TMT Portfolio Updates: Walking the Topline

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

FOR IMPORTANT DISCLOSURES 203.901.1633 /.1634

psagawa@ / apylak@ssrllc.com

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September 3, 2013

TMT Portfolio Updates: Walking the Topline

  • Sell side analysts love to back end load estimates for the companies that they favor, pushing sales acceleration and margin expansion into the back half or even into the next fiscal year. As we approach 3Q earnings, we thought it useful to identify the large cap TMT stocks where the next 4 quarter estimates were the most disengaged from the revenue and gross margin trends of the past 8 quarters. Overall the TMT components of the S&P have underperformed the broader index by 6.2% YTD, perhaps indicative of an 8 quarter trend showing slight sales deceleration and gross margin declines. In contrast, consensus forecasts assume a reversal of both trends. Looking at forecasts vs. historical trend for individual companies, NFLX, VIAB, INTC, and ADBE stand out as non-cyclicals having unusually positive inflection points embedded in consensus, while WDC, INTU, WDAY and ATVI are have the sharpest downward departures from trend. We note that AAPL has delivered the steepest sales deceleration and is forecast for the second most abrupt reacceleration in the sample. Turning to our model portfolios, the large cap portfolio outperformed the TMT components of the S&P500 by 720bp over the past 3 months, while the small cap model outperformed its analogous benchmark by 370bp. We are adding S and CCI in replacement for WPP and NVDA in the large cap model, and PAY, VALU and MKTO to the small cap in lieu of FIRE, WBSN and FIO.
  • Backend loaded estimates raise risk in 2H. Analysts love to push sales acceleration and margin improvement out to quarters in the back half and to the following year, hoping their favorite companies will beat the easier estimates upfront and set up the aggressive future projections as plausible. As such, downward revisions and quarterly misses are more likely in the back half of the fiscal year. We set up a screen to assess the risk of overly aggressive forward estimates in 67 TMT stocks with market caps above $10B. Using the last 8 quarters to assess trends in YoY sales growth and gross margins, we then analyzed the variation of the next four quarter estimates against those trends. Companies with estimates considerably above trend, and in particular, implying an inflection point reversing a previously downward slope could carry unusual risk of disappointments.
  • Large cap TMT growing at 7.6% annual pace. Over the past 8 quarters, our universe grew at an average 7.6% CAGR, with CCI showing the greatest acceleration and AAPL the sharpest deceleration. Analyst expectations show a substantial bias toward mean regression, with projected inflection points common, particularly for companies with the most pronounced deceleration trends. This is understandable in the cyclical technology names – e.g. MU, AMAT, XLNX, and TXN– that have been in an obvious downtrend over the past two years. With those stocks, we find several others – HPQ, ORCL, IBM, DELL, XRX, and CHTR – that have less obvious cases for a reversal of trend. At the top of the list, removing stocks affected by large acquisitions, are names projected to fall off of accelerating sales trends – e.g. Intuit, Crown Castle, Activision, etc.
  • 59% of 67 TMT large caps have seen declining gross margins. Excepting companies like GOOG, where large deals hit margins during the past 8 quarters, media stocks have seen the worst margin deterioration with TV, CHTR, and CBS all in the bottom 5. Considering the trends vs. consensus expectations, analysts are apparently expecting a serious downturn in payroll processing margins, with ADP 1st and PAYX 8th. Likewise, the recovery in disk drive profitability has not impressed the sell side, which places STX and WDC with the 3rd and 4th margin declines vs. trend. Meanwhile, consensus is far more bullish on media, expecting big margin upside for TV, CBS and VIAB vs. trend. Cyclicals MU and SNDK are getting the same benefit of the doubt.
  • Big expectations can be hard to live up to. Considering both sales growth and margin expectations against trend, the bar has been set very high for VIAB, INTC, ADBE, AAPL and NTAP, all of whom must reverse well established trends to meet consensus over the next 4 quarters. The other stocks in the bottom 10 are cyclicals (MU, AMAT, TXN and GLW) with reasonable expectation of an upturn, and NFLX, which has skewed trend lines due to a period of hypergrowth at the beginning of the 8 quarter period. At the other extreme, the 5 companies deemed likely to fall the furthest off of recent performance by analysts are WDC, ATVI, INTU, DISC.A, and VZ. Of these, we see WDC as a clear winner, even in the face of sell side skepticism.
  • Our large cap model portfolio performance has been strong. On an equal weight basis, our large cap model portfolio outperformed the S&P 500 by over 1000bp driven by the successes of companies like Netflix, Workday, NetSuite, and NVIDIA. In re-evaluating the portfolio, we are removing WPP because of recent merger activity in the advertising subsector and risk in the scalability of advertising services. We are also removing NVIDIA because of concerns over momentum of design wins and failure to penetrate a popular handset. We are instead adding Crown Castle as a result of our fundamentals screen and its positioning in wireless. Also, given the prospect of renewed rivalry in the wireless market and attractive spectrum assets for fixed wireless broadband, we are adding Sprint.
  • Our small cap model portfolio performance has been strong. Small TMT investing is inherently difficult given some of the most exciting opportunities have been co-opted by the platforms or remain in private hands in hopes of an IPO at a large cap valuation. Even so in this backdrop, our model portfolio outperformed the small cap S&P 600 benchmark by 1420bp and returning 28.1% since the last model portfolio update in April. Performance was driven by several companies with returns north of 45%: Web.com (+78.8%), Websense (+70.7%), Applied Micro Circuits (+65.0%), Sourcefire (+48.0%) and K12 (+47.8%). Also, because two of these companies were acquired: Sourcefire and Websense, we are adding Verifone and Valuclick to the small cap model portfolio. Thematically, Verifone is well positioned for POS devices that accept mobile payments. Also, Valuclick is one of the few publicly traded online advertising pureplays. We are also replacing Fusion-io with Marketo, a SaaS provider in the marketing space that IPOed in May.

