Another AMD Comeback: Stock Says Most Certainly Yes, But I’m Skeptical

At first glance you might very well think Advanced Micro Devices (AMD) is having a hugely successful rebirth. Here is two-year chart of the semiconductor company’s stock price:

After so many fits and starts and promises over the last few decades, with little to show for it in the way of sustainable profitability, I had not really looked closely at the shares, even during this huge run recently. Then I read an article in the July issue of Fortune that spotlighted AMD’s bet on new chips that apparently has gotten investors’ attention.

For a company whose annual revenue in 2015 and 2016 ($3.99 billion and $4.27 billion, respectively) were the lowest out of any of the past ten years, AMD’s current market value of $13.5 billion (today’s share price: $14.39) seemed pretty lofty, but I wanted to dig deeper to see if progress is really being made. The numbers are pretty ugly:

The aforementioned revenue trend is poor:

And profitability is hard to come by. Here is free cash flow over the last decade:

Okay, “hard to come by” might be overly generous… AMD has not turned a material cash profit, after required capital expenditures, in any of the past 10 years. Looking at the two-year stock price chart again, it is hard to understand why the share are trading above $14 each.

Evidently, optimism about future products is high, despite some clear setbacks as noted in the Fortune piece. But I suspect the stock may be ahead of those rosy expectations. Including half a billion dollars of net debt, investors are currently valuing AMD at $14 billion. Revenue is expected to reach $5.3 billion in 2018 (sell side consensus estimate), which would get the company back to 2012-2014 sales levels.

So what is a best case for AMD? I decided to try and pinpoint a number in order to draw a final conclusion about the current stock market valuation. To do this I like to assume that most metrics get back to previous peak levels and see what kind of stock price I would get if things go right from here. Call it the “bull case” as many analysts do.

Using the last decade as my data set, I see that gross margins peaked in 2010 at 46%. R&D spending troughed at 19% in 2014. Corporate overhead troughed at 11% last year. Let’s plug in those expense levels (equating to EBITDA margins of 16%) and further assume that AMD can get annual revenue back to $6 billion (40% above 2016 levels and 12.5% above consensus estimates for next year). In that scenario annual EBITDA would come in at $960 million. Let’s call it a billion.

What multiple should we use on that $1 billion of EBITDA? Industry behemoth (and the competitor AMD has never been able to strongly challenge), Intel, trades at 7 times. If we give AMD the same valuation the equity would be worth $6.5 billion, or roughly $7 per share. Even if we are generous and assign a 10x EV/EBITDA multiple, we only get to $10 per share.

At over $14 per share, AMD stock currently reflects very optimistic assumptions about the company’s future growth, profitability, and valuation ($1.4 billion in annual EBITDA, at a 10 multiple, for instance). If the last decade is any indication, the odds are not great that they deliver. As a result, I am not touching the stock. In fact, for those who short overvalued and underwhelming businesses, it might be a solid candidate.

Full Disclosure: No position in AMD at the time of writing, but positions may change at any time

 

Buffett Sells IBM, Jumps On Apple Bandwagon – Blessing Or Curse?

Warren Buffett’s decision to invest a large sum in Apple (AAPL) in recent quarters was so surprising because he once regarded tech companies to be outside his so-called “circle of competence.” Then six years ago he started buying IBM (IBM) shares, which only served to confirm that the legendary investor indeed should probably steer clear of the sector and focus on the areas of the economy he knows best.

In recent days we have learned that Buffett has begun selling off his IBM position (about 1/3 thus far), but his new tech favorite is clearly Apple, which he has been accumulating so much that it now represents his second largest single stock investment in dollar terms behind Wells Fargo (WFC).

His timing with Apple appears to have been quite good, although I suspect that is more due to luck than anything. For the last year or so, Apple bulls (other than Buffett) have been touting the idea that the company is not actually a hardware company, but rather a software and services company with valuable recurring revenue. It should follow, they say, that Apple stock deserves a much higher earnings multiple than it traditionally has received (below the S&P 500 due to the perceived fickle nature of technology products, especially on the hardware side of the business).

I am not convinced that this argument makes sense, at least yet. Every quarter we hear investors tripping over themselves about Apple’s service revenue growth, and yet whenever I look at the numbers I still see a hardware company. Consider the first half of Apple’s current fiscal year (which ends September 30th). Service revenue made up 11% of Apple’s total sales, versus 67% for the iPhone, 10% for the Mac, 7% for the iPad, and 5% everything else. Clearly, Apple is not a software company.

Now I know that services have higher margins, so although they represent 11% of sales, they contribute more than that to profits, which is a good thing. But in order for software and services to really become a large contributor to Apple’s bottom line, the revenue contribution has to rise materially, in my view. And that is where I think the “Apple is a services juggernaut” thesis gets shaky.

