When looking at the U.S. tech sector, you can be forgiven for feeling overwhelmed by iPhone sales reports and the potential earnings of businesses yet to turn a profit. As such, it’s easy to dismiss the U.S. technology sector as an apt example of today’s stretched valuations. Even the Federal Reserve is seemingly worried, with Fed Chair Janet Yellen recently stating that valuations in social media (and biotech) ‘appear substantially stretched’. However, amongst all the exuberant promises of world changing mobile apps there remains an old guard with proven and profitable business models. Many of these businesses have enjoyed healthy profit margins for decades and are adjusting their strategies for today’s big-data, service and cloud driven world.
Figure 1: Nasdaq Biotec Index PE Ratio
Source: Capital IQ
Our picks for the sector include IBM, Microsoft, Google, Oracle & Baidu. Four out of the five are from the US.
The most recent earnings season has really been a tale of old dinosaurs re-inventing themselves on one hand and social media start-ups over-promising and under-delivering on the other. Companies such as Microsoft and IBM were under significant pressure in the preceding 12 months, with the market questioning the ability of these company’s business models to adapt to changing trends in the technology sector. For Microsoft, questions were being asked in regards to its Windows licensing revenues, which were experiencing significant falls as well as the rapid slowdown in the desktop, and laptop PC markets, where the company had traditionally earned its revenues. For IBM, investors remained wary of the magnitude of the slowdown in the company’s software division, which covers areas like groupware products and enterprise systems management, as well as its hardware division, which includes its x86 servers.
Figure 2: Microsoft Price to Value Chart
On the opposite side, we have companies such as Twitter, LinkedIn and Yelp. Whilst each of these companies operate in different areas of the social-media space, their growth models are extremely similar. All of these businesses grew their user bases at a very fast pace by offering an easy-to-use and most importantly FREE service to their customers. As these companies’ user-base growth moderated, the pressure rose for management to begin monetising their business.
In what may seem like common sense to most investors, it is not all that difficult to run a loss making operation. This is not to undermine the fact that many businesses do this temporarily to build market share. However, it should be noted that for many of these companies to turn a profit it will require them to significantly alter their current business offerings. For Twitter, it will eventually have to get your eyes to spend more time on its advertiser’s content than your favourite celebrities. For LinkedIn, they will need to start charging businesses who use their service to scout for employees. This is the classic bait and switch, and it remains to be seen how the respective customers will react. Another name worth mentioning, although not disappointing the market this earnings season, is Amazon. It is a company which has grown its revenues and market share through offering goods at extremely-low margins and often offering free or highly subsidised shipping. How will Amazon adopt its model when investors demand that it starts turning a profit?
Coming back to Microsoft and IBM, we have two companies with proven (yet slowing) business models, established corporate relationships, strong access to international capital markets and an international pool of highly talented labour. Reinventing the core business of a company inevitably places a number of question marks over earnings, although when you consider the substantial advantages that these companies hold over their newer relatives, it is actually a more risk adverse investment decision than one may initially suspect.
And that was generally the story from this seasons reporting season. IBM experienced stronger than forecast growth in its emerging businesses, mainly big-data analytics and enterprise cloud services, as did Microsoft, as they managed to leverage their existing corporate relationships to swiftly find markets for their cloud computing platform, Azure. Twitter failed to extract as much revenue from its users as anticipated, with the usual metrics of clicks per user and new account growth giving way to the more traditional income and revenue lines. Whilst not missing forecast metrics by as much, LinkedIn revealed delays in one of its acquisitions as well as reducing revenue growth outlook by 6%, enough to send the stock tumbling more than 20%. This highlights the sensitivity of these unproven businesses’ share prices to even a slight earnings miss.
Another water-cooler topic from this earnings season and of late has been the ever-growing number of companies reporting non-GAAP statistics. GAAP (generally accepted accounting principles) is a standardised framework of financial accounting that obliges a company to use the same accounting practices as other companies when compiling financial statements. The idea behind this practice is to provide transparency and consistency to investors when they are assessing a company’s financials. Some market commentators argue that GAAP reporting may over exemplify EPS drops during downturns as asset write-downs and goodwill impairments are forced upon companies. However, some companies have taken this creative accounting a step further and do not include figures such as share-based compensation, amortisation of intangibles, payroll tax expenses and income tax adjustments. These metrics do indeed have a real impact on earnings today and in the future.
Taking Facebook as an example, between Q4 2011 – Q4 2013, non-GAAP EPS had exceeded GAAP EPS by $2.025b – amounting to the increase in reported profit by 110%. Quite the margin of difference. What this all really says is if you are willing to ignore the significant share and option compensation packages and amortisation of Facebook’s acquisitions, the business is making a significant profit. Should you ignore these metrics? We would suggest you should not.
Figure 3: Facebook GAAP and Non-GAAP Net Income
Source: Company Presentations
Whilst non-GAAP measures may have their place within the context of a market or sector downturn, we would urge investors to look carefully at the reported numbers of companies and to place a higher importance on GAAP numbers. The lesson from this earnings season is to keep ourselves grounded in financial reality. That means not getting carried away with the potential of companies that are yet to monetise their business, recognising the inherent risks in investing in a company, which is forecast to make profits versus one, that already is and the importance of looking beyond the headline numbers reported by companies.
Figure 4: S&P500 EPS: GAAP vs Non-GAAP
Disclosure: Clime Asset Management (Clime) owns MSFT.OQ and IBM.N on behalf of various mandates where it acts as an investment manager.