TMT Model Portfolio Update: The Tech Trump Slump

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Artur Pylak

FOR IMPORTANT DISCLOSURES 203.901.1633 /.1634

psagawa@ / apylak@ssrllc.com

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@PaulSagawaSSR

December 7, 2016

TMT Model Portfolio Update: The Tech Trump Slump

The election of Donald Trump sent tech investors running for safety amidst fears of trade wars that would disproportionately hurt America’s most successful export, technology. Since election day, the tech components of the S&P have underperformed the broader index by 450bp with a disproportionate impact on higher multiple internet and SaaS stocks. This reversed the relative performance our cloud focused model portfolio from strongly positive post-3Q earnings to negative. We believe that the tech-specific reaction to Trump’s victory is overdone, but see 4 key issues to watch: 1. Regulation – A Trump FCC is likely to roll back net neutrality rules to enable carrier “fast lanes” and “zero rating” – benefitting cable and telco names while taxing major cloud franchises and driving further content consolidation. 2. Trade – Aggressive rhetoric, particularly vs. China, could portend tactics around tariffs and intellectual property protection – US based tech hardware and entertainment content companies could be amongst the most vulnerable. 3. Taxation – lower corporate rates and a repatriation holiday would be clear positives for high margin tech companies. 4. Immigration – The tough talk on H1-B visas will likely only apply to the outsourcing sector – the administration may be amenable to more generous terms for foreign tech talent. On balance, we believe the impact of these factors on leading TMT names will me minor and see the relative weakness of the sector as an opportunity. We are adjusting our large cap model portfolio adding CRM and XLNX, while removing NOK and CCI.

  • The Trump victory hit tech. Since election day, technology stocks have underperformed the S&P 500 by 450bp – only consumer staples, utilities and real estate have lagged by more. High multiple cloud stocks – consumer internet and enterprise SaaS – particularly suffered, with the most prominent names down 1-5%. In contrast, wireless/broadband carriers and media names have rallied, likely baking in a possible reversal in net neutrality regulations. Our model portfolio beat its benchmark by 330bp over the past 3 months, 3Q16 earnings driven outperformance that would have been much greater without the Trump effect. We see four issues for tech companies as the new administration takes control.
  • Regulation. Reversing the reclassification of broadband services to Title II common carrier status could be complicated, but the administration could simply change working rules and relax enforcement. This would allow carriers to charge content/service providers fees for “fast lane” service and “zero rating” status. Carriers would also be able to favor their own content, creating incentive for vertical consolidation. This will add costs to big traffic creators (e.g. NFLX, GOOGL, FB, AMZN, AAPL, etc) but could disproportionately burden smaller rivals and drive further market share consolidation.
  • Trade. Concerned investors fear possible trade confrontations, particularly with China. Most cloud-based US businesses – both consumer internet and enterprise SaaS – have relatively little exposure there, but IT hardware and device companies, with most of their manufacturing overseas (AAPL partners employ nearly 3 million Chinese nationals), could be caught in the middle by policies intended to pull jobs back to the US. Entertainment and software firms, fighting for Chinese market access and respect for IP, could be vulnerable to retaliation. Still, we believe that the likelihood of major disruptions is more modest than the aggressive election rhetoric would suggest. The Trump administration could also lock horns with the EU over data privacy, tax havens, and tech industry anti-trust.
  • Taxes. Tech companies with substantial overseas cash holdings (AAPL, MSFT, QCOM, GOOGL, etc.) will be obvious beneficiaries of tax code changes that lower corporate rates or offer relief on repatriation assessments. The resulting capital flexibility could also encourage acquisitions and more aggressive capital return programs through dividends and buybacks.
  • Immigration. Despite charged campaign promises aimed at curbing immigration, Trump’s message relative to skilled tech talent is mixed. The H-1B visa program came under fire, specifically for perceived abuses by tech services firms (i.e. INFY and CTSH) hiring foreign temporary workers at low wages, but Trump has shown interest in retaining US-trained talent here. Restrictions on cheap, lower skilled H1-B visa applicants could open more of the 85K lottery slots for the engineering and scientific talent needed by R&D heavy tech names, like GOOGL, MSFT, AAPL, FB and AMZN.
  • 3Q16 strong for the cloud. Except for AMZN, which spent expected profits on investments, the big consumer internet names (e.g. GOOGL, FB, NFLX, etc.) delivered substantial upside for the quarter. The same is true for cloud-focused software names, led by MSFT, CRM, ADBE and NOW. In contrast, traditional IT names almost universally continued to deteriorate, the top telecom carriers slumped, and PayTV treaded water.
  • The Trump reversal. Despite the cadence of 3Q16 beats, consumer internet and SaaS names have suffered since election day, off 600bp and 900bp respectively vs. the S&P. Beyond recession fears, we do not see any reason for heightened concern for these stocks. The shift to the cloud and the rise of AI is a technology phenomenon yielding lower costs, better performance and new functionality – we see the current weakness as a significant buying opportunity. Meanwhile, telcos (+1330 bp), PayTV (+760 bp and TV media (+450 bp) have been Trump era winners – in part on net neutrality expectations. We are not so optimistic, particularly for the stocks with meaningful exposure to linear TV advertising.
  • Our model portfolio outperformed by 150 bp. Upside was largely driven by NVDA, NFLX, and TMUS, while NOK, WDAY, and CCI were the top 3 decliners since our last update. We are replacing NOK and CCI given global weakness in telecom capex, the possible negative consequences of Trump policy – the net neutrality reversal and possible carrier consolidation – and the long term deflationary impact of 5G. We are adding back CRM, off the recent drop, given its investment in AI and potential as a takeout candidate by a larger enterprise name. We are also adding the last remaining pure play FPGA maker XLNX, which is positioned well for AI components and semi content in autos.