Over the last six months, services made up 11% of total revenue. Okay, so clearly that number must be accelerating pretty quickly given how bullish certain shareholders are about Apple’s earnings multiple expansion potential, right? Well, in fiscal 2016 the figure was also 11%. In fiscal 2014 it was 10%. In fiscal 2013 it was 9%. Services thus far are not growing much faster than hardware, which actually makes sense when you think about the Apple ecosystem.

If you want more people to buy the services, they have to buy the hardware first. So maybe the two go hand in hand. Put another way, if many iPhone owners have not subscribed to Apple’s services yet, why would they suddenly begin to adopt them at higher rates in the future? At least, that is the argument for why services might not become 20 or 30% of sales over the next few years.

Interestingly, since Buffett started buying more Apple, the earnings multiple has increased. Much of that likely has to do with the prospect for corporate tax reform and the potential for the company to repatriate their large cash hoard ($30 per share net of debt) back home at a low tax rate, but some probably is linked to the idea that services are about to explode to the upside. Color me skeptical on that front.

Year-to-date Apple shares have rallied from ~$116 to ~$152 each. On a free cash flow basis, the multiple on fiscal 2016 results has risen from 12x to nearly 16x. As a holder of the stock, I am certainly happy about that, but I wonder how much more room the multiple has to rise. And will it turn back the other way if services growth disappoints or if tax reform is less aggressive than hoped? Perhaps.

If that happens, the stock price could very much depend more on Apple’s future product lineup than anything. On that front, I am nervous about the company. In recent months I have come to the conclusion that Amazon (AMZN) might be the “new Apple” in terms of tech innovation. Not too long ago it was Apple that would be first to market (the iPad, the iPhone, etc), and then everyone else would copy them (and fail). Lately it seems that Amazon has taken over that role and Google (GOOG), Microsoft (MSFT), and Apple then copy them.

I am thinking about Amazon Echo, which Google quickly copied and rumors are that Apple is not far behind in doing the same. With Amazon’s announcement this week about Echo Show I had the same thought. Dash buttons – same thing. Drone delivery – same thing. Apple is reportedly funding original TV shows and movies now (years behind the curve). The Apple Watch wasn’t first to market, etc. Oh, and the attempt to build an electric car in Cupertino? The perfect example of mimicry.

If that is the case, then Apple’s hardware growth, which has been halted, may be difficult to accelerate. And if services need to pick up the slack, there is a lot of work left there as they seem to be stuck as a percentage of total sales.

While I am not bearish on Apple as an investment – their ability to generate cash remains more than formidable – with the recent earnings multiple expansion I am starting to think about where future upside will come from. If the most exuberant bulls are right and the stock can garner a multiple a la Coca Cola (KO) or McDonalds (MCD) (20-25x earnings), that is definitely the answer. I am just not sure sure that makes sense, at this point anyway.

Full Disclosure: Long shares of Apple and Amazon at the time of writing, but positions may change at any time

Valuing Software Companies Getting Tougher As Firms Trade Short-Term Profits for Growth

There is little doubt that the technology sector is so dynamic today that investors trying to identify the big winners of the next decade or two are probably correct to be engaging in such an exercise. The proliferation of software-driven innovation is truly staggering, as are the number of new companies trying to capitalize. The IPO market is bringing new software companies to the public exchanges, ensuring there is no shortage of investment candidates.

So while there is enormous potential with these companies as we look over the next 10 years or more, it is also getting more difficult to analyze these stocks from a valuation perspective. There are hundreds of examples of investors who buy the right company – just for the wrong price – and wind up being disappointed with their return.

I say it is getting harder to determine what a fair price is for these small, high-growth companies because they have adopted what I call the “Amazon model.” The Amazon model is simply the idea that you should sacrifice short-term profitability for growth, especially in nascent industries where the first mover can oftentimes distance themselves from the competition.

Before Amazon came along very few companies were willing to have public shareholders and purposely avoid making material profits. The consensus view was that once you IPO, profits matter. And while Amazon bears tried to debunk their model for many, many years, the company’s success has proved that it can work. Simply put, if you grow fast enough and come to dominate a particular market, investors will eventually assign a fair value to the franchise you have built. If Amazon’s stock price performance in recent years does not reinforce that view, I don’t know what could.

Not surprisingly, tech companies are now copying the Amazon model and investors are okay with it. There are dozens of public tech stocks today that are growing at 20% plus annually (some much faster) and are losing money or simply breaking even. Maybe they are marginally profitable if you wave your magic wand and pretend that stock-based compensation is not a real expense (some firms have positive cash flow but if you then subtract stock-based compensation you realize they really aren’t profitable).

