Being non-consensus and right is the only way to generate superior returns in investing. Even if consensus is right, those who follow it only do as well as everyone else. Howard Marks detailed why in his 1993 memo, “The Value of Predictions, or Where’d All This Rain Come From?” But even before Marks and certainly after, other great investors recognized the importance of being non-consensus.
- Templeton: It is impossible to produce superior performance unless you do something different from the majority
- Buffett: Be fearful when others are greedy and greedy when others are fearful.
- Keynes: Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.
- Fisher: Huge profits are frequently available to those who zig when most of the financial community is zagging, providing they have strong indications that they are right in their zigging.
- Dalio: You have to be an independent thinker because you can’t make money agreeing with the consensus view, which is already embedded in the price. Yet whenever you’re betting against the consensus, there’s a significant probability you’re going to be wrong, so you have to be humble.
Consensus in the tech world right now is that the growth-at-all-costs mindset of the past near-decade is over, and profitability is the new game. Even before the coronavirus pandemic, tech investors were becoming wary of the disappointing public market performance of unprofitable growth stories like Uber, Slack, and Pinterest. WeWork served as the ultimate cautionary tale in growth over profitability with a side of poor corporate governance. Then the economic shutdown happened, private capital markets tightened, and the gradual lean into profitability now feels like a full careen of almost every tech company and investor focusing on profitability and sustainability.
Does the widespread shift of companies and investors to focus on profitability in tech create an opportunity to be non-consensus and right by embracing a passé growth mindset?
I think it does with caveats.
Growth is existentially important to tech companies. To deploy capital into technology is to deploy capital into innovation. Innovation is, by definition, new. If some new technology isn’t growing, then it isn’t creating meaningful value for customers to adopt it. The market doesn’t want it. A true tech company, first and foremost, must grow, otherwise it is dying. The speed of growth in tech adoption should happen as a byproduct of creating meaningful value for the customer such that the customer cannot ignore the tech. Likewise, the greater the value a technology creates for customers, the greater the pricing power the company possesses over the long term, which should lead to strong profit potential.
Tech and growth are necessarily intertwined, and the mechanism of value creation for the customer that fuels growth should also lead to profitability; however, growth alone doesn’t make for a great company or great investment.
Record levels of private capital available to tech startups over the past several years distorted this reality. Companies armed with tens or hundreds of millions of dollars could pour capital into not only building new technology but heavily marketing that technology. Pouring money into marketing and promotion can make the underlying demand for some new technology appear greater than the underlying reality of the value that the technology creates for customers. High growth begets more capital at higher valuations and the cycle continues until a high-growth company fueled by endless promotion needs to demonstrate profitability. If the technology doesn’t provide as much value to the customer as the growth trajectory would indicate, the company and investors are likely to be disappointed with the profit the business ultimately generates, and the more rational valuation that comes with it.
It’s not enough to ask only if there is a huge potential market. There are many potentially huge markets that can support tremendous growth when fueled by strong promotion. The question must include whether the tech truly changes the customer’s life or if it only makes the customer’s life a little better. Companies that really change the lives of customers usually get growth and the pricing power that can create great returns on capital. Companies that don’t, usually don’t.
Now we’re focused on profitability, but profitability alone also doesn’t make for a great company or great investment. Both growth and profitability are required for a company to be great, and the current growth shakeout should make us all realize there just aren’t that many great companies.
Therefore, the answer to our question about being non-consensus and pushing growth during a profitability trend is, yes, now is a great time to deploy capital into growth if you are one of those great companies that actually provides value for customers that will generate strong future profit. For these rare great companies, it makes sense to reinvest any profit and take on new capital to accelerate customer acquisition during what should be a period of lesser competition for new customers. The easy capital available to many growth-focused tech companies will be absent in the market for some period of time. Logically, this should create a window where customer acquisition can happen at much more reasonable levels than in the recent past.
Now is a great time for the few great companies to invest in growth, but what about tech investors? That leads us to another non-consensus opinion.
Investing, per Buffett, will likely always be a non-consensus act when it comes to tech growth.
