ZDNet, the website for information technology professionals, is currently running this cool feature how technology from the 2000s changed our lives, from the iPhone to Twitter. Collectively, the site’s retrospective spans 50 years. It is remarkable to think that technology has evolved and impacted us so profoundly over the course of five decades and continues to do so. Facebook (NASDAQ:FB), Twitter (NYSE:TWTR), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Apple (NASDAQ:AAPL). Many of these companies are a part of our lives on the daily, sometimes hourly. Some of us may recall the days before these tech behemoths pervaded our lives – before there was an Internet, even (yes, there really was a time the Internet didn’t exist). Now, it’s hard to imagine life without gadgets, search engines, blogs, and smartphones. In fact, technology is so pervasive, it seems, it may actually be giving the stock market a much-needed lift.
Where will technology take us next? It’s anyone’s guess, and Erich Reimer has a few. The author of Tech Investment Insights on Marketplace is excited about artificial intelligence, self-driving cars and data science automation (basically, the process of extracting knowledge or insight from data in various forms). These were once the outlandish ideas that made up the plots of futuristic space movies – now, they are being actively developed, and some, like self-driving cars, may on the cusp of commercial release. It is an exciting time to be in technology, and Erich brings his know-how and experience in this and other sectors to bear for Tech Investment Insights members to help them discover and capitalize on opportunities in this fast-moving, often misunderstood, and potentially risky space. In today’s Roundtable, he takes on Twitter, the mounting rivalry between Netflix (NASDAQ:NFLX) and Disney (NYSE:DIS), and the General Data Protection Regulation (GDPR), which became effective last week.
Seeking Alpha: Anyone who follows you knows you cover a lot of tech names. What about the tech space appeals to you? How did you first start investing in the sector?
Erich Reimer: My initial interest in the sector came from growing up amidst the early stages of the digital economy and seeing firsthand how quickly technology was developing and the impact it was having. It seemed, every month, there would be a new type of increasingly advanced cell phone or software product, as well as new lines of business for companies involved.
The real growth in the technology sector beginning in the late 2000s and throughout the 2010s was different from the tech bubble of the late 1990s in that there were no real revenues, earnings, and seemingly lasting business models. Essentially, the sector was investable, even if the underlying business confounded those who did not understand the products themselves.
SA: This article from Investor’s Business Daily says that the tech sector is buoying the S&P 500 with its 8.5% increase in 2018 and 25% weighting. Do you agree with that sentiment? Would it be a down year for the S&P without tech?
ER: Without technology, I think the overall markets would definitely be down. The recent turbulence with oil and tariffs hit non-tech sectors much more than technology, although tech companies based in hardware, which in production and assembly is heavily globalized, are affected to a degree as well.
While software products and other digitized intellectual property remains a point of tariffs contention with nations such as China in particular, the present situation has remained very stagnant and is unlikely to change significantly.
SA: What’s driving tech stocks higher right now?
ER: At the moment, it is primarily advancements in hardware that increase processing and computation ability, as the miniaturization revolution continues unabated even at its current stage. We see this with new products such as Apple’s iPhone X, Nvidia’s (NASDAQ:NVDA) boom in GPUs this past year, and in a variety of other new devices ranging from content streaming boxes to more efficient data-centers.
Very much linked to this is the corresponding link in software capabilities, specifically with the boom in artificial intelligence that has been brewing in recent years but is only coming to business fruition both at the moment and even more so in the upcoming year or two.
We see with companies such as Amazon (NASDAQ:AMZN) how cloud computing has been an enormously profitable revenue source. Blockchain and cryptocurrency have also similarly commanded great financial interest and likely will continue to do so. These software advancements are only continuing and are made possible by the development and distribution of the hardware able to host and process said activities.
I believe the biggest disruptive business lines for artificial intelligence and other high-level computing in the near-future include virtual reality, which will not only affect the gaming industry but entertainment, business presentation, simulations and training, and more. Self-driving cars also appear be nearing retail rollout. On a broader level, data science automation will begin to truly transform industries as well in a similar way manufacturing automation did. It is an exciting time with many companies poised to benefit greatly.
SA: Conversely, what factors, either known or that perhaps investors or the market haven’t priced in yet, could be potential headwinds for the sector?
ER: I believe the biggest potential headwind right now is government regulation. Although the product and business sides of technology companies are seeing massive innovation and growth right now, it seems that governments, whether regulatory agencies or legislative bodies, are increasingly now willing to put restraints on those activities.
In prior years, most governments adopted a hands-off approach due to seeing the massive societal and economic benefits of technology as well as the lack of any real negative impacts, scandals, or misuses, besides in data security against breaches.
However, now, it seems governments and regulators are increasingly distrustful of technology companies themselves. While the Facebook Cambridge Analytica events created a firestorm of public interest in the power and potential abuses of tech companies, regulatory sentiment has been shifting for a while – with an example being that Europe’s GDPR that went into effect recently was originally enacted back in 2016.
