It was of course inevitable (in retrospect) that the strong performance of the technology sector over the last year would suffer a reversal; it was just a question of when and what the trigger would be. In the end, there were two guns: tariff threats from the Trump administration, and rising concerns about taxes and regulation following the Cambridge Analytica revelations about the misuse of Facebook user data.
The technology sector (or to define it more broadly, the Tech+ sector, which includes the Internet and Direct Market Retail industry and companies such as Amazon and Netflix, normally classified as Consumer Discretionary), has been responsible for a disproportionate share of US equity returns over the last year. Although it accounted for just 21% of the market capitalisation of the (MSCI AC World) index, in the 12 months to the index’s peak on 1 February 2018, Tech+ made up 38% of the 25% gain in the US large cap equity market. After such a period of outperformance, it was always likely that a rotation away from the sector would take place.
The threat from tariffs and a disruption in trade is larger for the technology sector than it is for any other. American technology corporations generated 11% of their revenues from sales to China in 2016, which is several times more than was the case with the other sectors in the index. Similarly, Chinese tech companies’ sales to the US were several times greater than those by other parts of the market (see Figure 1). For some industries, such as electronic components or semiconductors, the share was over 20% or even 30%. Hence any tariffs or quotas would have a meaningful impact on corporate profits.
Although the initial list of goods targeted for import tariffs by the Trump administration did not contain smartphones or other major categories of consumer electronics, any continuing escalation could have repercussions for the technology sector supply chain, which almost entirely moves through China. Within a week, we twice saw the technology sector pull back sharply when Trump rattled his tariff sabre, and then recover as his advisors (US Treasury Secretary Steven Mnuchin and National Economic Council Director, Larry Kudlow) framed the process as a negotiation. There is evidence from third party Washington analysis firms that negotiations have been going on behind the scenes.
There are two different aspects to the administration’s trade concerns. The first focuses simply on relative tariff levels, which are higher in China on American imports than vice versa. For example, most goods categories (73%) face a tariff of less than 5% when imported into the US, according to World Trade Organization (WTO) data, whereas this is the case for only 17% of import categories in China. While the administration may be threatening protectionist measures, we believe the ultimate goal is to force a reduction of tariff levels in China, which would be positive for US exporters.
The second issue is the forced sharing of intellectual property for companies wanting to sell or invest in China (concerns that are shared by many governments and corporations in Europe), as well as national security concerns centred around investment by Chinese companies in America, many of which are government-controlled or related. If the administration can achieve a reduction in technology transfers, it should also benefit US corporations and their investment in R&D. The restrictions on Chinese investment in America, however, may become a permanent part of the landscape, as the government’s considerations are not simply economic. Nonetheless, we remain cautiously optimistic that the situation will not escalate to a trade war and in the end might even result in a net reduction in tariff levels.
The potential for increased regulation within the technology sector has been in focus, particularly around the issue of data privacy. The European Union’s General Data Protection Regulation (GDPR) will go into effect in late May and there is also the fallout from the misuse of Facebook data by Cambridge Analytica. The market impact from the data privacy issues seems currently more focused on the big social media names than on the broader technology sector.
The Facebook issue appears manageable, in our view, as the company is taking proactive steps to reign in the use of customer data by third parties, and to enable users to more easily access and manage their privacy settings. Many of the required fixes can be implemented with technology improvements to the platform. In the wake of the alleged misuse of social media platforms by Russia during the US and UK elections, Facebook had also been in the process of hiring thousands of employees to focus on managing content on the platform. With GDPR looming, Facebook is likely ready to enable ‘opt-in’ data sharing functionality on its platform, at least for users in the EU. To date, there is no evidence that material numbers of consumers or advertisers are abandoning Facebook, but we are continuing to monitor the situation. US legislation appears unlikely this year, according to Cowen analyst Paul Gallant, given the lack of coordinated momentum to craft a bill and the relatively small number of legislative days left before the mid-term elections.
