Motley Fool Hidden Gems Investing - 2 Companies Testing Investors' Patience

Episode Date: February 3, 2022

This is one of those times when almost no company is going to get the benefit of the doubt from Wall Street and investors in general. Meta Platforms and Spotify are two timely examples. Meta Platforms faces headwinds in the form of inflation, its own investments, and Apple's new iOS privacy changes. Spotify is showing growth, but guidance has some spooked and the latest controversy involving podcast host Joe Rogan isn't helping matters either. Tim Beyers analyzes both companies and discusses the very public roles that CEOs Mark Zuckerberg and Daniel Ek are taking as their companies deal with varying challenges. Plus, Dylan Lewis and Brian Feroldi do a deep dive on Digitalocean, a cloud company some are comparing to a young Shopify. Our free Investing Starter Kit includes 15 stocks and 5 ETFs. For a copy just go to http://fool.com/StarterKit Stocks: FB, SPOT, AAPL, ALGN, DOCN, AMZN, MSFT Host: Chris Hill Guests: Tim Beyers, Dylan Lewis, Brian Feroldi Producer: Ricky Mulvey Engineers: Dan Boyd, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

Chris Hill. Warren Buffett said the stock market is a device for transferring money from the impatient to the patient. Today's another day that's testing investors' patience. Motley Fool Money starts now. I'm Chris Hill, joined by Motley Fool Senior Analyst, Tim Beyers. Thanks for being here. Thanks for having me, man. Fully caffeinated, ready to go. Likewise. Before we get to the companies we're going to talk about, let me just say this for the dozens of listeners. We're in the middle of earnings season, and two things are clear to me. Whatever company you own shares of, don't expect them to get the benefit of the

doubt. That is the environment that we're in right now. It happens from time to time. There are other periods of time where we've seen the opposite, where everybody gets the benefit of the doubt. Unicorns for everybody. Exactly, and we're storing. The other thing that's clear to me is there are two types of challenges that companies face. One is just individual to the company, and we'll get to that in a second. The other is is the big bucket challenges, things like global supply chain, inflation, labor, and hiring. And I think it's worth everyone taking a moment looking at the stocks in their portfolio and saying, okay, in terms of the big bucket ones, which companies do I own are affected by global

supply chain. Which leads me to meta-platforms, because this is a business that is dealing with a lot of challenges. I would argue that inflation is one of them. They've got a big bucket challenge just when you think about ad spend. But they are also dealing with Apple's change to its operating system, the whole privacy changes Apple did. That's going to hit Facebook to the tune of $10 billion. They are investing heavily in their own metaverse aspirational operations. They are dealing with a lot. The stock is down more than 20%. Before we get into Mark Zuckerberg, because I do think this is a moment for the CEO, when you look at meta platforms at this moment in time, what stands out to you?

This is going to be a reckless statement, Chris. I fully expect to be challenged on this one. What stands out to me is that the company formerly known as Facebook is no longer the hyper-growth company, and maybe even to say growth company that it once was. those days for now are over. Because when you look at the data, this is growing a little more like an American manufacturing company than it is a Silicon Valley big tech company. I'm looking forward. I'm talking about the guidance there. I recognize year over year, they had some really strong growth. But looking ahead, Chris, growth story is over. Chris Hilliard I was with you right up until the end. Even

with the drop today, this is a $900 billion company. Even if they weren't dealing with the challenges that they are dealing with, you get to a certain size and it's reasonable to think, the go-go growth days are over, we're moving into a different phase here and investors should factor that in. Really? We're going to put them in a category with 3M? I'm not knocking 3M, but really, you're going to put them in that category? Well, like I said, it's a reckless statement. Now, the reason it's reckless is because there are other companies that have been there. We're going to talk about Apple in a minute here, but it wasn't that long ago that Apple was enjoying just single-digit growth and it was seeing serious stock returns primarily

