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Everybody loves the FANGs Here is why we don’t June 6, 2018

Given the relentless momentum in FANG stocks, we believe that taking a step back and

assessing each of our three vectors will provide insight on why we believe these stocks are at

risk of a fall.

THEY ARE FACING MAJOR MACRO RISKS THAT ARE NOT DISCOUNTED

Online advertising growth is not infinite

Google and Facebook have ridden the secular shift of online advertising for more than 15 years. It is

difficult to determine where online advertising will plateau as a percentage of total advertising

expenditure, but as magazines and newspapers are now almost entirely replaced, incremental gains will

be more difficult. Further, we would add that advertising is a cyclical business that does not grow any

faster than the economy. We are currently in the second-longest expansion recorded. Should economic

activity slow, so too will the growth of ad revenues for Google and Facebook.

Online advertising is a disappointment

Advertisers are realizing that the return on investment (ROI) is not as high as expected. A study by

Ebiquity, a data-driven media and marketing consultant, showed that the effectiveness of online and

social media advertising was lower than that of traditional media, and much lower than advertisers’

perception.

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In a 2018 CMO Council survey of 233 senior marketers, 62 percent indicated that reports of false metrics

from Facebook have pushed them to pull back on online spending. Procter & Gamble, Unilever and Adidas

are just some examples of large advertisers reducing their online spending.

Google and Facebook are showing signs of maturity

Google management has stated that the rebound in growth it has experienced over the last two years is

due to higher ad loads (which have roughly doubled), and not to page impressions (which refers to the

number of times a web page has been viewed). Facebook, for its part, is now pushing prices up as

impressions have slowed considerably.

Facebook: Quarterly price per ad and total impressions. (YoY growth)

Regulation over data protection is threatening Facebook and Google’s primary business

The General Data Protection Regulation (GDPR), which seeks to give users control of their personal data,

is being implemented in Europe on May 25, 2018. In essence, the law forces online companies to gain

consent from users before they can use their personal data, and if the users opt out, they shall receive the

same services. It is likely a first step toward a template for international regulation. Given the ROI of

online advertising, a reduction of data will compound this problem.

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Margins are coming under pressure

For Google, it is a mix shift. Desktop search is an extremely high-margin business. According to Google’s

CFO, anything they do outside of desktop search (including mobile search advertising), is margin-dilutive.

This can be seen in the steady move down in margins over the last 10 years. As for Facebook, it is ramping

up spending on security and video content and expecting expenses to increase at a rate of 50%-60% in

2018, from 30% in the last two years. Amazon has famously low margins, with the exception of its cloud

business, for which the company is enjoying a market share close to 40%. But competition for the cloud is

increasing steadily as Microsoft, Google and BM are ramping up.

FANG – Operating margins.

Sources: Hexavest, Bloomberg.

They are increasingly competing against each other

Speaking of margins, all four members of the FANG stocks are beginning to compete with each other,

which will inevitably impact margins and growth. All four companies now offer online video content.

Amazon and Netflix are in direct competition, while Google and Facebook are both offering free video.

Amazon, Google and Facebook are now selling online advertising, while Amazon and Google both offer

cloud services. They also compete on devices such as smart speakers. Amazon is trying to develop its own

browser and possibly its own search engine.

Governments are looking for ways to tax them

Newspapers have largely covered the fact that FANG stocks are paying very little taxes due to tax

avoidance strategies. International governments, notably the European Commission and India, are

studying ways to tax their revenues. The companies even get to benefit from very low tax rates in the US,

where they are domiciled. In 2017, Amazon paid no federal tax on $5.6 billion in US profits, according to

an analysis done by Matthew Gardner at the Institute on Taxation and Economic Policy. During the

previous five years, Amazon paid an effective rate of 11.4% on its profits of $8.2 billion, which is about a

third the statutory rate, Gardner states. As countries become increasingly concerned with the exploitation

of loopholes in international tax frameworks, the incidence of tax disputes and litigation will increase.

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Traditional players are catching up

Amazon took the retail world by storm, but competitors are now fighting back. Walmart, Target, Kroger,

CVS, Home Depot – all are now beefing up their online presence and growing online revenues faster than

Amazon. Netflix has revolutionized the way media is delivered (streaming) and consumed (binge-

watching), but it is still making TV shows and movies the same way traditional studios do, and these

studios are now changing the way they deliver content in order to compete with Netflix.