The precise form regulation takes could vary wildly and even differ greatly by region, although of course the United States still remains the prime mover and shaker in terms of setting the tone and its own massive impact. The policymaking process often acts as a reaction to events, meaning the most likely immediate regulations are going to be restricting data collection and usage.
How future regulatory events will develop remains uncertain, but undoubtedly now regulators are much more willing to act than before.
SA: Let’s delve deeper into the General Data Protection Regulation (GDPR) from the European Union that just became effective on May 25th. Can you go into more detail about what that is, why it matters, and does it have any wide-reaching implications for the tech sector and its investors?
ER: The regulation was adopted in 2014 and went in effect only a few days ago. While it has a large variety of provisions, essentially it creates a new requirement of data transparency, user control, and opt-in for all tech companies operating in the European Union and the European Economic Area. Explicit opt-ins are required for many forms of data collection, and there are certain standards required for data storage, encryption, protection, and reporting breaches.
Europe has always had a greater interest in personal data privacy than the United States in regards to technology, and indeed the GDPR is a manifestation of that. With many technology companies deriving a significant portion of their revenue from Europe, the GDPR may indeed be mildly hazardous to companies that rely on data science in particular if users really are reluctant to opt-in. It also affects a variety of non-tech companies that still utilize Internet and software-based data science and collection for various purposes.
The effect on markets likely won’t be substantial as there was an over two-year forewarning for this regulation. Most aspects of the regulation will not affect company business lines, even in Europe, too much as they generally focus on data encryption and security. However, the data collection opt-in will need to be watched to see how many users really do opt out, as they may throw a potentially significant wrench into companies, such as Google and Facebook, that rely deeply on data science to provide targeted advertising.
There also is the risk of a “regulatory chain reaction,” with Europe being an influential source for regulatory regimens. Even if the United States does not follow similarly, with both our general increased favor for free markets and acceptance of Internet-age lack of privacy, other nations may follow similarly. Whatever negative GDPR opt-in effects would then be multiplied. For now, though, we have to watch closely and see how it impacts average revenue per user in Europe and other similar analytics and financial information.
SA: Investors often see tech as a higher-risk asset class, as you’ve pointed out before. But you have ways of mitigating that risk. In fact, you have said, it’s not necessarily about risk – tech stocks are just “different.” What does that mean? How are they different? As such, how do you and members of Tech Investment Insights manage any risks you do encounter?
ER: To many people, tech companies are confusing because they follow a different life cycle than many other businesses. A company can be unprofitable for years, such as Amazon, yet still reasonably soar in valuation. In contrast, almost any other traditional “brick-and-mortar” company is expected to show profitability and sustainability in its business model much quicker.
Tech companies, even after going public, are always still experimenting with new business lines and products constantly. This is because the technology sector is advancing so quickly and constantly in terms of the technologies themselves the companies need to always keep up. In contrast, most other sectors see companies achieve a sustainable business model and mostly focus on accessing new markets or gaining market share, with the occasional technological breakthrough or other paradigm shift creating disruptions.
Therefore, in evaluating tech companies, it’s important to understand what exactly the company does, the specific sub-sectors it operates in and is connected to, and how different many of these companies really are even if they seem similar in business type, nominal age, or market cap size. Combined with the complexity of the underlying product and business at many tech companies, this can make technology a very confusing sector for many to analyze, particularly as the technologies themselves continue to develop rapidly.
At Tech Investment Insights, I look in-depth at a company’s business, structure, history, competitors, sub-sector, and potential future to determine its precise risk-reward profile. I provide my subscribers with a holistic analysis that takes into account the interaction of this large variety of complex sector fundamentals and individual company characteristics to provide a recommendation and determination, as well as a relatively straightforward rating system in which I shift a variety of companies into different risk-reward categories that are easy to understand and use for the regulator investor.
SA: You have business relationships with some of the management of the tech stocks you cover. As industry insiders, they likely have a unique perspective on the sector. What are they observing with regard to how the industry may evolve, say in the next six or even 12-18 months?
ER: The technology sector is constantly rapidly morphing, and it is difficult to predict with great certainty even a few years down the line, but it seems right now they believe the big advancements are in the breakthroughs in artificial intelligence, or essentially an extremely advanced form of data science.
While data science has been seen as an advanced form of analytics, “real” artificial intelligence and its corresponding products, such as “smart homes,” virtual reality, self-driving cars, automated human functions, etc., are a whole new market that is only now imminently being rolled out to the retail and business markets.
The monetization opportunities are immense and could be a huge boon for companies down the line. As we’ve seen with cloud computing, there may be a bit of a delay as customers, particularly businesses, try and test out programs before adopting them fully, but even so, the revenue impact could be enormous as tech really transforms again all the other industries and society as a whole.