Making TMT Great Again

With the Trump election, stock trends in the TMT universe took a U-ie. Excepting AMZN (which bumped up investment and missed EPS), the consumer cloud FANGs (and MSFT) had posted blowout 3Q numbers and were generally trending up. Similarly, SaaS stocks, which had more than recovered from a sharp February selloff, were flying ahead of solid results from the likes of CRM, WDAY and NOW. On the flipside, the wireless duopoly (VZ and T) were swooning on deteriorating sub bases, while the PayTV complex of MSOs and media giants was treading water at best. Then came November 8th.

The S&P500 has rallied 3.4% since, led by financials, industrials, energy and telecom, spurred by expectations of broad deregulation. Tech has been hit, with cloud and SaaS names taking it square on the chin. Candidate Trump suggested policy intentions in regulation, trade, taxation and immigration that could affect the tech sector, but we believe the selloff of best positioned names in the group is substantially overdone. Reversing net neutrality is a bigger blow to consumers than it is to big internet service businesses, who will likely pay a modest toll to carriers to assure decent performance for their must-carry anchor franchises, while would-be rivals face tough negotiations to sustain access to their customers. A feared trade war with China would have little effect for the FANGs, which have little exposure to that market. These stocks have more risk of a diplomatic conflict with the EU, where regulators have attacked on anti-trust, privacy and taxation bases. Taxation is a big positive for most companies in tech, many of which have substantial overseas cash holdings to repatriate in event of a tax holiday. Finally, from a tech perspective, the Trump stance on immigration may not be all bad – clearing out low value workers from the H1-B visa lottery could clear more spots for scientific talent.

Our model portfolio, heavy in consumer internet and SaaS leaders, performed very poorly since the election. At market close on November 8, relative performance was up 660 bp vs. the S&P 500 and up 300 bp vs. the tech components of that index since our last update in August. A month later, we are now down 430 bp and up 20 bp, respectively. GOOGL, FB, MSFT, ADBE, NOW, and QCOM all crushed their September quarters, but now have little to show for it, while NOK and CCI, which raised investor anxiety with their reports, were badly punished. To the positive side, NVDA, NFLX, and TMUS earnings were too good to ignore – with TMUS also benefitting from expectations of a net neutrality roll back and an increased likelihood of acquisition.

