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Weekly Issue: Among the Volatility, We See Several Thematic Confirming Data Points

Weekly Issue: Among the Volatility, We See Several Thematic Confirming Data Points

Key points inside this issue:

  • As expected, news of the day is the driver behind the stock market swings
  • Data points inside the September Retail Sales Report keep us thematically bullish on the shares of Amazon (AMZN), United Parcel Service (UPS) and Costco Wholesale. Our price targets remain $$2,250, $130 and $250, respectively.
  • We use the recent pullback to scale further into our Del Frisco’s Restaurant Group (DFRG) shares at better prices, our price target remains $14.
  • Netflix crushes subscriber growth in the September quarter; Our price target on Netflix (NFLX) shares remains $500.
  • September quarter earnings from Ericsson (ERIC) and Taiwan Semiconductor (TSM) paint a favorable picture from upcoming reports from Nokia (NOK) and AXT Inc. Our price targets on Nokia and AXT shares remain $8.50 and $11, respectively.
  • Walmart embraces our Digital Innovators investment theme
  • Programming note: Much commentary in this week’s issue centers on the September Retail Sales Report. On this week’s Cocktail Investing podcast, we do a deep dive on that report from a thematic perspective. 

 

As expected, news of the day is the driver behind the stock market swings

If there is one thing we can say about the domestic stock market over the last week, it remains volatile. While there are other words that one might use to describe the down, up, down move over the last week, but volatile is probably the most fitting. Last week I shared the market would likely trade based on the data of the day — economic, earnings or political — and that seems to have been the case. While we’ve received several solid earnings reports, including one from Thematic Leader Netflix (NFLX), several banks and even a few airlines, the headline economic data came up soft for September Retail Sales and Housing.

And then there was yesterday’s FOMC minutes from the Fed’s September monetary policy meeting, which showed that even though the Fed expects to remain on its tightening path, subject to the data to be had, several members of the committee see “a period where the Fed even will need to go beyond normalization of rates and into a more restrictive stance.”

Odds are we can expect further tweets from President Trump on this given his prior comments that the Fed is one of his greatest risks. I also expect this to reignite concerns for the current expansion, particularly since the Fed has historically done a good job hiking interest rates into a recession. From a thematic perspective, continued rate hikes by the Fed is likely to put some added pressure on Middle-Class Squeeze consumers. Before you freak out, let’s check the data. The economy is still growing, adding jobs, benefiting from lower taxes and regulation. It’s not about to fall off a cliff in the near term, but yes, the longer the current expansion goes, the greater the risk of something more than just a slower economy. More reasons to keep watching the monthly data.

Here’s the good news, inside that data and elsewhere we continue to receive confirming signals for our 10 investing themes as well as favorable data points for the Thematic Leaders and other positions on the Tematica Investing Select List.

 

Several positives in the September Retail Sales report for AMZN, UPS & COST

Cocktail Investing Podcast September Retail Sales Report

With the consumer directly or indirectly accounting for nearly two-thirds of the domestic economy and the average consumer spending 31% of his or her paycheck on retails goods, this monthly report is one worth monitoring closely.

Let’s take a closer look at this week’s September 2018 Retail Sales report. First, let’s talk about the headline miss that was making the rounds yesterday. Yes, the month over month comparison Total Retail & Food Services excluding motor vehicles & parts fell 0.1%, but Retail rose 0.4% on the same basis. The thing is, most tend to focus on those sequential comparisons, but as investors, we examine year over year comparisons when it comes to measuring revenue, profit and EPS growth. On that basis, Total Retail & Food Services rose 5.7% year over year while Retail climbed 4.4% compared to September 2017. That sounds pretty solid if you ask me. Now, let’s dig into the meat of the report and what it means for several of our thematic holdings.