thanks to its cash flow generation and massive buybacks. It's growing, I'm going to make up a number here, like 7% a year in the top line revenue, but it was growing the bottom line massively because there were just fewer shares, smaller pizza. That's not what's happening at Facebook, I'll just call it Facebook for now. But the year-over-year growth expected coming in fiscal Q1 of 2022, so we just ended and overall growth was up during the quarter 20%, roughly 20%. If you are going to take the midpoint, let's just take the midpoint of next year, which is $28 billion for the coming quarter. If you take that year-over-year, you are talking about, Chris, basically 1%. Let me back that up. I'm sorry, 7%. You're talking 7%

year-over-year growth heading into the next quarter. Now, there are some reasons for that, but I'll give you two other numbers here and then just pause for a second. Both daily active users, these are Facebook daily active users and Facebook monthly active users, barely budged sequentially, definitely up year over year, but you had basically 1.929 billion daily active users, that's a lot. That's up from 1.845 billion. There's a little bit of growth, there's single-digit growth, but versus in the prior quarter, 1.93 billion, down on a daily basis. Monthly active users, 2.912 billion. That was up slightly from 2.91 billion in the prior quarter. I'm not going to say it's 3M, Chris. I think you're right. It is a reckless statement.

However, it is verifiably true that Metaplatform's growth is slowing. It's not a speed bump. They have hit the curb, and now they need to change the tire. They're making a lot of investments. Mark Zuckerberg has made it very clear what he wants this company to be five, 10 years from now. If you believe he can do it, it looks like an opportunity to buy the stock if you have the patience, but it really depends on that. There are times when we focus on the underlying business, there are times when we focus a little bit more on the person leading the company. This seems like one of those times that if you are a believer in his aspirations and his ability to pull this off, then the stock's

down 25%. It seems like a buying opportunity. I acknowledge that. I want to give two points of context here to get people thinking about this, because it's not just, well, Well, the ad market comes back and things get a little better, and we're talking about some fine-tuning, and when that fine-tuning takes shape, then this company will double or triple from here. Possible, but I think we're talking about something different, Chris, and so you want to judge this accordingly. The ad market may get more robust, like inflation.

You pointed this out. This is a fair point. inflation may be impacting ad pricing, and that has an impact directly on Facebook. That's a fair point. There may be some upside that they can get from that when things start to normalize. They also have to fix the problems that they have with this change that Apple created in terms of privacy and privacy permissions, and it did take a toll. Facebook talked about this. They talked about it a lot during their call. I'll get to that in a second. That had a drag on their revenue as well. So let's say they fix that. Even if you assume those two things, Chris, the main thing

you're talking about that drives real returns from here is creating a real business around the metaverse. That is different. We have to recognize that that's a big lift. There is no business model that we know of other than selling really interesting, I'll call them interesting looking Oculus headsets. There's nothing other than that for a metaverse business model right now for Facebook, and they have to build that from the ground up. Before you get too excited about calling this a potential value, a beaten down stock that's going to double or triple in the next five years, recognize there is a complete business model shift that has to be erected from the ground up to bolster that advertising business that's been a little bit compromised,

that probably is going to be okay. But the other thing is not built yet, Chris. I wouldn't go too far yet. Acknowledge all of that. I will just remind everyone that when this company went public, the amount of revenue they were making from mobile advertising was precisely zero dollars. That was a huge question about the underlying business. Can they pull this off? They proved that. This is not exactly the same thing, but it does remind me of that moment in time. Before we move on to our next story, you would posed a question to me and producer Dan Boyd before we started recording. How many times Apple got name-checked in the conference call? Dan guessed 15 times. I'm guessing 12 times.

