Snap's Worst Day Ever

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Our advice is you need to be patient because we are at what feels like the beginning of estimate revision cycles across the space, and it feels like with rates doing what they're doing and the market doing what it's doing, that there's risk to 2023 numbers across the ad space.

Hello and welcome to the Barron's Streetwise Podcast. I'm Jack Howe. The voice you just heard is Lloyd Walmsley. He's an analyst at UBS covering internet stocks, and he says that the implosion for Snap shares this past week is a sign that advertising budgets could come under pressure. We'll also hear from a chip analyst who says that the industry could go from a shortage to a glut in a hurry. Now, those are two cautious views, but both analysts say that some beat-up stocks are worth buying now. And we'll hear from a money manager about small caps. He says the ones that are supposed to be expensive have become cheaper than the ones that are supposed to be cheap. Confused? A little, yes. Thanks for asking, but we'll get it all sorted out soon. Listening in is our audio producer Jackson. Hi Jackson.

Hi Jack.

Jam-packed episode this week, am I right?

I think so.

Maybe I'm overpromising. The episode is pretty full, but I am going to waste a little bit of your time. That's just my nature. I can't say I'm going to give it 100%. It sounds unsustainable if I'm being honest, but I'm shooting for a steady 70% and I'm guaranteeing adequacy. What do you say?

Time to fly like an adequate eagle.

That's my favorite low-cost regional carrier.

You'll make your connection, but just barely.

Let's start with Snap, which got snipped, losing 43% this past Tuesday. Slammed 30% after hours, cutting their earnings forecast for the second quarter.

And that alone sent the stock down, get this, over 40%. The announcement caused broad collateral damage across the tech sector.

Snap was recently selling for less than $15 a share, which is 85% below its high last September. It's also below its 2017 IPO price of $17. Even though the company is doing much better today than back then, its number of daily users has roughly doubled since its IPO to more than 300 million. Its revenue per user used to be less than $5. Now it's approaching $15. The company has gone from burning cash to generating positive free cash. So what went wrong? In a securities filing, Snap said that macroeconomic conditions have deteriorated faster than it had anticipated back when it reported first quarter financial results. At that time, it had issued upbeat guidance. Now it says it's likely to fall short of that guidance. In a memo to employees, it blamed inflation, interest rates, supply chain shortages, labor disruptions, policy changes from tech platforms, and the war in Ukraine. The thing is, Snap's guidance was only issued on April 21st, so the warning came barely a month later. That begs the question, if things are going south so quickly for Snap, how many other companies are affected? If you're not familiar with Snap, it makes an app called Snapchat where users exchange pictures, videos, and messages that disappear after a short while. It's popular with millennials and Gen Zers. Jackson, you're right on the border of those two cohorts. What's the importance of the photos disappearing after a short while?

You know, sometimes you have to send classified material to another consenting party.

Prototypes.

The Coca-Cola recipe.

Got it. Now, competitors to Snap include some of the industry's biggest players like Meta Platforms, which owns Facebook, Instagram, and WhatsApp. These companies offer their apps for free and make money from advertising. Facebook warned about an advertising slowdown back in February, you might recall, and its stock plunged 26% in a day. Now Snap is saying something similar, and that raises questions about Alphabet, Twitter, and other ad-driven companies. At the same time, Facebook is down by half from its high, Alphabet is down by more than a quarter, and Amazon which has a small but fast-growing advertising business, is about 40% off its high. So at what point is the bad news priced in? To learn more about that, I reached out to UBS analyst Lloyd Walmsley. I asked him, is Snap's blow-up week a sign of more trouble ahead?

Yeah, I think it's the sign of broader trouble coming. There are a few things idiosyncratic to Snap. I mean, they have a large concentration of customers among larger advertisers, and so they don't have as deep ad auctions as platforms like Facebook or Google. You know, one advertiser can be more of a needle mover for Snap, but I think it's broadly, we're starting to hear some cracks in the ad market when we talk to digital ad agencies.

Lloyd says that things seem to have gotten a little weaker in April and May, but that June will be more telling.