Right off the bat, we can’t ignore the 11.4% year over year increase in gas station sales during September, which capped off a 17.2% increase for the September 2018 quarter. With such an increase owing to the rise in oil and gas prices, we would expect to see weakness in several of the retail sales categories as the cost of filling up the car saps spending at the margin and confirms our Middle-Class Squeeze investing theme. And we saw just that. Department stores once again fell in September vs. year ago levels as did Sporting goods, hobby, musical instrument, & bookstores. Given recent construction as well as housing starts data, the Building material & garden eq. & supplies dealer category posted slower year over year growth, which was hardly surprising.

Other than gas station sales, the other big gainer was Nonstore retailers – Census Bureau speak for e-tailers and digital commerce that are part of Digital Lifestyle investing theme,  which saw an 11.4% increase in September retail sales vs. year ago levels. That strong level clearly confirms our investment thesis that digital shopping continues to take consumer wallet share, which bodes well for our Amazon (AMZN), United Parcel Service (UPS), and to a lesser extent our Costco Wholesale (COST). With consumers feeling the pressure of our Middle-Class Squeeze investing theme, I continue to see them embracing the Digital Lifestyle to ferret out deals and bargains to stretch their after-tax spending dollars, especially as we head into the holiday shopping season.

Sticking with Costco, the company recently reported its U.S. same-store-sales grew 7.7% for September excluding fuel and currency. Further evidence that Costco also continues to gain consumer wallet share compared to retail and food sales establishments as well as the General Merchandise Store category.

  • Data points inside the September Retail Sales Report keep us thematically bullish on the shares of Amazon (AMZN), United Parcel Service (UPS) and Costco Wholesale. Our price targets remain $2,250, $130 and $250, respectively.

 

Scaling deeper into Del Frisco’s shares

Now let’s dig into the report as it relates to Del Frisco Restaurant Group, our Thematic Leader for the Living the Life investing theme. Per the Census Bureau, retail sales at food services & drinking places rose 7.1% year over year in September, which brought its year-over-year comparison for the September quarter to 8.8%. Clearly, consumers are spending more at restaurants, than eating at home. Paired with beef price deflation that has been confirmed by Darden Restaurants (DRI), this bodes well for profit growth at Del Frisco.

Against those data points, I’m using the blended 12.5% drop in DFRG shares since we added them to our holdings to improve our costs basis.

  • We are using the recent pullback to scale further into our Del Frisco’s Restaurant Group (DFRG) shares at better prices, our price target remains $14.

 

Netflix crushes subscriber growth in the September quarter

Tuesday night Netflix (NFLX) delivered a crushing blow to skeptics as it served up an EPS and net subscriber adds beat that blew away expectations and guided December quarter net subscriber adds above Wall Street’s forecast. This led NFLX shares to pop rather nicely, which was followed by a number of Wall Street firms reiterating their Buy ratings and price targets.

Were there some investors that were somewhat unhappy with the continued investment spend on content? Yes, and I suppose there always will be, but as we are seeing its that content that is driving subscriber growth and in order to drive net new adds outside the US, Netflix will continue to invest in content. As we saw in the company’s September quarter results, year to date international net subscriber adds is 276% ahead of those in the US. Not surprising, given the service’s launch in international markets over the last several quarters and corresponding content ramp for those markets.

Where the content spending becomes an issue is when its subscriber growth flatlines, which will likely to happen at some point, but for now, the company has more runway to go. I say that because the content spend so far in 2018 is lining its pipeline for 2019 and beyond. With its international paid customer base totaling 73.5 million users, viewed against the global non-US population, it has a way to go before it approaches the 45% penetration rate it has among US households.  This very much keeps Netflix as the Thematic Leader for our Digital Lifestyle investing theme.

One other thing, as part of this earnings report Netflix said it plans to move away from reporting how many subscribers had signed up for free trials during the quarter and focus on paid subscriber growth. I have to say I am in favor of this. It’s the paying subscribers that matter and will be the key to the stock until the day comes when Netflix embraces advertising revenue. I’m not saying it will, but that would be when “free” matters. For now, it’s all about subscriber growth, retention, and any new price increases.

