Mad Hedge Technology Alerts!
There is a new investment theme that is starting to permeate Silicon Valley.
It hasn't gone mainstream yet but is starting to attract attention because of the spectacular numbers it will bring in.
I call it the "Legacy Turnaround Play."
It goes something like this. Find an ailing technology dinosaur from the Jurassic Period (i.e. the 1990's), infuse it with new management and technology, and the shares go ballistic.
The poster boy for the strategy is none other than the former beast of Redmond, Washington, Microsoft (MSFT), founded by my friends Bill Gates, and the company supervising adult, Paul Allen.
Up until the Dotcom bust, it looked like Microsoft would rule the universe forever. Almost two decades later, its Windows operating system still runs 70% of the world's computers.
The day Bill Gates retired from active management was the day (MSFT) went ex-growth. Steve Ballmer was never more than the custodian of a gigantic legacy business that went nowhere. The shares remained stuck in the doldrums for 15 years.
Also on that fateful day the Gates Foundation sold the bulk of its Microsoft shares, investing tens of billions of dollars into US Treasury bonds. I know this because I reviewed the fund's holding many years ago. It was one of the wisest investment decisions ever made.
Steve Ballmer mercifully retired in 2014, hiring Satya Nadella to replace him. The pick was controversial at the time because Nadella hailed from India.
However, he possessed a vision of The Cloud that was way ahead of its time and proved dead on correct. Since Nadella joined Microsoft, the shares have rocketed some 163%.
This has spurred a frantic search for the next Microsoft, and every legacy tech company is being put under a microscope to ascertain its possibilities.
Intel (INTC) and Cisco Systems (CSCO) are now in the running for "Legacy Turnaround" status, and their share prices are reacting accordingly.
The Silicon valley jungle telegraph has told me that another firm may be about to join its ranks.
That would be Western Digital (WDC). However, the burden of proof is still on the company's management.
You all remember the old Western Digital. Spun off from Emerson Electric Company, Western Digital was the world's largest manufacturer of chips for hand held calculators during the 1970s, the cutting-edge consumer technology product of its day. When the personal computer industry showed up, it moved rapidly into hard drives.
Since then, it hasn't really done anything new, except build bigger and faster hard drives in physically smaller sizes. The problem with that approached is that the world has been moving towards solid state storage now for years.
The hard drive is about to become one of the great dodo birds in the history of technology. Western Digital's shares are virtually unchanged in three years, completely missing the 2016-2018- tech melt up.
You can forget about buying Western Digital (WDC) for a quick-in-and out trade. HDD (Hard Disk Drive) sales are down a dreadful 5.6% YOY.
It was hard to identify a tech stock that didn't have a phenomenal year in 2017 unless it was tainted with terrible offerings like Snapchat (SNAP). The secular long-term growth story for technology is the crux of the bullish argument in equities.
A good chunk of Western Digital's business is derived from the declining HDD storage industry which is a continuing source of torment.
(WDC) is attempting to cross over into SSD (Solid State Drives) which is ripe for hyper-growth in tech storage. Gobbling up SanDisk in 2016 and Tegile Systems in 2017 were definitely positive steps in the right direction.
In 2014, HDD was a pristine $32 billion per year market, but sunk to $20 billion by 2017.
Begrudgingly, (WDC) dominate 40% of the HDD market along with Seagate (STX) who also control roughly 40% of market share.
HDD revenues still comprise the biggest portion of WDC's total revenue.
Once that number shrinks down to 30-35% then a resurgence in the stock could be in the cards and management can start beating the drums of resuscitation.
(WDC) sold off hard after last quarter's earnings first and foremost because of the bitter tussle with Toshiba who is mired in years of chaotic management and mislead investors.
Traders dumped the stock after finding out guidance for earnings per share between $3.20 and $3.30 down from the previous quarter of $3.95.
Making matter worse, (WDC) lost over $800 million last quarter. (WDC) undeniably have a few dilemmas to solve.
Contrarians can argue that (WDC) is cheap on a PE multiple basis. However, (WDC) has been cheap for the last 10 years with no multiple expansion and could still be cheap 10 years from now.
