AI Will Benefit Big Tech, Not Just Microsoft – Julian Lin With Kirk Spano

Summary:

• Margin of Safety Investing’s Kirk Spano talks to Best of Breed Growth Stocks’ Julian Lin about AI hype and mega-cap tech stocks.
• Is Microsoft fairly valued?
• Bing, ad revenue and Google.
• Contextualizing Meta’s parabolic moves.

Listen to the podcast embedded above or on the go via Apple Podcasts or Spotify.

• Is Microsoft (NASDAQ:MSFT) fairly valued? (0:28)
• Why is Microsoft pumping AI so hard? (7:20)
• Bing, ad revenue and Google (NASDAQ:GOOG) (NASDAQ:GOOGL) (10:30)
• Contextualizing Meta’s (NASDAQ:META) parabolic moves (14:10)

This is an abridged version of our recent conversation, Julian Lin And Kirk Spano Unpack Mega Cap Tech Stocks.

Transcript

Kirk Spano: Why don’t we start with Microsoft (MSFT). I know it’s not your super favorite stock. So let’s go there first. Tell me what are you seeing with Microsoft? It got quite a pop here on the stock price. I have some thoughts about the AI hype.

What are you seeing with Microsoft? What do you think about the share price? I think that most of us probably know that it’s a fortress company. But investing is about getting good value for what you’re buying. So why don’t you tell me what are you seeing with Microsoft in the cycle?

Julian Lin: Yes, so Microsoft, in my most recent report, I gave it a buy rating. But I also cautioned that it’s mostly a buyable rating, especially compared with some of the mega cap tech peers that I greatly prefer more than Microsoft on valuation. In regards to Microsoft, it’s — yeah, so as you mentioned, it’s being viewed as a fortress company. And that’s definitely driving the valuation. I’ll discuss my views on that in a moment.

I think the results heading into the quarter, I expected that the results will show some macro impact. But I didn’t think Wall Street would care too much, just because at this point, it’s becoming clear that the stock is being driven by this hype around AI, potential for Bing Search to become more popular.

It really didn’t matter so much what they reported. Just I mean, for starters, the stock wasn’t necessarily in a bubble, like a meme stock valuation. It was around 30 times earnings. Not cheap. But it’s fitting this narrative of being driven by AI and hype for Bing.

In the quarter, they did show some strong Azure growth. But it did seem that some of that growth was funded because they gave some money to OpenAI. But of course, that’s not necessarily a bad thing. I think in regards to my personal view of the outlook for the company, I think, whereas Wall Street is viewing Microsoft as being a safe haven in tech I view things differently.

I think Wall Street’s been very quick to reward Microsoft for the premium valuation relative to Google (GOOG) (GOOGL), Facebook (META) or any other enterprise tech company. The narrative might be that Microsoft is more insulated from regulatory intervention, which might be true, but more importantly, there’s this sentiment among Wall Street that Microsoft has maybe a best-of-breed enterprise tech portfolio or they have — like they’re safer. They’re not going to be disrupted. If anything Wall Street seems to think that Microsoft’s will disrupt all these smaller operators.

There’s this idea that because Microsoft is this big mega cap tech titan, they could just throw money at any product, and they will have a superior product offering to anything else. Take for example, Zoom (ZM), right. We’re recording this on a Zoom. Zoom stock is trading much lower than pandemic levels, or even pre-pandemic levels, largely, in part, because Wall Street views Zoom as maybe being disruptible by Microsoft Teams. That’s their offering. But if you’re actually looking and following that tech sector closely, you’ll see that the narrative is actually not -maybe not so true.

For example, even with just videoconferencing, Microsoft Teams, it’s not quite a comparable offering to Zoom. Whereas Zoom is very — it’s just a much more robust offering. Microsoft Teams leaves a lot to be desired. Even in cybersecurity, where Microsoft has a presence with Microsoft Defender and Endpoint Protection. Microsoft is losing. It’s not really competitive with the likes of CrowdStrike (CRWD) or SentinelOne (S). It’s quite well known if you’re looking for security, if you’re in the sector that Microsoft is not really defending, or not really offering good protection.

So there’s this mismatch of the narrative that Microsoft is much more superior than other smaller tech plays. And thus it deserves this premium, 30 times earnings multiple, even though earnings – revenue growth probably slows to the mid-single digit rate, over the coming years. So I mean, this 30 times earnings multiple is pricing Microsoft like a consumer staple stock, quite clearly, something that’s very consistent, should be able to just grow forever, while it takes market share. But there is the risk that at some point that Wall Street realizes that their fortress is not as strong as it seems.