Kicking the Can Down the Road

Over the past 14 years, TMT companies have missed consensus 4th fiscal quarter EPS estimates almost 18% of the time, a propensity 620bp higher than any other quarter of the year (Exhibit 1). Much of the blame for this can be laid at the feet of the sell side analyst community, which has a longstanding ethic of delaying the pain by backend loading overly optimistic forecasts. By scheduling a balloon payment in the form of a big 4th quarter number, an analyst can support a favorite stock over the course of the year without going out on a limb with aggressive short term targets. If the company beats numbers in the first half, the 4th quarter bogey can be shaved back a bit without requiring a downward revision to the full year estimate. If the company doesn’t beat numbers in the first half, that big 4Q number (and likely a big next fiscal year number as well) hangs like an albatross, portending a downward revision or a miss.

Exh 1: Percent of S&P 500 Tech Components reporting EPS misses by fiscal quarter, FY2000-2013

As we head into the fall, we thought it useful to identify the large cap TMT stocks where the sell side consensus implied the biggest reversal of fortune vs. the recent trend (Exhibit 2). To do this, we screened a universe of 67 TMT companies with market caps in excess of $10B, that had been public for the last 8 quarters and for which there were available consensus estimates for both YoY revenue growth and gross margins. For each of the companies and on both sales growth and margins, we ran regressions to establish a trend line and used it to project naïve estimates of the next four quarters for the stocks in the sample. These naïve estimates were then compared to the analyst estimates, determining the number of standard deviations each of those growth and margin estimates was away from trend.

Exh 2: The 67 large cap TMT stocks and implied forecast trend reversals

Growth is Good

In aggregate, the 67 companies in our analysis grew revenues at a 7.6% annual pace over the past two years, out pacing the growth of the S&P500 constituents by 222 bp over the period. Excluding companies where the growth trend was artificially boosted by major acquisitions during the period, the fastest average growth was turned in by Linked In, followed by Apple, which was still posting extraordinary numbers at the start of the analysis period, while Applied Materials saw sales drop at a nearly 17% CAGR to bring up the rear (Exhibit 3).

Exh 3: The top and bottom 10 large cap TMT stocks by retrospective mean top line growth – historical results and expected consensus top line growth

However, considering the acceleration or deceleration of sales from the slope of the trend line shows a different set of leaders. Crown Castle, which went from mid-single digit growth two years ago to the high twenties in recent quarters, showed the strongest acceleration in the sample, while Apple’s free fall from 73% and 82% growth quarters in FY12 to the 1% posted in the most recent quarter put it at the bottom of the heap.

Against that back drop, analyst expectations are particularly interesting. For 40 of the 67 companies, consensus projects that the next four quarters will be a reversal in the direction of the previously established trend – that is, companies that have been accelerating will begin to decelerate (9 cases), or more commonly, companies that have been decelerating will begin to accelerate sales (31 cases). This can be taken as evidence for a variety of possible explanations – bias toward optimism (3 times as many positive inflection points as negative), bias toward mean regression (60% of stocks projected to have trend inflection points), or our “can kicking” hypothesis posited up front.

