Odd Lots - Understanding The Big Tech Stocks

Episode Date: February 11, 2019

For years, the key to beating the stock market was to invest a lot in the big tech stocks like Facebook and Apple. But in 2018, they stumbled hard, amid a general selloff in the market, concerns about their growth potential, and concerns about regulation out of DC. So what's next for them? On this week's episode, we spoke to Leigh Drogen, the founder and CEO of Estimize, a site that gathers buy-side earnings forecasts. Leigh has a great feel for the business models of each company, and the challenges and opportunities that they face.See omnystudio.com/listener for privacy information.

Thanks for listening to Oddlots. Follow the show on Amazon Music for more future episodes or just ask Alexa play the podcast, Oddlots on Amazon music. Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthall. And I'm Tracy Allaway. Tracy, you know we're right in the middle of one of my favorite times of the year. Do you know what that is? Uh, Super Bowl? I don't know. It's not the Super Bowl. It was the Super Bowl last night. Yeah. For those listening, we're recording this the day after the Super Bowl. I didn't even watch it. And from what I understand, it was really boring. So I guess I didn't miss out in anything. I mean, it is February. But February is not one of my favorite times of the year because the weather is pretty miserable. No, we are in the middle or maybe slightly later part of the middle of earning season. What makes you like earnings season so much?

Well, so for those who don't know, and probably everyone does, most companies report their earnings four times a year. And they tend to cluster over the span of a few. few weeks. And so much of the time we talk macro, we talk about the Fed, we talk about trade, inflation, economic data, whatever. And then every once in a while we get to pause and actually hear from the companies themselves and really get a sort of a corporate perspective on how things are going. And of course, from an investor perspective, this is what really matters because you could sort have these broad movements and other times of the year. But if you want to know how sort of specific investment in companies are doing, this is when you glean the most as sort of raw information. So I'm going to take the other side of this and say that I normally don't get that excited

about earnings season. However, I'm willing to admit that this time around it is slightly more interesting than usual, but because we have a lot of really broad sort of macroeconomic themes that everyone is currently talking about. So a couple that spring to mind, you know, we have the slow down in China, whether or not that's actually affecting U.S. company's earnings. And we've seen some really heavy hitters, including Caterpillar and Apple sort of blame things on a slowdown in China. We have the retail apocalypse in the U.S. as well, this idea that bricks and mortar stores are doing worse than other types of stores. So some big, big, thematic issues and questions currently running through earnings season. Yeah, absolutely. And especially the violent sell-off that we saw

at the end of 2018, a lot of people, you know, people adjust their future expectations based on what just happens. We saw earnings estimates comes down for a lot of companies. And everybody wanted to know, because in the end, fundamentals, in theory, are what drive markets? Was that just a blip or are companies really seeing a decline in profits? And the other thing that I think is interesting from a sort of sectoral perspective is that for the last couple of years, especially a handful of really red-hot tech stocks that everyone knows about have just dominated markets. If you own them, you've done really well. Of course, I'm talking about companies like Amazon and Facebook and Netflix and so on. Apple, of course. And each one of them has sort of stumbled a little bit for

different reasons. And they've come well off their highs from last summer. And I think going forward, there's still this big question, like, are they just going to go back to dominating their respective industries like they did in 2015? through 2017, or did the sharp re-rating of these stocks sort of represent something fundamental where they're just not going to be able to put up numbers like they did in the past? Right. The famous fang stocks, which led the market higher basically for the past few years, and then suddenly let it very, very sharply lower in the latter half of last year. And to your point about a sharp re-rating, you kind of have to wonder what happened to make

everyone sort of collectively wake up and realize that their expectations for all these companies were sort of out of whack of the fundamentals. Like it's a bit chicken and egg, isn't it? Is it the market or is it actually that the fundamental picture has changed? Well, that's very well put. And today's guest on the Outlots podcast, I think, is someone very well positioned to talk about it. We talked to him a lot on TV around earnings time. And I thought, okay, I want to have a longer discussion about some of these companies. So today we're going to be talking to Lee Drogan. He is the founder and CEO of Estimize, which is a company that collects byside estimates for earnings. But he's also incredibly knowledgeable about the market overall, about the business models of these big tech