Valuation conscious investors who look at the financial statements of these companies cannot help but scratch their heads when trying to understand the Wall Street valuations. After all, it is hard to explain why a money-losing software company is worth 10 times forward-looking revenue.

A closer look at the income statement reveals that in addition to stock-based compensation there is another line item that is impacting profitability to a huge degree; obscene sales and marketing expenses. Why is this number so high? Because according to the Amazon model growth and market share are crucial in the short-term. As a result, the amount of money these companies are spending on sales and marketing dwarf anything we have really seen before.

Consider some of the largest, more mature software firms. Below is a list of several, along with what percentage of sales each spends on sales and marketing:

Google 12%
Microsoft 17%
Oracle 21%
Intuit 27%
Adobe 33%

Given how high the margins are on software itself (especially now that it can be downloaded rather than boxed and sold at retail), these kinds of numbers (sales and marketing costs of no more than one-third of revenue) make it relatively easy for companies to earn net profit margins of 10-20% or higher. And once investors can see those profits it is easier to assign a fair value to share prices.

The tricky part is what we see with today’s newer companies.  Below is a list of smaller, higher growth public software companies,. along with their sales and marketing expenses as a percentage of revenue:

Workday 37%
Zillow 45%
Salesforce.com 47%
Zendesk 54%
Palo Alto Networks 56%
Splunk 69%

I don’t care how cheap it is to make your software or how high of a price you charge for it, if you are spending 50% of your revenue on sales and marketing, you aren’t going to be able to make a profit. And that does not even account for the fact that these same companies are paying out a ton of stock as compensation (instead of cash) in order to be able to cover the cost of sales and marketing.

As long as investors are willing to give these companies a pass (which is likely as long as revenue growth continues), there is nothing wrong with spending money in this fashion. The bigger problem for investors comes when they try and figure out how much to pay for the stock of a company they want to invest in. In order to do you need to have some idea of how profitable the business model is. And with this much money being spent on sales and marketing, in order to maximize growth, there is no way to really know what a “normalized” level of profitability will be when the business matures and most of the market share has been divided up. Some firms might be able to earn 25% margins at that point, whereas maybe others will be 10%. There is just no way to know.

So what happens when you find a small company and love the story but look at the financial statements and see that they are losing money and then you look at the stock price and it trades for 10 times annual sales? Do you close your eyes and buy, or cross your fingers that they miss  a quarter or two and the stock falls to 5 times annual sales?

For me, it is hard to justify the former option. Amazon and Apple trade for 3x forward sales. Google and Microsoft: 5.5x. Facebook and Netflix: 11x.

For something to be worth 10x sales it really needs to be the second-coming of these tech giants. Sure, there will be a handful that make it into that exclusive group, but will most of them? How hard is it to pick and choose correctly? It is a very tough task.

So what should value-oriented investors do? Well, try and find companies that trade closer to 3-5x sales. If they will fetch a similar multiple once the businesses mature, and you think they have a lot of growth ahead of them, the growth itself will boost the stock (in the absence of multiple compression). Also look for companies that are growing quickly but maybe are only needing to spend 20-30% of revenue on sales and marketing. That could indicate they are more efficient with their spending, or perhaps they have fewer competitors (and therefore less need to hundreds of salespeople hunting down prospective customers).

Those are some ways you can reduce your risk with high multiple stocks.

 

Does Buffett’s Big Buy Signal A Top In Apple?

For decades legendary investor Warren Buffett refused to buy technology stocks. He missed the huge bull market in the mid to late 1990’s and people repeatedly questioned his decision in light of the obvious tech revolution. After the dot-com bubble burst he looked brilliant, for a while at least. Interestingly, Buffett avoided tech stocks not due to some core issue such as high valuation, but instead because he simply did not understand the industry. As someone who popularized the term “circle of competence,” his lack of deep understanding of the sector meant that he did not feel like he could analyze these companies well enough to make an investment.

Then in 2011 something changed. Buffett started to amass a huge stake in his first technology investment; IBM. Close followers of the Oracle of Omaha, especially those who knew a decent amount about the tech sector, were doubly shocked at hearing this news. Not only had Buffett violated his decades old rule, but he had chosen for his first tech investment a giant that was widely seen within the industry as being a symbol of “old tech” – one that was only going to be marginalized by newer companies and technologies.

Fast forward six years and Berkshire Hathaway’s 2016 annual report shows that Buffett’s firm owns a staggering 81.2 million shares of IBM. Since purchasing 63.9 million in 2011, he has increased his position by another 27% in subsequent years. That stake was worth $13.5 billion as of year-end 2016. The annual report also discloses his total cost basis in IBM; $13.8 billion. Given a cumulative loss since the initial purchase in 2011, it is hard to argue that Buffett should have ventured into an industry he admittedly knew little about.

