Interview

«Amazon stands out as a big winner»

Michael Pachter, long-time tech analyst at Wedbush Securities, believes the online giant will grow strongly even after the pandemic. He warns of a challenging earnings season for Facebook and Google and explains why he thinks that Netflix is massively overvalued.

Christoph Gisiger
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Tech stocks please investors with an outstanding performance. No other sector has done better since the beginning of the year. Tech titans like Amazon, Apple, Microsoft, Google and Facebook push the entire US stock market higher.

With the beginning of the quarterly earnings season, it will soon become clear which companies are actually doing well against the backdrop of the severe global slowdown and vast disruptions caused by the pandemic.

Michael Pachter has no doubt. The renowned financial analyst with twenty years of experience in the tech sector expects Amazon to print a strong surge in sales thanks to the delivery of groceries. He also spots great potential in entertainment software stocks like Activision and Electronic Arts.

Mr. Pachter, who works for Los Angeles based Wedbush Securities and doesn’t hold back with his opinions, is less optimistic for Google and Facebook. In his view, the two internet giants will disappoint with weak advertising revenue.

The long-time industry expert also questions the rich valuation of Netflix. «The truth is that Netflix is on a hamster wheel. They’re spinning away and are going nowhere,» says Mr. Pachter in this depth interview with The Market/NZZ which has been edited and condensed for clarity.

Mr. Pachter, U.S. stocks just finished the best quarter in more than twenty years. What are the perspectives for the second half of the year?

There is a disconnect in the market when it comes to the impact of the coronavirus on the global economy. Sure, some stocks are getting killed, traditional retailers like Macy’s or Nordstrom for example. But in general, investors are overly optimistic about the U.S. economy despite rising infection numbers. So this article will be timely in about a week or two when we see the death rates spike and the market is going to freak out.

Technology stocks are performing strongly in this challenging economic environment. The Nasdaq 100 is up nearly 18% for the year. What’s your take on the tech sector?

Some tech stocks benefit immensely from people staying at home, like Zoom Video for instance. Other stocks benefit from home productivity like Microsoft. If Microsoft can suddenly sell 50 million Office licenses because people are working from home, then you are going to see that in their numbers. But the guys who really benefit are the publishers of mobile games like Zynga and Glu Mobile because the longer you play their games, the more money you spend. They're killing it.

Big Tech dominates the stock market more than ever. What are your thoughts on other tech titans besides Microsoft?

I don’t cover Apple, but I’m not sure if people are buying more phones. Maybe we are, but probably not. So Apple is selling fewer phones. On the other hand, they benefit from much higher engagement with games in the App Store. But the one that’s really crushing it is Amazon.

Why?

The big boost that Amazon is seeing is grocery. We’re not buying more iPhone charger cords, TVs or other normal stuff because of the recession. But we are buying more groceries, especially when they are delivered to our door. In their first quarter earnings report, Amazon said that grocery is up 60%, and it’s gone up further since then. Most importantly, I think that’s permanent. Amazon convinced us that the stuff that comes from its delivery service is pretty good. Also, you can get a lot of items that are often sold out in physical stores. So getting groceries delivered by Amazon is something we’re getting into a habit of and trust. And, once they get you as a Prime member, you tend to ignore shipping costs, and you don’t compare price costs that much.

What does this mean for investors?

The problem is, I don’t know how much of that extra profit drops to the bottom line. Let’s just say their sales are going up $10 billion and the gross margin is 40%. That means $4 billion of extra profit. But they also said that they might be spending $4 billion more to keep employees safe. That makes it hard to guess since a few hundred million makes a huge difference in earnings. That’s why I can't say if they are going to beat expectations by one, five or zero dollars. But I do think the revenue gains are permanent, and the spending increases are not. So frankly, Amazon is the one big tech company that just stands out as a big winner and it persists.

You’ve just increased your 12-month price target for the stock to $3,050. What’s the next big growth driver for Amazon?

