For most of the last several years, it has seemed like technology was the one sector investors wouldn’t bet against. However, one fund manager has been betting against the sector, and while he admits that he has been wrong over the last few years, it isn’t time to quit. He says eventually the extremely good fortune and sentiment which have carried the tech sector for so long will evaporate, and he explains why.
Still betting against tech
RBI Capital Management’s Skip Tague noted in his first-quarter letter to investors, which was reviewed by ValueWalk, that tech valuations have gotten so high that it’s almost like the market doesn’t care about valuation. Sentiment has been high for quite some time, and he feels investors have forgotten what they should have learned in 1999, which was that valuation does actually matter.[REITs]
He cited Cisco Systems as an example of this. Its stock peaked at $82 in March 2000, but it now trades at $56. Even though the company’s revenue has surged 155% and earnings per share has skyrocketed 371%, its stock price has tumbled 32%. He predicts a similar fate for much of the tech sector eventually. This view did pay off toward the end of 2018, although fortunes reversed in the new year.
Tech blamed for depression and anxiety
He notes that sentiment on big tech has finally shown signs of shifting thanks to the privacy scandals and “monopolistic market positions.” However, he doesn’t believe investors have really thought about two other big problems. The first is that technology may be having negative impacts on mental health. He noted that the U.S. has been experiencing more economic prosperity in the last 20 years than in prior decades, but despite that, anxiety, depression and suicide have been increasing. He blames technology for this.
“We have a device in our hands every waking minute that pushes information and communication to us,” he wrote. We have social media, where it always appears that the ‘grass is greener’ in our friends’ lives. While there are many benefits to this consumer technological process, the drawbacks seem very significant. If consumers recognize this and unplug more regularly, ad spending drops, cloud infrastructure spending drops, etc.”
He also called attention to the tax inequity which appears to favor tech companies. He clarifies that he isn’t saying that these companies are illegally dodging taxes, but he does have some interesting statistics. He found that many tech names are paying lower than the corporate tax rate of 21%, so he feels officials should look for ways to close the loopholes “so they at least pay their fair share.”
“There are many legal reasons for this including research tax credits, tax benefits related to stock-based compensation, and international income,” he wrote. “However, those same situations also apply to companies in other sectors. Why do tech companies appear to be getting a break?”
Upon screening for companies which pay less than the 21% corporate tax rate, he found that many of them are in the tech sector. For example, in 2018, Adobe Systems paid a 4% rate, while Micron Technology paid a 5% rate, and Intel paid a 10% rate. Amazon paid a tax rate of 11%, while Alphabet and Facebook each paid 13%, and Apple paid 15%.
For the last three years total, NVIDIA paid $141 million in taxes with $9 billion in pretax income recorded, amounting to a 2% rate. Netflix recorded $2 billion in pretax income and paid a mere $15 million in taxes over the last three years in total, amounting to a less-than 1% rate. Salesforce had $1.4 billion in pretax income but actually generated tax credits somehow.
This is one issue that has gotten a lot of press in the past, but it has always died down with little more than a slap on the hand for companies dragged into the spotlight. It’s also a problem that probably won’t end until enough people demand that big tech pay up.
Shorting software and semiconductors
Tague said his shorts in the tech sector are focused mostly on software and semiconductors. He describes valuations in the software industry as “extreme,” citing the Ultimate Software acquisition for 10 times trailing revenues and 80 times trailing EBITDA as “the bell ringing.”
He also noted that the semiconductor industry is starting to decline based on statistics from the Semiconductor Industry Association, which reported a 7% month-over-month decline in February semi sales and an 11% year-over-year decline. Despite this, the semiconductor sector hit a new all-time high recently and is up 40% since before Christmas.
“Companies are betting on a 2nd half recovery and it appears the market believes them,” he wrote. “I think this is risky considering the already-slowing world economy and a U.S. economy that is due for a slowdown.”
Tague also pointed out that semiconductors were the second-worst performing sector in past bear markets, and software didn’t perform much better.
“History has shown that when the market shifts from bull to bear, the leadership changes,” he continued. “The leading sectors of the previous bull underperformed during the subsequent bear. That doesn’t bode well for technology stocks in the next bear, as they have significantly outperformed during this bull market.”
Further, he said tech stocks did the worst during previous times when the yield curve inverted.
RBI Capital’s long/ short portfolio was down 1.8% gross and 2.3% net for the first quarter overall. The fund’s short-only Kodiak fund was down 12.2% gross and net for the quarter. Tech stocks were strong during the quarter, so it’s no surprise that the fund’s tech shorts were among its biggest losing positions.
The fund remains short Netflix, which rallied 33% during Q1 following a 31% plunge in the second half of last year. Tague said he is focused on “valuation, debt, significant negative cash flow, content library accounting and upcoming competition.” He noted that Netflix is up against CBS, Amazon, Disney and many others in the fight over content, and it’s unclear whether they will all see returns on their content investments. He pointed out that Netflix’s contribution margin dropped “significantly” in the most recent quarter, which is “a new negative to watch.”
He also put Netflix’s tax situation into perspective. He said over the last 12 quarters, Netflix has seen $2 billion in pretax income, but it has only paid $15.4 million in taxes. Assessing a 21% tax rate to that pretax income, the company’s earnings per share for the last 12 quarters would be a mere $3.47. RBI continues to short Netflix
Shopify and Workiva
RBI also continues to short Shopify, which Tague describes as “one of the most expensive” in the software-as-a-service group on an EV/sales basis. Unlike many of Shopify’s peers, it doesn’t generate much operating cash flow, and its gross margin as a percentage of sales has been on the decline, which is also unusual for the SaaS business. Tague also noted that more competition is coming from Instagram Checkout, Square and Microsoft.
The fund also lost on Workiva, another SaaS name. Tague noted that the company’s valuation relative to growth is higher than that of its peers and its profitability and cash flow are lower than those of its peers, while receivables have risen significantly. He recently added to RBI’s short of Workiva because he believes Wall Street overreacted to the company’s February earnings report.
Winning on Tesla
While not technically a tech company, Tesla does behave like one, and this is one short that actually paid off for RBI during the first quarter. Tague said most of his thesis remains intact: “extreme valuation, low/no profits, high leverage, quality-of-earnings questions, management turnover / corporate governance, upcoming competition, declining tax rebate to buyers.”
However, he noted that one major piece of his thesis was negative cash flow, and it has improved to become “significantly positive” over the last two quarters. As a result, he is keeping his short in Tesla “small” as he watches this metric carefully. He adds that there has been other negative headlines about the automaker though, including news about job cuts, the closing of stores and the dispute with the Securities and Exchange Commission.