Chameleon Companies

Transmorphism has always been a feature of the stock market. Essentially, buying shares demonstrates faith in change – that companies will generate returns on capital by creating innovative products and cracking new markets. Even in ex-growth industries, holding stock implies optimism that businesses will adapt to a world in flux and keep throwing off cash to reward believers.

Chameleon companies might find a catalyst for rapid sales growth, or position themselves at the vanguard of new technology and secular trends. Sometimes they alter corporate structure to expose hitherto unnoticed value or facilitate the pursuit of new growth ventures. Those that get it right have proved to be exceptional investments.

 

Amazon: the great exemplar of change

Amazon (US:AMZN) is unsurpassed as a specimen of corporate Darwinism. Having gone from online bookstore to dominant global player in e-retail, evolution remains a hallmark of the business. Its prominence in cloud technology, through Amazon Web Services (AWS), is now a major strand of the investment case. Whereas five or six years ago, nobody was talking about AWS, this revenue line now makes it possible to look beyond quarterly retail sales expectations when assessing the stock.

 

 

Fund managers, like Charles Plowden of Monks Investment Trust (MNKS), believe in Amazon and maintain trust in its management to deliver. Mr Plowden says: “Flexibility and ambition don’t fit into a DCF [discounted cash flow] spreadsheet.” These qualities, which have rewarded investors handsomely, are the reason he isn’t concerned about granularity and focuses on “direction, not the detail” of the business.  

Further growth opportunities go beyond ownership of Whole Foods and mooted takeovers to expand into the online grocery business. Successful roll-out of the Alexa system, voice-recognition technology and huge data banks from more than 100m devices open new avenues to disrupt computing platforms as clicking and swiping takes a back seat to simply asking for information.

Smart innovation in artificial intelligence (AI) and the success of AWS are reasons why Mike Seidenberg, a portfolio manager and analyst at the Allianz Technology Trust (ATT) admires Amazon. Explaining that many young developers have grown up using AWS, Mr Seidenberg says it’s “a really powerful sticky revenue generator” for the business.

“Investing,” says Mr Plowden, “is about harnessing the future at a rapid rate. In Amazon’s case that’s the three-to-four next big things.” Although he doesn’t believe going head to head with Netflix (US:NFLX) is a core focus, Amazon has still spent $5bn on original content. Going further into food and applications of voice recognition and AI technology, particularly in healthcare, are areas to exploit.

 

Restructuring, simple as ABC…

Leadership in next-generation healthcare is a huge prize and Amazon will be going head to head with Alphabet (US:GOOG) for the spoils. The restructuring in October 2015 that saw online search giant Google spawn its own parent was a highly visible example of change as a statement of intent. Advertising revenue from the search business was to continue generating profits to justify the company’s valuation, while other subsidiaries, effectively funded by Google, focus on revolutionary products.

At this stage, some professional investors seem cautious. Even though ATT reduced its position earlier this year, Alphabet is a very good company in Mr Seidenberg’s view. His reservation, however, is that search makes other parts of the group difficult to value: “Great companies find incremental products and services that customers like. [The thing is] Google’s first product [search] is so good, [what is] the chance the second will be so great?”

Google’s innovations have been fantastic for individuals and advertisers, but are baked into the Alphabet share price (although Mr Seidenberg thinks there is scope to further monetise the incredibly useful Google Maps). What’s hard for analysts to estimate is the upside Alphabet’s earnings will eventually see from other subsidiaries, even those that seem exciting.

Ben Rogoff, the manager of Polar Capital Technology Trust (PCT), describes Alphabet as having “innovator’s dilemma”, where it’s “hard to reinvent yourself and hard to replicate market share in a new market”. Yet, in some of those markets Alphabet is targeting, the rewards will be significant. PCT was, at the time of speaking with Mr Rogoff, slightly underweight to its benchmark on Alphabet, but he explained his feelings towards investing in the group: “[Alphabet’s] value [is a] bit like a conglomerate of founder businesses – [you] want to be involved with brilliant people worrying already about where the pack is headed.”  Potentially, that direction is very lucrative. Alphabet’s DeepMind Technologies reported a breakthrough in using AI to predict patients’ risk of kidney damage on 31 July 2019 – exactly the sort of news that will start analysts thinking about valuing the group beyond Google.