That said, I am closely watching all the new streaming services that are coming to market. Two of the risks I see are a recreation of the cable TV experience and the creep higher in streaming bill totals that wipe out any cord-cutting savings. Longer-term I do see consolidation among this disparate services playing out repeating what we saw in the internet space following the dot.com bubble burst.

  • Our price target on Netflix (NFLX) shares remains $500.

 

What earnings from Ericsson and Taiwan Semiconductor mean for Nokia and AXT

This morning mobile infrastructure company Ericsson (ERIC) and Taiwan Semiconductor (TSM) did what they said was positive for our shares of Nokia (NOK) and AXT Inc. (AXTI).

In its earnings comments, Ericsson shared that mobile operators around the globe are preparing for 5G network launches as evidenced by the high level of field trials that are expected to last at such levels over the next 12-18 months. Ericsson also noted that North America continues to lead the way in terms of network launches, which confirms the rough timetable laid out by AT&T (T), Verizon (VZ) and even T-Mobile USA (TMUS) with China undergoing large 5G field trials as well. In sum, Ericsson described the 5G momentum as strong, which helped drive the company’s first quarter of organic growth since 3Q 2014. That’s an inflection point folks, especially since the rollout of these mobile technologies span years, not quarters.

Turning to Taiwan Semiconductor, the company delivered a top and bottom line beat relative to expectations. Its reported revenue rose just shy of 12% quarter over quarter (3.3% year over year) led by a 24% increase in Communication chip demand followed by a 6% increase in Industrial/Standard chips. In our view, this confirms the strong ramp associated with Apple’s (AAPL) new iPhone models as well as the number of other new smartphone models and connected devices slated to hit shelves in the back half of 2018. From a guidance perspective, TSM is forecasting December quarter revenue of $9.35-$9.45 billion is well below the consensus expectation of $9.8 billion, but before we rush to judgement, we need to understand how the company is accounting for currency vs. slowing demand. Given the seasonal March quarter slowdown for smartphone demand vs. the December quarter and the lead time for chips for those and other devices, we’d rather not rush to judgement until we have more pieces of data to round out the picture.

In sum, the above comments set up what should be positive September quarter earnings from Nokia and AXT in the coming days. Nokia will issue its quarterly results on Oct. 25, while AXT will do the same on Oct. 31. There will be other companies whose results as well as their revised guidance and reasons for those changes will be important signs posts for these two as well as our other holdings. As those data points hit, we’ll be sure to absorb that information and position ourselves accordingly.

  • September quarter earnings from Ericsson (ERIC) and Taiwan Semiconductor (TSM) paint a favorable picture from upcoming reports from Nokia (NOK) and AXT Inc. Our price targets on Nokia and AXT shares remain $8.50 and $11, respectively.

 

Walmart embraces our Digital Innovators investment theme

Yesterday Walmart (WMT) held its annual Investor Conference and while much was discussed, one of the things that jumped out to me was how the company is transforming  itself to operate in the “dynamic, omni-channel retail world of the future.” What the company is doing to reposition itself is embracing a number of aspects of our Disruptive Innovators investing theme, including artificial intelligence, robotics, inventory scanners, automated unloading in the store receiving dock, and digital price tags.

As it does this, Walmart is also making a number of nip and tuck acquisitions to improve its footing with consumers that span our Middle-Class Squeeze and in some instances our Living the Life investing theme as well our Digital Lifestyle one.  Recent acquisitions include lingerie company Bare Essentials and plus-sized clothing startup Eloquii. Other acquisitions over the last few quarters have been e-commerce platform Shoebuy, outdoor apparel retailer Moosejaw, women’s wear site Modcloth, direct-to-consumer premium menswear brand Bonobos, and last-mile delivery startup Parcel in September.