How many was it? Dan Boyd So, if we're playing by Price is Right rules, then Dan gets the . but he's still closest. Dan, you're still closest, it's 14. Yeah, I like closest to the pin. Those are the rules I go by. Yeah. I will go by that too. Price is Right rules feel patently unfair here, but yeah, 14 times. It's overwhelmingly the Facebook slash meta platforms executives that brought up Apple. In fact, I would say it was primarily Facebook enforcer, this is what I call her, Sheryl Sandberg, bringing this up. There was a lot of blame shifting to Apple. To be fair, they do have a

point. We know, and they've been talking about this, that the Apple privacy changes would be a a drag, and they did bring it up. The one thing I'm a little disappointed with from that call is they kept saying that Apple is hurting small businesses. Really? Is Apple really hurting small businesses, or is this you and your blame shifting? I think it's more of the latter, Chris. I was talking about Zuckerberg and how it seems like one of those moments where investors need to look at him and think, okay, how much do I believe in this person? I think it is somewhat similar with respect to Daniel Ek, who is the co-founder and CEO of Spotify, because their fourth quarter growth was strong. Their guidance for future growth is what has

shares of Spotify down 15%. We'll get to the Joe Rogan stuff in a minute, but this goes back to what I said at the top. In this environment, Spotify is not getting the benefit of the doubt. I completely agree with that. The overall numbers here are good. Let me just hit a couple of them. Total monthly active users up 18% year-over-year. I'm not going to give the sequential changes here because I don't think that matters too much. It's 406 million total monthly active users. That's a pretty impressive number. Premium subscribers up to 180 million, that was up 16% year-over-year. But there's a couple of numbers that I think are the drag here in addition to the guidance, Chris. Nineteen percent growth in ad-supported monthly active

users. That was 236 million. Here is the differential that I think as investors, I think we have, at least when I look at Spotify, I have thought what's great about this business is that it's not overwhelmingly ad-driven because that can be a little bit more. We just saw from meta platforms, you can get whipsawed in that market. Spotify is starting to be a little bit more ad-dependent here. Here are the numbers. Year-over-year, €2.295 billion, up 22%, that is for their premium revenue, but their ad-supported revenue up to €394 million, that is up 40%. Chris, we're both very familiar with the job of PR and that words matter. Let me read this to you, and you tell me whether or not you think this is a nice bit of clever

wordsmithing here. Ad-supported revenue reached a record 15% of total revenue in Q4. Now, if you read that, Chris, that sounds great. Who doesn't like a record? Who doesn't like a record? I don't think that's great. I think that is a little bit of spin on Spotify's behalf to try and say, hey, look, it's not so bad, but as you point out, the guidance in terms of their expectations for growth and monthly active users, not as good as the street wanted to see. There is this belief that maybe some members are canceling, maybe you pointed out the Rogan comments and just some of the hubbub around there. Maybe that's having a little bit of a drag. We don't really know, but there's some concern

there. I watched Daniel Ek on CNBC this morning. He was getting questions about the quarter, about the growth guidance, and about Joe Rogan. He talked about they have a balancing act that they're trying to pull off, the creative expression along with the safety of people who use the Spotify platform. X struck me as impressive in the sense that he wasn't really ducking tough questions. He's clearly an engaged leader of this business. He's engaged with all the appropriate parties. It reminded me a little bit of Neil Brennan, who's one of my favorite stand-up comedians had this thing where he was talking about entertainment media, but I think it applies to the investing world as well. Just the whole notion of a story bubbles up and it's like,

this seems like it's a problem. Brennan said, if I ever get in that situation where someone's going to write an article like, Neil Brennan's take on this topic is problematic, I'm just going to say say to the reporter, do me a favor, wait one month. Wait one month. And if a month from now, you still want to talk about this, yeah, I'll talk to you about this. I'm not equating the Rogan stuff with that, but we were talking before about Facebook, and there was a point in time where Cambridge Analytics was the hot topic on what is this going to mean for the business, you know, people boycotting Facebook. You know, these things often have a small shelf life. I think it benefits Spotify that the guy who's running the company is taking everything very