companies, about why investors either get excited or lose excitement towards these companies. And so just a great perspective, hopefully, to answer some of the questions. questions that we've posed right now. I've been, if you follow him on Twitter, he's been covering the trends we're seeing for years and years. And I think we'll have a lot to say about this topic. So, Lee, thank you very much for joining us. That's way too kind an introduction. No, but I'm serious because often, like, I think we tend to speak about these companies and sort of we abstract them. And so Facebook is online advertising, and social media or Apple, they have to sell a lot of iPhones. And one of the ones. And one of the ones,

of the things that I really enjoy talking to you about is you really seem to have a very good understanding of sort of where the levers are and where the hinges are in these companies that make them tick and get investors excited. And what is it about one that is more exciting and peeling to investors at a given time? And I feel like you can drill in to a level on some of these companies in a way that most people I talk to can't. I admittedly personally, I think live maybe five years in the future with like my interest in technology. But my experience as a PM and an analyst on the equity hedge fund side kind of draws me back into like what is the rational expectation for the next, you know, quarter year, two years in these stocks. So it kind of converges at some

point there. But yeah, we live in a time now when there's so much created destruction in tech and the kind of disruption multiple has increased so much for both. new technology companies that get disrupted by other new technology companies as well as old industrial companies and healthcare companies that get disrupted too. So yeah, it's interesting all around. Okay. So here's my first question based on the interaction that you and Joe just had. Joe said you're very, very good at pulling out the different parts of different tech companies. Should we be lumping all these different companies under the umbrella term tech? Like, for instance, we talk about the fang stocks, which is a particular subset of tech, but do they actually share much in common?

What do we mean when we say tech or fang? So the biggest thing that I think is going on in a macro sense, and we saw when Schumer and Sanders came out and said, basically, we don't want, you know, companies doing buybacks. you need to provide, you know, a certain amount of, you know, upward revision to your labor kind of cost. And what's going on is that technology throughout the entire ecosystem is driving gross margins because you need less people to generate that same revenue dollar. So I think that there actually is a general thing across the entire spectrum that goes on. Now, of course, you know, the business models are different. but overall the leverage that capital has on labor at this point is just it's expanding so quickly. I have a friend who used to be a PM, an energy PM at a hedge fund here in New York,

moved home to Austin, Texas to build a energy services technology company, right? Because he recognized that it's just so inefficient at this point, even in that industry. And I think that's happening across the board, with, you know, large companies and small companies. So then when we talk about the Facebooks and the Amazon's and the Netflix of the world, where do they fit into this trend? Is it that they are essentially the most leveraged in terms of capital to labor? Or are they facilitating other entities in their drive to be more efficient?

Honestly, I think it's the former. I believe, I could be wrong about this, but I believe Facebook is the company that has the highest revenue dollars per employee in history. Wow. Now, they've increased headcount over the last year pretty substantially, so I don't know if that's true anymore, but it definitely used to be. And you see that across the board. It's pretty amazing what's going on, honestly. And then you get things like Tinder, right, which have just explored. exploded in an entire industry of what people care about, right?

Like, what is one of the most fundamental things that you have to do is you find somebody to fall in love with and marry and be with? And these platforms have just made life so much more efficient for people. And the leverage that they have on people's dollars and time, I think the other thing that people haven't quite grasped yet. And it started with kind of the online games and remember it from like Zinga and stuff. But it was just such the like the front end of this massive trend is people are generally bored. People need to find things to do with their time. And the algorithms that we've developed that started as linear models and now are machine learning models and the massive amounts of data that we collect on people and their behavior inside of these platforms, whether it's Amazon with their shopping habits or Facebook with their reading habits or Tinder with their, you know, swiping habits.

it's it's on one hand amazing and the other hand I find incredibly dangerous that these models are managing people's behavior so well at this point that I'm not quite sure people really understand are they getting something good out of these platforms are they getting something bad of these platforms with the platforms or are massaging their behavior so much and that's obviously flowing through to their you know our poe their average revenue per user which facebook was up another like 17% this quarter. So they have so much leverage with the technology and the data on our behavior now that that's only going to increase that these models get better.