Driverless vehicles could be another AI jackpot for Alphabet through its Waymo division. As of March 2019, Waymo had 600 driverless cars on the road and had ordered 62,000 Chrysler Pacificas and 20,000 I-Pace vehicles from Jaguar to expand its fleet. That puts it a long way behind Tesla (US:TSLA) in terms of volumes (Tesla delivered 95,200 vehicles in the second quarter of 2019, source: Statista.com), but over the long run, being underwritten by the cash flows of a large tech conglomerate – that also has strategic investments in cab hailing app Uber (US:UBER) and ride-sharing app Lyft (US:LYFT) – is a source of considerable advantage for Waymo.

 

Ubiquity encourages scrutiny

Gathering, holding and controlling petabytes of sensitive information has naturally seen tech companies draw attention from regulators. The European Union’s general data protection regulations (GDPR) were designed to give consumers more control over what was being harvested, although companies have been crafty in using additional functionality of services as bait for consent. Of most concern to the tech giants is US antitrust threats to break them up. In the case of Alphabet, Mr Rogoff thinks this has been overplayed: “[The] business won’t get broken up, [it] drives utility to billions of people.” He also believes the risks to privacy that do exist are manageable.

For Facebook (US:FB.), which was already in hot water over the Cambridge Analytica scandal, there might be more cause to be nervous, especially if chief executive Mark Zuckerberg’s intention to move into the sphere of money creation with his Libra project upsets governments, central banks and regulators. From a competition perspective, the acquisitions of chat app Whatsapp and photo-sharing app Instagram have prevented the Facebook platform from being disrupted by apps that are more popular with a younger demographic.

Instagram has truly become a phenomenon thanks to its chat and photo sharing experience and the ability to follow celebrities. Famous users such as the Kardashian/Jenner sisters and Cristiano Ronaldo can command fees of up to $1m per post to push brands. The business is now one of the main bull points for Facebook in Mr Seidenberg’s opinion: “Instagram is incredibly good at satisfying advertisers’ needs. From a branding perspective, it’s a beautiful product, whimsical and visual, [the] series of photos [are] totally engaging.”

 

 

Changing nature of competition adds uncertainty for Big Tech

One of the major issues for the tech giants is that they are trying to out-do one another in new industries, not just disrupting lumbering incumbents as they have done in media, retail and telecommunication sectors since the late 1990s. Google Cloud Platform is lagging Amazon Web Services and Microsoft (US:MSFT) in one fast-growing market, and competition is heating up in healthcare.  

Microsoft’s experience in revamping its business after some disappointing years provides a useful case study in resilient features to watch out for in a maturing company facing growth challenges. The business has never come close to denting Google’s pre-eminence in search with Bing, and Microsoft failed badly in mobile with Nokia and the Windows phone operating systems.

What Microsoft has, however, is an outstanding core product in its Office software, which keeps generating cash. The useful life of its software allowed it leeway to endure some false dawns before finding another growth product. Now the cloud services business is another good reason to hold the stock in the view of Mr Seidenberg, who credits Microsoft with having “done an amazing job for customers on [their] journey onto the cloud”.

 

Do expectations of growth-challenged Apple need to change?   

Apple (US:AAPL) is a company that was long held up as a true innovator. It went from occupying a quality niche in desktop computer hardware to disrupting portable music, and creating the smartphone and tablet markets. Now, as consumers have switched from owning to renting music and media content, iTunes is no more and the quality end of the smartphone market is saturated. The challenge is finding new products and services that can take the iPhone’s crown as Apple’s sales growth driver.

Polar Capital’s Mr Rogoff has been a long-time admirer of Apple, but the fund is more underweight in its holding than it has been for some time, although Apple still dominates the quality end of the smartphone market. In North America, while in volume terms it faces serious competition from cheaper phones, in dollar terms it still has 40 per cent market share. Based on some simple short-cut calculations (dividing annual sales by active users) Mr Rogoff estimates that the replacement cycle for the iPhone is three to four years, with a trend towards lengthening.

With the unit market shrinking as it matures, innovation needs to switch to software and services, which is a challenging pivot for a business that built its position based on dominance in design. The departure of Jony Ive, the head of design in a period when Apple set the standard in tech aesthetics, could be interpreted as symbolic of the crossroads the company finds itself at.

Fund managers who have followed the Apple story for many years aren’t, unlike journalists, prone to hyperbole when interpreting every stage of its evolution. Mr Rogoff is clear that Apple continues to deserve credit for being able to throw off enormous amounts of cash and that “it’s not an incumbent in trouble, but is growth challenged”.

Efforts to diversify revenues from the iPhone haven’t been without success, Mr Rogoff says: “Apple music and Air pods [the company’s wireless headphone music system] make sense, [Apple is] now the 2nd biggest watch company in the world by revenue. Trouble is, it’s the price.” This assessment reflects the balancing act between quality and premium price positioning and growth.

