George Salmon, Equity Analyst 16 May 2019
The FAANG stocks often get lumped together for convenience. And why not? If nothing else, ‘FAANGs’ is just one syllable, compared to 17 for ‘Facebook, Amazon, Apple, Netflix and Google's parent Alphabet’.
In reality, they’re very different businesses. In the same way a video store and a newspaper don’t have the same drivers, neither do Facebook and Netflix. But there’s one unifying characteristic, and it’s an intriguingly attractive one.
The FAANG stocks all benefit from scale. And that’s probably for the best, since they have a combined value of $3.3trn.
This article isn't personal advice. All investments and any income from them can fall as well as rise in value so you could get back less than you invest. If you're not sure if an investment is right for you, please seek advice.
The social network effect
Let’s go back to Facebook and Netflix. Sure, they might be doing very different things, but they both have the same need for eyeballs on screen.
Facebook makes its money from advertisers looking to reach a bespoke audience. Think about what you see when you log in. Yes, messages, posts and event notifications, but also a long swathe of content from third parties advertising events, products and services.
The more people see these ads, the better for the advertiser, the more they’ll pay. It’s a juicy combination, but one that depends on user growth.
The Cambridge Analytica scandal knocked Facebook, but so far it’s served as a wake-up call rather than a derailing. CEO Mark Zuckerberg & Co. realised their audience couldn’t be taken for granted.
A year on and user numbers and revenue per user have both risen. That tells us its platform is more popular than ever, and for its customers, the adverts are still working. But Facebook isn’t resting on its laurels. Zuckerberg has unveiled a new strategy for the group, and is looking to push on with a new type of user engagement.
Facebook has spent years building up its network to enable users to connect in something that resembles a digital town square. But preferences are changing, such that users want to have the privacy of connecting in the equivalent of a living room.
As a result, Facebook’s pushing apps like Messenger and WhatsApp to the forefront, and building new tools for Instagram and Facebook.
Becoming more content
It’s a similar story at Netflix, but for different reasons. Rather than retaining pricing power over advertisers, Netflix’s need for regular users is about spreading costs.
That’s because if it’s going to establish itself as the dominant streaming service, it needs to get a whole raft of content lined up and ready to go at the touch of a button. The cost of content assets last year was a cool $13bn, by far the largest demand on Netflix’s accounts, and the reason it reported a $2.9bn free cash outflow last year.
This is where the scale comes in. The more users you can get on board, the thinner that cost is spread, and the quicker the group can stem the cash outflows. And once that happens, investors will hope its high-quality subscription revenue can drive profits and cash flows upwards.
Progress is rapid, but a valuation of 85 times expected earnings means the pressure is on the group to keep its 148.8m-strong audience growing.
Branching out into new fields
Apple is slightly different again.
The investment case isn’t about building extra scale. It’s about leveraging a user base that Netflix can only dream of (for the time being at least). The group says there are more than 1.4bn of its products in active use.
The Services division is the key here.
The division earns Apple a heady mix of high margin revenues, from straight up subscriptions to Apple music, transactions through iTunes and, perhaps most importantly of all, a cut of revenue from purchases on the App Store.
The reason the App Store is so valuable is the pricing power that comes with Apple’s user base. Not only do iOS users number in the billions, but they tend to be wealthier, so can spend more. If developers want their app to be the next Candy Crush, they need to be iOS friendly and that means agreeing to Apple’s terms. If that includes handing over up to 30% of in-app purchase revenue, so be it.
There are other attractions too – namely that Apple doesn’t really care which apps are successful, just that some are. And with global app spending rising 75% in just two years to break past the $100bn barrier, it’s clear the trend is in Apple’s favour.
For all the good news in services, demand for new iPhones has shown signs of spluttering. With well over 50% of revenue coming from phone sales, it’s an issue that can’t be ignored.
With competition catching up and sales in decline, there are two important questions outstanding: what will happen to the installed base, and how effectively can Apple monetise it?
As the owner of one of the strongest brands on the planet, we think it could be dangerous to bet against the group.
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A connected party of the author holds shares in Alphabet.
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