While the IBM story is old news for Buffett watchers, I think it is noteworthy given his recent comments on CNBC two weeks ago that during the month of January he acquired 76 million shares of Apple. Buffett admitted in the interview that he did not have an iPhone and that he queried his young family members to see how they like Apple products.

Apple shares have been on a tear in 2017, in part due to news that Buffett was buying.

I have to wonder if this second step into the tech world will share any of the same characteristics of the IBM investment.

Perhaps the bigger point is this idea of one’s circle of competence when it comes to investing. When I look back at my own career managing money it is obvious that my batting average is far higher within industries I am more familiar, and vice versa. There are multiple instances where I have lost money on energy exploration stocks and early stage biotech stocks, to name a couple of areas outside my circle. While I have never instituted a rule that prohibits me from buying stocks in certain sectors, over the years I have definitely allocated more capital to sectors I know best.

That decision does not always help me, especially when investment managers are compared with very diversified indexes. For instance, since the election of President Trump, companies focused on manufacturing, construction, and infrastructure have performed very well. I own very few of these types of names, and in some cases none at all. That lack of exposure to a strongly performing group has materially impacted my short term performance.

My hope is that my clients would rather me avoid sectors I don’t understand well (even if that means poor relative short-term results), as opposed to feeling like I need to have exposure to a little bit of everything in case sectors outside my circle of competence happen to perform well for a while. If I am going to be judged on mt ability to pick individual securities, I may as well stack the odds more in my favor, right?

Regardless, I can’t help but believe that such a strategy makes the most sense, even if it does not always pay off in spades. And if I had to guess, that probably goes for most other (both professional and amateur) investors too.

As for Apple stock, while I continue to hold some both personally and on behalf of clients, the recent run-up to $140 per share probably means that future returns will be more muted, as the stock now trades for roughly 15 times annual free cash flow per share.

Full Disclosure: Long shares of Apple at the time of writing, but positions may change at any time

The Downward Spiral of the Tech Hardware IPO: Are Acquisitions on the Horizon?

We see this happen so many times. A hot brand new technology hardware company with a cool new product decides to cash in via an IPO. All is good for a little while and then Wall Street’s expectations for growth become too ambitious as competition grows and the need to constant upgrade one’s device wanes. The company misses financial targets for a few quarters in a row and the stock goes from darling to laughingstock in short order. I think we can all agree that fitness band maker Fitbit (FIT) fits the bill. Here is the stock’s chart since the IPO in mid 2015:

Another obvious poster child for this phenomenon is GoPro (GPRO):

To me, it seems the only logical play is for these companies to be acquired by larger technology companies who can best harness the value and loyalty behind these solid brands to maximize their profit potential.

So why should a bigger tech player swoop in and take Fitbit and GoPro out of their misery? Quite simply, the public markets become broken for these young disappointments very quickly. Given the competitive landscape, it will be very hard for either of them to reaccelerate its business to the level that would be required for investors to warm back up to the story. As a result, the stocks are being valued extremely cheaply if you consider the value of the brand and the current user base. As a result, it should be a no-brainer for the big guys to snap up the small fries. This becomes especially true if we consider that the IPO markets have allowed these smaller players to amass large cash hoards.

Take Fitbit, for instance. At less than $6 per share, FIT current equity value is a meager $1.4 billion. The company’s finances are actually is very solid shape, with no debt and a projected $700 million of cash onhand as of year-end 2016. Net of cash, Wall Street is valuing the Fitbit brand and the more than $2 billion annual revenue base (2016 figure) that it brings are just $700 million. For a strategic acquirer, that price should be mouth-watering. Even offering a big premium of 50-100% to persuade current shareholders to sell would not impede value-creation from the deal. Offer $11 per share/$2.7 billion for FIT ($2 billion for the operating business plus cash onhand) and it is unlikely a company like Apple or Google would regret it.

GoPro would be an even cheaper purchase. At the current $8.75 share price, Wall Street thinks the company is worth just $1 billion (net of $200 million cash, no debt). Could Apple not add value to its company by paying $2 billion for GoPro, innovating the product line further, and integrating it into their existing user base around the globe?

So why have these deals not really happened? In some cases, large tech companies firmly believe they are superior to the upstarts. As a result, they prefer to challenge them with internal product development (me-too copycats) instead of merging and taking out one of their competitors. Apple is probably the most prominent company in this category, as they refuse to acquire any meaningful competitor. And yet, it is almost assured that their competitive positions would be stronger today has they bought companies like Netflix, Spotify, Pandora, etc. Instead, we read stories like the one recently that said that Apple is planning to go into the original content business. All I can do is roll my eyes.

