods inventory would signal that demand may be weakening, a trend we have yet to observe in the memory market.
The market has been brutal to ad-tech over the past few months. It’s certainly been a roller coaster over the last few years for this industry as covid created a one-time event that kept people indoors and resulted in a spike of streaming. After this, there’s been supply chain issues affecting advertisers at the exact time that these companies had high covid comps to clear. In the middle was Apple’s IDFA changes which threw an additional wrench into the mix.
I personally can’t imagine giving up on ad-tech companies because of the double whammy of a high growth hurdle combined with low macro ad spend, but that’s for each investor to determine for themselves.
Roku has been a strong and steady performer in terms of revenue growth and improvement in the bottom line since going public. In six years, Roku has been able to grow its revenue 850% from $398 million in 2016 to an estimated $3.72 billion for FY2022. The Trade Desk will have grown 687% on a lower revenue base while trading 3X higher.
Critics might point out that player revenue is included there, but Roku does pull in around $700 million per quarter on the platform. Critics will also point out that TTD has a much better operating margin – but time will tell if Roku has chosen the correct strategy to own the real estate. To me, this is arguably the better business model considering the average consumer owns their connected TV for seven years.
Unlike Zoom, which guided for some of the lowest growth in the cloud category – and then subsequently missed the guide – Roku is guiding for growth in the top decile of its category. Despite seeing headwinds in Q1, the company reiterated its already-strong guidance for FY2022. The reason mid-30s is considered strong is because the industry is going through two years of tough comps to clear; it shows resiliency to be at the top of your class. Only Snap is in the lead in terms of forward growth right now across ad-tech. Despite the market’s elevator drop following Roku’s earnings report, the company has leverage in its business model and the bottom line has been steadily improving – even with the return to a more aggressive, investment stance with cashthe company has leverage in its business model and the bottom line has been steadily improving – even with the return to a more aggressive, investment stance with cash. We dissect this and more below.
Before I continue, and while I have your full attention given we are in the intro of the analysis, I want to say the real risk to Roku is a lack of account growth. I want to isolate the account growth because the market will throw a lot of darts at a company and it’s hard to keep track of what the real concern is as we go through various growth stages for a single company. This is why management shrugged off Wall Street’s pressure for a perfect bottom line and took a hit on player margin. We revisit this from our Q3 analysis below. Moving into 2022, the management plans to continue to leverage their cash for account growth.
CTV Ads Overview:
I want to state a few reminders as to why the connected TV advertising model is in earlier stages than Netflix’s subscription model. I previously covered this here in an editorial.
Connected TV ads are at 18% penetration compared to 42% viewing hours and we will one day see 100% viewing hours on connected TV once cord cutters reach a tipping point.
Roku generates $3 billion in revenue, roughly the size of revenue Netflix did in 2011. Interesting enough, this lines up with the exact number of years SVOD was out compared to AVOD for Roku (roughly 4 years into the market – 2007 for SVOD and late 2017/early 2018 for AVOD).
Roku has determined that localized originals is the best way to break into a global market, such as Mexico and Brazil. The company is intent on taking Latam with originals. My takeaway from the call is they have enough visibility into the monetization and ARPU to believe this is the best global strategy. The market is beating up the stock price on this, yet this is the very reason Netflix is the powerhouse it is today.
Leveraging first party data (Roku) to become an ad exchange (OneView) across other properties and channels is a strong business model in the market. If you listen to TTD’s most recent earnings call, you’ll see that having the leading pureplay here isn’t a terrible strategy considering the migration of budgets and ad spend expected to continue to migrate. Our position in Roku is due to the first-party data the company can leverage to continue to participate directly and 100% in this market rather than diversified on markets with lower growth, like desktop or mobile. Here’s a quote from the most recent Roku earnings call: “2022 is a big year for OneView as well. We’ve made good progress with selling OneView into agency holding companies and lots of other advertisers. And I think it will be a breakout year for us. We just last week announced Nielsen DAR guarantees in OneView. This will enable an advertiser to use our data and our ad stack to optimize the age, gender goals when buying from programmers in the Roku ecosystem. We have sold that product with our own media for years. We’re extending it now in what’s an industry first to all impressions on the Roku platform.2022 is a big year for OneView as well. We’ve made good progress with selling OneView into agency holding companies and lots of other advertisers. And I think it will be a breakout year for us. We just last week announced Nielsen DAR guarantees in OneView. This will enable an advertiser to use our data and our ad stack to optimize the age, gender goals when buying from programmers in the Roku ecosystem. We have sold that product with our own media for years. We’re extending it now in what’s an industry first to all impressions on the Roku platform.” My comment: Nice one on timing – when mobile is going through a massive shift.
Roku: Q4 Earnings Review and Why the Stock Sold Off
The company reported revenue of $865 million compared to $894 million expected, for revenue growth of 33% YoY. This is a deceleration from 51% revenue growth in the third quarter and 81% revenue growth in the second quarter. The company guided for revenue of $720 million compared to analyst consensus of $748.5 million. EBITDA was also a miss with company guiding for $55 million compared to the consensus for $79.2 million in the upcoming Q1 quarter.
Despite lower growth in Q1, Roku reiterated full year 2022 growth in the mid-30s. I think that’s important to pay attention to as it confirms management believes the supply constraints are temporary. Going into the report, analysts were expecting 36% annual growth. The guide on EBITDA is for $150 million for FY2022.
Gross margin improved which helps to show business model leverage. In Q4, gross margin of 60% grew 24% year-over-year to $380 million. With that said, GM was down sequentially by 4.5 points due to a greater mix of video advertising. The company estimates without supply chain issues on the players, GM would be higher by 4 points, which offsets the sequential decline. The guide on gross margin next quarter is lower at 50%.
In Q4, player revenue declined 9% year-over-year and was up 7% compared to Q4 2019. In the Q3 earnings analysis referenced below, we had stated this was expected as management is (wisely) growing user accounts while Smart TVs are unable to ship. Player unit sales were flat year-over-year and down 4% overall for 2021.
The ad platform also missed analyst expectations at $703 million, up 49% year-over-year, compared to $732 expected. In Q3, the platform grew 82% in the third quarter. Due to video advertising, the gross margin was lower in Q4 at 60.5% compared to 65% in Q3. However, it would be tough to say the platform didn’t have a great year as it grew 80% YoY to help drive the overall revenue growth of 55%.
The EPS is negative at ($0.92) for FY2022 and Bradley discusses this more below in his notes as to what’s weighing on EPS. Notably, ROKU is expected to be profitable by FY2023.
The issue with Roku is not the miss on revenue but the miss on EBITDA. You will see below that operating expenses is the key thing the market is grappling with as the company plans to spend $1 billion on operations. The concern is whether this investment will make it back to the top line. Management states they are increasing headcount yet producing original content also can weigh on operations. We expand on this below in the last section.
