15 Stock TMT Model Portfolio: Removing QCOM, TMUS and Adding ZEN, ACN

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

FOR IMPORTANT DISCLOSURES 203.901.1633 /.901.1634

psagawa@ / trdessai@ssrllc.com

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February 26, 2018

15 Stock TMT Model Portfolio: Removing QCOM, TMUS and Adding ZEN, ACN

Our 15 stock TMT model portfolio performed very well over the past 3 months, beating the tech components of the S&P by 1039bp and the broader index by 624bp during that period. Performance was strong relative to both benchmarks during the early February downturn, beating the S&P500 by 74bp for the week ending February 8, and the tech components by 175bp. This comes on the back of excellent 4Q17 earnings for our picks, with big upside surprises from NFLX, NVDA, AMZN, and NOW and unambiguous beats from 13 of 15 names in the portfolio. We believe that an irreversible generational transition to a new Cloud/AI era is well underway, greatly favoring stocks positioned for the change. While we remain confident in all our current constituents for the long run, we are making two changes to address possible short-term turbulence. We are removing QCOM, as we expect pressure on the stock as AVGO’s takeover attempt fizzles, but we expect to add it back shortly thereafter in anticipation of a likely resolution w AAPL and 5G related growth. We are also removing TMUS, expecting rising competitive pressure and 5G capex to weigh on shares in 2018. In their place, we are adding ACN – which will benefit from the transition of enterprise IT to hybrid cloud architectures and the adoption of new technologies, like AI and blockchain – and ZEN – a fast growing SaaS platform for customer service that we chose as a top pick for 2018.

  • Our model portfolio outperformed its benchmarks since December 1. Over the past 3 months, our 15 stock TMT model portfolio beat the S&P500 by 1039bp and the tech components of the index by 624bp. Performance was led by NFLX, up 53.1% on the period, and AMZN, NVDIA, NOW and WDAY, all of which appreciated by more than 24%. The upside was partly offset by declines from TMUS, and QCOM, both down less than 4%.
  • Performance was resilient through the recent downturn. In the week ending Feb 8, the S&P500 was down 8.5% and its tech components 9.5%. Only GOOGL, FB, XLNX and NVDA from our portfolio delivered performance for that period worse than the broader market, and total performance was 74bp better than the S&P500 and 175bp ahead of the tech components.
  • 4Q17 results were very strong, suggesting upward revisions and further beats. Of the 15 stocks in the portfolio, only GOOGL, which beat on sales but missed on EPS, and TMUS, which missed on sales but beat on EPS, failed to top consensus expectations for the last quarter of 2017. On average, our constituents beat sales expectations by 201bp and EPS by 1364bp. Nonetheless, 2018 sales forecasts have risen just 122bp and EPS by 375bp on average over the past 60 days. We believe that all of the stocks in the portfolio are likely to beat the current consensus for 2018 and that all are very well positioned for the changes being catalyzed by the transition to the Cloud/AI era of TMT (http://www.ssrllc.com/publication/the-cloudai-era-a-perspective-on-the-next-decade-of-tmt-investing-2/).
  • AVGO/QCOM deal likely to fail, with fall out for both. QCOM, which is nearing completion of its own acquisition of NXPI, has rejected an offer from AVGO to be acquired for $82/share. We continue to expect the hostile takeover move to fail, a perspective apparently in line with investors who have kept the shares well below the offer price. A proxy battle will intensify to the March 6 board elections. While we agree with management’s assertion that the AVGO bid fails to adequately value the company’s potential (e.g. resolution of the AAPL dispute, imminent 5G buildout, datacenter and automotive opportunities, etc.) and that AVGO’s proposed strategy (e.g. unilaterally cutting IP royalty rates, while raising chip prices and cutting expenses) is destructive of value, we expect the stock to react poorly to the dissolution of the takeout attempt. As such, we see this as an opportune time to temporarily move out of QCOM until the proxy battle is over.
  • 5G buildout to hit carrier cash flows, including TMUS. We have written about the competitive forces that will drive spending on 5G network buildouts to exceed the guidance that had been offered by wireless carriers (http://www.ssrllc.com/publication/5g-rising-global-carrier-competition-to-drive-capex/). We believe that the battle for 5G supremacy has begun, and while we believe that portfolio constituent TMUS is well positioned to emerge as a leader, the cash flow impacts of heightened capex are a real risk to the stock. Given this, we are removing TMUS from the model portfolio.
  • Adding ACN – benefitting from enterprise move to cloud. Enterprise IT organizations are coping with the generational shift to cloud computing, AI-infused applications, and blockchain-based transaction solutions. For most, staffing up in a market of scarce talent is prohibitive if not impossible. We see ACN as well positioned to facilitate the paradigmatic change for many companies in many industries. Portfolio constituent IBM is also positioned to benefit from these changes.
  • Adding ZEN – category leader growing 40%+. In January, we selected ZEN as one of our 3 top picks for 2018, and have already been rewarded with a significant upside surprise for 4Q17 and 30% YTD appreciation. With the market cap safely above our $3B threshold for the portfolio, we are adding it to our constituents. ZEN is the clear category leader in SaaS software to manage customer support tickets, with annual sales growth exceeding 40%. Moreover, we see ZEN as a high probability acquisition candidate, as cloud platform leaders look to broaden their application offerings.