A key factor that exacerbated growth-at-all-costs over the past several years is the nature of tech “investing.” Most private and public capital allocated to tech is speculative, not an investment in the parlance of Buffett. Buffett says we speculate when we focus on price, and we invest when we focus on what the asset is going to generate. A large portion of venture and growth capital is expected to be returned through M&A or IPOs done at a higher share price than the cost basis of the asset without the underlying company ever having to generate a profit. When your exit plan relies on someone paying a higher price than you, you are speculating. This has worked over the last decade because high growth results in increasing private valuations on larger funding rounds to fuel more growth, which generate large markups in private portfolios and set a bar for future valuations or exits. So has been the nature of tech investing in the past, and so it shall likely be again at some point after the private markets regroup post-pandemic.
Investors, rather than speculators, get paid back through the return on capital generated by the asset, whether that return gets paid out in dividends, used for share repurchases, or reinvested back into the business through retained earnings. Because some great technology companies can take years, even a decade or more, to become hugely profitable, true tech growth investors must have a sufficiently long-term investment horizon. This potentially very long timeline to profitability for growth-focused companies is why most people who deploy capital into tech companies are speculators — it’s hard to wait for potentially 10+ years to start to see a traditional return on capital rather than just a higher price.
There is nothing wrong with speculation provided that you know you are speculating. The problem comes when you speculate but think you are investing. When many tech “investors” give capital to growth companies, they do so with the hopes of creating greater growth in the business that results in a higher price rather than investment returns generated by the business itself. The speculative nature of tech investing means that growth-at-all-costs was destined to be overdone and is destined to return and be overdone again at some point in the future.
Now is a great time for tech investors to deploy capital into those great companies that should be focused on growth, but investing, per Buffett, will likely always be a non-consensus act when it comes to tech growth.
Conclusion: Apple was the most at-risk large US tech company for reporting a disappointing March quarter due to the company’s hardware businesses and exposure to China. Given these headwinds, reporting 1% revenue growth is a win and is representative of the strength of Apple’s presence in our lives. That said, 2020 will remain unpredictable for all companies, including Apple.
What’s lost in March earnings is the significance of the measures the company is taking to manage the business for long-term revenue growth and profitability. That means Apple is continuing its previous product release schedule along with plans to invest in future products and services. This approach will likely yield a stronger product roadmap versus other competitors and larger growth opportunities in 2021. Also lost is the company’s financial strength, increasing the share buyback by $50B, which is unprecedented in the face of little revenue visibility over the next several quarters.
Regarding the near-term, Tim Cook was clear that Apple’s business is showing signs of an uptick in the month of April across all geographies, but cautioned that iPhone and Wearables (60% of revenue) would worsen in June. Those comments left investors modestly disappointed after hearing other tech companies report early signs of stabilization. It’s worth mentioning, even after the pull-back, Apple shares are up 17% in the month of April.
- We believe Apple’s revenue was growing at 12% for the first seven weeks of the quarter and was down 17% for the final five weeks. Since April, revenue growth has improved but is still likely down year over year. This is illustrated in Cook’s comments that all geographies are improving, but to expect iPhone and Wearables (60% of revenue) to “worsen from March.” In other words, Apple’s business has improved from its lows but has yet to stabilize, which we expect in the September quarter. The company did not give guidance, but we expect June revenue to be down 5-10%.
- Services (20% of revenue) will be stable. The negative of lower Google Search and Apple Care revenue will be offset by the positive of more app downloads and iCloud usage.
- iPad and Mac (16% of revenue) will improve quarter on quarter, driven by increased demand related to working, learning, and playing from home.
- Apple’s product roadmap is on track. We expect iPhone 5G to be announced in late September and to have broader availability sometime late in October. As a reminder, iPhone 5G’s breakout years will be FY22-FY24, given what will be modest global coverage upon launch.
- Apple’s supply chain took a dramatic step downward in the middle of the quarter and has since bounced back. This resulted in channel inventories exiting the March quarter surprisingly in line with expectations.
- China showed improvements from February to March and again in April. Overall, we think the China business is currently trending flat year over year.
Cash is king.
Apple’s earnings power is often missed during these messy quarters, reporting $11.3B in GAAP net income. As a point of comparison, Amazon reported March GAAP net income of $2.5B. Despite the earnings power difference, both companies are essentially valued at $1.2T. Amazon is growing much faster, likely 20% in the June quarter compared to Apple, which will likely be down 5%+. Fast-forwarding to next year, we expect Apple will grow revenue at a similar rate to Amazon.