Already, cheap-to-manufacture alternatives to hardware innovations such as the Airpod are emerging. New wireless headphones by brands such as House of Marley (which are eco-friendly and received positive reviews from tech blog Engadget) compete even on Apple’s premium design patch. Increasingly, a pivot to software and services looks to be the best bet for longer-term growth. In the meantime, maybe investors should be assessing Apple’s attractiveness against the book value of its assets (including a $37bn cash pile), rather than on a price-to-forward-earnings-growth basis. Of course, ultimately how that cash is used will interest investors most.

 

Altering corporate structure can aid strategy

Apple’s cash war chest is the stuff of dreams for most companies. Businesses not in that rare position can sometimes split out and spin off indebted divisions to create a leaner structure. Not only does this offer operational efficiencies, but it can precipitate a rerating for shares as analysts appreciate value that was hitherto hidden.

GlaxoSmithKline (GSK) hopes separating its pharmaceutical and healthcare businesses will galvanise its strategy to grow through investment in the pharma drug pipeline. The new healthcare division, a joint venture with Pfizer (US:PFE), moves a large chunk of debt from GSK, freeing up cash from interest payments for research and development. This renewed focus on future growth could still place the dividend at risk as more cash may be needed for the strategy. Shifting the emphasis to long-term growth is not exactly changing what the business does, but it does affect what investors should expect from the shares.  

Changes in corporate structure can be a way of defending against takeover bids, even if there is no change in the operational or investment focus of a business. Prudential’s (PRU) de-merger of its European M&G Prudential arm was done to reflect its true value. Charles Plowden of Monks Investment Trust describes the move as “an attempt to reduce discount to underlying asset values”, which is brought about by the perception of the Pru as a UK insurance company when 60 per cent of its business is now in Asia.

 

It’s not what a company does any more, it’s about what it owns

Geographical focus can gradually shift over time due to market penetration and development or thanks to the cumulative effect of mergers and acquisitions. A company’s essence in terms of its culture and the products it makes and sells can alter too. This change can be driven by acquisitions, trends or the external environment.

South African company Naspers (JSE:NPN) is, like its ancestral homeland, a poster child of change. The company started life as a newspaper publishing company in 1912 and had a very dark history as the mouthpiece for the Apartheid regime, until South Africa’s rebirth as the 'Rainbow Nation' with Nelson Mandela’s election as president in 1994. Nowadays, Naspers is more than a media company, with much value in its portfolio in emerging market assets and businesses that private investors have difficulty accessing. Concentration is skewed by a large holding in Chinese tech conglomerate Tencent (HKG:0700), but it has other emerging market exposure too, which Mr Plowden reasons gives something different: “Naspers is in all the other bits [of the global economy] that Google, Amazon and Chinese [companies] are not.”

 

Karma Chameleon – green concerns drive change

Some businesses are caught up in serious issues facing humanity. As existential crises go, they don’t come much bigger than global warming and companies that have a pivotal role in meeting the world’s 21st century energy challenges are facing demands to change. The London Stock Exchange (LSE) creating a category called non-renewable energy seems odd on one level – why make pariahs of Royal Dutch Shell (RDSB) and BP (BP.), two of the biggest companies in the UK? But it does demonstrate the seriousness with which capital markets are beginning to take environmental issues.

 

 

It should be remembered, however, that these companies have had to be experts at change. Fluctuation in energy prices, geopolitical tensions and currency movements have all had to be managed. Yet these businesses have been remarkably consistent in delivering earnings growth, maintaining cash flow and paying dividends. Arguably, the UK oil majors are better placed than global rivals to meet the clean energy challenges – compared with say Exxon Mobil (US:MOB), which is perennially on environmental, social and governance (ESG) naughty lists – which could even provide a future source of competitive advantage.

 

Being changed by the external competitive or technological landscape

The threat of Armageddon isn’t the only change issue that can affect the investment case for businesses that have long been staples of defensive portfolio allocations. One of the most difficult things for any type of change management is that little incremental adjustments aren’t noticeable, but the cumulative and compound effect of lots of little butterfly wings can eventually become a hurricane.   

Consumer staples businesses such as Unilever (ULVR) and Reckitt Benckiser (RB.) have long been prized for their dividends and low volatility, all underpinned by exceptional returns on capital employed (ROCE). Yet the change that has slowly occurred in the background makes these businesses far less defensive than in the past.

