How technology companies make their money

The global technology sector has had a fantastic run so far this year. By the end of August the prices of global tech stocks had risen 33.6% compared to just 3.3% for the global stock market as a whole.

US giants like Apple, Amazon, Facebook, Alphabet and Microsoft all call the technology sector home. However, the companies we all think of as technology vary hugely. In the UK, the official “tech sector” includes everyone from industrial design and management software group AVEVA to online peer-to-peer lender Funding Circle. The fundamental revenue driver for these two businesses is clearly very different, and it’s a similar story for the sector as a whole.

With that in mind we analyse what’s driving revenues at some of the world’s biggest tech groups, and whether we should really be lumping them all together.

This article isn’t personal advice. If you’re not sure if an investment is right for you make sure you ask for advice. All investments fall as well as rise in value. You could get back less than you invest. Past performance is not a guide to the future.

Investing in individual companies isn’t right for everyone. Our ideas are for people who understand the risks of investing in equities. It’s higher-risk as your investment is dependent on the fate of that company – if a company fails you risk losing your whole investment.

Investors should make sure they understand the companies they’re investing in, the company specific risks, and make sure any businesses they own are held as part of a diversified portfolio.

Apple – from manufacturer to service provider

Nicholas Hyett, Equity Analyst

Apple’s iPhone, first launched in 2007, sparked a revolution in consumer technology that continues to this day. However, its technological dominance has faded over the years – the gap between the latest iPhones and their Samsung and Huawei rivals has been narrowing.

Increased competition, and over 1.5bn active devices, means iPhone sales aren’t increasing by the 80-90% a year the group saw back at the start of the last decade. However, the group’s flagship device still accounts for the majority of sales – and when you include Mac, iPad and other devices, hardware sales account for 82.2% of the group total.

2019 sales by segment

Source: Apple 2019 Annual Report

Now we’re not playing down the technological wizardry that goes into an Apple phone. But as rival products approach parity with the iPhone there’s an increasing danger that the phone market becomes commoditised – that when one phone looks much like any other consumers simply opt for the cheapest.

As a higher priced product, Apple would lose out on a race to the bottom, eating into its attractive 25% operating margins.

Some might argue that Apple’s brand will help it protect its margins. However, it’s difficult to imagine that a company with over a billion active products can maintain a luxury image for long. Apple then is at risk of slowly moving from tech superstar to discretionary goods manufacturer – although that process is still some years away.

CEO Tim Cook’s answer is to turn to what we would generally see as a pure tech answer. Apple’s services business includes all the group’s software sales – ranging from the App Store to Apple Music. In recent times the division has been delivering double digit percentage growth, and crucially it ties users of Apple hardware more closely into the Apple ecosystem. Apple apps only work on Apple products, and as customers invest more in Apple software it will become harder for them to shift to rival platforms.

Best of all, these revenues are almost all profit – selling an app through the App Store costs the group nothing, so the revenue drops through nicely to the bottom line.

The recent focus on service revenues makes complete sense. If the group can successfully tie its loyal fan base even closer to the brand that will help it avoid margin erosion. However, investors should bear in mind that, as things stand, Apple’s revenues are based on the manufacture and sale of high priced discretionary goods – and historically that’s not been a great place to be in an economic downturn.

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Amazon – those aren’t retail profits you’re looking at

Emilie Stevens, Equity Analyst

Amazon set out to offer customers something they couldn’t get any other way. It started by selling books online in 1994, offering more books than physically possible to hold in a bricks and mortar store, tools to help find the right one, and open 24/7 365 days a year.

As the second largest retailer in the world (based on revenue) Amazon’s extended that model to most things money can buy. All the while offering new services to make retail more efficient. ‘Prime’ disrupted the delivery space, ‘Fulfilled by Amazon’ enables other sellers to reach Amazon’s customers, ‘Prime Video’ is a key player in the streaming arena.

But while retail brings in most of the group’s $245bn in annual sales, when it comes to profits there’s a far more important player. We also think it’s the part of the business that earns Amazon its status as a tech giant.

Amazon Web Services (AWS) is the group’s cloud platform. It offers everything from data backup and storage to machine learning data analysis tools. This division made up 12% of sales but 63% of profits last year.

2019 Net Sales

Source: Amazon Annual Report 2019

2019 Operating Profits

Source: Amazon Annual Report 2019

Like the retail business, AWS is the dominant player and captures around a third of the market. And when Microsoft and Google are your rivals – that’s no mean feat. The cloud computing market was estimated to be worth around $200bn in 2019, and estimated to be worth north of $761bn by 2027.

Driving the growth is businesses, institutions and even governments increasingly opting for cloud rather than physical computing power like servers and hardware. It’s cheaper, more efficient, more flexible and scalable if needs be. This shift is reflected in AWS’ growth too. The division made $7.9bn in revenue in 2015 versus £35bn last year, an average annual growth rate of 45% - nearly double the rate of retail.

