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US tech stocks: stop kissing frogs

Former City analyst Robin Hardy continues to explore the world of tech. This week he asks if the sector's most prominent companies still offer value.
US tech stocks: stop kissing frogs

Many people investing in technology want to hit the big one, find the next Apple, Microsoft or Amazon. It’s easy to see why given the returns early investors made in these stocks. Apple (APPL) has grown 243,000 per cent since 1980 and Microsoft (MSFT) 309,000 per cent since 1986. More recently Alphabet (GOOGL) would have made 5,000 per cent  (since 2004) while Meta/Facebook (FB) in comparison looks like a low returner growing only 416 per cent since its 2012 IPO. Even index trackers would have made big returns: the Nasdaq has risen 7,870 per cent since 1982. 

Trying to pick the small handful of stocks that might make such enormous returns is very difficult, but investors can easily save themselves the hard work – the existing tech giants still have a lot of potential to deliver very attractive growth. On top of this, most have been through a sizeable shakeout in the last six months, lowering valuations. A number of these stocks have share ratings that are almost mainstream: Apple’s price/earning (PE) ratio is 27 times, while Walmart not so much lower at 21 times. 

The big names in tech still have big ambitions. The problem is nobody knows what the next big thing(s) will be – nextGen mobile devices, VR, AR/Meta, AI/machine learning, self-driving cars? The big names don’t know either so they are casting their nets wide, playing an 80/20 game, but are doing so while still operating vibrant, fast-growing, scalable, profitable, cash-generative cores that will allow them to explore these new fields. Investors can more confidently expect high growth without having to cross fingers and hope that their start-up/small-cap pick or picks work out. 

We don’t have room to assess all the big techs here or address the big issues such as regulation, the threat of business break-ups, privacy or paying the right tax, but below we look at a small selection of the good and less good options in large tech.  

 

Amazon – not what you think it is

Amazon is not a retailer. At least, that is not where the value or the growth potential are. Retailing is still the bulk of revenue (70 per cent) but in the fourth quarter (Q4) of 2021 it lost money here despite rising sales. Yet the growth forecasts for Amazon between 2021 and 2024 average 40 per cent (backing out 2021’s $12bn (£9.1bn) windfall gain). Retail is still growing but makes little profit – $7bn on $400bn of sales, potentially a loss of $25bn if advertising income is backed out – it could yet be a loss leader, and potentially a point of substantial turnaround further out. 

In the meantime, where is the growth coming from – advertising, subscriptions and Amazon Web Services (AWS). These businesses are growing very rapidly and make high margins. AWS made 30 per cent in 2021; advertising potentially makes 60 per cent and subscriptions might be returning 50-60 per cent. AWS is the most interesting as industry forecasts for the Software-as-a-Service (SaaS) and Cloud Solutions suggest that by 2028, these industries will have grown another 500 per cent. AWS alone could generate $300bn of sales and >$90bn of operating income: the whole group only made $24bn operating income in 2021.

Table 1: Amazon divisional growth rates

 

CAGR 2014-2021

2021

Online stores

18.3%

12.5%

Physical stores

31.0%

5.2%

Third-party seller

36.4%

28.5%

Subscription services

41.8%

26.0%

Advertising services*

75.0%

57.6%

AWS

44.9%

37.1%

Other

17.5%

29.5%

Source: Amazon 10-K filing | *IC estimates

Amazon has also undertaken a 20:1 stock split: its share price was previously almost $3,000. A cheaper stock price makes it less complex to buy shares as smaller investors can avoid having to buy fractional shares for smaller investments. While some observers believe that smaller share prices tend to rise faster, this does not really bear scrutiny. Amazon looks expensive on a PE ratio of >60 times, but it is not high relative to what should be very strong growth. 

 

Microsoft – the tech elder statesman

Microsoft is just one of two stocks in the $2 trillion club but has surrendered the largest stock crown it finally secured last year back to Apple. A decade ago Microsoft risked becoming irrelevant as desktop computer numbers declined and locally installed servers began losing out to the cloud. Between 2002 and 2012, Microsoft shareholders made only a 3 per cent annual total return; Amazon’s investors enjoyed 29 per cent. 

But there has been a very successful pivot here. Even if Microsoft lags behind Amazon’s cloud services on quality and breadth, it is catching up rapidly. The overall growth for Microsoft may lag some of its peers, but this is due to it still having legacy (servers, Windows, Surface) products and lower growth (gaming) activities. It is seeking to address the latter via the Activision Blizzard purchase (the largest in sector history at >$68bn). 

Microsoft is now being driven by its cloud businesses, mainly under the Azure umbrella which bundles 200 cloud-based business services including Exchange email, Office, storage and networking. It is quite different from Amazon’s AWS in two key regards: 1) it is more ready to use out of the box especially for SMEs: a suite of solutions rather than a raw, complex toolkit; 2) it is supported by a large partnership networks of resellers and solutions providers which AWS lacks. It is also larger with $60bn of cloud revenues versus Amazon’s $18bn.