2018 Starts Strong for Cloud/AI Era Stocks

Our research work over the past several years has delineated a generational paradigm shift in TMT – from the device-centered PC Era that dominated from mid-80’s until about 2010, to a Cloud/AI Era built from hyperscale datacenters and AI-powered software. We believe that the trajectory going forward is clear and the biggest winners well established, and the broader set of beneficiaries aligned to the substantial market changes that are happening both within the TMT sector and in other parts of the economy that are being disrupted by it. To illustrate the investment implications of our research theses, we have maintained a model portfolio of 15 large cap stocks (Exhibit 1). This portfolio, updated once a quarter and balanced to equal weighting, has performed well historically, beating the S&P500 by 9162bp and the tech components of the index by 2096bp over the past 5 years (Exhibit 2).

Exh 1: SSR TMT Model Portfolio – BEFORE RECONSTITUTION

This quarter adds to that outperformance, with our picks far outpacing the S&P500 to the tune of 1040bp since December 1 of last year and beating the tech components of the S&P by 630bp (Exhibit 3). Netflix (+53.1%), ServiceNow (+30.8%), Amazon (+29%), Workday (+26.7%) and Nvidia (+24.5%) were the stalwarts, with only Xilinx (+3.2%), IBM (+1.5%), T-Mobile (-1.4%) and Qualcomm (-3.3%) failing to beat the broader market. We are pleased that our portfolio sustained strong performance through the recent market turmoil. Between February 1 and February 8, a week that saw the S&P500 fall 8.5% and the tech constituents fall 9.5%, our picks were down just 7.8%, adding ground on a relative basis.

Exh 2: SSR TMT Model Portfolio Historical Performance for 5 years

Exh 3: SSR TMT Model Portfolio Performance Since Last Update on Dec 1, 2017

The key force behind this resiliency was a consistent drumbeat of upside surprises for 4Q17 from our portfolio constituents (Exhibit 4). Only Alphabet – which topped revenue expectations but missed on EPS due to higher than expected traffic acquisition costs – and T-Mobile – which delivered better than expected earnings but missed on revenue targets – failed to report unambiguous consensus beats in their most recently reported quarters. (We note that Ciena Corp. and Keysight Technologies will report January quarter results this week) In particular, Netflix – which surprised with much higher than expected subscriber counts, Amazon – which blew past both sales and earnings forecasts, ServiceNow – which posted 40%+ growth and upside in new licenses, and Nvidia – which beat the top line consensus by 8.6% on huge datacenter sales, could be considered true “blowouts”. On average, our 15 stocks beat sales expectations by 2% and EPS by 13.6% for their most recent reports, impressive performance by any metric.

Exh 4: TMT Model Portfolio Constituents 4Q17 Earnings Surprises

Despite this, the sell-side consensus has been cautious in reaction (Exhibit 5). For these 15 stocks, the consensus 2018 sales estimate has risen just 1.2% on average over the past 60 days, while the EPS consensus has risen only 3.8%. We believe that this portends further quarters like this one until revisions rise enough to appropriately reflect the real potential of the group.

Exh 5: Model Portfolio Constituents FY18 Estimate Revisions – Cap IQ

Qualcomm and Broadcom

Since the moment Broadcom launched its hostile approach to Qualcomm, we have been skeptical that a deal could be reached. Qualcomm shares had peaked at over $68 in October of 2016, only to fall to less than $53 as a dispute with Apple over IPR royalties came to light. Qualcomm management believes that this dispute is the same in character as the many legal challenges that it has faced previously in more than 25 years of patent licensing. Having successfully navigated contentious negotiations with Motorola in the US, Nokia and Ericsson in the EU, Samsung in South Korea and the entire electronics industry and the government of China, it was confident that legal precedent is squarely on its side and expected to resolve the impasse to its benefit. With 5G just ahead, promising initiatives in datacenter processors and radio components, and an accretive acquisition of automotive chip stalwart NXP in process, the company was very optimistic that the market reaction to Apple’s gamesmanship was temporary.