Q4 Revenue Miss and Soft Guide:
The company stated the softer than expected revenue was from the “impact of supply chain disruptions on advertising spend.” Rather than dissect an event that is out of the company’s control, I’ll keep this section brief to say we believe this will clear up in time. Roku has been strong on revenue growth since launching the ad platform circa 2017.
As discussed on the call, ad-tech is going through an extraordinary period where advertising spend dropped off significantly in Q2 2020, then made up for it in Q4, which created a tough hurdle to clear in Q4 2021 alongside supply issues. I don’t think there’s much more to expand on here.
Regarding account growth, it was better than expected at 3.7 million, compared to 8.9 million for the year. Total active accounts were 60.1 million, up 17% YoY and higher than the 59.5 million expected. I’ve stated before that there will be quarters where Roku misses on active accounts yet beats on revenue. The reason why this won’t concern us – yet will concern Wall Street – is that Roku can monetize outside of its own audience through One View. We discussed OneView here.
Q4 Negative Player Margin:
After Q3 earnings, we wrote a detailed analysis about Roku’s plan to keep player costs low while smart TVs are delayed in shipments. This strategy was clearly seen in the higher player unit sales that exceeded pre-covid-19 levels despite a supply shortage. This strategy is what helped drive the beat on active accounts — which was to expand while competitors are incrementally weaker.
Here’s one way Roku is seizing the supply shortage: “As mentioned earlier, we chose to insulate our consumers from increased component and logistics costs, resulting in player gross margin decreasing to negative 15% in Q3.”
In addition, the company plans to keep dongles stocked so that if smart TVs sell-out or are too expensive for consumers, they can upgrade their current television with a Roku player.
Here's a question from Laura Martin on the call that is important to understand why Roku could come out ahead in light of supply issues: “But if you're going to sell out of those [dongles] anyway because TVs are running out why would you cut price [of the dongles]? Why wouldn't you double price and still sell out and just and still add as many subs, but at a higher price because you've got dongles in stock when all the TVs smart TVs are running out of inventory at the retail level?”
Here was the answer: “So the supply chain — in the case of players we're not — our goal wasn't to not sell out. We are paying more for expedited shipping for — to get chips get in front of the line for chips.
So, the results of all that is our costs are going up. But we haven't sold out yet. We've just been paying for air shipping and we've been spending money to insulate the retailer and the end customer from pricing issues and supply issues. So far we've been doing that relatively effectively.”. We've just been paying for air shipping and we've been spending money to insulate the retailer and the end customer from pricing issues and supply issues. So far we've been doing that relatively effectively.”
The translation is that they can air ship boxes of dongles and keep them on the shelves because of their small size while TVs sell-out and/or are cost prohibitive for consumers with average of 42% increase in price. “That [TV sales] is down. The market is down 31% year-over-year in part because pricing on U.S. TVs on average is up 42%. And the U.S. TV market is actually down below pre-COVID levels in the corresponding period in 2019.”
When asked why they aren’t doubling the price given the supply constraints (i.e., and appeasing Wall Street on the margins), the answer is that they are actually going to take a hit on the players at about (15%) because they want to keep costs low, which in turn, will grow active accounts. This goes back to the $40 ARPU. Once someone is a Roku user, there are high switching costs and Roku’s advertising flywheel can make up for the loss on hardware.
-END EXCERPT FROM Q3 ANALYSIS
So, Roku missed on player revenue for the reasons we discussed last quarter and this was not a surprise or a concern.
Increased OpEx and EBITDA Miss:
The increase in operating expenses is where the market is grappling with Roku’s long-term story as it could change a signal to the company’s story if producing originals weighs on margins. The management stated it was due to expanding head count yet I’m not sure the market fully accepts this answer in light of the originals being produced.
As stated above, forward-looking EBITDA came in lower with company guiding for $55 million compared to the consensus for $79.2 million in the upcoming Q1 quarter. The guide for FY2022 EBITDA is $150 million. Wall Street analysts were modeling for increased profits given the top line growth. Roku is deciding to go in the opposite direction by investing aggressively. Perhaps Roku management should have tempered expectations a few quarters back about their plans to ramp spending.
The company worded the EBITDA miss like this: “For full year 2022, we plan to maintain adjusted EBITDA roughly in line with 2020 levels on an absolute basis as we continue to invest against a significant opportunity and drive continued innovation on the platform.” Yet, the analyst on the call pointed out that it’s actually not in line with 2020 levels as it’ll be double and closer to $1 billion in operating expenses.
Here is what was asked by Michael Morris of Guggenheim. If I could have timed the moment when Roku went from being down 10% after hours to 30% after hours, I’m pretty sure it was during his question:
“And my second question, I really want to come back to this spending growth next year. By my math, it looks like your spending is going to almost double to well over $1 billion, just using your revenue and EBITDA guide. I mean, it’s a pretty huge number. And Steve, I think you just said kind of goes back to pre-COVID levels or behaviors, but it’s multiples of what you were spending at that time. Now you’re obviously a much bigger company now, but I think this is a really big deal coming out of the call. So, I want to take one more opportunity to ask sort of in more detail what you’re spending on? Like which areas do you think this is going to power? And when we should expect to see the return — the top line on this incremental spend? Thanks.”
The answer management provides to this question is long but can be summarized by these key points:
Increased headcount and wages as the company plans to expand the team: “In terms of how we usually invest, the main source of investment is people-based. And so, that headcount expense is the largest single line item on our OpEx.”
The Roku Channel: “The Roku Channel is growing much faster than the platform overall […] Really the scale of The Roku Channel and that growth trajectory is allowing us to invest more in the content. And it’s a combination of licensing. We’ve got 200-plus licensing partners there. But also in 2021, we basically came out with the Roku original side of the house, which we kickstarted with the acquisition of Quibi’s content distribution rights, but we’ve done a lot on that front as wellRoku original side of the house, which we kickstarted with the acquisition of Quibi’s content distribution rights, but we’ve done a lot on that front as well.”
The Roku TV Program: “And Roku is the leading operating system in the United States right now. We’re making great progress in other countries as well. And we’re just extremely well positioned to keep investing in that leadership position and grow that leadership position as consolidation continues to happen in the TV — in the platform spaceRoku is the leading operating system in the United States right now. We’re making great progress in other countries as well. And we’re just extremely well positioned to keep investing in that leadership position and grow that leadership position as consolidation continues to happen in the TV — in the platform space.”
