The S&P500 reached an all-time-high of 2 480 points in August, a new peak for the five-year long equity bull market. The bull market has coincided with the rise of a new financial acronym, “the FANGs”.
It was around 15 years ago when the first acronym of this kind hit the wires. Jim O’Neill, former Goldman Sachs chairman, coined the acronym BRICs (Brazil, Russia, India and China). This was quickly followed by the PIIGS during the European debt crisis, the MINTs. Blame character-constrained online environments or millennials who spend all day on their cell phones and can't be bothered to read or type things in full, but these acronyms have crept into everyday speech and, apparently, sell-side research.
The most recent acronym has zoomed in from a broader market allocation call to just four specific stocks. The term FANGs (Facebook, Amazon, Netflix, and Google) was popularised by CNBC's Jim Cramer in early 2013. The combined market capitalisation of the FANGs is ~$1.7 trillion, about the same size as the combined GDP of Switzerland, Netherlands and Venezuela, or half the size of Germany’s GDP.
The FANG stocks have been the market leaders so far this year. Facebook, Amazon, Netflix, and Alphabet stocks are up about 48%, 29%, 41% and 19%, respectively, to the end of August. This against the S&P 500's 10% rise. It also compares favourably against the South African market. This has become a trend and these stocks have outperformed for some time. The five-year performance composite relative to the market is illustrated below.
Stock price performance compared to JSE and S&P 500
Source: Bloomberg, Ashburton Investments
This strong performance has been driven by a growing interest in disruptive technology as a thematic and underpinned by strong cashflows and good profitability. But more recently, investors have grown fearsome that the popularity of the FANGs may be approaching ‘bubble’ territory – reminiscent the Dot.Com bubble of the late nineteens/early 2000s. We don’t agree.
When we compare the FANGs to technology stocks in the Dot.Com era, their balance sheets are more robust with large amounts of cash on hand, free cash flow margins are better and most importantly – they are profitable and trading at reasonable multiples relative to growth.
Herewith a quick look at the highlights from the grouping’s second quarter results.
Facebook beat earnings expectations in the second quarter of this year, and recorded revenue growth of 45% year-on-year and profit growth up 71% to $3.524 billion. While still robust, revenue slowed over the last year. Monthly users grew 3.4% to just over 2 billion.
Despite investing quite heavily in headcount during the period, the company managed to expand operating margin from 41% to 47%. Capital expenditure reached $1.44 billion, while cash and equivalents on hand soared to $35.45 billion. Facebook boasts a very healthy balance sheet with enough cash to effect acquisitions (even significant in size).
The traditional platforms performed well with Instagram and Messenger benefiting from stories and taking away from Snapchat’s recent success. The company is looking towards Artificial Intelligence (AI) to streamline the traditional platforms. Mark Zuckerberg has said that AI will replace some of Facebook’s human content moderators, find relevant content to show from people and pages you don’t follow. Ad targeting can also be optimized by AI in ways that would be impossible to do manually.
What we like about Facebook
- Ad-sales supported by an increased move towards digital platforms by advertisers (versus TV and print).
- Instagram has expanded rapidly and has successfully competed with Snapchat and other new entrants in photo-sharing.
- The markets in which the company plays have high barriers to entry.
- WhatsApp and Messenger expected to monotise in FY18.
- Add pricing expected to be favourable relative to a Google on mix weighing towards mobile adds.
- Integration of AI to improve user engagement and returns on investment by advertisers will support revenue and pricing growth at least near term.
- Risk of continued losses in WhatsApp and Messenger.
- Margin could come under pressure as the company continues to invest in virtual and augmented reality, video, AI and connectivity.
- Ad loads appear to be peaking on its core Facebook platform. Instagram could ramp up load, however.
Amazon Inc. offers online shopping services. The Company retails products such as television, computers, shoes, jewellery, books, toys, video games, grocery, clothing, and other products. Amazon serves customers worldwide.
Even at its scale, Amazon was still able to reaccelerate revenue growth to 26% year-on-year in the second quarter of this year, as it continued to ramp investments into high-potential areas. Spending on expansion clouded earnings, however. International retail margins fell 490 basis points year-on-year and the unit is still loss-making amid continued investments in market share gains. There were some positives though, seller units as a percentage of paid units hit record highs reflecting the strength of the company’s fulfillment network and the Prime ecosystem (which is viewed as a key annuity income stream) was a main driver of revenue growth.
The story for Amazon is its myriad of growth opportunities. These include video content, marketing, Amazon Web Services (leader in public cloud with 75% US share market, with only 10% of workloads in cloud today), Prime Now, Alexa ecosystem, India, Australia and Groceries (following its acquisition of Whole Foods). The grocery market, a $725 billion consumer spending category, remains underpenetrated by eCommerce at a rate of between 3% and 5%
What we like about Amazon
- Sales growth is anticipated to remain robust and the company has shown that it can execute on sales growth strategies in the past.
- We like the fact that the company has recognized the constraints of on-line grocery shopping by investing in a brick-and-mortar footprint. Execution risk remains.
- Cloud solutions (Amazon Web services) remains a high growth area from a structural perspective and Amazon has first mover advantage (although with other incumbents in tow).