It may be growing more slowly than AWS but it arguably has higher margins – not formally published but observers reckon its returns from cloud operations are close to 70 per cent. That slower growth results in a lower rating; in fact the PE ratio is half that of Amazon at <30 times. While its more dynamic businesses are growing at 30-40 per cent the overall rate is just 15 per cent as the still large legacy businesses hold it back, but these will increasingly become overshadowed. This gives Microsoft scope to see growth rates accelerating later in this decade as its peers decelerate. 

 

Nvidia – much more than gaming

Nvidia (NVDA) makes specialist chips for graphics and gaming (GPUs) and is the dominant market player with more than 80 per market share. Gaming is still a growth market (CAGR c.9-10 per cent to 2026) but offers far lower expansion than Cloud/SaaS, AI, big data processing or digital migration. 5G has ushered in cloud gaming (GaaS or Gaming-as-a-Service if you like) and the pandemic caused a step up in gamer numbers, but overall this market is maturing. Prior to the pandemic, Nvidia’s revenues ran flat for three years.

But growth is back, with an average >20 per cent for the next three years – nVidia has found new markets. Historically, Nvidia’s products were locally installed in PCs and (less so) laptops and it never pursued the mobile device market – it was waiting until it bought Arm and while that deal has fallen through, this is another potential new market via cooperation rather than vertical integration. The big new markets are in the data centres that form the ‘cloud’, and not just GaaS. Today, Nvidia derives 40 per cent of its revenues from data centres/cloud installations and growth has been > 50 per cent a year. 

The demand is due to the group’s adaptation of its GPUs to embrace AI and machine learning through the creation of DPUs or Data Processing Units, a ‘system on a chip’ (SoC) that is expected to make data centres dramatically more efficient. Traditional CPUs or general processors are not efficient at moving data whereas DPUs do a limited set of tasks but do them fast and, of growing importance, use less energy. 

This new data centre segment (DPUs and cloud GPUs) is expected to deliver more revenue than the historic heart from the gaming sector in 2023. There is new vitality in the business already, with more to come via greater presence in mobile devices, more open software allowing its graphics hardware to be used in new ways, AI & machine learning in the cloud and a nascent business in automotive AI. 

While Nvidia’s shares might be higher rated than some of its peers, a PE ratio of 45 times should drop quickly for a group moving forward rapidly on a number of different, new but ultimately still connected and well-understood fronts. This could prove to be the most interesting of the larger tech stocks. 

 

Tesla – a world of change, but finite change

Businesses operating in cloud services are (rightly) seen as operating in very large, very scalable end markets. For Tesla (TSLA), things are a little different as it operates in a much more finite market – automobiles. This is a very large market that is going through rapid, enforced change, but it is still finite. While there are still 275mn cars registered in the US and (in normal times) around 16-18mn new cars made each year that is likely to be about as good as it gets. Some economists believe that car ownership will decline (ie, millennials don’t own things) which could further limit the scope for a business like Tesla. 

What's more, there is big competition from the existing auto making world. While Tesla may be a complete package when it comes to electric and self-driving cars that does not assure it of dominance. The likes of Toyota, VW and GM will fight back and will tie up with big tech in order to stay alive. 

Tesla looks expensive on a PE ratio of almost 90 times. It is still well ahead of its pack and growing fast for now (c.40 per cent CAGR), but the competition will close in. The threat of an entire established industry ready to hunt it down is something other large tech stocks do not face. Then there is also the question of the extent to which it is a technology stock. It is also demonstrably an auto-manufacturer – General Motors trades on a PE ratio of six times and Toyota on nine times. It is streets ahead in self-drive but that is still a very long way from being able to make meaningful money. The best of the money may have already been made here after an 18-fold increase in the share price over five years. 

 

Apple – in need of a volte face

In a world where everything is about software, Apple is still largely a hardware business, albeit a very successful one and not one encumbered with legacy technology. But its phone sales (also Macs and iPads) largely look to have plateaued – you have to begin to question a business model based on camera quality and sustaining a cult-like following. Overall, Apple is forecast to grow by only 5-6 per cent a year through to September 2024 – that is a percentage point slower than Walmart. 

What Apple lacks is a commercial software side like AWS, Azure or Google Cloud – it does have subscription offerings, but they are for content, not services. The services it does already offer account for a quarter of revenues but >40 per cent of profit. Apple doubtless will take action on this front and buy its way in with its cash pile of still around $100bn, and many will flock to the brand – Apple Core or whatever.  Apple trades today on a PE ratio of 27 times against the Nasdaq average of 24 times, which reflects this lower growth and shines a light on its need to evolve. While Apple still seems able to wow the markets with new product launches for now, it is hard to see that lasting or being able to support a premium rating with below-average growth. Today’s Apple does not look like a great investment but it is probably a fairly short-odds bet that it will evolve. Even than, it is going to be playing serious catch-up.