After management answered, here was the final answer from Anthony Wood: “But the main driver is we just keep hiring a lot more people as we expand each of these key areas. Just one small example, we didn’t use to make originals. Now we have a whole team working on Roku Originals. We didn’t use to sell TVs in Brazil. Now, we’re building more and more models for Brazil. So those are places — those are examples of places where we increase our headcount.”
Producing originals worked for Netflix, and Roku will not need to do nearly the level of originals as Netflix as it’s only 1 of 4 ways that Roku monetizes. However, the main issue is that Roku isn’t providing too much insight into the budget that will be needed.
If we widen our view, we will see that 2020 was the first year Roku was EBITDA positive and the company is expected to remain EBITDA positive this year. Most importantly, Roku has leverage with a gross profit of $1.4 billion and they are choosing to spend for top line growth.
Overall, Roku is a more complex product story because the strategy is to conquer from many angles. It’s an ad exchange, it’s a content channel, it’s an operating system and it’s a hardware player. It also owns the best first-party data available on CTV ads and I tend to stick with the data in terms of ad-tech. So, that’s primarily the reason we own Roku and continue to own Roku.
A Few More Notes on Roku’s Q4 Earnings
By Bradley Cipriano
The $1 billion in expenses is not overly concerning although an adjustment in expectations as the Street may have believed that Roku’s earnings were quickly scaling, but this was impacted by a slowdown in expenses during covid, and now those expenses need to ramp in the upcoming year to remain competitive.
It looks like the ramp in costs going forward will be driven by headcount and content creation as the company scales. As a comparison, Netflix's operating expenses ramped nearly $1B YoY when it passed $3B in revenues in 2011, which Roku is nearing. Viewed differently, the expected revenue growth in FY2022 of $830 million will be accompanied by a $1B rise in expenses, meaning that each $1 of expenses will drive just $0.76 of revenue, which is the lowest value in Roku's history. This suggests that growth is much more expensive than in prior years.
However, this is likely due to the slowdown in investments made during 2020 and 2021, and the three-year average for the above metric is 1.08x (including FY2022), meaning that each $1 of expenses resulted in $1.08 in revenues. This is above the prior three-year average of 1.04x (2019-2017), highlighting that over a longer time frame, Roku is in fact demonstrating leverage, albeit it is lumpy. FY2021 and FY2022 also includes the Player gross loss headwind that wasn't the case in prior years, the three-year average would be even higher. My takeaway is that the rise in expenses seems in-line with historical trends once we account for COVID.
The lower EPS this year is a headwind to the company's valuation, but it is expected to be profitable in FY2023. The company should be cashflow positive in FY2022 and with $2.1B in cash on balance, likely should not need to dilute shareholders despite the losses. There is also some leverage to improve earnings as there were $82m in one-time expenses during the most recent year.
Below are some one-time expenses included in EPS:
The $96 million swing in player gross profit, due to lower volumes and higher costs. This was a material impact to the bottom-line during the year. Assuming that they can get player sales back to breakeven, then that’s a $0.37 EPS tailwind going forward. Management states it does not expect player losses to persist indefinitely but will likely persist into H1 FY2022.
There was $28 million in legal expenses during the year, $10 million of which related to patent infringement issues – this has been a lingering issue with ROKU and may be a lingering issue going forward as there are 14 more patent cases in court from UEIC v Roku. Assuming the $28m is one-time, then this was a $0.19 EPS headwind, but can be a tailwind going forward if the expenses do not repeat.
$8m in cost from the expansion of office space, likely mostly one-time = $0.06 EPS headwind.
Revenues accrued from changes in accounting estimates increased $15 million YoY, which is a one-time benefit to earnings and should offset the above one-time expense items.
In total, $67 million in net one-time expenses (or $0.47 per share impact) pressured earnings during the year. Going forward, there is leverage for earnings improvement if these costs do not repeat.
Regarding Roku’s revenue miss, Q4 was the first-time management had missed their topline guide, and they missed it by $28 million, or 3%. In the prior quarter, they beat by $1 million. The key takeaway is that modeling supply chain issues has been difficult across the board. Roku had previously done a good job of this but was impacted by events that are mostly one-off (shortage of autos and TVs likely hard to predict).
There is a rise in legal expenses including a patent case on the company that cost $10 million, which has been discussed previously on the forum a few quarters back. According to UEIC’s CEO, there are two separate cases against Roku that allege a total of 14 patent infringements.
Due to supply issues, days sales outstanding, which measure how long it takes Roku to collect on its sales, increased to 72 days, well above the average of 60 days. The extension of payment terms may have boosted Q4 sales by ~5%, which is inherently a one-time trend. Unbilled sales are up materially YoY and are high risk sales because they signal that sales were accrued before being invoiced. However, the balance declined slightly QoQ, which reduces the risk that sales have been manipulated. Lastly, Roku recognized $29 million of sales from prior performance obligations due changes in estimates. This is up from $14 million in 2020. While this is not material to sales (<1% of 2021 sales), the $15 million rise in sales from changes in estimates provided a $0.10 benefit to earnings during the year.
In summary, there are puts and takes related to Roku’s 2021 results. Earnings were impacted by numerous one-time trends, but there were also some one-time benefits. Sales are expected to grow strongly going forward, but Roku is taking longer to collect on its sales. We expect to see an improvement in these trends going forward as supply chain issues improve and the ad market normalizes.
Below, the team looks at Micron – a semiconductor company the I/O Fund has owned in the past. Micron is in third place behind Samsung and SK Hynix. We analyze both product and financials to determine if Micron has what it takes to capture more market share across data centers, automotive/industrial, and 5G smartphones and edge devices. Earnings are on December 20th.December 20th.
Micron is one that we are watching closely but do not own at time of writing. Please reference Trade Notifications archived on the dashboard and the forum for updates. on the dashboard and the forum for updates.
Overview of Micron’s Products:
By Beth Kindig
When we first covered Micron, the company’s revenue was two-thirds DRAM and one-third NAND. The company’s most recent earnings report shows a heavier weight on DRAM at three-quarters revenue compared to one-quarter revenue from NAND.
NAND memory saves data even when the power is removed, such as when a cell phone is turned off. Beyond mobile devices, NAND is found in traffic lights, digital advertising panels/displays, and anything with artificial intelligence that needs to store data.
Dynamic RAM, or DRAM, stores memory when a device is on, such as PC processors and graphics cards. DRAM is also used in gaming devices and video game consoles. DRAM is 100X faster than NAND, lasts longer, and is smaller in size. However, DRAM is known as volatile memory which means when power is turned off, it does not store data. The benefit of loading the data into the RAM is that reading the data is much faster than reading it from the hard drive.
According to the CEO of Micron, AI servers will require six times more DRAM and twice the SSDs compared with standard servers. In the most recent earnings report, it was also pointed out that “DRAM and NAND stem share of the semiconductor industry has steadily grown over the last two decades, from around 10% to approximately 30% today.” Today, data centers are the largest market for memory and storage due to the growth driven by cloud.
