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Opinion

Tech’s Wild Ride — Why FAANGs Are Down As Smartphone Boom Wanes

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The tech sector is getting rocked. Here are losses for the FAANG group since the start of October: Apple down $245 billion (23 percent); Amazon $205 billion (21 percent); Google $105 billion (13 percent); Facebook $80 billion (17 percent); and Netflix $50 billion (30 percent). Each of these companies has underperformed the NASDAQ average, which fell 12 percent. This totals approximately $685 billion of market value wiped out in a matter of weeks; to put this in context, it represents about 25 percent of the $1.6 trillion decline in the NASDAQ over the same period. Some of these losses are even worse compared to this year’s peaks; Facebook is actually down for the year and Google about breakeven.

So why is there so much pain right now? Is the FAANG group even viable anymore from an investment standpoint? Fingers are pointing in many different directions as investors and pundits attempt to get to the crux of the why. Some of the biggest concerns are regulatory risk, over-investments by fund managers in the FAANGs, and a worry that the incremental utility of the tech platforms may simply be diminishing.

Some argue there’s already sufficient correction in terms of valuations, since forward P/E multiples are now at or below market multiples. This is the case for Apple, Facebook, and Google, though Amazon and Netflix still trade at lofty premiums. Setting aside regulatory risk, it’s not hard to make the case that the pullback presents a buying opportunity in some respects.

But investors must make a massive assumption to assume that the music will keep on playing. We have to keep seeing an upward slope in smartphone adoption — and further capture of consumer time on the smartphone — across the developed world.  Unfortunately for the FAANGs, we are instead at the end of the smartphone boom in the geographies where it matters most.

Beats on earnings and raises in estimates will no longer be followed by even bigger beats and raises, as was the case for the last few years. Shortfalls are likely to be further punished due to a disproportionate market shift towards momentum-based investing, which will only exacerbate pressures on stock prices.

The end of the smartphone boom means that the FAANGs need to be evaluated through a different lens. The FAANG group best capitalized on the smartphone, which is why it accrued the most value. Now, 11 years after the introduction of the first iPhone, the end is in sight.

Evaluating the next cycle requires identifying the companies that can continue to achieve what I believe to be the primary purpose of technology — saving time. As smartphone adoption grew during the initial boom, a rising tide lifted most boats. But the winners going forward will be determined by who is able to take even more share of consumer time on the device itself. Winning mindshare and consumer attention is likely to be a function of providing quality experiences and time savings as a result of using the device, and will have to be coupled with a commitment to privacy and personal data integrity (i.e. not selling data to controversial third parties).

Based on this analysis, perhaps the best way to rank the FAANGs for the coming stage 2.0 is to move that “F” to the end, even if AANGF does not roll off the tongue. But then, today’s market conditions are already not feeling too palatable.

Here, in descending order, are the companies with the best prospects:

  • Amazon  It’s the most important company in recent history. But the stock’s recent decline doesn’t reflect that. Its disappointing guidance last quarter led to the quick retreat of its shares from the $1 trillion threshold reached earlier this year. Even with the pullback, the shares certainly aren’t cheap, at 59 times forward earnings. But Amazon’s mission is more aligned with the customer than any other tech company in the market, with the possible exception of Apple. Moreover, Amazon is best poised among the FAANGs to survive the inevitable growing regulatory heat, given the way the company contributes to consumer purchasing power by serving as a deflationary force.  It’s also fully calibrated to disrupt entire sectors of the economy such as grocery, media, and health. Most importantly, Amazon should be on the winning end of share shifts of consumer time on the smartphone given its expansion into new categories, home devices, and offline shopping efforts.  To be sure, recent headlines about its restive workforce both in the U.S. and Europe don’t help near-term. But when it comes to driving time savings and efficiencies for consumers, this company is second to none.
  • Apple – It does have a compelling valuation case at 12x forward earnings. Shares felt the pain in recent months due to expected shortfalls in unit sales and the disturbing message sent when the company announced it was ending the disclosure of how many iPhones it sells. What got lost among these worries is that Apple doesn’t really need to grow unit sales for profits to grow and for the stock to rise. It’s no secret that smartphone replacement cycles are lengthening, but rising average selling prices and the company’s share repurchases can propel the stock higher even if unit sales stay flat. Moreover, the fact that depreciation rates for Apple’s devices are superior to all competition should further reinforce the strength of the ecosystem and the company’s ability to augment its associated services revenue. The smartphone boom may be nearing an end, but Apple’s ability to outrank the field in product quality and experiences should suffice for the next stage.
  • Netflix  This is a tricky one. The stock is very expensive at 64 times forward earnings and faces extremely difficult comparisons to past quarters as growth rates drop. However, there is also no company better situated to take apart the traditional media landscape — and this includes all the TV networks, studios, and cable companies. Netflix relies on the cable infrastructure, but at the end of the day it owns and depends on the loyalty of the customer, not the internet service provider. Netflix has also shown an ability to build media brand ecosystems comprised of products, personalities, and related content.  Of course, heavy investments will continue to be absolutely necessary, so profit levels could disappoint in future. But this company time and again showcases its uncanny skill at producing quality content experiences, navigating the complex establishment framework, making bold bets, and turning negatives into positives.
  • Google  Google should technically be ranked one step higher given a relatively attractive 22 times forward earnings multiple, its content prowess with YouTube, and its amazing capabilities in search. However, two risks to the story place it in the fourth spot. First, and most apparent, is regulatory risk. Google has shown little skill in handling regulatory pressures and also flatly countered its “do no evil” credo by flip-flopping on China. Facebook may be Google’s best friend here, as it takes some of the regulatory spotlight away with its own ineptitude, but the risks for Google are also very real. Second, and less apparent, is the implicit risk associated with the search algorithm. It is paramount for Google to avoid any perception of censorship, bias, or privacy infringement. It’s easy to say that Google search saves time. But Google risks seeing declining utility and perceived value to the consumer (i.e. less consumer time on the smartphone) if it starts to tilt the balance in any way or reduces the quality of the consumer experience through unsavory monetization efforts. That also could increase the likelihood of heavy-handed governmental action.
  • Facebook  It’s remarkable that a company so well versed in building communication tools cannot handle PR crises. Most recently, the C-suite had longtime PR boss Elliot Schrage take a bullet for the team as his apparent last swan song at Facebook. What’s most ironic is that Facebook’s entire business model and incentives revolve around being open to all information without bias, but biases in its own approach seem to surface regularly like clockwork. Facebook itself increasingly appears to be a propaganda machine. In any case, it rode the smartphone wave better than any other company and now commands almost an hour a day of attention from users across its product portfolio. Facebook’s challenges do involve regulatory risk, but what’s not even yet appropriately factored into its already reduced valuation is the business risk as ongoing gains in smartphone usage will increasingly be derived from lower tier markets. In other words, Facebook is tapped out where it counts. To be fair, the valuation has come down to 18 times forward earnings, which is relatively attractive given its earnings growth and margin profile. The challenge is that the incremental utility of consumer time spent on the platform skews negative in developed countries. Couple that with the regulatory overhang and the uphill battle is twice as steep.

James Cakmak was for 10 years, until recently, a Wall Street security analyst covering the internet sector. He is also co-founder of Snailz, a nail salon booking app now operating in New York. Follow him on Twitter: @JamesCakmak

Ryan Guttridge, Adjunct Professor at Smith School of Business, University of Maryland, contributed to this article.

 

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