This company has shown zero EPS growth. There is a difference between cheap and great value.
Client Devices revenue for the December quarter increased by 9% YOY, primarily driven by significant growth in SSD's. Their Client Devices segment was down 1% QOQ because of the heavy drag of HDD devices.
One warning sign is how management obscures revenue segments by "client devices" instead of filtering them out into separate categories in the earnings report clearly stating SSD and HDD unit sales.
Management is inherently camouflaging the HDD segment headwinds. It appears less harsh to the novice investor to group HDD weakness with SSD strength.
Data has been created at a record rate worldwide and the value of data is increasingly fueled by advancements in mobile, cloud computing, artificial intelligence and the (IoT) Internet of Things.
The intense growth in data is ramping up demand for larger and more reliable storage infrastructure. To be on the wrong side of this momentum is a death knell especially if you consider tech investors are willing to pay such a premium for growth.
Unfortunately, Western Digital (WDC) utterly fails because it's eggs are in the wrong basket and there is no growth story. The rhetoric is mainly a legacy business that must worry about survival even though revenues are increasing and during a climate of global synchronized growth.
Investors love tech but only the right tech. The wrong tech are companies such as Gopro (GPRO), Blue Apron (APRN), or the Footlocker (FL) of video games, GameStop Corp. (GME) have defective fundamental pillars that should be discarded right away.
The growth percolating in the pipelines is across the board but not in legacy tech dinosaurs with a deficient business model.
The guidance for total gross margin next quarter is 42% to 43%, and although quite healthy, analysts believe margin growth has peaked and further improvement in total revenue is limited.
There are better options in technology with more exciting charts and clear-cut growth stories like Netflix (NFLX), which sport a parabolic chart and a long runway.
Tech is the poster child of growth, and any tech company not growing is not worth investing in.
There is a chance that (WDC) has put in a double top adding to the technically bearish sentiment.
If you look at the rest of your portfolio of tech names we have recommended they are most likely higher probability longs.
Even if you analyze a broad swath of tech from software services such as Salesforce (CRM) to hardware products like NVIDIA (NVDA), accelerating users/units and higher revenue with secular growth is the constant variable.
There is opportunity cost of owning stocks that are falling in a rising market. Stay out of Western Digital until positive clues surface concerning the turnaround.
And especially stay out (WDC) until there is visible momentum and incontestable technical support.
Remember that great companies beat on the bottom and top line sequentially then confidently raise guidance. (WDC) is not a great company, not yet anyway.
Mad Hedge Technology Letter
March 2, 2018
Fiat Lux
Featured Trade:
(WHEN WILL THE GOVERNMENT HAVE TO KILL A FANG?),
(FB), (AAPL), (NFLX), (GOOGL), (AMZN), (TWTR)
By now, we all have major over weightings of FANG's in our retirement portfolios. And the greatest threat to those holdings is the prospect of imminent government regulation.
The prospect of government involvement in the FANG's should therefore be more of just passing interest to us.
The relationship between large cap tech companies and the US government is not exactly a match made in heaven.
The hot button political topic of the day is how Russia used Facebook (FB) to influence the US presidential election. (FB) in effect lowered the drawbridge to allow our foreign enemies to come flooding in, and no one noticed until it was too late.
In fact, to say that government and tech are constantly butting heads would be an understatement. However, not all governments are created the same.
China's government has built a formidable moat around their tech industry, granting priority only to local firms and shutting out the rest. Notice that Alphabet (GOOGL) closed its offices in China five years ago.
Europeans have stuck with the school teacher approach by punishing their pupils individually. But the school itself has bigger sway in the grand scheme of things.
Broad based guidelines from the European Commission were handed down today dictating that Google (GOOGL), Facebook, and Twitter (TWTR) have one hour to remove unsavory content from their platforms, or else.
Keep in mind, these new protocols are "voluntary" and follow a series of other "voluntary" self-regulating precepts.
FANG's are still not accountable for anything posted on their platform and are thus insulated from liability. The notion that FANG's will self-police their own platform still pervades through official channels.
Fining FANG's appear authoritative enough to diverse political constituencies, but cash isn't a problem for FANG's. Each one is a mere slap on the wrist.