The second hurdle for these combinations is seller willingness to merge. From an emotional perspective, the board of GoPro would not have an easy time agreeing to sell the company for $15 or $20 when the stock price was $100 in 2014 and $60 in 2015. If they just come out with one more hit product the sky could be the limit! Same thing with Fitbit; we went public at $20 in 2015, how can we sell out for $10?

To me the playbook is obvious. Wall Street is telling you that your hyper growth days are over. The big guys have more resources and will slowly take your customers. For some reason, nobody realizes that combining forces is probably the best move for both sides in the long run. I will be interested to see if Fitbit and GoPro are public companies a year from now. Heck, maybe Steve Ballmer comes back to Microsoft and sees synergies with a Nokia/Surface/Fitbit/GoPro/X-Box product lineup (kidding, of course).

 

Beware of Seemingly Reasonable P/E’s on Growth Tech Companies

Pop Quiz:

Do all technology companies expense stock-based compensation in their financial statements? Perhaps more importantly, do sell-side analysts include such expenses in their quarterly earnings estimates, on which every quarterly report is judged by Wall Street?

Given that stock-based comp has been a hot button accounting issue for a couple of decades, and the chief accounting rule board (FASB) required GAAP financial statements to include such expenses way back in 2004, I suspect that most investors are not really paying attention to the issue anymore.

Since I am a value-oriented investor, most of my investments are outside of the high growth tech sector, where most of the stock-based compensation resides. Nonetheless, a few months ago I wanted to dig a little digging because I did not understand why market commentators in the financial media were seeming to understate the P/E ratio of the S&P 500. I have been closely watching S&P 500 index earnings for most of my career, so it struck me as puzzling when people on CNBC would claim something like “The S&P 500 trades at 17 times earnings, which is only modestly above historical averages.” In fact, the numbers I saw on the actual Standard and Poor’s web site showed the P/E to be more like 19 or 20x. Given that the historical average is around 15x, there is a big difference between 17x and 20x. So what the heck is going on?

It turns out that there is a large financial data aggregation company called FactSet, which supplies many investors with earnings data on the S&P 500. You can find their earnings data directly on their web site. After reading through it I realized that FactSet was showing higher earnings levels for the S&P 500 (which equates to lower P/E ratios by definition), and that is where the market commentators were getting their valuation information. For instance, the current FactSet report shows that calendar year 2016 earnings for the S&P 500 are projected at $119, which gives the index a trailing P/E of 19.3x. However, the S&P web site shows a figure of $109, which equates to a trailing P/E of 21.1x. Investing is hard enough, but now we can’t even agree on what earnings are? Maybe I’m making a big deal out of nothing, but this is frustrating.

The logical question I needed to answer was what accounted for the gap in earnings tallies. If earnings really were 9% above the level I thought, my view of the S&P 500’s valuation would undoubtedly change. I was shocked when I learned the answer.

It turns out that FactSet’s earnings data does not represent the actual earnings reported by the companies comprising the S&P 500, which is what the figures on the S&P web site show. Instead, FactSet uses the reported earnings that match up most closely with the Wall Street’s analysts’ quarterly forecasts. Put another way, if the analyst community excludes certain items from their earnings estimates, FactSet will adjust a company’s actual reported earnings to reflect those adjustments (for an apples to apples comparison to the Wall Street estimate) and those earnings figure are used when they tell the investment community what the earnings for the index actually are. If this sounds bizarre to you, it should.

Having followed the market for my entire adult life (and all my teenage years too), I immediately knew what accounted for much of the gap between these earnings estimates. Most technology companies still to this day report non-GAAP earnings results right along side GAAP figures in their earnings reports. For reasons I don’t understand (since the issue of whether stock compensation is an actual expense was resolved years ago), the analyst community excludes these expenses in their numbers, so when a tech company reports earnings, the non-GAAP number is comparable to the analyst estimate. As such, the non-GAAP number is incorporated into FactSet’s data. So whenever a stock market commentator quotes the FactSet’s version of the index’s P/E ratio, they are inherently ignoring billions of dollars of employee compensation that is being paid out in shares instead of cash.

To illustrate this point, Consider Google/Alphabet’s fourth quarter earnings report from last night. The analyst estimate was $9.44 per share and Google reported $9.36 per share. So today’s media headlines say that the company “missed estimates.” If you read the financial statements carefully you will see that Google’s GAAP earnings were actually $7.56 per share. The non-GAAP earnings figure, which is the ones that is reported on because that is how the analysts do their projections, was a stunning 24% higher than the actual earnings under GAAP accounting rules.

