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FAANGs: who are the winners of the future?

Third-quarter results from the US tech sector reveal the widening gap between the titans of the future and the former pioneers struggling to maintain their dominance
November 7, 2019

The front runner in the tussle at the top of the global leaderboard of public companies differs depending on metric. Walmart (US:WMT) sells more products than any other company. In the year to January 2019, it reported $514bn (£393bn) of total revenues – more than twice the annual revenues of digital retailer Amazon (US:AMZN). Apple (US:AAPL) tops the profit table, with $13.7bn of net income in the three months to September 2019. For company assets, head to the banking sector where JP Morgan (US:JPM) has $2.8 trillion of total assets.

But in the battle for market capitalisation, companies in the tech industry are the only real contenders for the top spot. In the past decade, as stock markets have strengthened, digital behemoths have claimed higher valuations than any company in history. In 2019, three of them have hit a peak market capitalisation of more than $1 trillion.

It is hardly surprising that investors value these companies so highly. Tech has infiltrated almost every industry in the world and digital companies account for seven of the top 10 most valuable brands, according to Kantar US Insights. With the growth of the tech industry unlikely to let up, companies that can benefit from the changes or – even better – drive them, are likely to remain favoured by global investors.

But there is a potential downside to the rising use of technology across multiple industries: if traditionally non-tech companies gain the digital expertise that once belonged exclusively to businesses like the FAANGs – the acronym applied to five of the world’s biggest tech beasts, Facebook, Apple, Amazon, Netflix and Alphabet’s Google – is the era of tech company dominance coming to an end? And will the tech titans be able to retain their positions as the most valuable companies in the world?

 

Beware the ubiquity of technology

Netflix (US:NFLX) is a prime example of these dangers. In the next few months it will face its first real competition when Walt Disney (US:DIS) and AT&T’s (US:T.) HBO launch their own streaming platforms. To deal with the battle, the company has a $10bn content budget for 2019 and is churning out more original titles than ever before. Chief executive Reid Hastings acknowledges this threat. “We did well during the first decade of streaming,” he wrote in his third quarter letter to shareholders. "We’ve been preparing for this new wave of competition for a long time.”

Preparation is all well and good, but competing with two of the world’s most loved production companies on their own turf is not going to be easy. Netflix has won a global audience of 158m thanks to its content recommendation features, ease of use and ability to satisfy its audience’s love of binge-watching. If DisneyPlus or HBO Max can match Netflix's technological expertise, they can let their superior production skills win over new customers. Netflix will then struggle to continue to maintain its quarterly revenue growth, which has averaged 28 per cent in the past three years.

Facebook (US: FB.) could go the same way. Alongside Google, it has gained a duopoly in the advertising industry built on a remarkable ability to collect data from an enormous global user base. But more media companies are beginning to use tech to capture large, targeted audiences, thus encroaching on Facebook and Google’s space. The two companies' share of the digital advertising industry has begun to fall in the past few years. 

 

FAANG financial results in three months to Sept 2019

 
 

Revenue ($bn)

Growth (%)

Operating Profit ($bn)

Growth (%)

EPS ($)

P/E Ratio (x)

Facebook

17.7

28.5

7.2

24.2

2.1

30.3

Apple

64.0

1.8

15.6

-3.1

3.1

19.8

Amazon

70.0

24.0

3.2

-18.0

4.3

87.5

Netflix

5.2

31.1

1.0

104.0

1.5

85.0

Alphabet

40.5

20.0

9.2

6.4

10.1

26.2

 

Data collected from company results statements. PE based on FactSet forecasts.

 

Compounding this potential issue is the fact that Facebook has a major image problem. True, third-quarter numbers helped to expel any immediate doubt about the popularity of its platforms (which include Instagram and WhatsApp): monthly active users rose 8 per cent and advertising revenue was up 28 per cent to $17.4bn. But that doesn’t take away from the fact that the company has been criticised for supporting addictive algorithms, allowing political advertising and damaging mental health. Regulators don’t want Facebook to continue to make huge amounts of money from the personal data of its customers. A clampdown could eventually restrict its advertising sales.