So aside from the potential societal damage, I mean, I think you just enunciated the bull case. Sorry, that's the biggest side. Yeah, it is the bull case. It's also the like, yeah, it's fearful societally, but it is the bull case. Right. So the bull case is sort of this, you know, technology. and the capital that tech has basically has this huge amount of leverage on labor costs,

and that's a big advantage in today's market. And so they're sort of accruing all these various benefits through that. I'm curious what you think happened in the fourth quarter and sort of late third quarter of last year, when we did have that big sort of sudden disappointment or disbelief in the tech companies that had, previously been leaders of the market? I honestly think, you know, looking at our entire data set, we collect estimates on everything in the U.S. public markets, as well as the economic estimate data. And I think the number one thing that we saw was that financials actually led to the downside,

not technology. And what that said to me, along with the fact that the credit markets were literally frozen, the corporate credit markets stopped everything for like a month. a half, that it was actually more of a macro thing than it was a technology thing. And the second those credit markets on froze, we got this huge rebound and everything. So as things freeze up, the higher beta names obviously get hit harder. And those were, you know, the tech names and portfolio managers that, you know, have to liquidate things, tend to liquidate the things that have been performing best, which is not a good strategy because you're supposed to hold your winners

and sell your losers, but that's just what happens in hedge fund and asset management world. So the re-rating of the multiple for these names, I don't think it was a fundamental thing. Yes, growth is slowing, obviously. We are probably going to have an earnings recession in FY19. But I don't think this was a technology-specific thing. I think it was just when you look at the beta of some of these names, when people sold everything across the board in what was kind of a slow-motion panic because of the credit market, It's, yeah, these things got hit the hardest.

Nonetheless, we have seen some of these big companies clearly run into some idiosyncratic stumbles. And it started actually not at the end of last year, but in the middle of last year. The first bomb was Facebook. I think it was one of the biggest single-day market cap losses any day. And they're like, yes, we're going to have to spend a lot more money than we thought. What is going on? Let's start with them. So what is going on with Facebook right now?

Because obviously, as you said, if not currently at some point, the greatest revenue in history per employee. But we also know that there's numerous scandals. It's unclear the degree to which they're really hitting the business model or if it's just a thing that media people like to talk about. But what is going on with Facebook's business model right now? So as it is with the other social media companies, I think the market still has some PTSD from the tech boom. or the tech bubble. Because in the tech bubble... You're talking about the one in 99.

Yeah, yeah. I don't consider this last round. No, no, I just want to make sure. Yeah, yeah. I think people are worried that as the user growth trails off, that as it was in the tech bubble, that the business will trail off as well and the growth will trail off. I think that is PTSD because it doesn't seem like that's actually going to happen this time, largely because we've learned a lot, or they've learned a lot, that by buying and bundling

these other platforms like WhatsApp and the rest, that they've kind of locked people into this ecosystem, especially on the social side. Brilliant model using OAuth to have people log in to all their other stuff. For almost forever, you couldn't do Tinder without logging in via Facebook, right? They became the social graph instead of just another social platform. So I think people were, and still are, in a sense, worried that as the growth trails off to sub 10% year-over-year kind of user growth rates, that their kind of leverage on that revenue stream kind of goes away. But the Arpoo numbers keep growing so quickly that they keep showing that they can just turn the dial

on, you know, what people, what they get out of people. The regulatory side, I think, is serious, and that's probably what re-rated the multiple, because the growth hasn't slowed too much. And I think that that's, it's fair. Do I really think that the government is going to clamp down too much on this? No, probably not. We probably don't have the, you know, the gumption to do that politically. We should, but we don't.

There's too many other, you know, cross currents going on there. But I do think that people on the by side assume that there is more risk than upside at this point, given the growth rate because there are so many other companies that are growing so quickly, especially in the enterprise tech space, that they could just rotate into. If we were in a situation where we weren't in this big kind of enterprise technology CAPEX super cycle, maybe Facebook would have held its multiple a little bit better. But at this point, you know, you can rotate into a lot of other things. The news doesn't stop on the weekends. Context changes constantly. And now blue,

Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Rafini. We'll bring you the latest headlines, in-depth analysis, and big interviews. All the stories that hit home on your days off. And I'm Lisa Mateo. Watch and listen to Bloomberg this weekend for thoughtful, enlightening conversations about business, lifestyle, people, and culture. On Saturday mornings, we put the past week's events into context, examining what happened in the markets and the world.