They are going to enter the video game business by creating an Amazon Echo enabled device that will serve as a video game console. In other words: They’re going to put a CPU and a GPU unit in one of the next Echo models. They will put something in there, and it will connect to your TV and you will be able to play video games. That’s the next big thing they’re doing and I think that’s sincere.

Entertainment software is one of your core competencies as a financial analyst. You’re also hosting an internet TV show called «Pachter Factor» about video games. What’s your outlook for the industry?

Game companies benefit immensely when you eliminate the hurdle of purchasing a console. If you already have a device at your home which could be a PC, your smartphone or a smart TV, and you can play a game on your TV without buying special equipment, the industry will sell more games. It’s just like watching an on-demand movie on your TV that comes from the internet without any special equipment. That’s what’s going to happen to the game guys: They get more people consuming their entertainment content over a longer time window which means they can monetize their games better. Think about the movie Titanic: Around 300 million people saw that movie at the theater. But how many people have seen it in total? Way more than 300 million, probably 2 billion.

Which video game publishers are best positioned to profit from this trend?

The guys who have the most popular games will benefit the most. But realistically, every game has an audience. For instance, «Call of Duty» sells 25 million copies. If you didn’t need a console, it would probably sell 50 million copies. The same is true for less known games like «Psychonauts». If they sell 2 million copies today, they are going to sell 4 million copies without the requirement of a console. So everybody should double their sales. The big guys are going to get bigger, and the little guys as well.

Which video game company is most attractively valued against this backdrop?

Activision: They have a lot of content coming up in the next couple years, and they’re exploiting their advantages better than other publishers. EA is second and Take-Two third. But they’re all going to benefit. They’re all going to see their sales go up.

When it comes to video gaming, Google and Facebook are trying to grab a piece of that pie as well. How are these two internet giants holding up in general?

Here’s the thing: Facebook makes more money if you consume more Facebook. The same goes for Google because they can sell more ads. But this recession is not a 1% GDP decline for one quarter. It’s more like a 10% decline for three quarters. So when people are unemployed, they’re buying fewer cars and they certainly take fewer cruises and flights and stay at fewer hotels. That’s why I think that Facebook and Google are seeing a massive decline in advertising spending even though they’re seeing a massive increase in engagement. The March quarter didn’t give us enough information. But both companies said that the ad rates dropped a lot in the last two weeks of the quarter. Therefore, I think these two stocks are set up to fail. They will do poorly when they print the June quarter.

Who can handle these headwinds better: Google or Facebook?

They all have the same problem: Demand for advertising is going down and that means ad rates are going down. Now, Google isn’t growing impressions as much as Facebook. Also, Facebook has a big growth business in Instagram. Yet, Twitter and Snap both are growing users much faster than Google and Facebook. They’re probably offsetting the decline in ad rates with higher network users or higher engagement which means more impressions and more ads. Remember: Ad revenue equals number of users times duration of visits times frequency of visits times frequency of ad views times ad rates. So ad rates could be down 30%, but if your engagement is up 25%, you’re only down 5%. That’s why I think Google is the biggest loser of those four. Snap is likely the second biggest loser, since TikTok is squarely aimed at Snap. TikTok is growing fast, and that’s not all new users, that's users from Snap.

Then again, you’re having an outperform rating on Google. Why do you like the stock?

That’s just a bad quarter. They’re growing revenues nicely, and YouTube is a big deal. I’m actually not a fan of the company’s strategy in spending on all sorts of stupid stuff. But if they ever decide to drop profits to the bottom line, they can make a lot of money.

Speaking of expensive bets: How excited are you about Waymo, Google’s self-driving car project? Especially, since Amazon just acquired the self-driving startup Zoox.

Honestly, I don’t understand why they’re pushing self-driving cars with Waymo. Maybe, sometime in the future self-driving cars can be integrated with Google Maps. That could be interesting. But the problem is that you can’t put a human driver on the same road as a self-driving car. The human driver will make it unsafe. So until we come up with a highway system where all cars are self-driving, this is going nowhere. People don’t even want to wear masks. How do you think they will give up their right to drive? We are 25 years away from something that works. Hence, I think that’s a real waste of time.