If you’re thinking that these moves sound very similar to ones that Amazon (AMZN) has made over the years, I would quickly agree. The question percolating in my brain is how does this technology spending stack up against expectations and did management boost its IT spending forecast for the coming year? As that answer becomes clear, I’ll have some decisions to make about WMT shares and if we should be buyers as we move into the holiday shopping season.

 

Is Now the Time to Panic?

Is Now the Time to Panic?

What we are currently seeing in the market is a symptom of a whole lot of leverage in equities that had been in rich territory at a time when, even though it is still moving along, signs abound that the economy is slowing. Is this a ‘buy the dip’ opportunity or is it just the start of a much bigger downturn?

It has been a stormy week from the onslaught of hurricane Michael to the sea of red in global equity markets as the market shift we have been awaiting finally took hold. Wednesday the Dow lost over 800 points and had its worst day since February. The S&P 500 has had its worst losing streak in two years with over half of the S&P 500 at least two standard deviations below their 50-day moving average – the highest such percentage since March. A full two-thirds of the S&P 500 is now down 10% or more from their respective highs – that is a broad-based decline. The Russell 2000 has blown through all support levels down through its 200-day moving average. The once high-flying NYSE FANG+ Index has fallen more than 16% from its recent highs. All 65 members of the S&P 500 Tech sector closed in the red Wednesday, something we haven’t seen since the beginning of April.

Outside the US markets have been struggling even more – the US is just starting to catch up. Germany’s DAX is down to 6-month lows, the MSCI Asia-Pac Index hit a 17-month low, the Emerging Market index hit a 19-month low and 13 of the 47 members of the MSCI all-country index are down 10% or more year-to-date. Korea hasn’t seen a decline like this in 7 years. Taiwan hasn’t seen a decline of this magnitude in over 10 years. China’s Shanghai and Shenzhen Indices are at levels not seen since 2014. For those who regularly read on commentary on TematicaResearch.com, we’ve been pointing out for months that the large outperformance of US equities versus the rest of the world was unsustainable.

 

The big question on everyone’s mind now is, “Is this a ‘buy the dip’ opportunity or is this just the start of a much bigger downturn and what should we expect as we head into earnings season?”

Let’s start with earnings season which is likely to see the reporting quarter’s performance decent relative to expectations, so I’m not worried about meeting target numbers. What I am worried about is investor reactions and guidance. Since mid-September 48 of the S&P 1500 companies have reported and while their results relative to performance have been solid, only 10 companies have traded higher on their earnings day and the average stock has declined 3.8% on the day. This is an acceleration of the reactions we saw from investors last quarter.

Expectations are being adjusted. Over the past month, analysts have raised forecasts for 358 companies in the S&P 1500 and lowered them for 534 which is a net of 12.2% of the index adjusted downward, the most negative EPS revision spread since March 2017. We’d warned earlier in the year that the benefits from tax cuts and the massive injection of federal spending would likely translate into weakness in the later part of the year – well, here you have it. We are no longer seeing dramatic increases in earnings estimates while corporate guidance is slowing shifting to the downside.

Looking at factors affecting forward guidance, we are seeing rising costs across a broad range of inputs – energy, tight labor markets, higher interest rates and let’s not forget everyone’s favorite ongoing trade war. Earnings season also means that one of the major buyers of equities, companies themselves, is forced to sit on the sidelines for some time.

The big picture here is that global liquidity conditions have materially changed as central banks have shifted gears in an environment that is full of extremes.

  • Banks are shedding assets with several having announced layoffs in the credit loan groups as credit growth has been slowing.
  • China and Japan, two of America’s largest creditors to the tune of over $1 trillion, are reducing their exposure to Treasuries at a time when the nation is running fiscal deficits typically only seen during a war or major recession with debt to GDP reaching levels not seen since World War II.
  • This year the net flows into US mutual funds and ETFs is 46% below that experienced in the first three quarters of last year.