Overall, we remain confident in our investment themes – the shift to the cloud, the rise of AI, wireless network evolution, and value concentration – and expect most of the names in our portfolio to rebound well from their recent election-driven weakness. We are removing NOK and CCI – scrapping net neutrality removes some incentive for network investment, while 5G technology could prove to be deflationary as it rolls out in a few years. In their place, we are returning CRM to the portfolio – we see a strong possibility that it could come in play as an M&A target (GOOGL, AMZN and MSFT are possible suitors) and we approve of their growing emphasis on AI. We are also adding XLNX, which is the last pureplay supplier of FPGAs, a chip technology that we expect to play a growing role for deep learning in both hyperscale datacenters and devices.

3Q16 – The Earnings Season that Was

The 3Q16 earnings season kicked off on October 17th, with IBM flailing once again and Netflix surprising to the upside on both earnings and subscriber growth, breaking a forming narrative that the company was beginning to plateau. A day later, Intel beat on sales and EPS but offered weak guidance for 4Q16. On the 20th, Microsoft delivered a major beat with confident management commentary, while Verizon and Crown Castle offered misses and excuses. The same story was buried inside of AT&T’s results, offered the following week. Investors were not too thrilled by Comcast results on October 26, nor by Nokia’s on the next day (Ericsson had preannounced a miss on October 12). Telecom was reeling.

Service Now and Texas Instruments had both delivered big upside in their results on the 26th, received with cheers by investors. The 27th brought some drama – Apple missed its numbers and sold off, while Alphabet beat and got a modest boost. Earlier in the day, T-Mobile had once again beaten expectations. Next, Amazon continued the drama beating sales expectations but badly missing the consensus EPS, as CEO Bezos abruptly resumed plowing new investment through the income statement. Investors, used to this behavior from Amazon, only eased off a little. The following week, Qualcomm delivered a big upside surprise to a market that was clearly not expecting it. Facebook also delivered a big upside surprise a day later, but this time, investors were not impressed and traded it down a bit. On Monday, November 7, Priceline delivered its own quarterly beat and its investors got one day to celebrate it (Exhibits 1-6).

Exhibit 1: 3Q16 Earnings Surprises – Internet Stocks

Exhibit 2: 3Q16 Earnings Surprises – SaaS

Exhibit 3: 3Q16 Earnings Surprises – Media

Exhibit 4: 3Q16 Earnings Surprises – Enterprise IT

Exhibit 5: 3Q16 Earnings Surprises – Devices

Exhibit 6: 3Q16 Earnings Surprises – Telecom and Pay TV

Tuesday, November 8, 2016

The surprise election of Donald Trump threw the market into chaos the next morning. While the general selloff that so many feared didn’t materialize, technology stocks were a casualty, while media and telecom names rallied. Notably, the high multiple cloud stocks – both consumer internet and enterprise SaaS stocks – fell hard, along with semiconductor names. A narrative emerged that a Trump administration would be hard on tech, with Net Neutrality regulation, possible trade conflicts and tighter visa requirements most often cited as specific obstacles for the sector. Of course, these same companies are likely leading beneficiaries of an expected reduction in corporate taxes, which could include a tax-holiday for repatriating foreign cash reserves. We believe that the threats of a Trump administration have been overstated for cloud-based businesses.

Regulation – Trump has suggested that he would do away with net neutrality regulation, the biggest TMT regulatory move of the Obama administration. Trump adviser Mark Jamison has advocated for drastically reducing the FCC’s authority to regulate communications services, a stance that would require legislation by the Republican congress. Short of gutting the commission, a Trump led FCC could propose a reversal of the 2015 reclassification of broadband services as covered under Title II of the Telecom Act of 1994. That move had given the FCC broad latitude to regulate prices and terms of access for both wireline and wireless internet access, blocking carriers, amongst other things, from providing preference to their own services or to 3rd parties willing to pay for it. Under this rubric, “zero rating” (offering a favored group of services that do not count against data caps) and “fast lanes” (enabling superior performance for a favored group while throttling competitive services) are clearly prohibited. Carriers had already begun to test the resolve of the Obama FCC, which has sent formal letters to both Verizon and AT&T questioning their plans to zero-rate their own over-the-top video services.