The same is true of Twitter (US:TWTR), which fell short of revenue and profit guidance in the third quarter. Advertising revenue in the quarter might have risen 8 per cent to $702m, but that was significantly lower than the $756m forecast by FactSet – not good enough considering Twitter generates 85 per cent of its revenue from advertising. By contrast, fellow social media group Snap (US:SNAP) managed to beat analysts’ expectations after adding 7m daily active users in the third quarter to send revenues up 50 per cent. But, like Facebook and Twitter, it also relies on gathering personal data of users. If the model comes under threat from regulation, there won’t be much room for any of these new age media companies to grow.

 

The superiority of software

Apple’s troubles start in China where the rising popularity of Huawei mobile phones has cut into the market long-dominated by the iPhone. Apple has been forced to trim its prices, which sent product sales down 1.5 per cent in the third quarter, despite reports of unexpectedly high demand for the new iPhone 11.

Fortunately, another surge in the group’s services division – which includes its iOS operating system – helped make up the shortfall. Apple’s services business generated gross margins of over 64 per cent, compared with 32 per cent in the products division. This level of profitability is more akin to software giants such as Microsoft (US:MSFT) and Adobe (US:ADBE), which generated gross margins of 69 per cent and 85 per cent in their respective third quarters.

The global software industry is in its prime thanks to a rise in the subscription business model, which was pioneered by Adobe when it switched from a licensing business in 2013. In the third quarter of 2019, 90 per cent of Adobe’s revenues came from reliable, recurring subscriptions, compared with 28 per cent in 2013. Subscriptions require very low ongoing expenditure, meaning the bulk of Adobe’s costs are sales and marketing ($812m in Q3) and research and development ($490m in Q3) – both of which in turn drive revenue growth. In the three months to August 2019, revenue rose 24 per cent to $2.8bn.

Many of the world’s software companies have jumped on the subscription bandwagon and are reaping the rewards. Intuit (US:INTU) – which will release its fiscal first-quarter results on 21 November – recently announced that it expects 10-11 per cent revenue growth in the year to July 2020, driven by strong demand for its QuickBooks software subscription.

But growth is most impressive at the king of all software companies: Microsoft. In the three months to September 2019, the world’s largest public company reported a 14 per cent increase in revenues and 22 per cent increase in earnings – substantially ahead of analyst expectations.

 

A trio of tech titans of the future

Microsoft’s Azure was the company’s standout product in the quarter, reporting 59 per cent revenue growth to drive sales in its intelligent cloud division up 27 per cent to $10.8bn. Amazon’s cloud business, AWS, was similarly impressive, with revenues up 35 per cent to $9bn and operating profits up 9 per cent to $2.3bn. The two companies boast a combined 63 per cent share of the fast-growing cloud computing market, which means they are in an enviable position as the world’s reliance on cloud-hosted data storage continues to grow.

Alphabet (US:GOOGL) is also well placed to benefit from the growth of the cloud. True, its market share (9 per cent) isn’t as impressive as Microsoft or Amazon, but it stands above its peers in its ability to understand and manipulate data. Extensive investment in artificial intelligence, including its 2014 acquisition of British AI start-up DeepMind Technologies, means the company can sell its pioneering AI alongside its cloud hosting services to companies seeking to make better use of their data.

Cloud and AI, which sit alongside Androids, Maps, Play and hardware in Google’s non-advertising division, reported $6.4bn of sales in the third quarter – a 39 per cent increase compared with the previous year, which reflects the company’s focus on investing in products set to drive growth in the future. Amazon is employing a similar strategy. In 2019, the group will spend $800m on improving its logistics, including automating its warehouses, improving the capabilities of its drones and investing in driverless lorries. The period of heavy spending seems to have spooked investors, who have sent the share price down 10 per cent since its summer peak, but chief executive Jeff Bezos insists the investment will drive even more impressive growth. In the third quarter, revenues leapt 24 per cent to $70bn – well ahead of expectations.