seriously, is out front, he's not sending out, you know, a PR person, he's out there himself. I think that matters, and I think it's to their benefit. I think so, too. I also would say that you get credit for being thoughtful, balanced, and willing to address tough questions. I think in Spotify's instance here, they're not going to get credit for being on the right or wrong side of the issue. They would get punished no matter what side of the issue they chose to be on. The only thing that matters is We're a business. We've hired this person. We want to hear concerns. We're going to be as balanced as we can be. And please give us your hardest questions so we can address them. And

if they do that, I think they're going to be okay. But we shouldn't presume that this is going to be easy, that it'll blow over quickly. I think they've probably done a decent job so far. But this also kind of speaks broadly, Chris, to one of the underlying, I'm not going to, I will call it a weakness. It is a weakness in Spotify's business model, is that it's two-tiered. They have the ad business, and then they have the premium business. They really favor one. They want the premium business. That's what they really want. And the future of the business really can't be too influenced by that ad-supported business because, as we know, podcast ads are just different and Spotify handles them differently. So that ad-supported side of the

business, that's largely music. That has really not that much to do with the podcasting, not from what I can see. But podcasting is a big part of the future of the business. So they kind of have to figure this out and ride this out. So the structural weakness is the more we see Spotify relying on ads, the more it sort of raises questions about the investments they're making in podcasting. And so I'm going to be paying a lot of attention to that revenue mix. I know they spun it positively. I want to start seeing it reversing. Let's get more premium revenue. Chris Hill. Before I let you go, give me 30 seconds on Align Technology. This is the maker of Invisalign Dental Braces. Good-looking fourth quarter. They said revenue this year is

going to rise by 20% to 30%. I get that's lower than last year's growth of 60%, but come on. Chris Hill. Yeah. The problem is that that's such a huge deceleration that it raises questions. I'll just mention this one thing. There are questions about Align that's coming from inside of our Fool community. One of the things I love the most about the Motley Fool community, this is inside our premium discussion boards, we have at least one, I think it's a couple of professional orthodontists who have said, we're looking at ways to get away from Align technology. I thought that was fascinating. I don't think it's really happening yet. The way these orthodontists were describing it is that what we really want, those Invisalign liners,

essentially what they are is something that you design and then you send it out and a line makes that for you and then you get it back. You pay a pretty big premium for this. Could we figure out some of these designs and do it ourselves in the office with 3D printing? I thought, Well, now that's interesting. I don't think Align Technology is being disrupted yet, but you see that large decline in the growth and you start to wonder, are some dentists making different decisions about how much they want to rely on Align Technology? I don't know, but this feels like something to watch, Chris, feels like an area to just be cognizant of. presume that the sell-off is entirely unjustified, maybe do a little bit more digging and the Motley

Fool discussion boards are as good a place as any to do it. Tim Beyers, great talking to you. Thanks for being here. Thanks, Chris. When it comes to the Cloud, there are obviously the major players, but that doesn't mean smaller competitors don't also provide opportunities for investors. For a closer look at one such business. Here's Dylan Lewis. Dylan Lewis Thanks, Chris. When people think about the Cloud, their head tends to go to names like Amazon's AWS, Microsoft's Azure, and Google Cloud. Today, we're diving into a much smaller Cloud player, DigitalOcean. Joining me is Brian Feroldi. Brian, a lot of people may have heard DigitalOcean

recently. Let's talk a little bit about where they exist in the Cloud market and who they are. Yeah. You mentioned that they were smaller, and they're smaller in numerous ways. First off, DigitalOcean's market cap is about $6 billion. That's obviously several orders of magnitude smaller than the big players in the space. But they're also interesting in that they focus on the smaller end of the market. The company is focused on providing infrastructure as a service and platform as a service, primarily for small and medium-sized businesses. When it comes to as a service, I think people are used to hearing us talk about software as a service, they can probably surmise what infrastructure and platform as a service might

mean, but let's actually define it here because I think it's important. Sure. Infrastructure as a service, or IaaS, this is basically the backend IT infrastructure for running applications and workloads in the cloud. This would include things like cloud-hosted servers, whether they're physical or virtual, as well as the storage and networking. Platform as a service is everything that's built on top of infrastructure as a service. You need to actually run the application. This would be the operating system, storage, databases, middleware. Then on top of that would be the software as itself, and that's where we include in the software as a service category. That's just ready-to-use cloud-hosted application software.