While the more drastic actions of reducing the FCC’s power or reversing Title II reclassification will take years to play out and could find opposition, the Trump FCC will likely take the more expeditious step of simply establishing new rules that allow “fast lanes” and “zero rating”. This would be unequivocally good for both wireless carriers and cable operators, who would begin collecting tolls from internet services and giving competitive advantage to their own content. Not surprisingly, this group is up 9.3% since the election. In contrast, consumer internet services, such as Alphabet, Amazon, Facebook, and Netflix, have fallen more than 2% on average (Exhibit 7-8).

Exhibit 7: Quarterly and Post-Election Returns – Telecom and Pay TV

Exhibit 8: Quarterly and Post-Election Returns – Internet Stocks

We think this relative swing is has been overplayed. While carriers enjoy philosophical support for deregulation with both the administration and congress, the companies are amongst the most hated by consumers. Heavy handed exertion of market power with brown-outs of internet sites unwilling or unable to pay for “fast lane” service could spark real consumer backlash and a dramatic return of even more onerous regulation in a future administration. We believe that the carriers will move slowly, focusing on popular services, like zero rating for baskets of streaming media that will include the most widely used services. In this scenario, must-have services, like Netflix, YouTube, and Spotify, would likely be able to cut sweetheart deals, while less trafficked alternatives faced a serious new barrier to competition.

We also note that candidate Trump also raised objections to the planned AT&T/Time Warner merger based on market power, a stance that suggests more sympathy for the goals of net neutrality than is commonly supposed. It also portends scrutiny of future carrier-content consolidation deals. It is not clear whether Trump’s comments on the AT&T deal speak to broader concerns about TMT consolidation. If not, the FCC and DoJ changeover could renew possible merger talks between T-Mobile and Sprint.

Trade – Tough talk on trade was the lifeblood of Trump’s campaign, with his opposition to the Transpacific Partnership (TPP) deal and sharp criticism of trade policies toward China (which is not part of the TPP). Investors fear that dissolving the TPP and taking a more aggressive stance toward China could result in tariffs, import regulations, and other tactics that would damage business for US technology companies. Furthermore, Trump’s focus on pushing manufacturers to create jobs in the US could result in new taxes and other punitive measures for companies that have focused operations overseas.

These concerns may be valid for hardware manufacturers, like Apple or Hewlett Packard, but should not apply to cloud based companies, most of whom do not have sizeable exposure to China. Alphabet, Amazon, Facebook, Netflix, Twitter and others already face sizeable competitive barriers erected by the Chinese Government favoring indigenous competitors – none of them derives a major slice of their sales from China. The same is largely true for SaaS application companies, and those that operate in China, host their services in country, and would be less likely to face tariffs (Exhibit 9).

Exhibit 9: China Exposure of SSR Large Cap TMT Model Portfolio Constituents

IT hardware companies and device manufacturers typically have operations in China, and would be more likely to face tariffs of shipments back to the US as part of a job creation policy than from a trade war with China itself. The same is true for semiconductor companies, which typically fab their chips in Asia. Software and entertainment content companies would seem to have much greater vulnerability, not only from the imposition of retaliatory import tariffs but also from reduced cooperation in fighting piracy. Trade conflicts could also arise with Europe. The EU has been increasingly aggressive in litigating against US tech companies on privacy, tax avoidance and anti-trust issues. Deteriorating relations with Europe could exacerbate these threats for companies like Alphabet, Apple, Amazon, and Facebook.

While we see increased risk of a negative trade scenario, we believe that the likelihood of a worst-case scenario, and its specific impact on technology companies, are likely overstated.

Immigration – The US tech industry is the prime user of the H1-B visa program, which allows 85,000 foreign workers to take jobs for which companies have been unable to find sufficient qualified American applicants. These visas are assigned to would-be hirers by lottery, and require that the workers be paid in line with domestic rates. In recent years, the program has drawn criticism for its abuse by foreign companies using it to bring in relatively low paid workers from overseas on a temporary basis, rather than to establish a more permanent presence in country. For example, IT outsources like InfoSys or Tata might bring low wage engineers from their Indian operations on H1-B visas to perform consulting projects in the US. Against this, some Republicans have suggested imposing wage floors or other means to assure that companies do not use the program to undercut US workers (Exhibit 10).