On the tax front, the European Commission is also planning to implement a digital tax. It made two proposals related to ‘fair taxation of the digital economy’ on 21 March, with implications for many firms including Facebook, Alphabet (Google), Amazon, Apple and Netflix.
Here is premise that underpins the proposals, with a link to the full summary:
In the digital economy, value is often created from a combination of algorithms, user data, sales functions and knowledge. For example, a user contributes to value creation by sharing his/her preferences (e.g. liking a page) on a social media forum. This data will later be used and monetised for targeted advertising. The profits are not necessarily taxed in the country of the user (and viewer of the advert), but rather in the country where the advertising algorithm has been developed, for example. This means that the user contribution to the profits is not taken into account when the company is taxed.
The European Commission’s two proposals in this area are:
1. To reform corporate tax rules to register and tax profits where the users reside, for businesses that have ‘significant interaction with users through digital channels’. This is a long-term solution that would enable EU member countries to tax profits generated in their territory even if the company does not have a physical presence there. The following would be taxed:
a. Profits from user data (including ad placement/selling online ad space)
b. Profits from connecting users, including online marketplaces (any activities which allow users to interact with each other and can facilitate the sales of goods and services between them)
c. Profits from other digital services, including subscriptions to streaming services
2. To implement an interim, temporary 3% tax on ‘certain revenue from digital activities’; this is meant to capture tax revenue on an interim basis until proposal 1) is fully implemented. It would tax revenue from the activities listed above as well as revenue ‘created from the sale of data generated from user-provided information’.
These proposals are due to be submitted to the European Council and the European Parliament for approval/consultation. If they pass, Cowen analyst Paul Gallant believes they could be implemented by the end of this year, but that companies might be granted a one-year phase-in period; thus, this would likely go into effect by the end of 2019 or the beginning of 2020. Facebook had 277 million daily active users in all of Europe (including countries not in the EU) in Q4 of 2017, which represented just under 20% of total users. So a 3% tax on revenues, if based roughly on the number of users, would be about 0.5% (most likely lowering ‘net’ revenue) to profitability – assuming that approximately 85% of European users are in the EU. This reduction would be temporary and would most likely evolve to Facebook paying higher taxes on its EU profits. We believe such an outcome would not fundamentally alter the investment case for the company.
The recent correction in the market has opened up some opportunities, although valuations remain above average on most metrics. The S&P 500 is down by nearly 6% from its peak in January this year (though it is roughly flat year-to-date as at 19 April 2018), and the Tech+ sector has declined by just under 4%. More important, though, is that valuations based on forward estimates have fallen even more, by over 7% for Tech+, because earnings forecasts have continued to rise.
Part of the premium an investor pays for the technology sector is the expectation of faster earnings growth, but that premium today is actually less than it is for some other parts of the market. The current forward price to earnings ratio (P/E) is around 20% above average, less than the premium for the utilities and energy sectors, and similar to that of financials and industrials (see Figure 3). It would appear, then, that one is getting better growth prospects at a reasonable price.
Perhaps more important is that the recent turmoil has done little to dampen analyst estimates of earnings growth, though admittedly this could yet happen. Long-term earnings per share (EPS) growth rate estimates have declined by 73bp but are still high at 16% compared to 11% for the rest of the market. Earnings estimates continue to march higher (see Figure 3).
We remain constructive on the technology sector, despite headwinds in the near term such as regulation, taxes and trade policy. From a cyclical perspective, IT spending growth is accelerating in 2018, based on Morgan Stanley’s CIO survey and other sources. As for valuations, multiples in the sector are above average but are in most cases supported by positive earnings revisions. On a 20-year view, the tech sector still trades below its median premium to the broader market. Strong secular growth drivers remain intact, including cloud computing, data analytics/artificial intelligence, automation/robotics, and the Internet of Things. These disruptive technologies are impacting industries and companies throughout the broader economy, enabling new business models and services and facilitating greater efficiency, which should ultimately drive sustained earnings growth.