That on Sundays we speak with journalists, columnists, and key political figures to prepare you for the week ahead. Join us as soon as you wake up and bring us with you wherever your weekend plans take you. Watch us on Bloomberg Television. Listen on Bloomberg Radio, stream the show live on the Bloomberg business app, or listen to the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio, and wherever you get your podcasts. Before we get into specific companies too much, for Facebook or for any other tech stock, or I should say for any of the big tech stocks like the fang stocks, do you think the share prices that we saw before, say, the middle of last year were justified by the earnings outlook or were they overly optimistic?

Yeah. I mean, I think given the growth rates in the, you know, 30s, 40s, 50% for some of these big companies on the revenue side, the multiples are certainly not outlandish. And given their ability to use their balance sheets and stock to buy other high growth names, I don't see why those multiples are not sustainable. Now, when you take a look at something like Apple, which relies on a whole different kind of set of things that is more, you know, sales. of iPhones based the, you know, when they got over a trillion dollars in market cap, yeah, there's some law of large numbers coming in there with just literally how many of these widgets can you sell every quarter, every year, and what is the growth rate for them and where are you in terms of saturation of the market? But Facebook isn't, Facebook's not really

growing their user base anymore. It's just how good can the platform get, how much leverage they have on the people there already? And I don't see that going on. away if and he's done an incredible job of just creating this universe of things that you're locked into. I want to get to Apple in a second, but before I want to go back to what you said about the sort of enterprise software upgrade super cycle in these enterprise software cloud names because actually in Q4 while we saw this big sell off, there were a handful of tech companies that almost seemed completely unaffected by it.

companies like Workday, which probably not a lot. I think not a lot of people are probably that familiar with, but I think they're kind of like a Salesforcey type company. What is this class of companies that people got really excited about? And why didn't they get caught up in the downtraft to the same degree? They did. They weren't down 30, 40%. They were down, you know, 15, 20%.

Again, high beta names. If you listen to Mark Beanoff, the Salesforce CEO, on his earnings calls, the last two years, basically. He has been dead on right about the fact that he believes there is a super cycle going on in CAPEX for enterprise technology. Basically, we got the tax legislation and that freed up a lot of money for investment, supposedly, right? Now, for really large companies, we kind of saw them do share buybacks. But also, when you look at the financial sector, they hadn't gone through a huge CAPX cycle in a long time. A lot of legacy technology sitting around.

there, they did take the money and invest a lot in software. I think one of the reasons why people may not see as much CAP-X that they thought they would or should have happened because of those tax cuts is because it doesn't cost as much money anymore to do the CAP-X spending because a lot of it's not physical things, right? It's software driving your business. It's not hiring 100,000 people, right? It's hiring a couple people to manage the software. And so, we, We are seeing this massive investment in new software products, SaaS products, right, that you don't have to spend... Software as a service. Software is a service that you don't have to spend a ton of money to simply buy and install.

You're spending money every month, every year, right? It's not this massive investment up front. And BNoff has been right, and it is driving everything from, you know, HR, which is kind of the workday thing and updating how you manage your people to how you manage your, you know, internal systems, how you manage your logistics, how you manage your payment network. Square is on fire right now because every, you know, every store that you go to, every juice bar is now running a square machine, right? And then on top of that, it's amazing that companies like this, now they have all the data and they can offer that juice bar owner debt, right, and to, you know, invest in their company and, you know, kind of sidestep the whole regular financial

system. So it's all adding up to a lot of leverage for these companies that are small and mid-cap companies mostly, but their growth rates are incredible. And there's really no reason those growth rates should slow significantly unless we get a real economic downturn. Okay, I'm going to jump in and steal Joe's idea for the next question, much like any tech entrepreneur, really. Apple, we were going to talk about Apple. Lots of concerns. around Apple at the moment, is it going to be able to sell as many phones in the future? Are its current phones too expensive or not innovative enough to make people buy new models? Plus, you have this sort of glaring issues around China and this notion that maybe Chinese

