#8 When markets behave irrationally
A review to the Q1 earnings of Amazon, Apple, Facebook and Google
Amazon 15% down. Facebook 13% up. Hundreds of billions erased from the market. But is the wealth generated by these companies disappearing?
Markets are sovereign and stupid.
"The stock market is a device for transferring money from the impatient to the patient."
A tribute to Warren Buffett today, when he is once more hosting, and hopefully for many more years, the Berkshire shareholders meeting.
In the last few days we have had the first quarter results presentation of many big companies. A difficult quarter marked by the slowdown of the economy, aggravated by the supply shock after the pandemic and by the war in Ukraine, but whose ultimate origin is the unbridled monetary expansion that has taken place in the world in the last 14 years.
In this situation, the only way to try to protect ourselves is to possess extraordinary assets. Some of these special assets, for various and different reasons, are the 4 companies whose results we are going to review today: Google, Facebook, Apple, and Amazon.
Alphabet (Google)
Quarter summary:
Strong results driven by a solid growth of the core business. Amazing cloud growth (still generating operating losses) and deceleration in YouTube growth rates after many consequential outstanding quarters. Furthermore, the board authorised an additional $70B repurchase program which could create substantial long term value given the current valuation.
Positive developments:
The business runs smoothly despite economic uncertainties around the world.
They are using almost all FCF to buyback shares.
Negative:
YouTube growth might show some exhaustion symptoms (we all can suffer the increase we have seen in the last year) and might show little conversion rates to premium subscribers at the moment.
Stock based compensation keeps accounting for 1/3 of the shares repurchased.
To find the reason of the decrease in the EPS despite the good results, we have to go to:
Alphabet is one of the best core businesses ever created. There might be some points that are not optimal, but despite its current size, it is still a high-growing business, with a huge moat, with very attractive returns on capital and trading at a very interesting valuation.
What is discounting the market at current prices? I have made a rough and dirty model to check the growth leves and IRR implicit currently at the price:
Meta (Facebook)
Quarter summary
Meta is lately fighting against several macro economic, regulatory and geopolitical headwinds, resulting in a weak business performance. Furthermore, the management reduced the repurchase of shares during a quarter when the price was depressed and there were almost $30B authorised from the buyback program.
Positive developments
Despite all the headwinds, the company managed to grow both in active users (6%) and revenues (6%). All this growth was achieved at a high ROIC and in spite of large investments for the development of the Metaverse.
We love the transparency from Mark in general. We believe the key points of the conference call was listening to his approach to these 2 main strategic topics: the relation between investments/margins and the current investment priorities:
“On the Family of Apps side, I am confident that we can return to better revenue growth rates over time and sustain high operating margins. In Reality Labs, we're making large investments to deliver the next platform that I believe will be incredibly important both for our mission and business […] So over the next several years our goal from a financial perspective is to generate sufficient operating income growth from Family of Apps to fund the growth of investment in Reality Labs while still growing our overall profitability. Unfortunately, that's not going to happen in 2022 given the revenue headwinds, but longer term that is our goal and our expectation.”
Main investment priorities: Monetise Reels, solve signalling problems for ads after Apple’s move and the investments in AI & Metaverse: “We're making major AI investments to build the most advanced models and infrastructure in the industry. Over the next year or two, we hope that this drives better recommendations for people, higher returns for advertisers, and increases our revenue growth even in the face of signal loss. Over the longer term, I think that these large technology investments can provide a sustainable competitive advantage over others in the industry.”
Negative
Price per ad decreased a worrisome 8% YoY. There was no further discussion about this topic apart from the known fact that they are still facing difficulties in monetising short-video format with Reels, which is the area bringing the largest time of engagement. Signalling difficulties, inflationary pressures on advertisers and the economy slow down could be affecting also.
Capital allocation issues: for us, the biggest disappointment of the results. After the $20B+ share buybacks in Q4 with the share at $330 and this one, we were expecting a huge commitment and investment with the share below $200 and a remaining authorised program of 30B.