You usually get some budget flush in June. You also get what are known as optimization budgets. So if someone's running an experimental campaign, they're halfway through their budget and it's not working and it's the end of the quarter, they'll dump that into platforms they know work like Facebook or Google.

Apple has made sweeping privacy changes that give iPhone users more control over whether app makers can track their data. That makes it more complicated for those app makers to measure the performance of their advertising. Even so, Lloyd says that ad buyers still feel like they have pretty good visibility into performance on Google, which he says leads in measurability, and Facebook, which he calls a close second. But some of the smaller venues like Snap, Twitter, and Pinterest he calls nice to have as opposed to essential for advertisers.

Even Snap advertisers say, we don't buy that platform with as much measurement rigor as a platform like a Facebook or a Google. And so when times get tough, those are easier budgets to, to carve up.

So if ad buyers shift money to Facebook and Google in June, it could be bad news for some of the smaller venues. And even Google and Facebook could be hit by a downturn eventually. Here's Lloyd.

Looking at what's happening to the economy, hearing what's going on at some of the major US retailers, and just the psychological impact to executives from watching stock prices fall. The market indirectly and investors directly are telling executives, you know, slow your investments. We want to see profits. It's profits that provide support for stocks. And so I think it's likely to flow into the ad market. Across the space.

For investors, the takeaway seems clear: stick with the giants, maybe, and steer clear of the small fries. But keep in mind that valuation matters. If a company is challenged but also cheap enough, its shares might be worth buying. And that's just what Lloyd sees with Snap.

If the Street numbers come down by 18% for 2022 revenue, and they decline another 5% next year, a pretty draconian scenario, and if Snap troughs at its historical trough multiple of 5 times revenue, that's about $13, which is what we hit yesterday. So it does feel like it's completely washed out. If you have duration, if you can wait out until things get better, I think there's huge upside in the stock in our bull case.

Lloyd calls Facebook controversial but also, quote, incredibly cheap. And he says it can make money on things that are under-monetized now, like Instagram Reels, which are short videos sort of like on TikTok. Alphabet, Lloyd says, could have a fair amount of downside from here if we go into a recession, judging by where it has traded in the past. But he says shares are attractive for long-term investors based on the company's earnings stability and its opportunity to sell more ads on products like Google Maps, and the likelihood of Alphabet's cloud computing business growing from operating losses into profits. And I'll mention Amazon because it does a growing business in ads for product searches. By Lloyd's math, the company's cloud computing business is worth $1.3 trillion, and Amazon as a whole was recently valued at $1.2 trillion. That means that stock buyers, in Lloyd's view, are getting the e-commerce business for free. He predicts the company could reach $100 billion in free cash flow in 5 years. There are only 2 companies that are remotely that profitable today. One is Saudi Aramco, the state oil monopoly of Saudi Arabia. The other is Apple. How about a quick word about small caps before we get to chips? We've talked before about how growth stocks are getting punished due to rising rates. Credit Suisse recently pointed out that price-to-earnings ratios for large-cap growth stocks have come down by a median of 37% versus 26% for the broader S&P 500 index. The selling has been bad for small-cap stocks too. P/E ratios there have also come down by a median of 37%. So what has happened to stocks that are both growth stocks and small caps? Something unusual.

All of a sudden, growth companies are trading at a discount to value companies. So if you look at the S&P 600 growth versus the S&P 600 value, the growth stocks are actually trading cheaper on a price-to-free cash flow basis than the value stocks. And that's kind of head-scratching.

That's Brad Newman. He's the director of market strategy at Alger, which manages more than $20 billion with a focus on growth stocks. Brad calls the discount for growth stocks head-scratching because growth stocks are supposed to be more attractive on just about everything except price.

Not only do these growth companies grow faster than value stocks, obviously, but they have generally better return on capital, or at least return on incremental capital. They have better balance sheets in the forms of lower debt. Generally higher margins, or at least higher gross margins. All those things should lead you to want to pay a premium for growth stocks over value, and typically you do.