Hyperscale data centers are growing faster than DRAM supply can keep up with. Due to higher capacities and low latencies, DRAM is being used across health care, the military, automotive, networking systems, and data centers. DRAM is being used in the Internet of Things (IoT) due to low latency with automotive using up to 80GB compared to 5.5GB in PCs and 2.5GB in handsets.
NAND is used to store pictures or music on a mobile device and is also particularly well suited for edge devices because it’s ideal for high data storage density. Although DRAM drives the majority of Micron’s revenue right now, NAND is the growth segment to watch as AI workloads move to the edge and will require NAND for the increased energy requirements, portability, and ability to store massive amounts of data.
According to FiorMarkets, Global 3D NAND Flash is expected to grow at a 32.3% CAGR from 2019 to 2025. 360 Research Reports put the CAGR at 20.6% between 2021-2026. Overall, NAND is expected to grow at 11.05% between 2021-2026. DRAM has a CAGR of 7% between 2020 and 2026.
Micron’s revenue segments
By business unit, Micron saw the most revenue growth from Embedded (EBU) at 108% year-over-year and 23% QoQ growth. This was also the largest growth in the prior year. EBU refers to memory and storage products used in automotive, consumer markets, and industrial applications. In 2019, Micron had expanded its wafer fab facility in Virginia with a $3 billion investment to manufacture 20nm/1xnm DRAM and 3D NAND for automotive infotainment, advanced driver-assistance systems (ADAS), and also industrial automation and surveillance applications. Two years later, the investment and engineering expansion appears to be paying off.
This is a key segment to watch as industry CAGR for automotive processors is expected to be 65% through 2023, according to IDC. This is driven by automation and the memory content per car will increase up to 16GB of DRAM and 1TB of NAND to run AI, supercomputer, and high-def mapping. Micron holds 48% of automotive memory market share and is the primary supplier to Nvidia and Intel.
Compute and Networking (CNBU) grew at 26% growth year-over-year and 15% quarter-over-quarter. This is the segment that serves cloud servers and PCs, plus graphics and networking markets, and this segment is the largest source of revenue and operating income for Micron. Bradley expands more on this in his write-up below.
Mobile Business Unit (MBU) focuses on mobile and smartphones and mobile saw its highest-ever mobile revenue in fiscal year 2021. This is partly driven by the uMCP5 multichip package which allows smartphones to handle data-intensive 5G workloads. Micron has also released low-power DRAM for edge devices in a promotion with MediaTek. Micron offers a combined chip for both NAND flash storage and DRAM for 5G smartphones to extend battery life and increase performance without taking up circuit board space. This segment is also one to watch as the memory in smartphones will increase exponentially with 5G due to large data volumes.
Micron has exposure to PCs. This has been a boon during the past few years yet could also weigh on Micron if consumer spending slows.
3D NAND product update
Last year, Micron released a 176-layer 3D NAND product that has a layer count 40% higher than the nearest competitor, which is Samsung. The new NAND device is 10 times denser than previous 3D NAND devices which allows smartphones and edge devices with capacity limitations removed and increased power efficiency. Cloud storage also benefits due to being data intensive.
According to Micron, this device has the “industry’s highest data transfer rate” of 1,600 megatransfers per second (MT/s). The device is the same height as the 64-layer design with a fabrication technique that removes stack height limitations to provide higher storage capacities. The company uses CMOS-under-array (CuA) to build a multi-layered cell stack for more memory to be leveraged in a smaller space while also decreasing die size.
The replacement-gate (RG) flash technology replaces the traditional floating-gate design, and according to Micron’s whitepaper, helps the device remain competitive in terms of time it takes to program and/or to limit the reduction in performance. Micron points out in the paper that extending the number of tiered stacks creates cell-to-cell capacitive coupling, which leads to lower program times. Therefore, the more tiers or layers that competitors release will not necessarily result in better performance due to design limitations. This performance becomes critical as program algorithms can add to time delays when writing the data.
In this iteration, Micron changed the design to mitigate issues of the “cell-to-cell capacitance structure,” or a reduction of electric field duration and increase in voltage threshold (VT), which results in higher endurance life span, increased power efficiency, increased storage capacity, and doubled speed of write performance. The company also changed the material from polysilicon to metal. These two improvements result in Micron’s RG 3D NAND to perform up to 2X faster than other current 3D NAND devices.
Memory and storage can be very competitive in terms of price, so we want to track incremental product improvements. According to Micron, “current 3D NAND design has begun to reach the limits of its monolithic die-level maximum capacity. It will continue to fall short of the immense system-level storage capacities demanded by future data-driven applications. Cell-to-cell capacitive coupling complications and smaller etch requirements account for many of these limitations.” If Micron is correct, then this could be an opportunity for the company to see more market share on 3D NAND.
NAND is expected to see a 30.8% increase in total bit demand and an oversupply in the second half of next year. Competition is expected to drive a decrease in average sales price (ASP). In the earnings presentation, Micron forecast calendar year 2022 growth of 30% in NAND.
DRAM product update
Moore’s Law states that the number of transistors or processing power on an integrated circuit doubles every two years while the cost is halved. This has led to shrinking the circuits to fit more transistors or memory cells in the limited space. At one point, you could see a transistor and now they are measured in nanometers, which is not visible by the human eye. This helps chips switch faster and use less energy and are cheaper to make, as well. As size decreased, memory chips moved to the Roman and Greek alphabet to name nodes which is why Micron calls their DRAM “1-alpha.’ This provides a 40% improvement over bit density compared to the 1z node and power consumption has improved by up to “20 percent.”
These chips are manufactured without EUV, or Extreme Ultraviolet Lithography. This manufacturing method uses smaller 13.5nm wavelengths of ultraviolet light to etch wafers as opposed to lasers from Deep Ultraviolet Lithography (DUV). You could argue that EUV is a point of weakness for Micron as Samsung is using this manufacturing method while Micron is delayed until 2024.
DDR5 is the company’s increased bandwidth product that will increase core count resulting in up to 85% increase in bandwidth. The double date rate (DDR) product has been primarily focused on more bandwidth while previous generations focused on reducing power consumption to serve the needs of mobile applications and data centers. The performance increase is between 1.36X and 1.87X. This has not been released yet but is expected to be released soon.
DRAM is expected to see a decrease in average sales price (ASP) next year while DRAM bit demand will increase by 17%. This will lead to an oversupply in the second half of the year. Micron is forecasting DRAM revenue to be in the mid-to-high teens.
