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What makes a trillion dollar company?

Sophie Lund-Yates explores what investors can learn from some of the world’s biggest companies.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

The race to become the world’s first trillion dollar company was won by Apple back in 2018. Since then the likes of Microsoft, Amazon and Google’s parent company Alphabet have joined the exclusive club.

But the world’s biggest listed companies didn’t achieve their accolades by accident. So, what does make a trillion dollar company?

As always, keep in mind the value of investments can go down as well as up, so you could get back less than you invest.

Same lemon. More juice.

Most of the US tech giants have high levels of what’s known as operating leverage. Sounds a bit jargon heavy, but bear with me.

A company with a high degree of operating leverage is able to generate more profit from each additional sale, because it doesn’t have to significantly increase costs to produce that extra revenue. That’s achieved from having a mostly fixed cost base, which can sustain an increase in demand without needing to be “dialled up”. This type of company will see gross margins (revenue minus the cost of goods sold) increase as sales increase.

Software companies are a classic example of this kind of company. Developing high-tech software is a very expensive undertaking, but once built, adding a new customer is essentially free.

That’s a concept Microsoft knows all about.

Microsoft's early success was built on the Windows operating system, launched back in 1985. Getting things off the ground didn’t come cheap, but once up and running each new Microsoft Office customer is almost pure profit. That helps support a gross profit margin of over 66%.

And Microsoft isn’t the only one putting this operating model to good use. Apple’s services business, including the App Store and Apple Music, has the same benefits. Over at Google, its search business is able to service new customers with few raising costs for the same reason.

It’s worth noting though that this kind of operating model is only good news if things are going well. If sales struggle or dramatically slow for any reason, having a big fixed cost base becomes more burdensome.

See the latest Microsoft share price, charts and how to trade

See the latest Alphabet share price, charts and how to trade

iHoard

Not only are these companies hugely profitable, but they’re quite capital light, which keeps investment requirements low. That means more of that profit can drop straight through into tangible cash.

The amount the tech giants can generate is pretty staggering. Amazon announced in the third quarter it generated $23.5bn of free cash in the previous 12 months. And strong cash generation means a lot of these companies are sitting on huge piles of accumulated cash - at the time of writing Alphabet is sitting on $105bn of the green stuff.

A big cash reserve offers an attractive layer of protection if things were to get tough. But it also raises some questions.

Forecast full year net cash position ($bn)

Source: Refinitiv Eikon 23 January 2020

We’d argue no company needs to be hoarding that much, and it doesn’t represent the best use of investors’ capital. Some are trying to fix that - Apple used some of its cash by launching a mammoth share buyback scheme, returning $139.6bn to shareholders over 2018 and 2019. But as the chart shows, it’s still sitting on a sizeable nest egg.

See the latest Apple share price, charts and how to trade

See the latest Amazon share price, charts and how to trade

Head in the clouds

One benefit of all that cash is it allows these companies to try their hand at different things. Giving them a strong competitive advantage when it comes to adapting to change.

That’s driven Alphabet to invest in side-projects like Waymo, which is a self-driving car business. It’s a small part of the operation, but could be very lucrative in the future. And with so much stashed away it won’t break the bank if these “other bets” don’t work out.

Similarly Microsoft has branched into the complex but lucrative world of cloud computing in more recent years, as personal computing revenues account for a shrinking portion of revenues. Azure, Microsoft's flagship cloud business, saw revenues grow 63% in the first quarter of this year.

Fast growing yes, but it’s also costing a lot. Capital expenditure is likely to stretch past $16bn this year. And Microsoft isn’t alone in this sphere, Amazon has a mushrooming web services business, and Google’s making a go of it too.

Proportion of Microsoft cloud revenue to total revenue (%)

Source: Refinitiv Eikon 24 January 2020

Five star rating

Unsurprisingly companies with such positive characteristics are highly valued. In other words, investors are willing to pay a lot for each $1 of profits, as measured by a price to earnings (P/E) ratio.

High growth companies tend to have higher P/E ratios, because they’re expected to increase profits more quickly than others in the future. For that reason, a lot of the big tech companies have fairly lofty valuations. Amazon for example has a P/E of 68.1, which is lower than it’s been in the past, but much higher than the US market average.

That’s a sign of confidence from the market, but it does also mean the share price can be sensitive to a fall if growth disappoints.

What does this all mean?

There’s a lot of factors which have to line up for a business to get as big as the giants we’ve looked at here. But, crucially, they need to boast slick operating models and stellar cash generation, which enables them to hop over one of the biggest barriers to entry to new markets and products.

In turn that means they can tap into new ways to potentially make more profits, and the cycle can continue, although past performance isn’t a guide to the future.

It’s good practice to take note of things like operating model, cash position and valuation when considering an investment, but they’re not the whole story. These are all factors we explore in our share research, and you can sign up here.

Remember, if you’re unsure if an investment is right for you please seek advice.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments 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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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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