The long-term view.
2020 is an unknown. However, the powerful trends that were in place within technology, media, and health will still be in place when this current period of uncertainty ends. Some of these trends include:
- 5G driving both a device upgrade cycle and trailing benefits from what the technology enables.
- Original content and SVOD increasing share of media time spent
- Software services continuing to penetrate more industries.
- Health becoming personal and preventative – wearables for data collection, AI for analysis, and consumer software as the interface.
- Augmented Reality emerging as the next major computing platform.
In other words, many of the prevailing tailwinds over the next decade are at Apple’s back. Additionally, the 2020 downturn may prove to be a positive for the company, given Apple’s financial strength, anchored by $83 billion in cash, which will be used to retain and acquire talent and companies to advance their agenda.
This is the third consecutive quarter of favorable results that support Tesla having an outsized opportunity to play a key role in the future of mobility. As a reminder, there is typically a four-week lag between Tesla announcing deliveries and full financial results, so a holistic takeaway from a given quarter should be viewed with both of those releases in context.
Takeaways from the April 2nd delivery announcement:
- March quarter delivery numbers were up 40% year over year to 88.4k compared to the overall US auto industry down 29%, despite the Tesla-specific headwind of the elimination of the $1,875 US tax credit in the quarter.
Takeaways from today’s earnings announcement:
- Auto gross margins, which are foundational to sustained profitability, were better than expected. Shanghai Model 3 margins are already approaching Fremont Model 3’s and Model Y is already profitable in its first quarter of production. Auto gross margins of 20% were above the consensus of 16.8% and up sequentially over last quarter’s 18.9%. The debate around Tesla’s future is rooted in the likelihood that the company can sustain profitability, and today’s data points are positive signs for overall margins going forward.
- Commentary that the company can produce and deliver at least 500k vehicles in 2020 is a sign of confidence that the Shanghai and Model Y manufacturing processes are making measurable improvements and will not undergo the same production setbacks the company experienced ramping the Model 3. In the past, Elon Musk has described one of Tesla’s long-term competitive advantages as building the machine that builds the machine. Tonight’s comments are evidence of progress toward that goal.
- Free cash flow would have been positive if not for the inventory rebuild. Tesla had negative free cash flow of $895M, but inventory growth accounted for $981M. The biggest reason for the increase in inventory is that the pandemic-induced shutdown resulted in postponing the end-of-quarter delivery surge.
- Updated consensus estimates call for 403k total vehicle deliveries for 2020. While it’s dependent upon the unknown of when Fremont reopens, we see upside to that number and think it will fall somewhere in between that and Tesla’s prior guidance of 500k vehicles.
- Elon was asked about the possibility of offering FSD as a software subscription rather than a one-time purchase option when buying the car. He said Tesla does plan on offering it on a subscription basis by the end of this year. Our best guess at a monthly price is $100 to $150. We believe this would lead to higher uptake on FSD, which is a clear benefit to Tesla and the timeline for releasing autonomous driving features.
- On the call, the company mentioned that it exited the quarter with its largest-ever order backlog, indicating that demand is intact and growing despite several headwinds.
The liquidity outlook
Tesla did not give an update on the call regarding its cash position at the end of April. They exited the March quarter with $8.1B and should get a bump in cash with the delivery of 14k vehicles that were produced last quarter. Importantly, raw materials are the biggest use of cash and are a variable cost. We believe that variable cost dynamic will allow Tesla to navigate the next 18 months favorably.
Inching toward induction into the S&P 500
We think there is a 60% chance that Tesla is added to the S&P 500 by the end of 2020. For that to happen, the company must have a cumulative GAAP profit over the previous four quarters. The September quarter results should complete the company’s resume for induction, which would then be in November or December. The reason we have assigned it 60% probability is that June quarter earnings are virtually impossible to predict. If Tesla loses a significant amount in Q2, it could bring the four-quarter total below GAAP profitability. While being added to the index doesn’t change Tesla’s fundamentals, it would give the company’s shares a potential boost.