Alphabet, the parent company of Google, changed its leadership with Google CEO Sundar Pichai taking helm. Also, they’re starting to get more transparent with their cloud business. Do you think Alphabet is getting more investor friendly and maybe even starts paying a dividend?

I think that’s a fantasy. It’s an unfriendly company and it has worked for them. So that’s their formula. They have no reason to get friendly right now. But if the stock goes down, they get friendly and everybody forgives them. Amazon got really friendly when their stock went down to $265.

Over the past few days, we’ve seen several large consumer brands like Coca-Cola and Starbucks announcing boycotts against Facebook and other social media platforms. What’s your take on these developments?

Advertisers are the only group that can bring any pressure on Facebook to change its content. There’s enough of a movement from advertisers which are opposed to conspiracy theorists, racists, and false information proliferating on Facebook. They are going to pressure the company to manage free speech and manage incorrect information like untruths about the virus or about voting by mail. So I expect that Facebook will make changes much the way we’ve seen Twitter make changes where they put disclaimers on political ads and remove hate speech.

How will these boycotts impact Facebook’s earnings?

Obviously, Facebook needs to do a better job. I would say that the number of advertisers that are scaling back is between 10 to 20% of total ad spend. So let’s just pretend this boycott lasts for exactly 36.5 days which is 10% of the year. If it lasts 10% of the year, and it’s 10% to 20% of ad spend, then it’s a 1% to 2% hit. You won’t hardly notice that. Also, it won’t take Facebook longer than 36.5 days to get together with its advertisers and explain to them what they’re doing to address their concerns.

It’s not the first time Facebook finds itself in a storm of criticism about the way it handles problematic content. What are your thoughts on Mark Zuckerberg’s performance as a CEO?

He’s a good product guy and a visionary as far as how to make Facebook’s websites more attractive. But he’s not the right business guy. Clearly, he’s tone-deaf. He works the same way as Jack Dorsey at Twitter. Somehow, they think the First Amendment governs them. Sort of like: «People can say whatever they want, we’re not here to censor free speech». In 1964, there was a famous US supreme court case about pornography. At that time, Justice Potter Stewart who wrote the opinion said: «I can’t define pornography, but I know it when I see it.» The same is pretty much true for Zuckerberg and Facebook: You know when something is offensive when you see it and you know it when something is empirically false. So I expect it won’t take more than 10% of the year to fix this.

With just four months to the election, we’re also seeing more political pressure on Big Tech. Which antitrust investigation should investors worry about the most?

I don’t see a lot of risk of them being broken up. The bigger risk for these guys is taxation. Google is going to be looked at pretty hard from a privacy standpoint, but U.S. antitrust risk is low, since the law is clear: It requires anticompetitive behavior, there is no law against being too big. Yet, if you do something to keep your competition from being able to compete like Microsoft did by automatically installing the Bing search engine in every version of Windows, then antitrust laws apply. From that perspective, Facebook doesn’t have a lot of risk, nor does Google or Amazon. Internationally, laws are different. So if the EU decides we don’t like how you operate your business, they can put some type of a barricade in front of you.

You’re one of the very few analysts who are bearish on Netflix. How come? Isn’t Netflix one of the biggest winners in the context of the pandemic?

It comes down to the business model: If a company charges by the minute for its service, then greater consumption of service equals more dollars. But that’s not true of Netflix since you pay one flat fee. They said it clearly on their earnings call: Anybody who doesn’t join Netflix during the pandemic is probably never going to join Netflix. They said it to be funny, but that’s what’s going to happen. You are going to see a massive spike in subscriptions which is going to set up an impossible comparison next year.

Is that why you think Netflix is overvalued?

Well, Netflix is overvalued because it’s trading at a $215 billion market cap and they don’t make money. So we’re paying $215 billion because some day they might make money. Really? I don’t get that at all. That’s paying $1000 per subscriber, and I don’t understand how they ever generate $1000 per subscriber. You would have to be a subscriber for ten years and they can keep all the money. That’s just not possible. This valuation makes no sense at all. The truth is that Netflix is on a hamster wheel.