Being U.S. based, plus MU, lowered exposure to China
It’s very helpful that Micron is the only U.S. based manufacturer of memory during a time when suppliers are relocating to the United States. Micron announced that it intends to invest $150 billion globally over the next decade in “leading-edge memory manufacturing and research and development (R&D) including potential U.S. fab expansion.” The U.S. Senate passed the U.S. Innovation and Competition Act (USICA) which includes $52 billion in federal investments for the domestic semiconductor research, design and manufacturing provisions in the CHIPS Act. Congress is also considering legislation called the FABS Act that would establish a semiconductor investment tax credit. Policy could strategically help Micron compete with Samsung.
The next hurdle for semis long-term is relying on China sales. Micron changed how they report geographic information from ship-to location to customers headquarters. Micron also lost Huawei revenue during the same time period which Keybanc estimates was 7-9% of Micron’s revenue.
Here's a snapshot from fiscal Q4 2018 where “ship-to location” was heavily weighted to China.
If we go on customer headquarters then we see that Micron has about 18% exposure in FY2021 if we include China and Hong Kong.
Competitors
Micron was the first to build and ship a 176-layer NAND last year and SK Hynix was close behind. In early 2020, Kioxia and Western Digital released a 112-layer device and are expected to move to 160-layer soon based on split-gate architecture by stacking two 80-layer structures. By splitting the gates, the cell size is reduced in half and this increase the capacity. YMTC was a new competitor from China that released a 128-layer very quickly by skipping the 96-layer generation. The company uses an expensive copper hybrid bonding technique that enables higher bit density. YMTC is likely to take market share in China across all memory and storage competitors.
According to TrendForce, SK Hynix saw the largest increase QoQ on NAND flash sales with a 25% QoQ increase and Kioxia reported 3D NAND sales of 20.8% QoQ compared to Micron’s 8% increase QoQ. In terms of DRAM, TrendForce reported that Samsung grew it’s lead with 11% growth QoQ while Micron also grew it’s lead with 12% growth QoQ compared to SK Hynix at 8% QoQ.
Micron is Becoming Less Cyclical
By Bradley Cipriano
Micron has reported strong results over the last few years and this continued into 2021. Micron is a key player in the memory market, which is going through a structural change. Demand is no longer dependent on PCs, rather memory demand is now being driven by much stronger tailwinds such as datacenter server growth and the rollout of 5G. This structural change is making Micron less cyclical.
Looking forward, Micron expects these structural tailwinds to continue to drive growth at the company. CEO Sanjay Mehrotra explained it well during the Q4 FY2021 Conference Call when he said that “Industry trends like the broad integration of artificial intelligence into all computing, proliferation of the intelligent edge, continued data center growth, and deployments of 5G networks create new and expanding opportunities for Micron.”
The rise of cloud data centers has led to a structural increase in demand for semiconductor components such as DRAM and NAND memory, which helps smooth out the boom and busts cycles that Micron was historically exposed to. Micron explained the new market dynamic in its 10K when it stated that “data is today’s new business currency, and memory and storage are a critical foundation for the data economy”.
The IDC estimates data creation will explode going forward (pictured below), driven by the rise of cloud computing. Furthermore, the IDC estimates that less than 2% of data is saved today, and that data creation is far outpacing data storage capacities.
Furthermore, the ramp of the metaverse also requires massive scaling. During Marvel’s (MRVL) Q3 Conference Call, the company stated that the metaverse “will significantly accelerate a number of key trends, which are already occurring in the cloud today, including the need to store huge amounts of data”. With Meta (aka Facebook) guiding for $34 billion in capex in 2022 to develop the metaverse, the demand for data storage will likely be strong for the foreseeable future.
We can see the structural change underway by looking at results over the last four years. For instance, aggregate gross margin over the last four years was 44%, well above historical (cyclical) periods, and aggregate operating cashflow margin was ~50% over the same time period. In response to the structural change underway in the memory market, management recently initiated a quarterly dividend ($0.10 per share), which highlights management’s contention that the memory market is becoming less cyclical. I discuss Micron’s recent financial results in more detail below.
New memory technologies keep pace with cloud innovation
To address the issue of exploding data creation, Micron has innovated on some key new technologies that will enable datacenters to capture and retain much more data. Two of these key new technologies are 176-layer NAND and 1-alpha DRAM, which Micron began shipping in volume this year.
Micron stated that the introduction of “176-layer NAND and 1α (1-alpha) DRAM represent major technology breakthroughs for our company and the first time in our history that we have achieved industry leadership across these two flagship technologies”. 176-layer NAND is an extension of 3D NAND, and as the name implies, has 176 layers of cells that dramatically increase memory capacity. Previously, NAND was on a 2D plane with just one layer, and Micron has significantly increased capacity by expanding beyond a single layer of memory. Furthermore, the 1α DRAM memory node was introduced in 2021 and materially improves the performance of DRAM memory (20% to 30% higher yields), which is critical for cloud servers that rely on low latency and high performance.
With the continued development of AI, cloud servers require significantly higher quantities of DRAM, as the number and capabilities of these intelligent edge devices increases, more data is stored, processed and accessed in the cloud. The demand for storage in the cloud environment is growing exponentially and Micron’s industry leading 1α DRAM nodes should be able to capture market share in this fast growing segment in FY2022. We can see the strength in cloud computing by looking at Micron’s Compute and Networking segment (CNBU) sales, which increased 34% YoY to $12.3 billion during FY2021 and rebounded from an 8% YoY decline in the prior year.
CNBU is Micron’s largest segment (44% of sales) and continued strength here will be rewarded by the market. With that said, there was a deceleration in this segment between fiscal Q3 and fiscal Q4 both YoY and QoQ from 49% down to 26% YoY growth and down from 25% to 15% on QoQ growth.
In Q2 FY2021, Micron also began shipping 1α DRAM nodes for mobile, which improved power efficiency in mobile phones, and allows for memory intense use cases like smart photography. Management explained on the Q4 call that 5G phones have 50% more DRAM than 4G phones, meaning that the continued adoption of 5G phones should be a significant tailwind for Micron going forward.
Micron also began volume shipments of 176-layer NAND for mobile in 2021. On the Q4 call, CEO Mehrotra explained that “176-layer NAND-based mobile product went from just introduction to 1-million-unit shipments in a record time. Fastest RAM in the history of the Company”. The ramp in 176-layer NAND helps put into perspective how much demand there is for Micron’s new technologies. Following this strong demand, Mobile (MBU) segment sales increased 26% YoY to $7.2 billion in FY2021, a record high. The continued roll-out of 5G phones will likely be a tailwind for Micron going forward.