You can probably guess why there was such a large gap. During the fourth quarter alone, Google incurred stock-based compensation expense of… $1.846 billion! Multiply that by four and Google’s run-rate for stock compensation is $7.4 billion per year! That is $7.4 billion of actual expenses that are being excluded from FactSet’s earnings tally, and that is just from one company (albeit a big one) in the S&P 500 index.

So how does this impact investment decisions? Well, there are many people that look at Google and see an $850 stock price and $34.40 earnings for 2016 and conclude that the stock is quite reasonably priced given the company’s growth rate, at less than 25 times trailing earnings (850/34.40=24.7). Of course, the actual P/E is 30.5x because when you add back stock-based comp Google’s earnings per share decline from $34.40 to $27.85.

The valuation differentials get even larger when you consider younger, smaller technology companies because these firms seem to be addicted to stock-based compensation. Google pays out a lot in stock, but even that $7.4 billion figure is only 7% of the company’s revenue. Paying out 7% of sales as stock compensation is indeed a very large figure, but other tech companies dole out far more.

I looked at some other fairly large ($5-50 billion market values) tech firms and the numbers are staggering. During the first three quarters of calendar 2016, Salesforce.com (CRM) paid out 9% of revenue in SBC, but that seemed quite low compared with some others. Zillow (ZG): 13%. ServiceNow (NOW): 23%. Workday (WDAY): 24%. Twitter (TWTR): 26%. Can you believe that some tech companies pay a quarter of revenue in stock-based compensation? Not total compensation, just the stock portion!

Importantly for investors, these companies are getting very large valuations on Wall Street. In fact, those five tech companies have current equity market values that cumulatively exceed $100 billion. I wonder if investors might view them a little less favorably if they realized they might be less profitable than the appear on the surface.

For me, the takeaway from all of this is that all investors should dig deeper into valuations in general. Don’t just take figure you hear on CNBC or read in press releases as gospel. Just because a web site says a company has earnings of X or a P/E ratio of Y does not mean there isn’t more to the story.

This Is How Amazon Will Become America’s Most Valuable Company

In 2014 I invested in Amazon.com (AMZN), much to the bewilderment of many of my clients. Even though the stock had fallen from more than $400 to below $300 per share, the consensus view was that the company was a money-losing unfocused endeavor that prioritized innovation over financial considerations. In many minds, there was no way to justify Amazon’s market value, so $280 per share was pretty much just as crazy as $400 per share.

Fast forward 30 months and Amazon shares trade in the mid 700’s. The company is reporting GAAP profits and still growing 20% per year. Prior skeptics missed several things, but at the core they did not account for the fact that Amazon sees no boundaries in terms of areas in which it will compete. The company was losing money in the accounting world, but in reality certain businesses were making money and those profits were being used to subsidize growth initiatives in other areas, some of which would fail and others that would succeed but not turn a profit on their own until years later.

We often hear growth investors focusing on a company’s total addressable market, or “TAM,” when trying to figure out how high a stock could go over a 5 or 10 year period when growth is more important to management than short-term profitability. Many Amazon investors try to gauge the company’s TAM by looking at the total retail market, and assuming e-commerce ultimately represents X percent of retail spending, and Amazon gets Y percent of that e-commerce market. That method of analysis would work for most companies, but not Amazon. The problem is that it implied that we know what categories will have an e-commerce component and that the e-commerce penetration of each category will remain somewhat consistent (such that we can predict what it will be).

Why is that problematic? Watch this video, unveiled today by Amazon:

You see, Amazon is not a traditional company. It is creating new businesses that don’t exist and it is re-imagining business models, like the convenience store. There is really no way to know what businesses Amazon will get into in the future. All we really know is that they are more willing than any other company on Earth to venture into something new that may or may not seem to make sense. This is why I believe within the next five years Amazon will become the most valuable U.S. company. There is nothing stopping them from growing because they never limit themselves.

The “Amazon Go” store you saw in the video (see the related Seattle Times article here) will open in 2017 in Seattle, about 10 miles from my house. I will eagerly await its arrival and share my initial experience when it opens. As for the stock, as the price warrants I will reduce my position over time (I already have sold some), but it is probably the only stock I have ever owned that I will continue to hold at least some of my shares almost no matter how high it goes. As long as I cannot predict where Amazon’s growth will take it in the future, it will be hard for me to confidently say the company is overvalued.

Full Disclosure: Long shares of Amazon at the time of writing, but positions may change at any time.

