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Big tech blues (part 1)
One annoying thing about journalism is that when you say something stupid it leaves behind a permanent record. In Unhedged’s first year or two, I have written a lot of nice things about the biggest US tech companies. To sum up, the house view is that companies like Apple, Amazon, Microsoft and Alphabet are “smart, relatively low-risk things to invest in” even when their valuations look a bit high. They have immensely strong competitive positions in industries that grow much faster than the economy; and they are hugely profitable, so they can invest heavily in strengthening those competitive positions and maintaining their growth.
I have largely dismissed the argument that as rates rise, fast-growing tech companies will be hit particularly hard. I’ve argued that Amazon looks pretty cheap (it is down 24 per cent since). I have called Apple “the ultimate quality stock.” I’ve made the case that big tech will be a good place for investors to sit out a downturn. And on and on.
As of right now, all this looks dumb. The canonical “Faang” stocks — the four just mentioned, plus Meta and Netflix — are, on average, 50 per cent off their highs. Only Apple has held up better than the market, and even it is down 24 per cent from its peak. It is tempting for me to take Facebook and Netflix out of the picture here as I have not (that I can remember) said anything nice about those stocks specifically. But if you say nice things about big tech generally, as I have, you have to include the good with the bad.
This is a moment, in short, to reconsider Unhedged’s sunny view of big tech.
The first question is whether I have been too credulous about the ability of these companies to maintain high growth rates. As we have recently noted, looking across stocks in general, above average revenue and profit growth does not persist. Why should this handful of companies be different?
A simple way of looking at the meltdowns at Netflix and Facebook is the following. No one ever really knew how long they could grow at a high rate — which is to say, exactly how large their addressable market is, how deeply they would penetrate that market, and how long it would take for competition to make meaningful inroads. But it finally happened, there was a massive repricing which was going to happen sooner or later. Here is quarterly revenue growth at the two companies, and for Amazon’s online store operations (going back as long as the company has broken out the numbers for it):
Should every big tech price in the fact that one morning we are going to wake up and find growth much diminished, and that we don’t know when that is going to be no matter how confident we feel? Of course the Meta and Netflix slowdowns seemed inevitable — but only in retrospect. And perhaps the same thing is happening now with Amazon’s once-invulnerable online store operations (although the trend is harder to read due to the distorting effects of the pandemic).
I have probably been too sanguine about the barriers to entry at my favourite big tech companies. Not to say that they are slowing down now; it is just that I need to take on board the lessons of Netflix and Facebook. Here is 20 years of growth rates at Apple, Google and Microsoft (I took Google’s early years out because growth was so high it made the chart hard to read):
The growth performance of Microsoft and Alphabet has been remarkably consistent over many years. Apple, while no longer putting up stratospheric numbers, remains a strong grower. But we have to recognise our limits. Predicting how long this will go on is a mugs game, and we should be careful what we pay for growth far into the future.
Note, however, that with the exception of Netflix all of these businesses remain astonishingly profitable, even as growth has slowed for some. Some numbers:
Look at free cash flow margin (free cash/revenue). For every dollar in sales Amazon, Apple, Meta and Microsoft pull in, they capture 20-30 cents of distributable cash. Even Amazon, which generates relatively low free cash because it invests so heavily, squeezes 50 cents of gross profit out of every dollar of assets it owns every year (the others, bar Netflix, are not far behind). Microsoft has been massively profitable for more than three decades now, and Google for two decades. The recent collapse of Meta’s free cash flow is not about a change in its core business but instead reflects massive investment in the Metaverse (and this may be ending).
Such high returns are suggestive of the kind of profits Amazon could post, if investment were less of a priority. I think it is reasonable to expect that super-profitability will persist pretty strongly at all of these companies, because it speaks to structural barriers to entry and business structures, rather than market penetration.
Though I am chastened about paying up for growth, I still think paying up for profitability makes sense. The question is how much to pay up. Looking at the forward price/earnings multiples above, Alphabet is trading around market valuation (17 times earnings for the upcoming 12 months) and this seems cheap. Apple and Microsoft deserve a premium because of their profitability, but is 22 times earnings too much, especially as we sail towards a recession? It pains me to say so after banging the table for a while, but it may be. Here is a thought experiment: if those two companies were to be 5 per cent growers for the foreseeable future, do they look expensive at their current price? To me the answer is: yes, but not terribly.
Netflix is neither super fast growing nor profitable. If it ever was, it is no longer a big tech in the sense I outlined above.
That leaves Amazon (expensive looking) and Meta (cheap looking). More thoughts on those two coming tomorrow.
One good read
Aswath Damodaran on Meta’s governance.