The roll out of these new technologies is just now beginning to ramp. To accelerate the roll out of these new technologies, Micron expects to increase its annual capex by 20% YoY to $12 billion, which follows a 22% YoY rise in capex in FY2021. Micron explained that capex will be driven by its continued transition to 176-NAND, as well as infrastructure support for the introduction of new technologies such as EUV lithography. While increased capex spend does not guarantee increased sales, there are also signs in Micron’s balance sheet that point to heightened demand in the near term, which I discuss in more detail next.
Micron’s financials
Following the roll out of new technologies during the year, Micron reported strong results to end its fiscal year. Specifically, Micron’s Q4 FY2021 sales increased 37% YoY to $8 billion, an acceleration from the 36%, 30%, and 12% YoY increase in Q3, Q2, Q1 respectively. Gross margin increased 1,300 bps YoY to 47%, the highest level since Q3 FY2019. On a rolling four-year basis, gross margin was 44%, highlighting the strong success Micron has experienced in recent years. As shown below, the sustained improvement in four-year rolling gross margin suggests that Micron’s business is becoming less cyclical.
The strong gross margin flowed down into operating margin, which increased 1,600 bps YoY to 36%. On an annual basis, operating margin improved from 14% in FY2020 to 23% in FY2021, while non-GAAP operating margin was 28%, up 1,200 bps YoY. The strong margin performance was driven by pricing increases across DRAM and NAND products and ongoing product transformation. Looking forward, management guided that gross margin would remain strong at 47% +/- 100 bps in Q1 FY2022, as the company continues to benefit from the new product releases (discussed in more detail above).
Continuing down the income statement, GAAP EPS increased 175% YoY to $2.39 and on an annual basis GAAP EPS increased 117% YoY to $5.14. In the last five years, Micron has reported an aggregate $28.94 in GAAP EPS, or nearly five times as much as it had earned in aggregate earnings over the prior 33 years (dating back to 1984). As discussed above, Micron had historically been a cyclical company dependent on PC demand for memory, but tailwinds from datacenter and mobile have structurally changed the demand environment for memory and have made Micron’s business less cyclical and more profitable. Below, we look at the 4-year rolling gross margin to discuss the continued strength in the company.
We can also see this outperformance in cashflows. Micron’s annual cashflow margin was robust at 45%, and FCF margin was also strong at 9%. Annual FCF margin has been positive in all but one year since 2012 and has been positive for five consecutive years. As a result of the strong cashflow performance over the last few years, management initiated a quarterly $0.10 dividend.
CFO Dave Zinsner stated on the Q4 call that “the initiation of a dividend is an important milestone that reflects the structural transformation Micron has undergone over the last several years, and it shows our confidence in the sustainability of our cash flow generation”. He added that Micron expects to return more than 50% of FCF to shareholders through dividends and buybacks going forward. If the memory business is becoming less cyclical, then shareholder returns could be substantial going forward given Micron’s robust profitability and cashflow generation.
Finally, inventory trends also highlight the strong demand for Micron’s products. Inventory declined 17% YoY despite the 37% YoY growth in sales, as Micron has struggled to replenish lean inventory levels in response to strong customer demand. Typically, in cyclical industries, elevated inventory levels can be a sign of concern, so the drawdown in inventory highlights the strong demand for memory in the current environment.
Inventory composition is also bullish, as raw material inventory increased to 11% of total inventory, a three-year seasonal high, while finished goods inventory declined from 19% of inventory to 11% in Q4, a five-year low. The drawdown in finished goods highlights that Micron is shipping its product faster than it can be replaced, highlighting the strong demand it is experiencing. A rise in raw materials and decline in finished goods means that management is quickly selling its product and anticipates that this demand will continue.
Outlook and valuation
However, a risk with the low inventory levels is that Micron will not be able to fulfill the strong demand in the near term. There are also supply chain issues outside of Micron’s control that may impact demand in the near term. CEO Mehrotra explained on the Q4 call that some PC customers are adjusting memory purchases in the near term due to non-memory component shortages. He added that supply chain constraints for IC components will limit some large shipments in the near term.
This commentary helps explain Micron’s Q1 FY2022 forward guide miss. Micron guided Q1 sales to be $7.65 billion at the mid-point, 10% below the Street’s initial estimate at $8.5 billion. Micron also guided Q1 EPS to be $2.10 at the midpoint, or 15% below initial expectations of $2.48. CEO Mehrotra explained that while there are near term supply chain issues, “shipping growth will resume in the second half of the fiscal year, and we're planning to deliver record revenue with solid profitability in fiscal 2022”. While Micron only quantified its Q1 guide, CEO Mehrotra’s statements suggest that growth will rebound in the second half of the year as supply chain issues and low inventory levels normalize.
Looking forward, Micron is expected to report Q1 earnings on December 20th. Q1 sales are expected to increase 33% YoY to $7.65 billion and non-GAAP EPS is expected to rise 169% YoY to $2.10. For the year, Micron is expected to grow sales 16% YoY to $2 billion and to report $9.01 in non-GAAP EPS, which gives it a 9.2x fwd EPS multiple. This is slightly below Intel’s fwd P/E multiple of 9.7 but above Western Digital’s fwd P/E of 6.7x. Furthermore, Micron’s fwd P/E of 9.2x is below the 15.8x level it reached earlier in the year, which highlights that there is room for multiple expansion going forward.
Micron also trades at a slight premium based on trailing earnings. Its TTM P/E multiple of 16x is 45% higher than the peer median of 11x (peers include Samsung, SK Hynix, Intel, and Western Digital). Micron is likely being awarded a premium over its peers due to its current technological lead in key technologies discussed above.
Conclusion
Micron’s sales grew 29% YoY in FY2021 and management expects this growth to continue into FY2022 as demand for memory remains robust. The memory market is becoming less cyclical due to numerous tailwinds that have expanded demand for memory beyond PCs and into more memory intensive markets such as data centers and mobile. Micron is ramping capex to keep pace with outsized demand and has innovated new technologies to keep pace with the cloud environment.
Management also issued a quarterly $0.10 dividend, which further highlights management’s contention that its market is becoming less cyclical. Micron currently trades at 9x fwd P/E, which is near Intel’s and above Western Digital’s multiple. If the company can prove to the market that its business is less cyclical and that its 40% gross margin and 50% cashflow margins are sustainable, then its multiple will likely expand going forward.
In November, Beth Kindig discussed winning tech stock picks on the Fox Business News show ‘”Making Money With Charles Payne.” Below are video previews of her discussion and an overview of what the two of them discussed.
Despite the current tech rout, we still believe that Roku has the top operating system, is priced reasonably and fits well with smart TVs. Another advantage for Roku is that it has the first-mover advantage in the advertising-based video on demand (AVOD). Roku not only benefits from the cord-cutters but also the brand advertisers. When Beth wrote her initial thesis in 2018, she used to hear questions, “What about Google, Amazon, Netflix, etc.?” Now, the stock has been a multi-bagger for her readers.