KS: Yeah, I think you really brought up a couple things, I want to go back to. And I think we’re going to merge it into a discussion with the other two big cloud players, which are Google and Amazon. But you mentioned the valuation, and I’m a Peter Lynch guy. So I like PEG ratio, forward-looking PEG ratio, and at a PE of 30, but a growth rate of say, around 10, you’ve got a PEG ratio of about three, which is really high. And Peter Lynch always talked about you want a PEG ratio between one and two.

Small caps, you can often get for around one. Sometimes you get them under one, because people just don’t recognize what they’re looking at. But all your large caps will get a bit of a premium valuation. So maybe it’ll be close to two, and you can still call it fair value. So I think you’re spot on that Microsoft might be getting overvalued. We took a look at Microsoft on that last decline, because we were wondering if the AI hype would give a kind of a V shaped recovery, kind of one of those parabolic rebounds. And that’s what’s going on, especially the other day, when it go up $15 a share.

So we’re taking a look at the chart. And that’s the fourth leg in our process. We look at secular trends, and then governments and central bank policy, then the fundamentals of an industry and the companies involved. Then finally we use tech and quant analysis. So I’m a quant, and my partner is Elliot Wave and Harmonics tech analyst. So we take a look at all this. And we take a look at the chart on Microsoft right now. And as an author, you’ll understand what I’m about to say.

If I go out and say that I think Microsoft is overvalued, and it can correct 20% or 30%, I’m going to get beat up with trolls and big keyboard billy clubs, right.

JL: Yeah.

KS: So with Microsoft, I think I’m on board with you. I think that it’s getting to a point, and tell me if you think I’m right, or at least it’s something to be concerned about, I think it’s getting back to a point where it’s approaching its all-time high. And if it doesn’t break out from there, which would be unusual on a parabolic move, then I think that you have a pretty significant bleed down on Microsoft that could occur, especially relative to some of these other big tech stocks, which there’s seven companies that kind of drive the entire S&P 500. I guess you throw in Salesforce, there’s maybe eight or nine. But you take a look at the giant companies and I don’t know, I think Microsoft might be kind of priced for perfection. What do you think about that?

JL: I think that’s definitely a reasonable assessment that I could agree with. I think maybe investors should be wondering, why is Microsoft kind of behaving a little bit like a meme stock? It’s definitely trading, sort of like with this narrative investing that got so many tech investors in trouble, before this crash. I think another question to ask is why is the Microsoft management seem to be kind of pumping AI so hard, given that it’s kind of a small, very small, not really significant component yet.

Of course, it’s possible that Bing becomes much more successful, but at the same time, Microsoft, it must bear repeating Microsoft is already a very, very big, big company. So I mean…

KS: Hard to move the needle.

JL: It’s hard to move the needle, right? It’s 30 times earnings, just to give an idea, right, if you’re talking about Microsoft at 30 times earnings, Google at 20 times earnings. And Google — and I’m sure we’ll discuss Google in a moment. Google, it’s the valuation should be — it’s actually even cheaper than 20 times earnings, just due to some loss generating businesses. With Microsoft I mean, just they could grow their earnings by 30%. And assuming Google doesn’t do anything, it’s the same valuation. But there’s an important distinction I think tech investors must understand with Microsoft and other companies in that I’m of the view that Microsoft’s margins are quite tapped out. Meaning that — I mean, I’m sure many have seen all of the layoffs happening in the tech sector, which quite unusually, right, you’re seeing all these tech companies do a very large amounts of layoffs with seemingly minimal impact to their growth rates.

Yes, it’s quite true that in the tech sector, these companies, they’re kind of over investing in growth, which is good and bad. It might be bad in that it means that the profit margins are lower in the near term, but it’s good in that in the future, right, I mean, this just reflects a lot of fat that can be taken off. You could compare this to companies like Walmart, or your neighborhood grocery store, which are probably operating very lean, right. So you can’t really expect so much margin efficiencies from those more mature companies going forward. But from a company, like maybe Facebook or a Google, there’s still a lot of fat left on the bone, even though they’re already generating high profit margins. But I can’t really say the same for Microsoft.

So you get this weird mismatch, where forward revenue growth is probably going to be mid-single digits, earnings growth, maximum, high-single digits, double-digits for a couple years, but it’s trading at 30 times to earnings. So definitely, I would think if this hype for AI were to subside, and if investors were to start focusing on, maybe comparing Microsoft to more cheaper, mega cap alternatives, I mean, the stock could be due for some volatility.

KS: So if we flip over to Google since the ChatGPT, and Bing is the hype, and Google is the one that’s the leader, what do you think about that? Do you think that Google has a lot of exposure there, or if it’s around the edges? I have an opinion, but I’d like to hear what you think. Is Google really exposed there? Or is it more of a minor consideration?