Preventing a FANG's unstoppable business model is the only solution and that will never happen.
Obviously, the E.U. have a sluggish grasp of how Fang's actually work.
FANG's are an entirely American made creation. Government, by and large, subscribing to the wonders of dynamic market forces, allowed the contest to play out in the trenches and not behind the scenes.
America's hyper competitive business model is also a graveyard littered with once promising tech companies, like MySpace, Napster, and Blackberry's (BB) mobile phone division.
The hope is that FANG model will continue to naturally evolve and self-regulate.
The big takeaway from government is that regulating big tech is a complicated issue. And government will deflect responsibility if pressured into destroying a Fang.
In essence, the net benefit of keeping the FANG's around could be greater than the net cost of getting rid of them for a sovereign nation, especially the consumer.
Today, FANG's are untouchable in cloud services, social media, search capability, e-commerce, advertising, tablets and mobile. The modern economy can't function without them.
Google and Facebook are observing and tracking every user's move, and that feedback is following through back to their reservoir of big data.
The colossal data profile they possess on each individual deduces users' hobbies, purchases, search trends, browsing patterns, location history, and loads more, even sexual orientation.
This probing system refines their hyper-targeting model, which has many unintended consequences, such as the ability to weaponize parts of the platform by rogue elements.
Fixing this problem is challenging and it's possible there are no good fixes out there at all. Jack Dorsey pleaded to users today to give suggestions on making Twitter a better user experience.
He knows the increased pace of weaponization on his platform will ultimately come back to haunt him as the CEO.
FANG's apply user data as inputs for evolving Artificial Intelligence (AI) consisting of a collection of filters. This check lists controls the content that pops up on to your screen based on the structure of finely tuned algorithms.
Google and Facebook (FB) offer the highest quality hyper-targeting in the world and advertisers pay for that quality.
If a negative unintended consequence transpires from a rogue algorithm, the FANG's have proved adept at paying lip service to the right actors to stave off the heat for another day. Kicking the can down the road seems to be their long-term strategy.
Complicating the mess is the fact that 100% of the blame cannot be directly pinned on an unknowing FANG if a team of nefarious hackers cause a ruckus from their computers in some distant land.
The fundamental idea of profit through data privacy and accumulation violently conflicts with the FANG's core business aspirations: hyper-targeted advertising based on increasingly intrusive personal surveillance. They will not change themselves if it means hindering their profitability.
Who would?
One challenge that the American government must hurdle is understanding the magnitude of the situation at hand. Do our politicians understand how to instill more algorithmic accountability and instill privacy policy transparency?
Effectively, playing Tech God is a slippery slope to go down. It's easier said than done, and there are many moving parts to this game. American big government is not ready to destroy a FANG in the land of free enterprise.
You can kiss the nine-year equity bull market good-bye if the government actually kills off Facebook or a Google!
The consensus view is the FANG's will continue to increase our standard of living.
Accelerating additional hyper-targeting, greater algorithmic favoritism, squashing competition and widespread erosion of adjacent industries. And most importantly for investors - higher profits and share prices.
Consumers have benefited immensely from all these free services. It's the competition that's complaining because they aren't FANG's themselves. Life must feel very unfair if you don't have the same tools as FANG companies.
Amazon was clever enough to take profits from their Amazon Web Services (AWS) division to bolster their loss-making e-commerce division. In the process, they crushed American brick and mortar retail.
Shareholders call this genius, while competitors and politicians call this a breach of anti-trust.
Any regulatory blow back that results in a dip of share prices should therefore be bought once the dust settles.
That day could be sometime in the far future, but there will be many twists and turns until we arrive there.
Investors need to ask themselves, does the government have the authority and the determination to ruin a FANG? The answer is no.
What the government is telling investors is they will dabble with the bare minimum of token regulation, but aren't ready to drop the guillotine on large cap tech. The long-term secular growth story is still intact albeit with occasional regulatory friction.
Every dip will be bought by investors queued up for years patiently waiting for an entry point, and the shares upside will be tapered by occasional regulatory headlines.
Regulation will never amount to more than that.