nationals just aren't buying as many phones as they used to. Maybe they're buying from non-Apple competitors, like, you know, domestic manufacturers. where do you stand on Apple and which concerns do you think are sort of justified at the moment? I think there's some near-term concerns and some long-term concerns that are much bigger. I think near-term, the risks aren't that high. The Apple multiples are already pretty low. The installed user base, you know, for the phones isn't going away tomorrow. It's going to take at least two to three years to really turn over that installed base if something else were to

out to kind of subsume the market. Near term, though, the risk is China, really, which has been driving a lot of the growth. They were down 20% year-over-year in revenue this quarter, this past quarter. And I think Tim Cook has a little bit less visibility than he used to on his revenue because of the fact that China is such a question mark. So I think investors have to look at that, but it's very hard to believe that they're going to be able to push the multiple for Apple down too much further. It's already a pretty cheap stock as it goes. I think, you know, people look at the services side of the company, which is growing very quickly, which has a higher margin and say, hey, you know, this company should have a higher multiple. I don't necessarily believe that's the case.

And I think the market agrees as it hasn't given the company that higher multiple. I think that that services revenue is also more at risk than people think if the installed base of hardware kind of disappears, long term, the risk is basically this, the AI is coming and it's coming to consumers. You know, Alexa is great for Amazon in terms of their ability to collect data on what you want. God knows it's listening to me in my living room because I get ads like five minutes later for things my wife and I are talking about that we have never searched for at all.

They're definitely listening. But that AI is not the AI I'm talking about. I'm talking about something that probably comes out of Google. or some left field place that Google buys that completely changes the paradigm for your interaction with the operating system. And if somebody gets there before Apple, and a lot of companies are investing in this stuff,

specifically Google, the Chinese companies are obviously investing heavily, and they have tremendous amounts of data that drives all of this, if they get there before Apple, which has notoriously been bad in this specific space, and it has not had success.

As Syria is a disaster. If they get there before, Apple risks the hardware not becoming important anymore if it's just the software. I want to talk about this a little bit further, this idea of the hardware becoming less important to software. Because something I think you pointed out during a TV appearance recently is how in China, whereas in the U.S., we think of iOS as being the main platform that we use, we download apps from the app store, or so forth, that it's really we chat and the software that is the main thing that people interact with, and then people can add all kinds of services onto that. So I want you to explain that, but also a story that's emerged recently in the U.S., or just emerged recently, period, is some of these fights between Apple and Facebook and Apple and Google, referring to developer access.

And I'm wondering if there's a connection there where Apple is starting to worry that even in the U.S., that these services from the likes of Facebook and Google could essentially become the user's main home rather than iOS. So explain this issue because I don't think maybe people totally understand it and say, is this kind of what we're seeing the battle now playing in the U.S.? Yeah, so I'll explain it from my own personal perspective, frankly. I switched over to Apple from BlackBerry in 2005, something like that, right, to get an iPhone. And I've refused to switch over to Google, which all of my other productivity apps are on Gmail, calendar, just like Google Docs, everything, because I don't like the Android operating system. Apple just simply, I think, has a better operating system. The apps work better.

It's more seamless. All of these things. So I am stuck in that operating system. But in China, and I don't care about the hardware anymore. Google's hardware is just as good as Apple's hardware at this point. In China, they've now gone to the next step above that, where we chat and we pay are an ecosystem in and of themselves. So people just go into these apps,

and they have all sorts of amazing utilities inside of it. They're literally paying for everything at stores inside of these apps. They've got their email. It's everything. And so the operating. doesn't matter anymore because it's subsumed inside of the app. You have to know that Google is thinking about this with kind of the ecosystem that they've built. And there are others. And Apple, which is not good at building software outside of the OS, like what's the last

piece of software that you love from Apple, right? Maps was a disaster. And so Apple risks seriously falling way behind and having the hardware just not matter at all. It could be that we get to a payments place in the U.S., which we're way behind on, where one of these apps subsumes it. It could be something else. It could be a social thing. It could be whatever. Facebook has tried to bundle all these things together. But, like, you know, I don't think it's worked that well inside of one app.