So, when it all comes together as a customer offering, what exactly is DigitalOcean providing to customers, and what does the relationship with their customers look like? Sure. So, DigitalOcean is focused on the infrastructure as a service and the platform as a service, as you teed up, kind of like Amazon Web Services, Microsoft Azure, and Google Cloud. However, they are focused specifically on small and medium-sized businesses. You wouldn't think there would be room for them to compete in that market, given some of their competition. But they've done a good job about carving out a little niche for themselves. And by niche, I mean they already have nearly 600,000 customers that are spread across the globe. And what's interesting

about that is, already, about 65% of the company's total sales come from outside the United States. Developers and small businesses hire and rent from DigitalOcean to handle all of their basic website functions. That can include hosting it, compute power, providing a cloud-based VPN, maintaining a database, basically everything that they need from the back-office perspective to have their software up and running. You mentioned before that this is a company that is operating in the space of titans. I think it's safe to say that this is a David to many companies' Goliaths. It is easy when you look at those market dynamics to say, how does this company stand a chance? These big companies have this wrapped up. I think it would

be tempting to say that for infrastructure as a service and platform as a service, but I think the way this market breakdown and the way that the customers exist and those relationships show there's actually a pretty good opening, and that's often a misguided way to look at some of these bigger tech markets. Yeah, that was my initial inclination to be like, there's no way a company can compete against the cloud titans that are out there. But DigitalOcean's numbers clearly suggest it's doing just that. I think it's focused specifically on small and medium-sized businesses as what is allowing it to stand apart. The company points out that small and medium-sized businesses just have different needs and different pricing

sensitivity than the big cloud providers can offer. A lot of small companies just need very simple runtime environments, and they want to get it at an affordable, straightforward price. DigitalOcean really prides itself on simplicity as well as low cost. In fact, if you go to the company's main website and price things out, they have a price comparison tool where they can show you how much your needs would be hosting on DigitalOcean versus all three of the major tech titans. Just to give one number out there, bandwidth on DigitalOcean's platform costs about one cent per gigabyte per month. For comparison, the nearest closest big boy would be about five cents per month, so about 5X the cost. DigitalOcean is really going after customers that want

simplicity and low pricing. That direct comparison is so effective for storytelling for them and being able to acquire customers. I've heard some people liken DigitalOcean to an early Shopify in the sense of when the company was maybe a $2 billion to $4 billion company, not the $100 billion company we know it to be today. A big part of that, Brian, is it's easy when you look at these markets to ignore the needs of those smaller players because it takes a lot of small fish to become worthwhile for some of these businesses to go after. The reality though is if you can create an option that works for those small players and then grow with them in a symbiotic way, it can become a very large business as we've

seen with the likes of Shopify. Yeah, for sure. The comparison to Shopify isn't exactly one-to-one, but the company is following a similar pathway. Shopify initially got its start by really catering to the needs of small individuals and small businesses that just wanted to set up a shop online. For a lot of reasons, some small businesses didn't necessarily want to have to rely on huge e-commerce players like Amazon and Walmart for everything. For them, building a site on Shopify in order to build a direct relationship with their customers really made sense. You can make a similar argument for DigitalOcean today. Some small and medium-sized businesses don't want to have to deal with the complexity