Called the “Third Industrial Revolution” by some, with the “Second Industrial Revolution” having been the original creation of the Internet, it indeed could transform everything on a far greater and faster scale than even the incredible developments of the past decade.
SA: You’ve written very recently that the Netflix bubble now borders on the absurd, and that it’s in for a “hard landing.” What does that look like, and what do you think is the timeframe for such an event? Any thoughts on what the catalyst might be for that ultimately fall back to reality?
ER: Netflix still retains an extremely high growth multiple, 200+, even at its current over $160 billion market capitalization. The market’s extremely optimistic expectations are based on continued Netflix growth as it has done in the past, particularly in international markets.
I believe Netflix will be most seriously challenged in 2019 by the launch of Disney’s streaming subscription service, and even before that by Facebook’s increasingly successful “Facebook Watch.” Even YouTube and Amazon Prime Video are still hanging on, with their massive parent companies figuring out new potential innovative ways to keep them going.
The biggest real game changer for Netflix though is Disney, I believe. Netflix’s rise in recent years has been heavily due to Disney’s star-power brands, ranging from Marvel to Star Wars, which appear to remain vibrant and growing. Disney is already in the midst of pulling all that content in preparation for its own service, which it will also develop new content for at potentially a lower price than the still-cash-burn-heavy Netflix.
Once Disney officially launches, I believe we will soon begin to very quickly see a slowdown in Netflix’s growth numbers as well as a potential even greater increase in content costs than its already-incredible (and increasing) $8 billion for 2018. At that point, Netflix’s multiple could contract greatly – with a corresponding plummet in price and valuation. A slowdown or reversal could even happen before then, as the market begins to see the potential risks.
SA: GameStop (NYSE:GME) is one of those companies that has had an extremely rough go of it in the past few years. Used video games and consoles aren’t really “hot ticket items,” and with so many game experiences available digitally, its business model doesn’t necessarily make sense in today’s environment. First, how has GME managed to hang on so long, especially as mall-based retail has struggled as a whole? And second, you’ve written that its revival depends on its ability to survive in a digital economy. People can read your article, but can you summarize why you believe this, and how GME needs to transform to survive?
ER: I think GameStop has hung on so far because of the complexity of the gaming market and its historical brand as the one-stop-shop for games, accessories, and hardware. Online retailers have undoubtedly cut into Gamestop’s business, but it has still retained much of its business due to its knowledge of the labyrinth-like and rapidly morphing gaming industry and its selection of products and custom solutions in ways that broad and generic online retailers simply haven’t been able to match.
The biggest risk GameStop now faces is that CDs and other “hard” forms of information storage are no longer needed to purchase games, and thus the brick-and-mortar shop or even the distributor themselves are increasingly put in peril. Rather, the bulk of console games are now downloadable online directly from its developer or an online distributor. Furthermore, much of video games’ growth in recent years has been through mobile, with GameStop essentially unable to capture just about any of that revenue.
Since games, both new and used, have been the bulk of GameStop’s profit, if it wants to grow or even keep its current size, it will need to find new business lines as ‘vintage’ games will likely not keep up its current revenues. I believe GameStop may find a future in being a gaming hub, as “E-Sports,” or video game sporting competitions, is seeing massive growth and broadening public interest.
SA: What’s one investment idea you’re excited about, and what’s the story behind it?
ER: I am excited about Twitter. The company has long been seen as a collapsed mess, unable to see consistent growth, let alone any profit, to justify even its lowest valuations of recent years. It scorned investors as well with its fall from its post-IPO high of about $70 a share to just about $15 a share less than a year ago.
Yet recently, all that has been changing. The company has cleaned up many of the problems that deterred advertisers, such as a poor analytics system and the widespread activity of trolls and nefarious actors on the platform. It has already seen the benefits of that, with renewed public interest and growth, its first profitable quarters ever, and a doubling of its stock price in less than a year from $15 to $33.
I think in the future it has even more opportunity to grow, as now it has essentially found both its “purpose,” as CEO Jack Dorsey has said (as a platform focused on public figures and news in contrast to a Facebook-like “friends and family” center), and the optimized business operations to help it grow from here on out. It currently is still barely 5% the size of Facebook’s $500 billion+ market cap, but I think in the future it has a lot of potential to catch up.
In five years, I could easily see Twitter being a $100 billion company from its current $25 billion market cap, although, as its history has shown, that trajectory still has much uncertainty.
Big thanks to Erich for sharing his tech-savvy on the Roundtable. If you’d like to read more of his public insights and ideas on the tech sector, click here. For multi-faceted analysis of the latest industry trends, their impact on sectors and companies, and related investment opportunities and risks, check out his Marketplace service, Tech Investment Insights.
Be sure to follow us for all things Marketplace. Summer is right around the corner, and we’ve got hot, hot, hot updates, developments and interviews coming your way.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Erich Reimer is long FDN.