Leading Tech Companies All Chasing The Same “Next Big Things”

I miss the old days of tech investing. Times were simpler. Companies were more focused. There were one or two companies that tended to be dominant within a certain fragment of the industry. Google was search and online advertising. Amazon was e-commerce. Intel was chips. eBay was marketplace. Microsoft was operating systems and productivity software. Cisco was networking. Apple was high-end devices. Facebook was social networking. Netflix was movies. You get the picture. Oh how times have changed.

The tech landscape now has led us down a different path. Each of these companies has been extremely successful in conquering their home turf. They are all wildly profitable and have more money than they know what to do with. So they repurchase shares and pay dividends and buy startups to add talent and new technology. And after they do all of that they still have billions of dollars extra sitting around. What to do?

It appears the answer now is to become a tech conglomerate. Heck, if we took over one area of the marketplace, why not shoot for the stars? Why not be everything to everybody? So now when we talk about the leading tech companies (Apple, Facebook, Google, Amazon, Microsoft) the future looks far less predictable.

In the old world Tesla would be the de facto electric self-driving car play. But Google is building cars. So is Apple.

In the old world Oculus would have been the virtual/augmented reality play. But in the new world Facebook acquires them and then Microsoft and Apple and Google all start working on the same thing.

In the old world Netflix would be the benchmark for streaming video. Nobody would argue that households looking to get rid of their $100/month cable bills would substitute them with a half dozen individual services that cost $10-$20 per month. The expensive cable bundle is no worse than a bundle of Netflix, Amazon Prime Video, Hulu, HBO Now, YouTube Red, and CBS All Access. And as if there are not enough competitors vying for your TV dollars, it was recently reported that Apple has decided it has identified the next big thing; producing original TV content. Are you kidding me?

I understand that self-driving cars and streaming over-the-top video and virtual reality could all very well be huge markets over the long term. But everyone can’t be a winner. Do you really think GM and Ford lack the ability to produce self-driving, electric cars? Are the Big Three auto makers going to be replaced by Apple, Google, and Tesla a decade from now? Are we really going to cancel our Comcast service and pay the same amount of money for less content by buying subscriptions to 6 or 8 streaming services?

The leading tech companies got to where they are today by being laser-focused on creating or improving upon one big tech trend. Becoming indispensable in that arena has made them billions of dollars and created a ton of shareholder wealth. They did not win out after a long, brutal battle with the other tech titans at the time.

The biggest risk to Apple, for example, is that the innovation they are focused on revolves solely around virtual reality, electric cars, and streaming TV and movies. That is not how Apple became Apple. And it is not the secret for them to stay at the top. The same goes for Google and Microsoft and Facebook. As long as these companies are battling against each other, as opposed to paving their own way to the future, I am afraid that those of us hoping for the next big thing to come out of the mega tech stalwarts may be disappointed. To truly develop a market-leading position you have to try something new and do so long before everyone else. Nobody is likely to catch Amazon in the public cloud computing space (although Google and Microsoft are trying, of course). They are years ahead because they saw the trend before anyone else and went all-in to the number one.

Microsoft/LinkedIn: Maybe The Folks In Redmond Will Finally Get An Acquisition Right, But Don’t Hold Your Breath

I am often asked why some companies trade for sky-high valuations even when a majority agree that the price does not make a lot of sense. In part, the answer is that there are always people who perceive value differently and will overpay for companies. The saying goes that something is only worth what someone else is willing to pay for it. That might be true in many instances (in the short term especially), but many stock market investors would argue that a company’s worth is actually tied to its future free cash flow. And that is what makes a market.

If you had to pick a tech company that has a miserable history with acquisitions, it would be Microsoft (MSFT). Just in the last nine years MSFT has paid $6.3 billion for online advertising firm aQuantive, $7.6 billion for Nokia’s phone business, and $8.5 billion for Skype. That is more than $22 billion for three companies that have all struggled under Microsoft’s ownership. The most logical from a strategic perspective, Skype, seems to be a flop. With its huge installed based of Windows, Outlook, and Office users, Microsoft had a huge opportunity to build and integrate the world’s most dominant audio and video corporate communications platform. Oh well.

Today Microsoft announced they are paying more than $26 billion for corporate social network LinkedIn (LNKD), a 50% premium to last week’s closing stock price. Will this deal finally be the one that gives MSFT deal credibility? The odds seem long. Product synergies seem sparse and even industry pundits are using odd justifications for the deal. One tech commentator thought this was a boon for Microsoft’s Azure cloud business because LinkedIn is big and growing quickly, and therefore would give MSFT a lot more data flowing through its cloud infrastructure. So LinkedIn doesn’t use Azure now but it is a smart deal because the tie-up will force them to use Azure in the future? Yikes.