 

This contracting liquidity is occurring in the context of a variety of extreme conditions.

  • The recent tax cuts and federal spending boon represents the largest stimulus to the economy outside of a recession since the 1960s, that at a time when the economy is already above full employment.
  • We’ve seen an explosion in debt across the globe with the ratio of global debt to GDP rising from 179% in 2007 to 217% today, according to the Bank for International Settlements.
  • According to S&P Global Ratings, the percent of companies considered highly-leveraged (with debt-to-earnings ratio of 5x or more) has risen from 32% in 2007 to 37% in 2017 – so much for healthy balance sheets in the corporate sector.
  • Around 47% of all investment grade corporate debt is in the lowest category (BBB-rated) both in the US and Europe, versus just 35% and 19% respectively in 2007.
  • Total US non-financial corporate debt as a percent of GDP is near a post-World War II high.
  • The quality of corporate debt is at extreme levels as well with 75% of total leverage loan issuance in 2017 covenant-lite versus 29% in 2007.
  • There was an estimated $8.3 trillion in dollar-denominated emerging-market debt at the end of 2017, according to the Institute of International Finance, accounting for over 75% of all EM debt. According to Bloomberg, some $249 billion needs to be repaid or refinanced through next year with the US dollar having strengthened considerably against their local currencies, making that debt all the more expensive.
  • It isn’t just debt that is at extreme levels as the percent of household net worth in equities has never been higher.

 

The Bottomline on the Recent Market Turmoil

We’ve got a whole lot of leverage in the system with equities that had been in rich territory at a time when while the economy is still moving along, signs of slowing abound. Is this time to panic? Definitely not. The US stock market is getting in sync with what has been happening with yields, what is going on outside the US and with more realistic growth prospects. Both myself and Chris Versace, Tematica’s Chief Investment Officer, will be examining and re-examining thematic signals identify well-positioned companies in light of our 10 investing themes. This means being on the lookout for confirming data points that give comfort and conviction for positions existing Thematic Leader positions and opportunities to scale into them at better prices. It also means building a shopping list of thematically well-positioned companies to buy at more favorable prices.

This means asking questions like “Where will the company’s business be in 12-18 months as these tailwinds and its own maneuverings play out?”

A great example is Amazon (AMZN), which our regular readers know continues to benefit from our Digital Lifestyle investment theme and the shift to digital shopping, as well as cloud adoption, which is part of our Digital Infrastructure theme and with its significant pricing power, our Middle-Class Squeeze theme which focuses on the cash-strapped portion of the population. And before too long, Amazon will own online pharmacy PillPack and become a key player in our Aging of the Population theme. Amid the market selloff, however, the company continues to improve its thematic position. First, a home insurance partnership with insurance company Travelers (TRV) should help spur sales of Amazon Echo speakers and security devices. This follows a similar partnering with ADT (ADT), and both arrangements mean Amazon is indeed focused on improving its position in our Safety & Security investing theme. Second, Bloomberg is reporting that Amazon Web Services has inked a total of $1 billion in new cloud deals with SAP (SAP) and Symantec (SYMC). That’s a hefty shot in the arm for the Amazon business that is a central part of our Digital Infrastructure theme and is one that delivered revenue of $6.1 billion and roughly half of the Amazon’s overall profits in the June 2018 quarter.

At almost the same time, Alphabet/Google (GOOGL) announced it has dropped out of the bidding for the $10 billion cloud computing contract with the Department of Defense. Google cited concerns over the use of Artificial Intelligence as well as certain aspects of the contract being out of the scope of its current government certifications. This move likely cements the view that Amazon Web Services is the front-runner for the Joint Enterprise Defense Infrastructure cloud (JEDI), but we can’t rule our Microsoft or others as yet. I’ll continue to monitor these developments in the coming days and weeks, but winning that contract would mean Wall Street will have to adjust its expectations for one of Amazon’s most profitable businesses higher.