and the power, and they don't need everything that Amazon Web Services or Microsoft Azure has to offer. They really just want to get a website up and running or a platform up and running globally, and they want to do so cheaply and affordably. That niche is providing DigitalOcean with an area to carve out market share for itself. All told, the company has turned a lot of small businesses into a pretty decent top line number, just about 400 million over the last 12 months at a 58% gross margin. They grew revenue at a 37% clip last quarter. We know that the cloud in general is a very high growth space. When we look at the growth that this company experiences, Brian, in typical

as-a-service fashion, this is a mixture of new customer acquisition and growth in spend from the existing customers that they have. The company is doing that very well. To throw some other metrics out there that we like to track with companies like this, the company's gross retention, which is just keeping a customer from one year to the next, figure is currently hovering at 86%. What that means is that they're losing about 14% of their customers any given year. You might be alarmed by that, but that actually is just the nature of the kind of companies that DigitalOcean is going after and servicing. Small businesses and medium-sized businesses have much higher churn rates than they do in the enterprise

grade, which is why the big players really aren't designed to go after them. The good news is, if you look at net retention, which not only includes churn, but includes upselling, that figure has historically been hovering around 100%. The company is keeping from a revenue perspective 100% or more in any given year. What's particularly interesting about that number is that it has grown quite rapidly over the last couple of quarters. In fact, in the most recent quarter, that figure jumped to 116%, which suggests that DigitalOcean is doing a better job about keeping its customers and upselling them even faster. Brian, when we look at businesses, we like to say, if they don't work out,

it's not from a failure of opportunity. I think that that's certainly the case here. You want massive tailwinds that are pushing a business forward. The combined infrastructure as a service and platform as a service markets are estimated to be worth $116 billion by 2024, up from $44 billion in 2020. Huge opportunity here, particularly because the small business piece overall is massive as well. Yeah, the company points out that around the globe, there's about 100 million small and medium-sized businesses, and just as important, about 14 million new small and medium-sized businesses are started every single year. Employed by those businesses are about 45 million total developers, or at least they're estimated

to be by the year 2030. Again, for comparison, this company has attracted so far about 600,000 total paying customers. The market opportunity that this company is going after, even though it's focusing on small and medium-sized businesses, is gigantic. When we see big opportunity, we also know that means heated up competition. We've already talked about the fact that there are some deep-pocketed players in the space, Brian. That's probably one of the more obvious risks for this business, but it's not the only one. Yeah, for sure. That's going to be something that investors always have to think about it. It is possible that Microsoft Azure or AWS or Google could try and go downmarket

and provide lower-priced, simpler offerings that would more effectively compete with the likes of DigitalOcean. To say nothing of the fact that there are other more direct competitors out there, such as a company called Vulture, Heroku, and Linodee. There's a lot of competition in the space. However, that competition has always been there and DigitalOcean has still been able to grow in spite of that. One other risk that's worth noting is that we at The Fool love to invest in founder-led businesses. DigitalOcean was founded in 2003 by two brothers. Those brothers have since moved on and are no longer involved in the day-to-day operations of the business. The company actually handed over the CEO reins in 2018 to a CEO named Mark Templeton. He only

lasted about one year before he was shown the door, and a new CEO, the current CEO, named Yancey Spurill, was brought in. Now, he is exactly the kind of CEO that I think that you want. He was formerly the CFO and COO of a company called SendGrid. If that name sounds familiar, that's because it was recently bought out by Twilio, and it has become a hugely popular company. But leadership transitions and having a new leader in the corner office is always a risk for investors to keep in mind. The ticker is DOCN, the company, Digital Ocean. An interesting business if you want to study where the cloud is going, particularly infrastructure as a service and platform as a service. Also a good company to kind of challenge some of your commonly held

beliefs about market dynamics and who can rise in markets dominated by big companies. Brian, thanks so much for helping me break it down. Thanks for having me, Dylan. That's all for today, but coming up tomorrow, we'll have the latest on Amazon, Pinterest, and a lot more. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.