Brad also says the growth stocks typically underperform following the beginning of a rate hiking cycle from the Federal Reserve, but only for a few months. And the Fed started hiking in March, so Brad thinks growth stocks could begin doing better this summer. I asked him to tell me more about that.

Value stocks typically outperform 6 months prior to the rate hike through 3 months after the first rate hike. Why would that be? Value stocks are typically more cyclical, more economically sensitive. You know, think about what's in value. You've got things like banks and financials, energy, materials, industrials. They do well when the economy is doing well. And why is the Fed ever raising rates? Well, they're doing it to slow the economy. So before they do it, certainly the economy's growing well, so value stocks should be in favor. But once they raise rates and the market starts to price in that, oh, the economy is slowing, then you probably want to be more in growth-oriented secular-driven companies that are less economically sensitive and less weighted in economically sensitive value stocks. And I think that's probably what's going to play out as the market continues to price in more and more probability of a recession.

I asked Brad for 3 stocks he thinks investors should buy now, and all of the ones he mentioned generate subscription revenue from software. He says they're all deeply integrated into their customers' businesses, which makes them somewhat defensive, and they all have strong balance sheets. The first is Avalara, ticker AVLH. They help companies automate what's called transactional tax compliance.

You click on a company's website and order something, could be apparel, could be electronics, could be, could be anything. Unbeknownst to you, there's a lot of tax compliance that that has to go through. Could be shipped from one country, arriving in a different country, in a particular state with its own tax consequences. And all of that is very hard for kind of a human to figure out and process each transaction. But for a computer system, and particularly software that has a good database of what all the tax implications are of different jurisdictions, You know, it's not that hard.

The second company is Bentley Systems, and the ticker there is BSY. You think it would be BS for Bentley Systems, and BS was definitely available when the company came public 2 years ago because that's the old Bethlehem Steel. So that's been available now for almost a couple of decades, but no takers so far. Jackson, this is a SPAC opportunity.

Smells bullish.

So Bentley Systems, BSY, makes software for infrastructure engineers. Here's Brad.

You know, think about like a liquid natural gas terminal, very expensive, complex, takes a long time to build. Well, you want to make sure that when you're building it or maintaining it, you understand every aspect of it. So this software is used by engineers to kind of simulate the build process where there could be structural deficiencies, model it in 4D, you know, predict various outcomes.

That's a niche business. Bentley generates solid free cash flow. I asked Brad about how important it is to him that his stocks produce free cash, and he says no one goes looking for unprofitable companies. But if a company has attractive gross margins, meaning its products or services are lucrative before taking into account corporate costs. And if it's growing into a large market, then free cash flow will come. The third stock he likes is called Guidewire Software, GWRE, which serves more than 450 insurance brands including MetLife and Nationwide. Guidewire has 3 times the market share of its nearest competitor and is in the process of moving its software to the cloud.

When you're writing insurance, you need all the data points you can get. And so they have artificial intelligence that helps these companies do analytics. There's 85 million transactions per day running across the platform, 100 million policies in force. And so all that data helps their clients, um, write better insurance policies.

Thank you, Brad. Time for a look at chips, including Broadcom's big deal, when shortages will end, and which stocks to favor now. That's next after this quick break.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.