Those are a number of positives for Amazon that will play out not in the next few days but in the coming 12-18+ months. It’s those kinds of signals that team Tematica will be focused on even more so in the coming days and weeks.

 

Digital Infrastructure: the underpinning of today’s digital super highway

Digital Infrastructure: the underpinning of today’s digital super highway

 

 

In our recently reconstituted Digital Lifestyle investment theme, we combined our former Connected Society, Content is King and Cashless Consumption themes to better reflect the increasingly connected and digital consumer. If you missed that post, click here to read the details.

Of course, much the way a car would be challenging to drive if there were no roads or a radio would only play static if there were no radio stations, there would be no Digital Lifestyle to live if the underlying high-speed data networks, increasing computing power, and falling storage costs that make it possible didn’t exist, which is where our new theme, Digital Infrastructure, comes into play.

We define Digital Infrastructure as the foundational services and technologies that enable continuous access to information, commerce, communication, and entertainment that have become a daily fact of life for billions. These include mobile, cable and satellite networks, the equipment that comprise those networks, the companies that build the networks; data centers and the servers, racks, routers and other equipment that enable them; payment processing networks and their point of sale devices; chipsets and modems that allow devices to connect to these networks. But more simply, while the Digital Lifestyle investing theme focuses on the consumer aspect of the connected world, the Digital Infrastructure theme is the highway that connects these devices and carries the data traffic they create.

 

 

The Digital Landscape

Today, there are billions of connected mobile devices, more than 3.5 billion mobile broadband subscriptions, more than 1 billion fixed broadband subscriptions and some 5 billion Internet of Things devices. All of them connect to 1 billion websites and each one is expected to work anytime, anywhere. That is just the beginning. As internet-based technologies are implements in areas such as healthcare, education, and government services both in the developed countries as well as in emerging ones, access to digital services will only become more crucial in the years to come for individuals, businesses and other institutions.

According to Cisco Systems’ most recent Visual Networking Index:

  • Globally, there will be 27.1 billion networked devices in 2021, up from 17.1 billion in 2016.
  • Globally, internet traffic will grow 3.2-fold from 2016 to 2021, a compound annual growth rate of 26%.
  • Globally, the average internet user will generate 57.0 Gigabytes of Internet traffic per month in 2021, up 139% from 23.9 Gigabytes per month in 2016, a CAGR of 19%.
  • In 2021, the gigabyte equivalent of all movies ever made will cross the Internet every 1 minutes.

 

That unquenchable thirst associated with our Digital Lifestyle investing theme periodically leads to network capacity constraints, which in turn leads to the building of new digital networks that expand capacity, improve data speeds and enable a host of new applications. That, in turn, leads to incremental network capacity additions over the ensuing years to alleviate bottlenecks and improve the user experience, and oftentimes creates an opportunity for players such as those in our Disruptive Technologies investment theme to step into the void.

Even as companies such as AT&T and Verizon are building out their next-generation 5G networks they continue to add incremental 4G network capacity to improve network coverage and performance. The same is true for Comcast as it builds out its Xfinity Gig-Speed internet offering that has come a long way from dial-up and DSL service.

For some historical perspective, let’s remember mobile telephony was originally voice-based. That was until the rollout of 2G technology, which brought networks that allowed basic messaging and data services at data speeds up to 250 kilobits per second (Kbps). With a minimum consistent Internet speeds of 144Kbps, 3G was the first move into what was called “mobile broadband”. Next up, of course, came 4G, which offered high speed, high quality and high capacity to users while improving security and lower the cost of voice and data services, multimedia, and internet over IP. The emergence of 4G, in turn, paved the way for mobile applications such as mobile web access, IP telephony, gaming services, high-definition mobile TV, video conferencing, and streaming services.