Turning on a Dime

At one end of the list of 67 large cap TMT companies are several that are expected to fall off their impressive recent growth. Leading that list, excluding companies like Western Digital and Google that have integrated recent acquisitions, are Intuit, Crown Castle and Activision Blizzard, with Scripps Networks, Time Warner Cable, Qualcomm, Citrix, and Yahoo just behind (Exhibit 4). For these companies, sustaining recent momentum may be sufficient to deliver top-line beats in coming quarters. Of this group, Qualcomm and Citrix are already components of our large cap model portfolio. We believe that consensus expectations for Qualcomm are far too pessimistic given the company’s growing dominance of smartphone and tablet system-on-a-chip products. Citrix is on the list for decelerating growth and a small standard deviation, but both consensus and trend line forecast growth in the teens. We are also adding Crown Castle to the portfolio. We will discuss our rationale later in this piece.

Exh 4: The top and bottom 10 large cap TMT stocks by expected performance deviation from trend – expected trend line growth versus consensus

More troubling are the stocks at the bottom of the list, where the sell side is projecting the most dramatic up turns from recent performance. Four of the bottom 10 companies are classically cyclical – Micron, Applied Materials, Texas Instrument, Xilinx. Here, analysts may be making a strong call for an inflection point at the bottom of a cycle – MU, AMAT, XLNX, and TXN shares have already run up YTD, perhaps in anticipation of an industry up-cycle. The others on the list – HPQ, ORCL, IBM, DELL, XRX, and CHTR – can’t count on industry dynamics to turn the tide.

On the Margin

Only 27 of the 67 companies in our analysis were able to generate upward trending gross margins over the past 8 quarters. The top five margin improvers is led by Priceline, followed by Scripps Network Interactive, and includes both major hard disk makers, Western Digital and Seagate, along with Activision Blizzard (Exhibit 5). Not surprisingly, all five have been excellent performers this year. The bottom, again excluding companies affected by M&A, there is an eclectic collection of media and related companies – Groupo Televisa, Charter Communications, CBS and Netflix are all in the bottom 5, along with Apple.

Exh 5: The top and bottom 10 large cap TMT stocks by expected margin growth

Like the consensus forecasts on revenue growth, margin estimates overwhelmingly expect margins to regress to the mean, with 41 of 67 of the companies in our analysis projected to reverse the direction of their recent margin trend. Just 13 companies that had delivered declining margins over the past 8 quarters are projected to continue the margin decline in the next 4.

Considering the degree that estimates diverge from trend, the analysts are obviously skeptical about disk drives and payroll processing – ADP, Seagate and Western Digital are all amongst the top 5 companies with estimates farthest below trend, with Paychex in the top 10 (Exhibit 6). Entertainment is also there with Discovery Communications and Time Warner, while Priceline and LinkedIn are representing the Internet community. We are more confident than consensus on the likelihood that Seagate and Western Digital, in a more consolidated industry, can avoid the cyclical price competition that has scuttled margins in the past.

Exh 6: The top and bottom 10 large cap TMT stocks by expected margin difference from consensus

On the other extreme, analysts appear a bit bipolar on entertainment stocks, with Groupo Televisa, CBS, Viacom and Scripps amongst the ten companies with forward estimates furthest above the 8 quarter trend. Also getting benefit of the doubt from Wall Street … cyclicals Micron, SanDisk and Applied Materials. Yahoo, Sprint and Netflix finish out the bottom ten. We share the enthusiasm for Sprint and Netflix – both are in our large cap model portfolio. We are nervous about media companies with exposure to US television advertising.

Putting it Together

Considering expectations vs. trend on both sales growth and margins together, four of the ten companies with estimates highest above their trend lines are cyclical technology companies – Micron, Applied Materials, Texas Instrument, and Corning – which may be good candidates for an inflection point in growth and profitability. The other six –Adobe, Intel, Omnicom, Netflix, Charter, and Dell– carry the burden of very high expectations heading toward the end of the year (Exhibit 7). Of these, we are the most comfortable with the prospects for Netflix, which exhibited a strong reversal of trend over the past three quarters.

Exh 7: Summary of sales and margin estimates versus trends

At the other extreme, the 5 companies deemed likely to fall the furthest off of recent performance by analysts are WDC, ATVI, INTU, DISC.A, and VZ. Of these, we see WDC as a clear winner, even in the face of sell side skepticism, given the rationalization of the disk drive industry and the prospects for cloud-driven demand growth.

The Large Cap Model Portfolio

We’ve maintained a large cap model portfolio since May 2011 consisting of 15 stocks we believe are well positioned to perform given growth themes occurring in the sector. Of the current portfolio constituents, CRM, GOOG, ARM, and QCOM have been in the portfolio since inception and we continue to have conviction in those names. Since our last model portfolio update in April, the S&P 500 returned 6.4%, while our model portfolio constituents brought back 18.2% to investors. Our model portfolio also beat the S&P 500 tech components by 840 basis points. The key performer in our large cap model portfolio has been Netflix, which has been up over 76% on a string of positive news including new content deals, Emmy nominations for original content, and subscriber growth. Other strong performers included Workday, NetSuite, and NVIDIA, which have been up on growing cloud software and services, as well as mobile device components. With every constituent bringing back positive returns since the last update, our rationale for updating the portfolio is based re-weighing exposure to key growth themes.