In this context, Broadcom’s $72/share offer was unwelcome, particularly combined with commentary on its licensing practices that Qualcomm management believed was naïve at best. Broadcom proposed an alternative slate of director candidates to signal a proxy battle for Qualcomm’s March 6 investor meeting, and subsequently raised its offer to $82/share. Contentious negotiations saw the two sides far apart, and Qualcomm proceeded to raise its own offer for NXP, gaining the support of investors pressing for a better price and making it very likely that that deal could be completed, raising the price of buying Qualcomm by $44B. Broadcom responded to this last move by lowering its own offer by 4%, citing its assertion that the NXP price represented a transfer of value.

For a would-be acquirer ahead of a contentious proxy vote, this is a curious strategy – perhaps an indication that Broadcom CEO Tan Hock is hearing concerns from his own shareholders. This is not surprising – the deal would involve as much as $100B in debt to an already leveraged balance sheet. Moreover, Qualcomm continues to raise questions to Hock’s strategic plan to unilaterally cut its royalty rates – the source of 72% of its profits – and to raise prices on chip products where hungry rivals lie in wait. We agree that the math just doesn’t add up. In addition, Broadcom’s roll-up strategy, always needing to buy bigger things to push EPS growth as it writes off deal intangibles, leaves its GAAP earnings far below its pro forma. It seems unlikely that Hock will raise his bid to try to get a deal done. Expect Qualcomm management to prevail at the vote.

Investors, who have not taken Qualcomm shares anywhere near the $81 bid that is ostensibly on the table, clearly do not expect the deal to go through either. As the soap opera has unfolded, Qualcomm shares have inevitably dipped with every signal that an agreement was less likely. We believe that the final dissolution of the deal will bring downside to shares. While we believe that Qualcomm’s narrative – an agreement with Apple and substantial upside from 5G – will play out, those catalysts seem to be 2H18 events at the earliest. With an opportunity to step to the sidelines, we will remove QCOM from the model portfolio, for now.

Exh 6: Global Wireless Carrier Capex / Sales Forecast

5G Capex Could Weigh on TMUS

We have watched T-Mobile take advantage of changing competitive dynamics to reap market share in the US wireless market. While we still expect the company to have the better of its bigger rivals, going forward, we believe that the costs of building out 5G networks will prove greater than has been communicated to investors. We have written of the game-theory competitive pressures by which one carrier’s spending will force all carriers to follow (http://www.ssrllc.com/publication/5g-rising-global-carrier-competition-to-drive-capex/). In the long run, this may well benefit T-Mobile, which has been facile in introducing popular, customer -friendly service innovations, but for the near term it will affect both earnings and cash flows (Exhibit 6). We are going to step aside, for now, until the network building dust is more settled.

Enterprises Need Help – ACN Can Help Them

In a period of great transformative change for enterprise computing – cloud hosting, containerization, artificial intelligence, block chain networks, etc. – IT departments lack for the skills and resources needed to even get started. We believe strategic IT consultants will continue to find extraordinary opportunities in this environment. We already have IBM in our model portfolio (http://www.ssrllc.com/publication/ibm-are-we-there-yet/http://www.ssrllc.com/publication/the-tmt-model-portfolio-15-well-positioned-stocks/), but we see room for additional winners. Accenture is clearly one of these. The stock has risen 50% YoY, but we see further upside given nearly 12% revenue growth and a skeptical consensus projecting a trajectory of significant deceleration (Exhibit 7).

Exh 7: ACN Financial Snapshot and Valuation Summary

ZEN – One of Our Top Picks for 2018

In our January 2 list of 2018 predictions (http://www.ssrllc.com/publication/ten-investible-things-that-we-think-will-happen-in-2018/) we called out Zendesk as one of our top picks for the year (Exhibit 8). The company got off to a ripping start with 4Q17 results – sales of $123B were well above the company’s $116-120B guidance and the $119B consensus. Importantly, the 39% sales growth was accompanied by surprising, positive free cash flows, and was driven by new deals with ever larger customers. This performance has Zendesk shares up 20% YTD. While it is too late for us to get the benefit of that move for our model portfolio, we see a lot more to come (Exhibit 9). Moreover, Zendesk’s category leadership with its customer service management platform makes it an attractive potential add on acquisition to Salesforce, Microsoft, and their would-be rivals.

Exh 8: ZEN Financial Snapshot and Valuation Summary

Exh 9: SSR TMT Model Portfolio – RECONSTITUTED

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