They don’t disclose much, lowering visibility

For several years now, the SEC has been requesting more disclosure from the FANGs. Google doesn’t

break out YouTube revenue, Facebook doesn’t disclose much outside of its core Facebook business and

Amazon is famously secretive on a variety of metrics, though segment disclosure has improved recently.

Capex are also a large black box for all four companies. Some financial analysts we met admitted that

their models are not particularly robust due to lack of inputs. They were forecasting a top-line growth rate

and margin. As such, future result estimates are simply an extrapolation of previous results, and not a

genuine forecast.

IT WILL TAKE YEARS BEFORE THESE COMPANIES’ EARNINGS REACH

COMPELLING VALUATION LEVELS

Analysts are extremely aggressive in their forecasts

The EPS growth of the FANGs can be extremely volatile and difficult to predict.

Sources: Hexavest, Bloomberg.

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Notwithstanding the potential headwinds facing the companies, analysts have extremely bullish estimates

going forward. As shown previously, we believe that Google and Facebook’s growth trajectories are the

most at risk of disappointing.

Even with aggressive forecasts, it will take years for FANGs to grow their multiples

In spite of these bullish estimates, the companies are extremely expensive, especially AMZN and NFLX. To

highlight their excessive valuation, we added up our top overweight positions until we reached the

combined market cap of the FANGs. This led us to 14 names. We used a relatively aggressive hypothesis:

20% EPS growth for the FANGs and 5% for our top 14 holdings. One must note that from 2007 to 2017,

only 6% of S&P 500 stocks had an EPS growth above 20%. The graph below is self-explanatory: FANGs’

earnings will only catch up to those of our top 14 in 2024.

Earnings projections: FANGs vs. 14 largest positions in the Hexavest Global Equity Strategy. Assumption: 20% CAGR for FANGs and 5% for Hexavest positions

Source: Bloomberg as of May 15, 2018.

Source: Bloomberg as of May 15, 2018.

Growing cash burn highlights risk of underpricing services

Netflix has no path to free cash flow. The company guidance shows it is expected to burn through $4

billion cash this year and to have negative free cash flows for the next several years. In fact, the

company’s rise in subscribers roughly coincided with the increasing cash flow burn rate. Some will say it is

creating an unrivaled library, but others might argue that media is more like fashion: based on current

hits, not old ones.

3 Yr CAGR 3 Yr CAGR

2015 2016 2017 (15-17) 2018E 2019E 2020E (18-20)

GOOGL 8% 22% 28% 19% 53% 13% 18% 27%

FB 17% 171% 77% 78% 39% 21% 22% 27%

AMZN nmf 290% -7% 90%* 349% 39% 45% 108%

NFLX -55% 54% 209% 29% 150% 57% 50% 200%

* AMZN had negative EPS in 2014 therefore 2 -Year CAGR (16-17)

YoY % YoY %

FANG Profits T12M (M$) Market Cap ($B) Price/Earnings

Facebook 20 117 541 27x

Amazon 3 149 780 248x

Netflix 709 142 200x

Google 26 997 765 28x

Total 50 972 2 227 44x

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Amazon’s cash flow situation is better, but it too, generally spends more than it makes. The growing cost

of international expansion and content building is not being met with commensurate increases in cash

flow.

Source: Amazon’s company report.

Truth is that both companies’ competitive moat is based on a lack of profitability. Some will argue that

once they reach scale, they will reverse these facts, thereby justifying ridiculous multiples. What if they

never can? What is the value of growth if it can’t be monetized?

THEY ARE RIDICULOUSLY ADORED

Fund flows have been exceptionally strong

Those of you familiar with our investment philosophy won’t be surprised to learn that the overly bullish

sentiment on FANGs is a major turnoff for us. As contrarian investors, we have a strong conviction that

crowded trades like this one always end badly. Fund flows to e-commerce are rivaling those of the dot-

com bubble, while tech flows have also gone parabolic.

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They are part of the momentum/growth bubble

The price performance of the stocks also brings back memories of the tech bubble. This performance has

been driving the value/growth and momentum/market outperformance since 2016, pushing the relative

performance of these strategies in line with the early 2000s.

All our vectors suggest caution toward the FANGs at the moment, most notably valuation and sentiment.

Of course, we continually reassess these vectors, but for now, we strongly believe that excluding them

from our portfolios is consistent with our analysis and will benefit our clients’ portfolios.

The Hexavest team

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