Moving beyond smartphones, as the cost of connectivity has fallen from both a chipset and service perspective, there has been an explosion in the types of connected devices in other aspects of our lives. Home appliances, door locks, security cameras, cars, wearables, vacuum cleaners, dog collars, and many other devices are getting connected. Gartner predicts that nearly 21 billion devices will be connected to the Internet by 2020.

With 5G technology, we are looking at another leapfrog in network capacity and data speeds that are expected to give rise to the Internet of Things, autonomous cars, virtual reality and other applications that will foster new network connections and demands as well. As 5G networks spread across the globe, we can expect the number of connected devices to explode even further, which of course will begin to bottleneck the 5G networks, necessitating further spending on infrastructure and technologies.  As you can see, the cycle goes on and on and on.

 

 

Making 5G a Reality

North America will likely be the first 5G market as AT&T, Verizon and T-Mobile US/Sprint look to launch those networks in 2019. The latest GSMA Intelligence report on 5G estimates that U.S. operators will spend about $100 billion (excluding spectrum acquisitions) between 2018 and 2020 upgrading their 4G LTE networks and investing in 5G. This should drive incremental revenue for mobile equipment companies Ericsson, Alcatel Lucent, Nokia and Cisco Systems, while also driving activity at those companies like, Dycom Industries, that build the physical networks. Over the longer-term 5G networks will launch in Western Europe and across the globe. Moor Insights & Strategy sees this driving massive IT hardware spending to the tune of $326 billion by 2025. This includes 5G data processing, storage and networking needs in the data center and edge computing, carrier network transformation projects, and 5G modems and IP.

Here’s the thing, the buildout of these next-generation networks takes time as carriers obtain the necessary spectrum and then build the physical network. SNS Research estimates that by 2020, 5G networks will account for nearly 5% of all spending on wireless network infrastructure rising to more than 40% by the end of 2025. What this means is that mobile carriers will continue to spend on soon-to-be legacy 3G and 4G technologies in the interim as they buildout existing network capacity to accommodate demand associated with our Digital Lifestyle investing theme.

Then there is the incremental spending on various backhaul aspects of the network that include wireless solutions as well as fiber, microwave, carrier Ethernet and satellite that moves data to the network backbone to distribution points around the network.  According to Deloitte, without deeper fiber deployment, carriers will be unable to support the projected four-fold in mobile data traffic increase between 2016 and 2021. While a majority of Internet traffic terminates on a wireless device, nearly all of that traffic relies on WiFi access points, homespots, and hotspots connected to wireline broadband infrastructure services such as fiber, coax, or twisted-pair copper. Wireless networks only carry 11% of traffic, implying wireline networks support nearly 90% of total Internet traffic.

And let’s not forget the chipsets needed to connect devices to these 5G networks – the 5G chipset market is expected to grow from $0.4 billion in 2016 to $2.03 billion in 2020 to $ 22.41 billion by 2026, a CAGR of 49% from 2020 to 2026. The primary driver of this will initially be smartphones, which are expected to reach 80-100 million units by 2021 up from 2 million in 2019.

As Hans Vestberg, CEO of Verizon, put it, “5G is an access technology” that will drive even greater data consumption as connected devices move past smartphones. This is expected to create demand for incremental data centers, cloud services, payment processing network capacity and the hardware that powers them. And that’s just inside the US, a more global view that focuses on the global population likely means more consumers adopting our Digital Lifestyle as these connected devices and networks reach their shores.

  • Long-term, IDC expects spending on off-premises cloud IT infrastructure will grow at a five-year compound annual growth rate (CAGR) of 10.8 percent, reaching $55.7 billion in 2022.
  • The global data center deployment spending market is expected to reach $83.7 billion by the end of 2022 up from $44.3 billion in 2017. This reflects the growing number of small and medium enterprises who need servers and other hardware, the emergence of the Internet of Things (IoT) and big data, and surge in the number of smart devices that can be interconnected.