Asana is another excellent example of our stock-picking strategy. In this article, you can review how I/O Fund used to blend both fundamental and technical analysis to make gains on this cloud stock. You can also view the webinar from our portfolio manager Knox Ridley where he explains the patterns. Our premium subscribers receive regular trade notifications, trade setups, and market updates from Knox, which helps them to navigate the uncertainties in the markets. The I/O Fund went onto recently closed ASAN for a 285% gain in less than 10 months.
We have been building our positions with one or two strong picks in a year. For example, we have a position in Nvidia since 2018. We had rightly predicted that Nvidia would be a major player in Data Center and Artificial Intelligence. The market questioned our thesis back then. However, we have been firm and increased our position in the stock. Rather than rest on our laurels with long-ago entries from 2018, we continually buy and release our entries. For example, we were able to buy back into NVDA multiple times in this range, which led to 57% returns in less than 2 months. On 9/28 we stated in our service “If we see price move between $200 – $196 starting today and into Friday, that's a strong buy.”
Sign up for I/O Fund's free newsletter with gains of up to 1100% – Click hereSign up for I/O Fund's free newsletter with gains of up to 1100% – Click hereClick here
As you notice in the recent results, the company’s data center revenue accelerated by 55% YoY to $2.94B. Since we entered the stock very early, we have had big gains in Nvidia. Nvidia is also forefront in the Metaverse. We have covered earlier this year and we continue to be bullish on Nvidia.
We always like to start with small positions in a company and then build large positions. Our portfolio manager Knox Ridley guides us to entry and exit positions since he is an expert in technical analysis. Knox also tracks the broader market which helps us to develop a good risk management strategy.
Zoom is another cloud winner, which we started coverage well before the Covid-19. Beth has been bullish on the company due to the great product fit. In her own words, “Product-market fit is what led me to call Zoom Video the best IPO of the year in 2019, why I encouraged investors to know their winners during the cloud selloff, and why we reiterated a buy signal on my research site when Zoom Video was at $65.”
I/O Fund was also one of the early investors of Bitcoin. We started to build positions in Bitcoin in 2019. You can view our sample entries and exits here plus our press release on how Bitcoin contributed to our gains this year.
Short selling of ARKK
There are reports that investors are betting against ARKK Fund and the short interest in the ARKK has been increasing. Tuttle Capital Short Innovation ETF was launched to give an inverse return of ARKK. We believe that the investors are betting against the fund due to the macro environment shifting towards heightened inflation/slowing growth. High beta, low quality, and heightened risk assets tend to underperform in these environments, and ARKK has express no interest in pivoting their portfolio for this macro picture. However, we have a diversified risk management strategy in place. We recently have begun to book gains in high fliers and cut losers that would continue to struggle in a low growth environment. Since the secular bull market began in March of 2009, we have seen 3 slow down periods, which culminated in deep corrections. Each time the FED was forced to reflate the economy, and thus shifting risk-on assets back in the driver seat. We believe that we are entering one of these environments now. Regardless of the noise, and expected volatility, the bull market is not over yet. We always root for Ark and also for innovation so the I/O Fund (respectfully) hopes the shorts get burned!
I/O Fund is comprised of a team of analysts who share their research publicly as they build a portfolio of 30 stocks. Our team has record results for a retail Fund and we also have four-digit gains on some of our free newsletter coverage. You can learn more about our premium service by clicking here or sign up for our free newsletter here. clicking here or sign up for our free newsletter here.
Disclaimer: This is not financial advice. Please consult with your financial advisor in regards to any stocks you buy.
This article was originally published on Forbes on October 29, 2021, 12:07am EDToriginally published on Forbes on October 29, 2021, 12:07am EDT
Microsoft has taken the coveted top spot as the world’s largest company by market capitalization – passing even stock market darling Apple. Microsoft was nearly left for dead, like peers IBM or General Electric, as one of the leaders from previous decades that couldn’t innovate fast enough to keep up. The period after the dot-com bubble and then the financial crisis of 2008 were difficult years for Microsoft’s stock as the company greatly lagged its peers in gains.
Source: YCharts: Microsoft, Alphabet, Apple and Amazon Stock performance 2014-2020
This trajectory began to change when Satya Nadella, formally of the Azure division, became CEO in 2014 after working his way up through the company over the course of 19 years to president of the cloud business. The stock is up nearly 800% since the new CEO took over. Nadella’s multi-decade cloud experience and intense focus is what has helped Microsoft climb out of the hole that Bill Gates and Steve Balmer following decades of fighting open-source communities and anti-trust issues.
Source: YCharts: Microsoft, Alphabet, Apple and Amazon Stock performance 2014-2020
We’ve analysed earnings calls to see how Microsoft’s cloud focus compares to a company like Alphabet, which is diversified across many sectors, such as advertising. The contrast is remarkable in terms of how determined Microsoft’s management is on staking their ground on cloud computing with nearly every statement in the hour-long calls tying back to this sector.
Amazon Web Services could arguably be the hardest competitor in technology and Microsoft accepted this challenge despite AWS having a nearly four-year head start. Growth rates for both companies’ cloud divisions are in the 35% to 40% range.
Since 2018, we’ve covered in detail Microsoft’s hybrid cloud computing strategy and why we thought this strategy would be enough to propel Microsoft’s stock past its peers. Nearly three years after our coverage of this hybrid strategy began, we are now looking to the bellwether to analyse what trends we should pay attention to next across the cloud ecosystem.
Why Microsoft Azure Has Doubled Its Market Share
According to Gartner, cloud growth will remain robust next year on already large numbers. Public cloud services forecast on end-user spending will reach $482 billion in 2022, up from $396 billion in 2021 for growth of 21.7%.
Cloud IaaS will outpace this growth at 32.9% from $91.5 billion to $121.7 billion. Gartner also points out that public cloud spending will exceed 45% of all enterprise IT spending, up from 17% in 2021.
Amazon Web Services, Azure and Google Cloud are the top three IaaS players in the market with Azure nearly doubling its market share from a low of 11.2% in 2018 to 21% in the most recent quarter. We can see that despite this growth, AWS has not given up any turf and has remained level at 32% market share while the overall cloud IaaS market has grown substantially over time, affording others such as Azure an opportunity to capture this growth.
Primarily, it’s hybrid cloud computing that has helped drive Azure’s market share. We first covered this in 2018 and expanded on Microsoft’s strategy in 2019 when we stated:
“Investors should pay close attention to hybrid cloud when looking at Microsoft. Looking at it carefully will give them perspectives about how the company is positioned to set itself apart from other cloud companies like Amazon and Google.