- Prime is expected to continue growing top-line and the type of income it provides (subscription based/annuity) is attractive.
- The Whole Foods acquisition does offer distribution capability for Amazon’s other businesses.
- The company’s % add revenue relative to the market is still quite low. Gains in this area is likely.
- Virtual and augmented reality could be a game changer for on-line retail – especially in clothing. It could have a strong impact in purchase rates and lower return rates.
- Amazon’s ongoing investments in fulfillment and new business lines will be at the expense of near tern margin.
- There is a real risk that on-line grocery penetration remains muted given the nature of that market. Grocery also adds more complexity to the business model.
Netflix Inc. specialises in and provides streaming media and video-on-demand online and DVD by mail as well as film and television production and online distribution
Its second quarter result crushed Wall Street Estimates with 32.3% revenue growth as it added 5.2 million members, well ahead of estimates of 3.23 million. The international segment now accounts for 50.1% of the total membership base.
Netflix may be losing content from its most important supplier in Disney, but its strategy to pivot to originals, build its own global content brand (30% of total spend), and vertically integrate into self-production mitigate this loss. This loss of Disney-branded films will not impact the service until the second half of 2019.
Netflix released 14 new seasons of original series globally and 9 feature films in Q2, plus 13 original comedies, 6 original documentaries, and seven original kids’ series. Last quarter, Netflix said it would spend over $1 billion in 2017 on marketing costs alone, projecting that the company would have negative free cash flow for "many years" as it invests in original content.
What we like about Netflix
- Original content, including House of cards, Narcos, and Orange is the New Black has driven subscriber gains. This is expected to continue driving adoption.
- International is expected to become profitable soon despite major investments in launches and content.
- With supplier relationships coming under the microscope, the company has shown good discipline in cost control by foregoing certain expensive arrangements.
- While China is impenetrable directly due to the regulatory and censorship framework in the company, it has could engage in a licensing deal with Baidu’s video platform iQiyi giving it a foot in the door of one of the world’s largest internet user basis.
- Original content has pinned it against content suppliers as it has become a major ‘studio’. This could materialise in a loss of content contracts or a rise in content costs – Netflix is still regarded as a price taker in this regard. This could change as on-line streaming continues to drive ‘cord cutting’.
- Original content is expensive to produce and this will remain a drag on margins as subscriber growth is still ramping up.
- The model is not highly profitable and margins are set to remain in the single digits medium term.
Alphabet is the parent company of Google – the world’s largest search engine and it also owns YouTube, the world’s largest on-line video sharing platform. Google is multinational technology company specialising in Internet-related services and products. These include online advertising technologies, search, cloud computing, software, and hardware.
For the second quarter of this year, both earnings and revenue were comfortably ahead of consensus. The solid result was primarily driven by healthy core Google and Network advertising revenues, as well as increasing contributions from YouTube, Play, Google Cloud and Hardware. Earnings per share came in $0.58 and included a $2.74 billion EU fine for anti-competitive behaviour. Excluding the EU fine (the company may appeal) the company reported diluted earnings per share of $8.90 versus $8.42 in the second quarter of 2016. Revenue was up 21% year-on-year (23% in constant currency terms) to $26.01 billion, beating consensus by $410 million.
The key takeaway from this result was higher traffic acquisition costs in the core Google search business. This trend is expected to persist with the shift to mobile platforms and programmatic advertising channels. Aggregate paid click growth accelerated to 52% while pricing declined 23%. This saw margins come in below expectations. The CFO’s comment on lower-than-expected margins was “…we’re focused on revenue and operating income dollar growth and not on operating margins”.
The “Google Other” division, which includes Google Play, cloud apps and services and sales of Google branded hardware saw revenue increase 42% to $3.09 billion. While “Other Bets” reported an operating loss of $772 million on revenue of $248 million this was an improvement on the loss of $855 million on revenue of $185 million a year ago.
The company had net cash of $90.7 billion at the end of the quarter or $129 per share, with 60% currently overseas. $1.6 billion of stock was bought back in the quarter.
What we like about Google
- Ad-sales (on Google search and You-tube) are supported by an increased move towards digital platforms by advertisers (versus TV and print)
- Market leading/monopoly position in search and video
- The markets in which the company plays have high barriers to entry.
- You Tube is now branching into Pay TV/On-demand space and will compete with Netflix, Amazon, and local options like Showmax. Apparently, they are launching 40 original shows soon and have got guys like Kevin Hart and Ellen DeGeneres on board with unscripted shows.
- Apart from the revenue drivers being in place, earnings will further be enhanced through cost control measures.
- This company is trading at an all-time high
- 'Other Bets' could induce volatility into earnings.
- The company has struggled to break into the social media sphere with a messaging platform still lacking.
So, do the FANGs still represent value?
The expectation is that the FANG’s will not just change with time but will continue to change the way we spend our time. While the valuations are rich, top-line growth is expected to remain robust and over time the investment in revenue will filter through to the companies’ respective bottom lines.
Our preferred counter among the grouping is Alphabet (Google) while its growth trajectory is slightly more modest the valuation is more realistic and the business model the more tested and settled among the four.