Some of Wall Street’s most esteemed analysts and strategists are beginning to worry about tech stocks, which are richly valued into earnings. Since June 8, the tech-heavy Nasdaq is up 7.8%, outpacing the S&P 500’s gain of 0.3%. Cyclical value stocks have been dumped into correction -- and in some cases bear market -- territory. Economic uncertainty has gripped the market as coronavirus cases surge out of control, state reopenings are paused, interest rates remain near rock bottom and more fiscal stimulus hangs in the balance. Investors want secular growth that can steamroll through economic turbulence. The NYSE FANG Index, which has a heavy market cap weighing in the S&P 500, is up 17% since June 8. Semiconductor stocks, which are somewhat of a blend between growth and cyclical value, have performed handsomely, but not like the FANG group.
Let’s start with what happened to Netflix.
Netflix was up 25% from June 8 to earnings last week. The stock was at $548 a share into the print, or 49 times next year’s earnings on an enterprise value to EBITDA (earnings before interest, tax and non-cash expenses) basis. That’s in-line with its 5-year average and well above the analyst average of roughly below 44 times. On the earnings print, Netflix wiped the floor on revenue and subscriber growth, as consumers stayed at home and signed up for Netflix. Earnings missed estimates on the lack of an expected tax benefit. And management said the explosive subscriber growth is temporary and a mere pull-forward of demand, rather than an accelerated growth trend. The market is now trying to price in the still-lofty growth rates expected for Netflix, which is also still fairly close to becoming free cash flow positive on a sustained basis. That would add more stability to the valuation. In any event, the stock fell as much as 10% from its level just before earnings and is down about 9% from that level as of Monday July 20.
“The second leg of the correction should be led by growth stocks after their dominance in June,” wrote Mike Wilson, Chief U.S. Equity Strategist at Morgan Stanley in a note.
Wilson also pointed out that near-term tech earnings estimates are too high. In most recessions, Wilson said, tech earnings estimates for the next 12 months fall harder than the average estimate on the S&P 500, but this year, they have only fallen 10% as much as S&P 500 estimates have. While S&P 500 earnings per share estimates for all of 2020 fell as much as 30% during the course of the year, tech estimates are only down a few percentage points, with many companies down in the single digits.
But Wilson says the idea that a tech company, one that can grow though economic headwinds, is purely growth and not at all cyclical, doesn’t fully make sense. Some forms of information technology spending are cyclical, as businesses need less tech capability when they scale down their businesses. But cloud spending, for example, is fighting against that uphill battle. As more businesses switch to cloud from traditional data storage, especially in the work-from-home environment, cloud spending may be getting a boost. Here lies the importance of Q2 tech earnings.
But on cyclicality elsewhere, ad spend comes down when brands see revenues come down, which they have. Facebook’s total 2020 EPS is expected to still be 2.5% below 2019’s, even though revenue is looking to grow to $77 billion from $70 billion, according to FactSet consensus estimates. And since the first quarter, when management cited a decline in ad spend contraction (meaning an improvement) in the few weeks ending the quarter, the stock has surged. It’s up 66% since its 2020 low in mid-March. The steam has been taken out of upward revisions to estimates while that stock run-up has happened, and estimates may still have to come down from here. Revenue has only been revised up 1% since Q1, according to internet analysts at Goldman Sachs. Facebook’s valuation has exploded.
According to Goldman, Facebook is trading at about 25% higher than its average 3-year EV-to-EBITDA multiple, at 15 times forward one year. Google’s valuation metrics are identical to Facebook’s. Amazon, seeing an e-commece tailwind from COVID, is trading at 29 times EV-to-EBITDA, about 26% higher than its 3-year average. Microsoft, not mentioned in Goldman’s report, is trading at 20 times next year’s EBITDA, fairly high.
The expected revenue and earnings growth rates may support these valuations, but the expectations may be too high. It’s also possible that, regardless of the earnings estimates, the valuations over reflect the fundamentals.
The point: between the small dose of cyclicality found in these stocks, the recent stock-run up and the fact that COVID may not be as much of a long-term tailwind as investors think it is, these stocks may have to come down a bit on earnings. Let’s watch.