Hybrid cloud is a technology which enables companies to store some of their data on their own servers while simultaneously sending other data to the private and public cloud. Companies love hybrid cloud because it is cost-efficient, transparent, and safe. Azure’s strength in hybrid computing has made it the main player in the industry. The product is used by 95% of Fortune 500 companies.”
Satya Nadella pointed out another important key aspect as to why Microsoft’s stock price has done well in the current environment where there are inflationary fears: “Digital technology is a deflationary force in an inflationary economy. Businesses – small and large – can improve productivity and the affordability of their products and services by building tech intensity. The Microsoft Cloud delivers the end-to-end platforms and tools organizations need to navigate this time of transition and change.”
I made this point over two years ago prior to the pandemic when the market was greatly doubting cloud and I said the following: “My prediction is this may be one of the last cycles when tech is considered less safe than value stocks. As the market will find out (the hard way), cloud software is actually very safe. It is insulated from trade wars and overseas manufacturing issues. It reduces costs for enterprises, which is ideal for a recession. Cloud software is at the beginning of a rapid growth cycle compared to its counterparts in tech — such as mobile, e-commerce and advertising — which are reaching saturation, are finding themselves in the cross hairs of anti-trust and are susceptible to consumer spending changes.”
Microsoft acquired Github in 2018, which helped Microsoft address its weakness of a poor reputation in open-source communities and lacking in developer relationships. Developers help determine the cloud IaaS service an enterprise or SMB customer will choose, so in-roads into this community via an acquisition has likely helped Microsoft hedge the developer favorite, AWS.
4 Key Trends from Microsoft Ignite 2021
As one of the bellwethers for cloud, Microsoft is a key company to monitor for trends that are leading the market. At Ignite 2021 Satya Nadella said, “we’re moving from a mobile and cloud era to an era of ubiquitous computing and ambient intelligence.” This next growth phase includes four key trends.
The first is the hybrid work-from-home trend with 73% of employees wanting flexible remote work options and 67% want more in-person connections. Microsoft believes the future will support both a collaboration between the physical world and digital world. Microsoft Mesh, which the company calls the Metaverse platform, can be embedded in Teams. Mesh introduces 2D and 3D meetings with personalized avatars that use AI to imitate movements even when the camera is off. Organizations can also create virtual spaces that resemble the physical office environment.
Sign up for I/O Fund's free newsletter with gains of up to 403% – Click hereSign up for I/O Fund's free newsletter with gains of up to 403% – Click hereClick here
Microsoft Loop is a new collaboration app that will expand Office. Through Microsoft Teams Connect, the company plans to make cross-organization communication easy and secure when there are meetings outside of an organization.
The second trend Microsoft pointed towards in the keynote is hyper-connected businesses. This refers to a “business process transformation” where supply and demand is informed by data and AI to help improve outcomes, such as the supply chain issues the market has experienced this year. At Ignite, the company announced Azure OpenAI Service with a video clip that showed how real-time summaries can be generated during the WNBA play-off. This will help content editors choose the right content in a few seconds using AI. Notably, Microsoft introduced the world’s first AI supercomputer five years ago during Ignite 2016 and today has some of the most powerful AI supercomputers in the cloud.
The third trend for the next phase of growth is that digital business will drive multi-cloud and multi-edge infrastructure. The company has already partnered with telecom operators like AT&T, Verizon, Telefonica, BG, Telstra, and SingTel to use its cloud services. Earlier this year, AT&T decided to move its 5G network to Microsoft Cloud. 5G and the Internet of Things could get a further boost recently as the Infrastructure Bill has been passed. The bill is expected to cost $1.2 trillion over eight years, which includes $110 billion for roads, bridges, and infrastructure, and $65 billion for broadband.
The final trend is the requirement for strong end-to-end security. The pandemic has increased digital transformation and with every business being operated remotely, the complexity has increased. According to the company, Cybercrime costs about $6 trillion per year and is expected to reach $10 trillion by 2025. In the earnings call Satya Nadella mentioned, “Our goal is to help every organization strengthen its defense through the zero trust architecture built on end-to-end solutions that span all clouds and all platforms. We analyze over 24 trillion signals across email, endpoints, and identities each day and translate this intelligence into innovative features to protect our customers.” The company has nearly 650,000 customers using its security solutions, which is up 50% YoY.
Microsoft Fiscal Q1 FY 2022 Report
The company’s revenue in fiscal Q1 FY 2022 increased by 22% YoY to $45.3B, which beat the consensus estimates by 3%.
All the three business segments showed promising growth. Revenue in the Productivity and Business Processes segment increased by 22% YoY to $15B primarily helped by the growth in Office products and LinkedIn revenue. Intelligent Cloud segment revenue increased by 31% YoY to $17B, it was primarily helped by the 50% YoY growth in Azure & other cloud services. The Personal Computing segment increased by 12% YoY to $13.3B.
Total cloud revenue growth was 36% YoY to $20.7B in comparison to Amazon Web Services 39% YoY growth to $16.1B. Notably, Microsoft does not break out Azure revenue.
78% of the Fortune 500 companies use the company’s hybrid offerings. This quarter GE Healthcare and Procter & Gamble migrated their critical workloads to Azure.
The company also updated in the earnings call that GitHub has 73 million developers. 84% of the Fortune 100 companies use GitHub.
LinkedIn has nearly 800 million members and hiring on the platform rose 160% YoY. LinkedIn revenue grew 42% YoY.
Microsoft Teams is also growing steadily. 138 organizations have more than 100,000 users of Teams. Due to the hybrid work environment Teams chats increased 50% YoY. Schlumberger, Westpac, and SAP have chosen Teams Phone in this quarter. Microsoft 365 subscribers reached 54.1M at the end of the quarter.
The company had a free cash flow of $18.7B. Net income grew 48% YoY to $20.5B and adjusted net income grew by 24% YoY to $17.2B. Earnings per share came in at $2.71 and adjusted earnings per share came at $2.27, which beat the consensus estimates by $0.19.
Management’s revenue guidance for the next quarter is $50.6 billion across all three segments, which represents year-over-year growth of 17%. The analysts’ consensus is $50.47 billion with adjusted earnings per share of $2.31.
Conclusion:
Microsoft’s strategic bet on cloud became clear when the company placed the president of the cloud division as CEO. There is a stark change in terms of Microsoft’s performance as a public company since 2014 and we believe this new era where Microsoft leads could be just beginning. Apple must contend with consumer sentiment (and China) and must also break into new markets to maintain growth, Alphabet is spread thin across many segments with little overlap, and Amazon’s e-commerce weighs on AWS profits. Meanwhile, Microsoft’s singular focus provides a rare pure play at a $2.5 trillion market cap while cloud is setting up to capture gains from artificial intelligence.
Royston Roche contributed to this article
Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.