Welcome back. There's a California chip company called Broadcom, which is not as well known as another California chip company called Intel, but which is actually larger by stock market value and at the moment by free cash flow. Broadcom has long made what I would describe as doodads, some of which have been fairly forgettable, like mouse sensors, and others of which have become enormously important, like filters that enable high-speed data service on smartphones. The company has also become what you might call a roll-up, a business that specializes in buying other businesses. The chip industry had a lot of subscale players, meaning small companies with good products. Earlier I mentioned gross margins. If a small chip company has excellent gross margins but lousy operating margins, it could be a sign that customers are willing to pay up for its products, but the company just isn't big enough to make up for its corporate overhead, and one fix for that is for a bigger and more efficient player to buy that company and its products. That's basically what Broadcom has done, and it has been remarkably successful. 20-year holders of the stock have made 4,000%. The ticker is AVGO because the company used to be called Avago Technologies. It bought Broadcom in 2015 and took the name. Now, in 2018, after Broadcom had failed to buy another chipmaker called Qualcomm, it reached a deal to instead buy CA Technologies, and that one made investors a little nervous because it meant that Broadcom was going into software for big organizations instead of chips. But it's done well with software too, so when news emerged this past week that Broadcom was buying another software maker called VMware, it made perfect sense. Timothy Arcuri, who covers Broadcom for UBS and is bullish on the stock, wrote in a report that the two customer bases go together nicely and that although Broadcom will be left with more debt, it should be able to quickly pay it off. Earnings next year and the year after that could get a 10% boost from the deal. Free cash flow could hit $20 billion a year, and as early as next year, Broadcom could boost its dividend to a level that would give the stock a yield of about 3.5%. That's more than Intel pays. Timothy also wrote that the VMware deal would bring Broadcom's semiconductor exposure down to about 50%, which could work out well if the semiconductor cycle rolls over in the quarters ahead. And when I read that, it was a bit of a record screech moment. That's a little cliché. What else you got, Jackson? Yeah, when I read that, it was a bit of an a-wooga horn moment. We've been talking for so long about chip shortages. We're still talking about them for cars and other goods. So why is Timothy discussing the possibility of a chip downturn? I reached out to ask him.

You can look at it upstream and downstream, but it all starts downstream. That's what pulls components at the semiconductor level is if downstream, which is, when I say downstream, I mean all of the contract manufacturers and all the companies that build stuff that consumes semiconductors. If inventory is chasing demand, then they're in the inventory build part of the cycle. However, once inventory starts to grow and it begins to grow faster than revenue, that's when you get into the back half of the cycle. And in the past few quarters, you've seen inventory downstream has begun to grow.

If you're not used to the terms upstream and downstream, and if you're not a salmon, that might be confusing. Basically, the companies that buy chips to put them in products had a difficult time getting all the chips they wanted, so they over-ordered. And that's difficult to do precisely, especially when lead times are long. Here's Timothy.

When you're a customer and you need 5 of any given widget and you're told, "Well, it'll take a year and a half for you to get 5. I can ship 3 of them to you in a year." So, you know, what are you going to do? Well, you're going to place orders for 2 more because you need 5 on the hopes that you get the extra 2 sooner. And so, you know, now you've got 7 on the books when you only need 5. But from a chip company perspective, you think there's demand for 7 when really there's only demand for 5. And there's certainly a lot of that that's happened. And I kind of call that supply buy that sort of creates artificial demand.

Timothy says everything now depends on consumer demand. If it remains healthy, companies can make good use of their chip inventories, but if end demand softens, the industry could go straight from shortages to a glut. That would be particularly bad for chipmakers with a lot of consumer exposure, unless they're benefiting from growth trends that aren't tied directly to the economy. Timothy likes Broadcom because the markets it serves, like data centers and infrastructure, are likely to hold up relatively well. He also likes Nvidia.

Nvidia is a core holding, and, you know, you can talk about valuation, you know, where you want to buy it tactically, but this is going to be a huge piece of the digital transformation of society and of all these 3D worlds. I mean, I don't mean to use, you know, Ready Player One as an example, but There's a lot of aspects of our life that are going to become a lot more like Ready Player One, and the company that's going to make all that happen is NVIDIA.

When Timothy mentioned Ready Player One, he was talking about a 2018 movie about virtual reality. I haven't seen it yet. Jackson, 10-second synopsis, go.

I read the book.

Uh, stop bragging. Go ahead.

The world's bleak. Everyone lives in trailers that are stacked up on top of each other, and so they spend their day in virtual reality.

I can't believe I haven't seen that one yet. You make it sound so fascinating.

I'm available for preview voiceovers.

Thank you, Brad, Lloyd, and Timothy, and thank all of you for listening. Jackson Player One Cantrell is our producer. Subscribe to the podcast. Thank you all for the lovely reviews on Apple. You can follow me on Twitter, that's @jackhoug, H-O-U-G-H, and Jackson is no longer on Snapchat. See you next week.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.