For starters, the rise of web retail – Amazon again – has removed the physical barrier to entry that branded consumer staples once had, namely that supermarket shelf space crowded out the competition. Online, unlimited shelf space and the ability to sort results on price mean brands win relatively less prominence.

Secondly, as Phil Oakley has argued in Investors Chronicle, the quality of own-brand goods has improved greatly and distributors such as Amazon are starting to push theirs aggressively. Thirdly, the power of advertising is owned by influencers on new channels such as Instagram and YouTube, where before brands would purchase blanket TV advertising. In the case of Amazon, its status as a huge conglomerate means it can dominate advertising in its own TV and web distribution channels and, going even further, its AI and voice recognition technology can even prompt purchases and steer consumers to its own goods.

These aren’t changes that were all easy to spot, but the sales outlook for companies such as Reckitt Benckiser and Unilever is now not as certain as their safe defensive nature would suggest. In the long term this could mean risk to dividends, especially if money is thrown at brand-building unsuccessfully. The cash return on capital invested (CROCI) at Reckitt Benckiser has been in a downward trend, which could be taken as a sign of the difficulties it faces in generating future shareholder value. 

 

 

Other defensives that have changed include utilities. This is a classic case of complacency. The threats are not only regulatory and legal – with the UK’s precarious politics, a nationalising Labour government under Jeremy Corbyn can’t be ruled out – but they are social, environmental and technological. The falling cost and rising demand for green energy, the impact of less reliable rainfall and population density, mean there are growing capital expenditure demands on utility businesses. Coupled with the overhang of years of borrowing against future cash flows – which creates an interest expense – then the free cash flow positions needed to support maintaining, never mind progressing, dividends looks far from assured.

Worryingly, as the economic situation deteriorates around the world, there are fewer sources of safe defensive income for investors to ride out bad times. Low bond yields forced investors into defensive income-paying stocks counter-cyclically, so these businesses are already expensive and pricey stocks aren’t where you want to be if the market falls.  Counter-intuitively some of the better income bets are to be found by sifting through the rubble of the last crisis.

Banks can never be compared to utilities or consumer staples in the 1990s, they are too vulnerable to so many outside factors, but this does mean they aren’t as expensive as other income stocks, and banks once again offer some of the most generous payouts in the FTSE 100. Banks aren’t chameleons in terms of what they do – although there is an inner identity struggle between focusing on retail or investment banking – but their role in a portfolio is markedly different now than pre-2008.

In the mid-2000s banks were all about total returns – using unsafe leverage to grow the value of their loan books underpinned capital growth, along with delivering substantial net interest margin which helped ramp up forward expectations and support a generous dividend. The growth aspect of holding bank shares is, even for companies such as HSBC (HSBA) and Standard Chartered (STAN) which focus more on emerging Asia, far less assured than in the past. Repaired balance sheets, however, have enabled the banks to redistribute more of the profits they do make as dividends.

The thing about change, however, is sometimes that there are just new risks that replace the old. In the case of banks, the core equity tier one capital ratios used to judge solvency and the robustness of balance sheets depend largely on the safety rating assigned to various assets, ie loans. Once again, mortgage lending is potentially an issue. So, while banks may look like the best value dividend payers out there – making them chameleons in the sense of the role played in a portfolio – they haven’t morphed into low-risk bond proxies. In recent results, it is notable that net interest margins (effectively banks’ profits from loans) have been coming down amid competition for UK mortgages, so investors should be prepared that recent generosity in dividend payments might not continue.

 

Keeping an eye on change

So how do investors keep an eye on the companies that are successfully effecting change? Which businesses are either value or quality traps and which have potential to positively rerate or continue to deliver growth, respectively? There is also something to be said for the school of thought that managers and investors can be blinded by the narrative around change when it is delivering very little true value for the business.

At the company level, there needs to be a rigorous assessment of change. Firstly, the year-on-year trends revealed by the financial statements. True, there are years when the cash flow statement can look to have deteriorated, but this may be due to investment, a buyback or special dividend. Likewise the income statement could be hit by cyclical weakness.

Management decisions and the responses businesses make to external challenges must build resilience and seize opportunities change presents. To this end, one of the best approaches is to drill into the success of business investment. This doesn’t have to mean line-by-line minutia, but measurements such as the cash return on capital invested (CROCI) is a good indicator of whether the business is getting its change strategy right for the most part. The trend in cash profits generated as a proportion of capital employed give an idea whether a business is going in the right direction. For companies where the trend is downward, it may be a sign that they are more dinosaur than chameleon.