What do you mean by that?

They’re spinning away and are going nowhere. Everybody talks about their content library, but the value of their library to an existing member is questionable. My wife and I watch a lot of Amazon Prime. So recently, I listed all the shows that I’ve seen on both services, and Amazon is better than Netflix. It’s not even close. Netflix has quantity, but Amazon’s shows are pretty good. Netflix is doomed to spend billions and billions of dollars every year to create new content to keep people like me from quitting. And then, they are going to run out of new customers and the old customers are going to get bored. So they are going to have to spend even more.

On the other hand, Netflix is rapidly growing internationally.

Well, they’re generating growth by giving their service away for free. It’s like one or three dollars a month in India. So who cares? They’re not making money there.

What’s more, Netflix recently changed the way it reports its user data. What’s your take on the company’s accounting practice?

They capitalize their content spending. So net income reflects lower expense than they’re spending on content. Cashflow is a good proxy for how much money they make, and they haven’t made money in six years. They may benefit from Covid by getting an acceleration of subscribers and by slowing their spending, but they couldn’t produce content for the last three or four months. So that’s temporary. Next year, they are going to have to spend even more. I just don’t see them making money for another three, four or five years. And when they do, they’re not going to make very much. Cash flow is reality, net income is an accounting convention that assigns a huge value to their library that I don’t think it has.

Another company you’re covering is Logitech, a Swiss manufacturer of computer peripherals. Why did you downgrade the stock to a neutral rating recently?

Logitech is doing everything right, and their products are superior. But I’m just not sure how much the gains that they are going to see during the pandemic are permanent. There was an acceleration in work from home, and an acceleration in gaming. They are going to print amazing numbers for the June quarter and probably again in September. But once you’ve bought a webcam to do Zoom calls from home, you’re probably not going to buy a new one next year. So the comparisons are going to be very hard. The stock is trading at 25 times my 2022 earnings estimate which is as high as it ever traded. I don’t think my estimates are crazy which means the valuation is stretched.

Michael Pachter

Michael Pachter is an equity research analyst at Wedbush Securities, providing coverage of the Entertainment Software, Entertainment Retail, Social Internet, E-Commerce, and Movies & Entertainment sectors for the last 20 years. He also hosts one of the most significant and highly-regarded industry events during the annual E3 conference. Previously, Mr. Pachter spent two years as the Director of Research at Wedbush Securities. Before joining Wedbush Securities, he served as the Director at Management Resource Center, a middle-market investment bank. Before that, Mr. Pachter spent 15 years in various financial and management positions at Atlantic Richfield Company, most recently as Director of Strategic Planning. He has been recognized as StarMine’s Top Earnings Estimator year after year and Best on the Street by the Wall Street Journal. Mr. Pachter holds an M.B.A. from the Anderson School at the University of California at Los Angeles, a Juris Doctor from Pepperdine University, an LL.M. in Taxation from the University of Florida, and a bachelor’s in Political Science.
Michael Pachter is an equity research analyst at Wedbush Securities, providing coverage of the Entertainment Software, Entertainment Retail, Social Internet, E-Commerce, and Movies & Entertainment sectors for the last 20 years. He also hosts one of the most significant and highly-regarded industry events during the annual E3 conference. Previously, Mr. Pachter spent two years as the Director of Research at Wedbush Securities. Before joining Wedbush Securities, he served as the Director at Management Resource Center, a middle-market investment bank. Before that, Mr. Pachter spent 15 years in various financial and management positions at Atlantic Richfield Company, most recently as Director of Strategic Planning. He has been recognized as StarMine’s Top Earnings Estimator year after year and Best on the Street by the Wall Street Journal. Mr. Pachter holds an M.B.A. from the Anderson School at the University of California at Los Angeles, a Juris Doctor from Pepperdine University, an LL.M. in Taxation from the University of Florida, and a bachelor’s in Political Science.