If I was a Microsoft shareholder I would be most concerned with the $26 billion all-cash price tag (to be funded entirely with debt). In 2015 LinkedIn had free cash flow of $300 million. Subtract non-cash stock based compensation of $510 million and you can see that LNKD is not “profitable” really, non-GAAP accounting aside. EBITDA in 2015 was about $270 million, so the deal price equates to a trailing EV/EBITDA multiple of roughly 90 times. Even if one believes the strategic rationale for the deal is sound, making it worthwhile from a financial standpoint is another story.

While it totally makes sense that Microsoft feels its relevancy fading, and thus wants to make a splash and try to get “cooler” in the world of tech, there are plenty of obstacles in front of them. It will be tough task to make this move one that we look back at in a few years and say “Wow, that LinkedIn deal really paid off.” So even with a new CEO, maybe MSFT has not changed all that much at all. Time will tell.

Full Disclosure: No position in any of the companies mentioned at the time of writing, but positions may change at any time

Is Facebook Stock Approaching Bubble Territory?

Here is a list of the U.S. companies that are worth at least $300 billion today based on stock market value:

  1. Apple $522B
  2. Microsoft $392B
  3. Exxon Mobil $365B
  4. Berkshire Hathaway $357B
  5. Facebook $336B
  6. Amazon.com $318B
  7. Johnson & Johnson $311B

If you are surprised to see Facebook (FB) registering as the 5th most valuable U.S. company you are not alone. Given the company’s high growth rate, many investors do not mind the stock’s valuation. At $117 per share, the stock trades at 33 times this year’s consensus forecast of $3.54 per share of earnings. Given that Wall Street is currently estimating more than 30% earnings growth in 2017, this P/E ratio seems high, but warranted, if you are a true believer in the company’s future.

I am not going to delve into the company’s future growth prospects in this post, as I have been wrong about them so far. My thesis was that Facebook usage would decline over time as early adopters such as myself tired of the service and the network became overloaded with parents, grandparents, aunts, uncles, etc. That has proven to be wrong. Perhaps Facebook has evolved from a cool place to connect with friends to a crucial hub to connect with family. At any rate, the stock’s valuation is what has peaked my interest lately.

Facebook is one of a growing number of growth companies in the technology space that is overstating its profitability by paying its employees with stock and not treating it as an expense when speaking to Wall Street analysts. The official GAAP financial statements do disclose how much stock they dole out to employees (for instance, in 2015 the figure was a stunning $3 billion), but when investors quickly look at earnings estimates, they see the $3.54 figure for 2016 which does not include stock-based compensation.

So what happens to the stock’s valuation if we treat stock compensation as if it were cash? After all, if Facebook decided to stop paying its employees with stock, we can assume they would have to replace it with cash. Below I have compiled the company’s free cash flow generation since 2012 and subtracted the dollar amount of stock they have paid their employees. This simply tells us how much actual free cash flow Facebook would have generated if they compensated solely with good ol’ U.S. dollars and cents.

FB-FCF

As you can see, adjusted for stock-based compensation Facebook had free cash flow of $1.09 per share in 2015, which is about 50% less than their actual reported free cash flow ($2.13). Put another way, Facebook’s employees (not their shareholders) are being paid out half of the company’s profits.

From this perspective, Facebook stock looks a lot more overvalued. If you annualize the company’s first quarter 2016 free cash flow adjusted for stock compensation ($0.38 per share), the company trades at a P/E of 77 ($1.53 of free cash flow). There is certainly an argument to be made that such a price resembles bubble territory. That potential problem could be rectified if the company continues to grow 30% annually for the next five years, resulting in $4.05 of “adjusted” free cash flow in 2020. But buyers of Facebook stock today at paying about 30 times that 2020 estimate right now, which is still a very high price.

Below is a summary of Facebook’s stock market value relative to reported and adjusted free cash flow since 2012, as the stock has nearly quintupled in price:

FB-Pr-FCF

How do situations like these typically play out? One of two ways. The less likely scenario is probably one where Facebook’s growth hits a wall and investors quickly slash the P/E ratio they are willing to pay by 2-3 times. That would be ugly, but does not appear to be the most likely outcome given their momentum right now. The more likely scenario is the one that we usually see with very good companies that have staying power but simply have seen their stock prices get ahead of the fundamentals. In that case, the cash flow multiple comes down slowly over a period of several years, resulting in the stock price lagging the company’s underlying profits.

If I had to guess, I would say the latter seems like a real possibility going forward from here. Regardless, investors should check to see how much of a hit a high-flying tech company’s cash flow would take if stock compensation was factored into the equation. As Warren Buffett likes to say, “if stock-based compensation is not a real expense, I don’t know what it is.”

Full Disclosure: No position in Facebook at the time of writing, but positions may change at any time