JL: Do you mean exposed to the threat of ChatGPT?

KS: To Bing taking some of their advertising revenue.

JL: Got it. So it’s definitely a possibility. I think search are similar to any like social network media thing. It’s not necessarily the best product that wins. It could be the most viral product that wins. I think Nicholas Nassim Taleb, in his book Fooled By Randomness, noted how even Microsoft right, even when Bill Gates became famous by being very successful with Microsoft Word, and all those Office suites, those weren’t not necessarily the best products all the time, but they were the most used products and the most popular products. And it was a winner take all scenario.

So yes, it’s possible that Google right now they’re the dominant leader. It’s possible if, for example, Bing were to become more and more popular, but the newer generation is that, that trend could shift. But I think Wall Street’s been quite quick to believe this narrative as almost a certainty, and I think they’re under estimating Google’s ability to invest. I think there, for starters, it’s not like more search activity on Bing just immediately drives so much more advertising business. Google is definitely benefiting from the fact that they have this huge network, they have this huge scale, advertisers are going to be more willing to do more consistent business with them. That’s just a fact.

So I think that right now, Wall Street’s very bearish on this idea that AI could disrupt search, but they’re underestimating the ability for AI to actually benefit Google. Google, I mean, right now, yes. The common public may view Microsoft to be a big leader in AI. But the reality is that it might be different. I think, Google, Amazon, Facebook, all three of these companies, arguably have actually — may probably have been investing heavier in artificial intelligence, than Microsoft in OpenAI up till now. The only difference is that they haven’t traded this generative AI customer facing chat bot that would give the impression of being in the lead.

So I think, Google, I mean, they’ve been using artificial intelligence already. Like Facebook, in the earnings call, they highlighted that on average 20% of what their users see on the feed are recommended by artificial intelligence. These are posts from people, traders that the users don’t even follow, but the AI just knows that they will like it. But at the same time, no one’s really saying, oh, Facebook is a big AI play.

But in regards to Google, I think AI, yes, I mean, if there’s a chat bot that might reduce the gross margin on search. But I think investors are missing the point. AI at the same time could reduce other costs, other ways, right. It could increase the efficiency or the relevance of the search results. It could reduce the operating expenses related to, I don’t know, content management. It’s not such a one-sided view that the Wall Street is taking.

I think AI is going to benefit all of these companies enormously, not just Microsoft, even though Microsoft seems to be the only stock that is going up due to AI.

KS: Amazon (AMZN) and Google, I see a lot of disruption coming in the post-TikTok world, which I think is about to happen. I think that there’s some winners from that, too.

So if Congress actually decides, hey, it’d be popular to pick on China, and they get rid of TikTok, who are the winners there? Well, I think YouTube is a clear winner there. Right. So they just introduced shorts.

And then Facebook, Meta is a winner there. And that was a company that when it was 250, 300, whatever the heck it got up to, I told everybody it would go back to 100. It was in an article on Seeking Alpha. And man, again, keyboard trolls, man. I took it right on the head. But then it got down to 100. And I should have loaded up, I should have backed up the truck. It did exactly what my chart said it would do. It went through the business change that I expected and I didn’t buy it.

So now Facebook (META) is up whatever it was, 15% the other day on earnings. I think there’s one pull — I think there’s a pullback coming, just because it was too parabolic as well, as you alluded to earlier, they’re going to have to do some spending on AI. And Zuckerberg just said that. So tell me about Facebook, Meta, Meta Facebook, I call it Meta Face sometimes. Are they aligned enough good for the future? Because I don’t know. I’m not a Zuckerberg fan. I wish he just becomes Chairman, and hire somebody likable to be CEO, because then I think he could get back into the young market. I don’t know there’s something about that dude, I don’t like. And maybe it’s me. Should we be thinking about getting back in there? I think you’re probably already in there.

JL: Yes. So Meta heading into this print, it was my largest position by far. And I confess that, after the — today and yesterday, I did sell some Meta to put into Amazon. But Meta remains my number three position. I remain — I realize a lot of investors might be looking at this parabolic move in Meta, and thinking, oh, it’s time to take profits. It’s too expensive. It’s 20 times, 29 times earnings. But again, I’m in. So it had gotten too low. So to kind of view this relative performance and be like, oh, it’s overvalued. I mean, you got to understand it was too low at 100. So maybe, maybe comparing the current price to wherever it got at the lowest is not the best comparison.

And in my view, Meta definitely represents a very bullish thesis at this point, right. And this past quarter, what we saw was the company, I guess, let’s frame it this way. The company was facing headwinds from both Apple, this idea that due to the privacy changes, they will lose the ability to monetize certain advertisements as much, as well as competition from TikTok. These are the two most important issues. I mean, again, besides just the tough macro that’s affecting everyone. these were the two issues facing Meta. But this recent quarter, and to that regard, the past two quarters even Meta has executed very strongly, right.

