Microsoft & Facebook – 2 good runs.

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2 good runs could come to an end in 2018.

Microsoft FQ2 18.

• Microsoft reported good FQ2 18 results, but the shares have been so strong recently that all the good news for the current year looks already priced into the shares.
• FQ2 18 revenues / adj-EPS were $28.9bn / $0.96 nicely ahead of expectations at $28.4bn / $0.86.
• Azure was once again the star of the show putting in 98% YoY growth with Office365 recording a very healthy 41% YoY.
• This was supported by steady performance in its server infrastructure products which also saw double digit revenue performance.
• This offset by Microsoft’s consumer facing businesses where gaming grew by 8% YoY and Surface hardware was flat.
• This has been the tone for some time with enterprise going great guns and consumer underperforming the average.
• The outlook for the rest of the year is more of same and consequently, Microsoft increased its revenue and profit forecasts for the full year.
• However, the shares failed to react to the continuing good news giving me the distinct impression that its 15% rally in Q4 17 has already taken this into account.
• Microsoft’s PER ratio is now above 25x, a level it has not seen since 2004, and well above its 10-year average.
• I am comfortable that this is a different company and one deserving of a much better multiple than at the end of the Balmer era but expanding much beyond current levels looks challenging.
• Consequently, I think that the multiple-expansion contribution to price performance is now in the rear-view mirror leading to a more pedestrian outlook from here.
• Microsoft has been a favourite of mine since 2014 but it could be time to start thinking about taking some profits on what has been a fantastic run.

Facebook Q4 17.

• Facebook reported good Q4 17 results as the planned changes have yet to meaningfully impact financial performance meaning that the outlook for 2018 is likely to be one of underperformance relative to its peers.
• Q4 17A revenues / adj-EPS was $13.0bn / $2.21 comfortably ahead of expectations of $12.6bn / $1.95.
• This was driven by continued growth of usage on mobile devices as the measures to increase the quality of engagement (see here) have not yet been in force for a full quarter.
• This move to put its users ahead of its shareholder’s is not born from altruism, but instead reflects the need to maintain user loyalty as it transitions to becoming a fully-fledged ecosystem.
• Consequently, I expect that Sheryl Sandberg’s cash register will be able to fully monetise this increased loyalty in due time, resulting in a pause rather than a curtailment of Facebook’s long-term prospects.
• However, in the short-term the outlook remains difficult as Facebook is curtailing revenue growth while at the same time continuing to ramp up both OPEX and Capex.
• Consequently, I think that in 2018 revenues could grow somewhere between 10% – 20% while OPEX has been guided to grow 45%-60%.
• This is going to have a meaningful and deleterious impact on financial performance that I not convinced the market has fully digested with a PER 2018 ratio of 34x.
• This is largely a result of Facebook’s weak position in AI.
• I have long held the view that Facebook’s AI is not good enough to spot offensive content before it has been widely seen and as a result it is hiring 10,000 humans to do the machines’ job.
• I also hold the view that humans are not fast enough to spot offensive content in time and as a result, I think that the improvement that Facebook is looking for will not be as good as expected.
• The net result is likely to be continued problems with content on its service as well as a steep decline in profitability this year.
• RFM research has shown that progress in AI is much slower than people in the field will have us believe and hence, I think it will be a long time before Facebook sees real improvements in AI impacting its bottom line.
• This, combined with the fact that its ecosystem remains a work in progress, leads me to think that there is space for a lot of profit taking.
• I would prefer Tencent or Baidu.