Or it could be an AI. So it could be any of these things that just rips Apple's revenue flow away from it from selling, you know, this hardware, which is $1,000 for a phone, right, where you can get a good one for like $200. So you mentioned the possibility of an earnings recession, I think you said this year in 2019. So is there a risk that part of that earnings recession comes from tech companies as a whole? Or are we going to see weakness in one firm, say an Apple offset by strength in another firm, like Google, to the point you were just making about a sort of closed software ecosystem? And secondly, if we get an earnings recession, how disastrous is that for the markets, given that earnings have been pretty strong for a few years now? Yeah. So on the first question, I think it's the latter.

I think it's going to be a bit more idiosyncratic. The enterprise market is going to continue to be really strong unless the general economy falls off a cliff, which I think is, you know, on likely. Maybe we get a recession in, you know, late 19, 20, something like that. but I just don't think it'll matter too much for that cycle. At some point, that cycle will come to an end, but it doesn't seem to be ending anytime soon right now. Yeah, certain companies will have their own issues, but I don't think a broader earnings recession will come about because of tech. The way that we're seeing the numbers, it looks like if it happens, it's going to happen because of two things. One, industrials because of China and two, the consumer in the U.S.

We think consumer estimates are still too high for 19. You have a great analyst over here, Seema Shah. I think we're in agreement there that we're probably on the back part of the, you know, top of the hill for consumer growth. And the risk there is that those estimates and actuals continue to come down further. We're seeing in our data set, which tends to lead the cell side data set in either direction up and down, that estimates have come down quite a bit. And we're right now, we would be projecting an earnings recession for, which would mix

between Q1 and Q2, FY19. Well, on that cheery note of expecting an earnings recession. It won't matter. It's not, so the second question, sorry, I don't think it's going to matter that much, unless you get another credit market issue or some other macro issue, just because you're negative on, you know, the earnings number. Again, market's going to look forward a year, right? And the numbers right now, you know, people are taking that into consideration.

All right. Well, on that positive note, Lee Drogan, really appreciate you on. I was very excited to have a chance to talk with you for a longer time than we get on TV. And I really just learned a lot. So thank you very much. Yeah, thanks for having. I love the odd lots name for the five. It's a double entendre, I think.

Yeah. Thank you. Thanks, Lee. Tracy, I always. learn a lot talking from Lee, and I feel like even in that short conversation, some of these ideas, like about the platform wars, how AI could really upend, how we interact with the internet and our computers, why people are so excited about some of these enterprise cloud companies. I feel like I just learned a ton about the current landscape of tech and tech investing.

Yeah, it was a great conversation. But you know what? I always wonder, whenever we're talking about tech. I always wonder if tech more than other industries is something of a wild card when it comes to making earnings estimates or forecasts for the future, just because, I mean, technology is basically all about searching for the next paradigm or the next breakthrough in business. And it seems so hard to figure out what that might be. And so, I don't know, I just find it more difficult than a lot of other things. I also think it's interesting, too, that I think a lot of the people who are running these companies come from sort of non-traditional backgrounds where maybe they don't feel as beholden to this idea of like, oh, we got to like hit this estimate. And Jeff Bezos is probably the

most famous in this respect of not thinking about the quarter, thinking about each quarter's numbers as being so important to hit. So there are just a lot of wild cards in the industry, both short term and long term. And yeah, as you said, like, whatever is the, you know, there was one day when it looked like IBM had ultimate lock in and then no one even like talks about them anymore. So absolutely, there is short term and long term volatility in terms of where all this is going. Yeah. And for every Jeff Bezos, I guess there's a sort of Elizabeth Holmes, right, who made far too outlandish promises and basically, well, didn't make it. Let's put it that way. But anyway, earnings recession in 2019, that'll be something interesting.

That'll be a story we're watching. On that happy note, yes. Okay. So this has been another edition of the Aw Thoughts podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway. And I'm Joe Wisenthal. You can follow me on Twitter at the stalwart.

And you should definitely follow Lee on Twitter. He's at El Drogan. Also, be sure to follow our producer, Tofor Forges. He's at Forges T. as well as the Bloomberg head of podcast, Francesca Levy, at Francesca Today. Thanks for listening. You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris.

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