GVA’s Garrity: Tech Investors Should Look At Apple Over Amazon

Bloomberg Markets AM with Pimm Fox and Lisa Abramowicz.

GUEST: David Garrity, CEO of GVA Research and columnist at Investopedia, on Amazon disappointing, this week’s tech earnings highlights, and outlook for the sector.

Listen to the replay here.

AMZN 2Q17 Results Reflect Profit Margin Pressure From Heavy Investment Spending, Will Margins Expand in 2H17?:

While AMZN is at the forefront of multiple large secular trends with significant multi-year growth potential (e.g. Cloud computing: ~10% penetration now & early with large enterprise customers; Retail: ~12% online penetration with potential to exceed 30% over time), profit margins are being compressed as AMZN invests to exploit major growth opportunities (e.g. data centers, Echo/Alexa, video content, Prime, fulfillment centers, grocery, India etc.) so investors will look to 2Q17 results commentary and management conference call discussion to see whether there is profit margin expansion potential to be realized in 2H17.

Meanwhile, note that Amazon Web Services (AWS) is seeing competition from Microsoft which posted estimated 2Q17 cloud computing revenue of $4.725bn, a level ahead of Street 2Q17 expectations of $4bn+ (i.e. +39% y/y, 1Q17A +43% y/y, 2Q16A +58% y/y). Nevertheless, AMZN AWS remains positioned as the dominant competitor to beat in Cloud Computing (see: https://www.g2crowd.com/categories/cloud-platform-as-a-service-paas & https://www.g2crowd.com/categories/infrastructure-as-a-service-iaas). This is the backdrop against which investors will assess AMZN’s 2Q17 results (Street revs $37.2bn, +22.3% y/y; EPS $1.42, -20.2% y/y).

The two major questions investors will want AMZN management to address are:

1) How will AMZN be able to offset the heavy investment impact on profit & AWS revenue growth? and

2) As AMZN attracts institutional investors reallocating retail & consumer sector portfolio allocations, will traditional technology sector investors become disenchanted with slowing AWS growth?

Once 2Q17 Earnings Season Over, Investors Should Focus on Names With Rising Profit Margins Off Increasing Sales:

Coming out of the June 2017 tech pullback, we note that the sector benchmark Technology Select Sector SPDR ETF (XLK) is up +3.81% since 6/12/17, continuing to lead the broader S&P500 (+2.04%) with 5 stocks (AMZN, FB, GOOGL, MSFT, NFLX) outperforming by a wider margin (+10.99%). Factors supporting both the tech sector and broader market gains have been the prospects for: 1) regulatory reform, 2) corporate tax rate reduction, 3) overseas profit repatriation, and 4) higher GDP growth. We caution that diminished political prospects may cap the sector’s rebound once 2Q17 earnings season is past and that investors should be selective.

Meanwhile, to that end, the table below shows the current next quarter growth forecast for sales and earnings for tech sector leaders along with the percentage decline of their shares from their respective 52-week highs and the P/E/G (price/earnings/growth rate) ratio contrasting the current 2018 P/E ratio with the EPS growth rate over the 2016-2018 timeframe. With possible concerns around economic growth, it is important investors consider those names where profit margins are expanding (i.e. EPS growth greater than sales growth) over names where profit margins are under pressure or where EPS are seeing outright declines. When faced with uncertainty, selectivity is critical to preserving capital and, along with it, performance.