In contrast, most US technology companies are using the program as it was intended, generally attracting US educated engineers and scientists to help fill a perennial shortage of these highly skilled workers. Actions to curtail H1-B abuse would not likely constrain their hiring, and could, by eliminating lottery entrants misusing the program, create more slots for them. We do not believe that the populist sentiment, which fueled Trump’s support, has its attention on the 85,000 H1-B visas awarded annually – most of which go to highly educated elite workers, often hired in coastal “blue states” anyway. As such, we believe this will be a non-issue for most TMT companies over the course of the Trump administration.

Exhibit 10: Top 25 US H1B Visa Sponsors, 2015

Taxation – Much lower corporate tax rates and a likely tax holiday for the repatriation of foreign cash holdings are considerable positives for tech investors. Tech companies account for 46% of the $1.7T in cash held overseas by US corporations, with Apple, Microsoft, Cisco, Oracle and Alphabet alone holding $488B (Exhibit 11). Assuming this cash is taxed at 15% rather than 35%, could yield as much as $340B in value to tech investors, with $88B for the top five names alone. While these companies will surely leave some portion of their cash to cover their foreign operations, we assume the large majority of it would come home to fund capex, M&A, and capital returned to shareholders. Presumably, this would unlock further value that could not be realized with the cash sitting in foreign banks.

Exhibit 11: Top 5 Tech Companies Holding Cash Offshore, 3Q16

The Model Portfolio

Our 15 stock long-only model portfolio performed well vs. the benchmark in the past 3 months, beating the tech constituents of the S&P500 by 330 bp. Performance against the broader market was a bit softer, up 250 bp. Performance suffered mightily since election day, gaining 20 bp vs. the benchmark and losing -430 bp vs. the S&P500 just in the last month on the sharp selloff of the large consumer internet and SaaS application software stocks that are the backbone of our roster. Given our view that the investor concerns for technology stocks raised by the Trump victory have been overplayed, we see the current situation as a significant buying opportunity for most of the stocks in our portfolio (Exhibit 12).

There are two exceptions. We added Nokia a year ago on the belief that synergies from the combination with Alcatel and a generally robust carrier capex environment would yield upward revisions and multiple expansion. Instead, global capex has languished ahead of 5G, which could take 2-3 years to really accelerate. We are removing it from the portfolio. We are also removing Crown Castle, which depends on US wireless capital spending to drive demand for its towers. We believe that the reversal of net neutrality could be a negative for wireless capex, as well. Longer term, we have been concerned with the impact of 5G and its small cell oriented architecture on demand for macro base station tower placements.

In their place, we are adding Salesforce and Xilinx (Exhibit 13). We had held Salesforce in the portfolio until mid-2015, when we removed it due to concerns around its infrastructure investment. While we still believe that Salesforce will need an infrastructure partner for the long term, we also see the significant value that Salesforce’s applications and customer relationships could have for a would-be acquirer or partner, like Amazon or Alphabet. Indeed, we believe that both cloud infrastructure players are likely to begin to build portfolios of hosted applications to better compete with Microsoft, which could also be a potential buyer. We are also supportive of Salesforce’s growing investment in AI.

After Intel’s acquisition of Altera, Xilinx is the primary pureplay supplier of field programable gate array (FPGA) chips. FPGA’s are an increasingly important tool for AI, both as part of the hyperscale data centers used to develop the systems and in the devices where many of them will run. Xilinx recently launched a software product it calls an FPGA Accelerator Stack designed to make it easier for datacenter operators to work with its chips. Two major cloud operators, Baidu and IBM, have signed on to work with Xilinx. We believe the opportunity is substantial.

Exhibit 12: SSR Large Cap TMT Model Portfolio, Performance Since Update and Election

Exhibit 13: SSR Large Cap TMT Model Portfolio – RECONSTITUTED

©2016, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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