However, management decided to buyback “only” 9B this quarter. Having said that, it is also true that Q4 repurchase rhythm was not sustainable over the long term. Additionally, we will have to wait 3 months to see what they have done during the last weeks with the share trading at a lowest of $172.
Disappointedly, not a single analyst raised the question during the conference call.
We believe that despite the short term volatility and poor results, a visionary CEO shall remain focused on building sustainable competitive advantages, allocating capital efficiently and providing excellent returns on capital. Current valuation assumes the worst case scenario. Despite errors and potential concerns, we believe Mark has proven his value and will continue delivering.
Again, what is already discounted in the price?
Apple
Quarter summary:
Apple never disappoints. They keep executing unaltered with the overall headwinds. Services are growing and becoming more important in the overall business, increasing margins and returns on capital.
Positive developments:
Services grew 17% , a business with a current gross margin of 72%.
Apple keeps using almost all its FCF to buyback shares. In fact, the board of directors has also authorised an increase of $90 billion to the existing share repurchase program. A deeper analysis on whether shares repurchases at current prices are actually creating value or not. Buffett always claims the beauties of Tim Cook capital allocation skills. I have my doubts and would like to dig into it. It is also fair to say that the share price performance is there.
Negative:
Product growth stayed at a 6%, somehow influenced by a decrease in iPad sales.
Revenue growth was given mainly by America, since the rest of the world stagnated (influenced also by other currencies depreciation against the dollar)
Apple is one of the most remarkable businesses of our time. The brand moat is simply not comparable to any other brand in its segment. They sell high-margin products, but still affordable for a great share of the developed-countries population. And best of all, they are still conceived as premium. We have seen something like that very little times. Valuation is demanding, but nothing out of reason for such a great business.
Apple is always expensive compared to others. We have heard that everywhere. But is it? Take a look at the invested capital in the last 5 years. It has declined from 274b to 225b, while the operating income has grown an annualised 15%. This is remarkable. However, a simple model tell us the expected IRR for Apple, not considering any kind of optionality, is below its FAANG peers with a 8%.
Amazon
Quarter summary
Challenging quarter for Amazon on many fronts.
Positive developments
AWS: this little monster business grew a 37% YoY driven (although less than Azure or Google) by the digitalisation tailwinds of the industry. The TAM is continuously growing and it comes with juicy margins.
Negative
Where to start…
Negative operating cash flow!
Despite the growth of AWS, net sales increased only a 7%. We don’t have the margins for each of the businesses beneath e-commerce, but it seems clear that the 1P business line is simply destroying big value. Whether this line is enabling the flourishment of others, it is in the management to decide. From outside, with the Capex requirements, is simply difficult to justify.
It seems they overestimated the demand for their services and it has impacted in higher CAPEX expenses + personal hired than needed, all this in an inflationary economy to worsen the things: "we quickly transitioned from being understaffed to being over staffed, resulting in lower productivity"
Stock based compensation keeps diluting the shareholders, $10B last year.
Large CAPEX cycle ($61B last year) might be over:
“E-commerce business has grown 23% annually over the past two years, with extraordinary growth in 2020 of 39% year-over-year that After doubling the size of their fulfillment network during the last 2 years, they will focus on improving productivity and cost efficiencies throughout their network. This may take some time, particularly as we work through ongoing inflationary and supply chain pressures.”
They keep innovating throughout a large variety of fields. Amazon’s culture has been always based on continuous innovation and experimentation. They are doing nothing different. Critics are hitting them from every single point, specially targeted to Andy Jassy. They are all fair attending to the numbers. We will now see his leadership and charisma. Challenged times ahead.
AWS business is impressive and quite “simple” to value. The problem comes from the core low-margin business. Many analysts value it at $0 or worse, add some billions for the prime + ads business. It doesn’t look that easy from our side. This capital-intense side of the business could destroy shareholder value in the upcoming years. Or not and we are just facing some bad quarters. Uncertainty and this is what the market is pricing.
We believe Amazon’s entrepreneurial culture and values will successfully overcome the current headwinds as they have done many times before.
As always, we share the slides in pdf format: