MAY 2020: WHICH ‘FAANG’S WILL OUTPERFORM?
21st May 2020
‘Big Tech’ has thrived during the Covid 19 crisis, and they come no bigger than the ‘FAANG’s which are of course Facebook, Apple, Alphabet, Netflix and Google (now known as Alphabet).
So which of the above look best at this time for new investors? I have taken a fresh look at both the technicals and fundamentals for each below. I have also included Microsoft in this analysis, as it is another ‘Big Tech’ sometimes included in the above acronym which becomes ‘FAANMG’!
Facebook (FB)
Share price: $229.97
P/E: 31.55
The technical position for Facebook is very positive, as it has just broken through its previous all time high of $221.14 on 12th January 2020. This is due to its recent announcement of the launch of ‘Facebook Shops’ which will compete directly with Amazon and others is enabling businesses to sell their goods and services on-line.
The fundamentals also look good. The recently announced quarterly results to 31st March 2020 revealed a huge increase in diluted earnings per share of 101% (from $0.85 to $1.71) compared to the same quarter for 2019. However, the Covid 19 crisis did not kick in until the final three weeks of that quarter, and Facebook did say that there was a severe contraction in advertising revenue during that time. Notwithstanding this, the net profit margin (as for all Big Tech) is huge, around 27%.
Again, in common with all Big Tech stocks, Facebook has a cash mountain on the Balance Sheet of $55 billion as at 31st March 2020. With 2.9 billion shares outstanding, that equates to about $19 per share, which represents just over 8% of the current share price.
On a very reasonable P/E of just under 32 for a stock that has registered a 100% growth in earnings per share, quarter on quarter, the new Facebook Shops does not need to do too much to keep the momentum going.
Apple (AAPL)
Share price: $318.82
P/E: 25
Apple looks set to test the all time high of $327.20 reached on 12th February 2020. If it can break through to a new high, then expect it to go on a further run upwards. However, it is more likely to find resistance at the $327.20 level and then drop back.
Apple recently announced results for the quarter ended 28th March 2020. Cash and marketable securities total $191 billion, less total debt of $99 billion, gives net cash of $92 billion. Divide that by 4.4 billion shares outstanding gives net cash per share of $20.90. That represents 6.5% of the current share price. Net profit margin is a mammoth 20%.
These quarterly results, however, confirm an absence of growth at Apple. The earnings per share for the quarter is up only 3.6% (from $2.46 to $2.55). Anything less than 5%, in my opinion, is really zero growth. It is quite easy to fiddle around with a few accounting policies and show apparent growth of 1% to 5% by releasing a few over-provisions for accruals or restructuring expenses, for example.
The iphone was the new product that transformed Apple back in 2007, but that is now a mature product no matter how much Apple tries to hype up the various versions of it that have been produced since then. We need to see successful new innovation at Apple – the Apple watch, Apple TV and various other new products and services have not gained traction yet.
Amazon (AMZN)
Share price: $2,497
P/E: 119
The recent breakthrough the resistance level at $2,000 has resulted in a big run upwards in price. A new investor buying now would probably be guilty of ‘chasing’ the price. The most likely outcome, using technical analysis, is that the stock will pull back at some stage to $2,000 and this old resistance level will become the new support level, as so often happens.
Amazon was famously loss making for many years, but investors were prepared to back it as revenues have grown at breakneck speed. The assumption that investors were making is that the enormous growth in revenues would lead to market dominance in several sectors, and Amazon could then hike up prices, and realise enormous profits, when it had obliterated the smaller ‘bricks and mortar’ competitors who could not match Amazon’s low prices.
There is nothing new about that type of business model. The supermarkets here in Ireland, and elsewhere, did the very same thing, resulting in the closure of almost every corner shop and small store in the country. At one time it was considered ‘predatory pricing’ and in 1987 we brought in the ‘Groceries Order’ to prohibit below cost selling by the supermarkets. It was quietly abolished in 2005 having failed to do what it set out to do. However, when all of the small shops had closed, prices did not rise as feared, as there was sufficient competition between the supermarket chains.
The on-line aspect of Amazon’s business does represent genuine technological innovation.
Amazon started out in 1995 selling books on-line. However, it now sells a wide variety of goods and services on its e-commerce website. It also has a very successful marketplace website, enabling other businesses and services sell their products and services on Amazon’s platform. By 2018, Amazon had a 49% market share of the US e-commerce market – that is more than double the total market share of the next nine companies (including eBay, Walmart, Best Buy, Apple etc) combined, per visualcapitalist.com. This level of market dominance has never been seen before in the retail sector. In 2016, Amazon’s market share was 38% and in 2017 it was 43.5%, so there is no indication yet of a slowdown in growth.
There is some uncertainty with these figures – a report by Bank of America in February 2020 estimated Amazon’s market share of US e-commerce at 40% for 2018 and 44% for 2019. However, consider also the continued growth of e-commerce. Per oberlo.com, e-commerce sales represented 9% of all retail sales in the US in 2017. That percentage is expected to increase to 12% in 2020.
So in terms of fundamentals, Amazon is a business that while historically loss making, is growing rapidly and has recently turned its first profit, is growing its market share in a sector (e-commerce) that is in itself growing rapidly at the expense of traditional ‘bricks and mortar’ retailers. Amazon also has some physical shops, a cloud computing business called Amazon Web Services, and is also competing with Netflix with its Amazon Prime service.
It is very difficult to value such a business, due to the tiny profits it is currently making. Yes, it could be grossly overvalued and perhaps the shares will crash and fall 70% to 80%. Conversely, it could actually be still grossly undervalued and the share could have the potential to double or treble from here.
Here is a conservative scenario:-
Retail sales remain static for the next 10 years. Amazon’s market share of total e-commerce plateaus at 50%. E-commerce continues to grow its share of total retail sales at 10% per year until it reaches 20% around 2020 and then stalls. Based on the current P/E of 119, Amazon has earnings per share of about $21. E-commerce is now 12% of total US retail sales. Amazon has 44% share of same, representing 5.28% of all US retail sales. In year one, Amazon’s share of e-commerce increases to 50% but total retail sales remain static. Amazon’s share of total retail sales is now 6.6% (50% of (12% x 1.1)). That equates to an increase of 25% in Amazon’s earnings per share to $26.25. Then for years two, three, four and five, Amazon’s earnings increase by the same percentage increase in e-commerce sales; 10% per annum. That brings the earnings per share to $38.43 by 2025 bring the P/E down to 65. Earnings and revenues are then flat from 2025 onwards, justifying a P/E of around 12 therefore a fall of 80% in the share price from its current level is projected based on these figures.
Here is a less conservative and more likely scenario:-
Retail sales grow 5% per year for the next 10 years. Amazon’s share of total e-commerce continues to grow at 10% per year for the next 5 years, bringing its share from 44% in 2020 to 70% in 2025 and then plateaus. E-commerce sales as a percentage of total US retail sales grows 10% per year for the next 10 years, going from 12% of all sales in 2020 to 19% in 2025 and up to 31% in 2030. By 2025, Amazon’s earnings per share would be expected to grow from $21 in 2020 to around $67.50. Amazon’s earnings from 2025 onwards are now expected to grow 10% per year, in line with the overall growth in e-commerce’s market share plus 5% growth in overall retails sales. That represents earnings growth of 15.5% per year which could justify a P/E of around 37, required to in turn to justify a share price of $2,500 being the current level.
The above however is all based on the minimal earnings of around $21 per share that Amazon is projected to make this year. That fails, however, to recognise Amazon’s pricing power in the market. Its dominant position makes it a price maker rather than a price taker, so a modest increase in prices charged looks inevitable and would have an enormous impact on earnings. A company that turns the corner from losses to profits on rapidly increasing revenues, and with huge market dominance, could easily see an increase in earnings per share from $21 to double that, year on year.
Amazon has that pricing power to double or quadruple earnings per share, right now, in my opinion. It looks to me that it does not want to attract too much attention to itself by announcing billions of profits, seeing that the Trump administration has recently announced an anti trust investigation.
The balance of probabilities therefore for this stock, which is so difficult to value, is that it is still significantly undervalued at around $2,500, in my opinion.
Microsoft (MSFT)
Share price: $185.23
P/E: 31
Microsoft is likely to test its all time high of $188.70 reached on 10th February 2020. If it breaks through that level, then it is likely to run further upwards in the short term registering a number of successive highs. The more likely scenario, however, is that it will fail to break through that level and drop back in the short term.
Quarterly results to 29th April 2020 revealed that diluted earnings per share was up an impressive 23% on the same period last year. The main source of growth is in the relatively new area of cloud computing. Net profit margin is an impressive 30%. The cash mountain on the balance sheet is $137 billion. Deducting total debt of $68 billion from that, leaves net cash of $69 billion. With 7.6 billion shares outstanding, that results in net cash of $9.98 per share, being just under 5% of the current share price.
Stripping out the net cash per share from the share price, reduces the P/E ratio to 29.35 times. That look reasonable for a stock with such a high growth rate.
Netflix (NFLX)
Share price: $447.67
P/E: 91
The stock has had a big run upwards since it broke through the ‘double top’ at $375 reached in September 2018 and February 2019. The lockdown and absence of sport in the past few months has lead to a surge in new subscribers to Netflix’s on-line streaming of movies and other entertainment.
The quarterly results to 31st March 2020 revealed diluted earnings per share of $1.57 which is double the corresponding figure of $0.76 for 2019. However the surge in new subscribers due to lockdown is flattering these figures. The diluted earnings per share figure for the same quarter in 2018 was $0.64. That indicates an underlying growth of 19%.
Nearly 60% of US households now have Netflix, so further growth in the US looks limited. The diluted earnings per share for the year ended 31st December 2019 was $4.13. That puts the stock on an historic P/E of around 100 times earnings. Growth in overseas markets will have to be very impressive indeed to compensate for a mature US market.
Netflix’s market share, which was reported to be as high as 90%, is under attack from Amazon Prime and Disney which recently acquired Hulu. Also Netflix recently stated it had no plans to raise subscriptions, almost certainly due to this increased level of competition.
The chart indicators remain bullish for Netflix but the fundamental analysis does not support a P/E as high as 91 times earnings.
Alphabet (GOOG)
Share price: $1,406.72
P/E: 28
Alphabet reached a new all time high of $1,526.69 on 19th February 2020, and is lagging behind the other ‘FAANG’s in performance during the past three months.
The quarterly results to 31st March 2020 showed cash, cash equivalents and marketable securities of $117 billion. Deducting total debt of $5 billion results in net cash of $112 billion. There are a total of 738 million shares (class a, b & c – these have different voting rights) outstanding, giving a net cash per share of $152, representing 11% of the share price.
The diluted earnings per share for the above quarter was $9.87, being a 4% increase on the corresponding period for 2019. Stripping out the net cash from the share price, reduces the P/E to 25 times earnings. However that looks high enough, at best, from a fundamental viewpoint.
Conclusion:
Facebook and Microsoft look to be the best picks from the FAANMGs based on both a technical and fundamental review of all stocks. Amazon is worthy of consideration on any weakness in the stock.
Apple and Alphabet will struggle to justify their high valuations unless they demonstrate an ability to generate higher earnings growth.