The bottom line is that if there is no Digital Infrastructure to carry mobile payments, online and mobile searching and shopping, stream audio and video content, to carry Tweets and emails as well as Facebook posts, there can be no Digital Lifestyle. As 5G and other new technologies are deployed, the number of data-creating connective devices will expand, eventually pressuring networks and require incremental capacity additions and the deployment of next-generation technologies. Recently Motorola and Verizon launched the world’s first 5G capable smartphone, the Moto Z3, but it’s not what it claims to be as not only are there no 5G capable mobile networks there are no 5G modems available as yet. What the Moto Z3 boasts is a modular and upgradeable structure for when both are available. While clearly intended as marketing to attract attention, it’s a sobering reminder that the disruptive impact to be had with 5G cannot occur until the necessary infrastructure is in place.

 

Tematica’s Digital Infrastructure investing theme and Dycom shares

Tematica’s Digital Infrastructure investing theme focuses on those companies that will benefit from both the buildout of new and existing digital infrastructure from networks, base stations, data centers and related hardware to the chipsets and materials that power them and grant connectivity to a growing array of devices.   As we introduce this new theme, we are using specialty contractor and current Tematica Select List company Dycom Industries (DY) as a sample case study.

As a reminder, Dycom builds the physical networks for AT&T (T), Verizon (VZ), Comcast (CMCSA), CenturyLink, Charter Communications, Windstream Corp. and others. Those six named customers account for 82% of recent quarterly revenue with AT&T being the largest at just over 24%. Of note, while Verizon clocked in third place at just under 17%, that business grew substantially compared to 8.5% in the April 2017 quarter.

The combination of continued 4G mobile network spend, combined with the accelerating spending 5G and gigabit fiber networks across its customer base bodes well for Dycom in the coming quarters. While we acknowledge there have been some timing issues associated with the initial timing of 5G networks, as we’ve heard during the 2Q 2018 earnings season, network operators are shifting their capital spending to favor these new networks ahead of expected launches in the coming quarters.

Verizon expects to launch its fixed 5G service “by the end of ’18” and in May Samsung received FCC approval for the first 5G router. Along with its 5G launch, Verizon is reportedly looking to deliver bundled TV service in partnership with either Apple and Alphabet. AT&T plans to launch its 5G service in a dozen US markets before the end of 2018 alongside its construction of FirstNet, the country’s nationwide public safety broadband platform dedicated to first responders. Rounding out Dycom’s top three customers, Comcast continues to invest in line extensions to reach more business and residential customer addresses as well as other network investments including the buildout of its gigabit fiber offering.

That pick up in spending is expected to drive a 23% increase in revenue during the second half of 2018 compared to the first half with further growth in 2019 as 5G network building continues. As building activity for these new networks escalates, Dycom’s margins should benefit from greater absorption of labor and field costs as well as SG&A costs that drives favorable incremental operating margins and Eps generation.

Dissecting Dycom’s most recently quarterly earnings and revised outlook that calls for EPS of $1.78-$1.93 in the first half 2018, to hit its new full year 2018 target EPS of $4.26-$5.15, it means delivering EPS of $2.98-$3.22 in the back half of the year. In other words, a pronounced pick up in business activity that reflects network buildout activity from its customers. As that activity continues in 2019, consensus expectations have Dycom earnings nearly $6.50 per share, up from $3.88 per share in 2017. Our $125 price target equates to roughly 19x 2019 EPS expectations.

Dycom’s business tends to be seasonal in nature given the impact of weather, particularly winter weather on construction conditions. This can result in work disruptions and timing issues, which is one of the reasons that we prefer to look at Dycom on a multi-quarter basis.

  • As we introduce our Digital Infrastructure investing theme, we are reiterating our $125 price target on shares of Dycom Industries (DY) as we reclassify the company in this new theme.

 

Examples of other companies riding the Digital Infrastructure investment theme tailwind:

  • Adtran (ADTN)
  • Alcatel Lucent (ALU)
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