In true Amazon style, AWS offers customers more functionality, a wider global reach. And with a flexible pricing structure - you only pay for what you use – it’s an affordable and accessible solution for organisations big and small. Thanks to its unrivalled offering AWS’ customers include everyone from NASA, to Standard Chartered and Coca-Cola.

As the preferred computing platform for the world, and Amazon’s continued focus and investment in AWS, we’re excited by the growth opportunity it presents. However, with the market willing to pay 82 times future earnings per share, there’s a lot of pressure for Amazon to deliver the goods.

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Facebook and Google – as old school as they come?

Sophie Lund-Yates, Equity Analyst

Advertising has been around for hundreds of years. It’s not a groundbreaking concept. Where circulars and newspapers used to be an advertiser's haven, today two of the biggest tech stocks are arguably nothing more than digital versions of these.

Advertising is Facebook’s bread and butter. This revenue stream made up a whopping 98% of its $18.7bn quarterly revenue. It’s not even necessarily high flying multinational corporations that make it tick, Facebook has bigger exposure to small and medium sized local businesses.

This means the group’s exposed to some pretty age-old headwinds. Namely that economic downturns will have an immediate impact on the top-line. In tough conditions, marketing budgets are usually the first thing to get cut. But this is where Facebook starts to look a bit more modern than a traditional broadsheet.

Facebook Q2 revenue

Source: Facebook Q2 results 2020

At the height of coronavirus advertising revenues were much lower than normal, but still managed to stabilise by April. That’s because the data Facebook’s 2.7bn monthly active users leave behind are very attractive to marketers, and has made the digital platform indispensable. It’s the backbone of today’s digital marketing revolution.

Relying on advertising means Facebook isn’t an out-and-out technological beast. But the way it’s developed data analytics means it’s fair to say this giant is a tech hybrid. Only a company with a decent amount of tech in its veins can tip the status quo of an entire sector on its head. And that attribute offers Facebook some shelter when the going gets tough.

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Google owner, Alphabet is a bit different. Ads certainly make up a huge piece of the story (78% of revenues last quarter to be exact), but Google has some more obviously tech strings to its bow.

The remaining portions of the Alphabet soup include a loss making, but envelope-pushing business known as “other bets”. It’s using its money to fund some frankly funky stuff, like Waymo self-driving cars. This division is decidedly small fry at the moment.

The group’s also a player in the cloud computing arena. Not only is this arguably more of a straight tech service, it’s good for margins. Adding a new customer costs virtually nothing once the infrastructure’s in place. This division made $3bn in revenues last quarter alone, and helps support operating margins of 17%.

Alphabet Q2 operating profit/loss

Source: Alphabet Q2 results 2020

Overall, Alphabet’s heart is that of an advertiser’s. But its extremities are that of a fledgling tech company. In time these smaller areas of the business could swell to become a more vital part of the system, and that offers opportunity. For now though, these divisions won’t move the dial – Alphabet is a tech star in training, and in the meantime is beholden to the old world of advertising.

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Microsoft – True Tech?

Nicholas Hyett, Equity Analyst

Microsoft was an original tech darling. Between the first week of January 1995 and the first week of January 2000 its shares rose 1,371%. However, unlike many of its contemporaries in the dotcom bubble, it’s gone on to deliver pretty impressive returns for investors in the subsequent two decades. Remember that past performance is not a guide to the future.

These days the group has fingers in just about every ‘tech’ pie going. It owns LinkedIn, MSN advertising and manufactures the Xbox – although old classics like Windows and Microsoft Office remain the great money spinners.

However, the real game changer in recent years has been the emergence of cloud computing. Shifting traditional businesses into the cloud and expanding the services on offer, have become the most important drivers of revenue growth.

2019 revenues by product

Source: Microsoft annual report 2019

At HL we tend to think of Microsoft as one of the iconic tech stocks. Its technology is used by practically every business on earth. Newer products like business management software Dynamics and video conferencing set up Teams have put it at the fore-front of the remote working revolution sparked by the pandemic as well.

Since Microsoft is primarily a software developer it benefits from the economies of scale that go with all software sales. Once the programme has been developed selling an additional licence is essentially costless and very profitable.

The launch of cloud based versions of core business programmes now means Microsoft can provide the computing power as well as the software that runs on it. That should give it an increased share of customer wallets.

You might have noticed a shift to subscription based models in Microsoft software – Office 365 for example. The shift to ‘software as a service’, or SaaS in industry jargon, makes revenues reliable and customers sticky.

Microsoft’s cloud business, Azure, is now one of the world’s two largest providers of cloud computing, and with uses of cloud computing expected to expand rapidly that has the potential to secure Microsoft’s position at the heart of the tech revolution for years to come.

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Unless otherwise stated estimates are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Past performance is not a guide to the future. Investments and income they produce can rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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