So we’re seeing user growth return. There was this one quarter, I think it was three quarters ago where users declined sequentially. Users — user growth has returned, right. And revenues grew again this quarter, and operating expenses, even though there was a lot of those restructuring charges, in this quarter, operating expense — operating margin was — declined by a lot less than it has in the past couple quarters.

All right, this is a company that it’s — in spite of the fact that CEO Zuckerberg is really investing in this Metaverse vision, even though they’re investing, I think at this point, it’s a run rate of, $15 billion annually on the Metaverse. That’s a lot of money. They’re spending that much money on this thing that might not happen for next 10 years. But they’re still making this much money, right. The stock is still trading at 29 times earnings after Metaverse investments. And I think there’s two things that investors should keep in mind when thinking about Facebook stock going forward.

The first one is that earnings should go up. One, I mean, as the macro improves, the revenue growth accelerates, this company is executing against competing against TikTok (BDNCE) and as you mentioned, Maybe TikTok gets banned. That would be extremely bullish for Facebook. I think, just a couple quarters ago, I might have been of the view that Snapchat would be the biggest beneficiary of a TikTok ban. I mean, and they might still be but the problem is that I think over the past couple quarters, amidst this intense competition from TikTok Meta has taken advantage to take market share from Snapchat as well. And there’s a big difference between these two companies in that, whereas Meta is deeply, deeply profitable and investing heavily, right, in innovation, Snapchat wasn’t as profitable.

So when TikTok became so strong, Snapchat just was not able to invest enough to stave off that competition. So I think in a TikTok ban, Facebook, they will — there will be a big impact to the top and bottom lines, although I know, I’m not really factoring in a ban in my bullish thesis for Meta. But besides this you got to focus on the fact that Meta did lay off 21,000, roughly 21,000 workers. I should preface by saying layoffs. I’m not going to say layoffs are good for society or anything, I definitely feel for people who lost their jobs. But just as an investor in Facebook, right an investor in the Meta stock, the reality is that when the company lays off 21,000 people over five months, and I note that five months ago, Meta had like 80,000 headcount. So they laid off 25%. This is a huge company, which is already extremely profitable. They laid off 25,000 of their headcount, just like that. And this is not something that they had to do, right.

So this is not like, oh, when the economy improves, they’re just going to hire them all again, or whatever. No, this company, even CEO Zuckerberg, which a lot of people seem to dislike, they’re showing this focus on profitability that Wall Street has not seen before, okay, or at least from this company, right? Perhaps maybe — and this has happened a lot around tech, where Wall Street was of the view that these tech companies, they just could not be profitable. These management teams did not care about profits. There was just that prevailing view, when in reality, it wasn’t really the case. It was just these management teams wanting to invest in growth.

And then now that the tech stocks crashed, a lot of these management teams have taken steps to show oh, actually, we could show profits, right, like here Meta is laying off 25% of their workforce while still maintaining this growth rate. In other words, as the macro improves, revenue growth comes back and but their operating expenses don’t. That’s a big, big thing.

I mean, just for an example of how dramatic that change could be. Just look at Uber (UBER), look at the financials of Uber going into the pandemic, and coming out of the pandemic, right. Going into the pandemic everyone thought of Uber as a cash guzzling, they’re just losing money on a non-GAAP basis, which is pretty bad. Now Uber is generating actual cash flow, obviously, on a non-GAAP basis, but it’s night and day.

Facebook, heading into this was highly profitable. What happens after they have 25% less headcount moving forward? It’s unusual. So I think that as Wall Street is viewing this somewhat hyperbolic rally in tech stocks and Meta, yes, there’s very likely that there’s always going to be pullbacks. That’s just the reality of the stock market. That’s how it works. However, Wall Street may still be under estimating this impact. The cost rationalization happened across a lot of these tech companies, just even just on a two year, three year timeframe, you should start to see the positive effect of these layoffs on the bottom line.

KS: Yeah, I think that that’s a pretty astute observation. Again, I’ll go back to the Amazon example of when they suddenly put up big profits. We’re a year into an earnings recession. I think four out of five investors don’t know that. Earnings have been coming down for a year. That means that we are less than a year away from the comps looking really good for a lot of companies. And that could be even sooner, could be as soon as this autumn, could be October. But within a year from now, this earnings season, your comps are going to look pretty good because I don’t know if we’re bottoming out on earnings right now, if there’s maybe one more quarter because of the banking tightness, maybe getting a little tighter. We’ll see. We’re close though.

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