Exh 8: SSR Large Cap TMT Model Portfolio – Performance since 4/18/2013

We’re removing two strong performers from the model portfolio. WPP and NVIDIA. We’re concerned that WPP may have lost momentum given a wave of merger activity in the sector and that professional services like advertising are only scalable to a certain degree. Mega-ad holding companies like the one that will result after the Publicis-Omnicom merger will have difficulty gaining scale advantages as some advertisers would be weary to keep business under the same brand as competitors. Also, media buying advantages gained from such deals may be de minimis. We continue to like digital advertising as a theme as a vulnerable TV advertising industry continues to lose eyeballs to online video and time-shifting, but would prefer some pure play digital names which fall into small cap territory. With regard to NVIDIA, while it’s had a decent run of design wins in tablets, its exposure to the WindowsRT platform and a lack of major smartphone sockets led the company to guide downward for the next quarter and the 2014 fiscal year. The mobile apps processor market has become concentrated over the past year with Texas Instruments exiting the space, and competition heating up between Qualcomm and Samsung, while iOS devices will likely continue to see Apple chip designs fabbed by third parties. With Qualcomm dominating the market, Intel trying to claw its way in, and a host of small Asian SoS designers like MediaTek setting their sights on the low-cost smartphone market, it is hard to see where NVIDIA can make a strong growth play. .

In lieu of WPP and NVDA, we are adding Crown Castle International and Sprint as a result of our trendline analysis and thematic bullish view on wireless (Exhibit 9). Crown Castle exhibited a strong topline growth trend along with expected margin growth for the next four quarters. The company also fits well with the wireless growth theme as carriers look to tower companies in placing wireless equipment. The tower industry is notoriously fragmented with the top 3 tower companies controlling about 60% of tower assets, with the rest either owned and operated by carriers or small companies. Despite this, tower companies like Crown Castle have the potential to leverage economies of scale in the rollout of any new wireless technology, especially with LTE rollouts underway and a clear roadmap of future technologies such as LTE Advanced. Crown Castle fits our model portfolio best as it is not a REIT like American Tower and has been reporting positive earnings unlike SBA Communications. We are also adding Sprint to the model portfolio as we believe renewed wireless rivalry in the US will benefit secondary carriers. Sprint is the best positioned secondary carrier given it has superior spectrum assets to take advantage of fixed wireless broadband and the backing of a tenacious foreign wireless player, Japan’s Softbank.

Exh 9: SSR Large Cap TMT Model Portfolio – New Constituents

The Small Cap Model Portfolio

Our small cap model portfolio also exhibited strong returns on the back of acquisition activity and outperformed the underlying S&P 600 small cap index by over 1420bps. To be fair, it’s been a good run for S&P 600 tech components which have returned 22.3% since our last update versus the 28.1% return of our model portfolio. Two of our model portfolio stalwarts held since 2011: Sourcefire and Websense were acquired by Cisco and Vista Equity Partners respectively (Exhibit 10). We’ve often noted the difficulty of small cap TMT investing given the most exciting opportunities are often co-opted by large platforms or remain in private hands in hopes of high IPO valuations. We typically screen new model portfolio candidates by theme, and in this update are replacing the acquired names with Verifone and Valuclick. We are also taking out Fusion-io and replacing it with SaaS marketing software platform Marketo.

Exh 10: SSR Small Cap TMT Model Portfolio – Performance since 4/18/2013

Exh 11: SSR Small Cap TMT Model Portfolio – New Constituents

With interest in Mobile Payments on the rise and an ongoing turf battle between card companies, bank issuers, wireless providers, platforms, retailers, payment incumbents, and a range of start-ups, an investible play is point of sale equipment. Verifone is a leading provider of POS equipment and already has partnerships with leading payment initiatives like wireless carrier-backed Isis, Google Wallet, and retailer-led consortium MCX. We are adding Valuclick since it is one of the few pure play digital advertising companies currently trading. As advertising shifts from traditional channels like print and television, digital focused advertising agencies and platforms stand to benefit. Finally, we are adding Marketo which IPOed in May. The company offers a centralized and intuitively easy to use marketing software platform that’s been well adopted by SMBs and some large enterprises with slightly over 2,000 end customers. While it is a nascent player with small revenues having brought in $58M in 2012, and a run rate slightly north of $80M for 2013, on a market cap of $1.3B. While consensus doesn’t see positive earnings before 2015, Marketo is a strong acquisition candidate.

Appendix: Large Cap Model Portfolio Constituent Iso-curves

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