Mark Mahaney: Talking Tech With a Wall Street Legend

Amanda Heckman: Hello and welcome to this special Manward Letter tech sector update. I'm Amanda Heckman, I'm the editorial director here at Manward. I'm joined by Andy Snyder, the founder of all things Manward, of course. Andy, how are you?
Andy Snyder: Pretty good. Thanks for tackling this for us.
Amanda: Of course. Also joining us is a very special guest. One we're so pleased to introduce to Manward readers. Mark Mahaney is a legend on Wall Street. He's a top ranked stock picker and the longest running internet analyst on the street. He's a frequent guest on CNBC, Bloomberg TV, Bloomberg Business, Vox Business. His opinions and research have appeared in thousands of columns from the Wall Street Journal, the New York Times, the Financial Times. He's even advised Peter Lynch. Mark, we're so excited to talk to you. Thank you for being here.
Mark Mahaney: Thanks for including me. Thanks for inviting me, Amanda. I'm thrilled to be starting this series.
Amanda: Before we kick things off, I just wanted to say that we've put together this conversation to talk about what's going on in the tech sector. What's coming next? No question, the sector has been hurting this year, but will it last? Both Mark and Andy are experts on the subject. Andy, your venture fortunes trading research service finds the best opportunities in the tech sector. Mark, you've written the book on how to invest in the tech sector called, "Nothing But Net." Let's get started with the biggest elephant in the room and Andy's favorite subject, interest rates. The tech sector has, for years, benefited from ultra low interest rates, which has made it possible to develop and grow businesses by borrowing money on the cheap. With interest rates on the rise, is tech dead? Should tech investors move on? Mark, I'll hand it to you first.
Mark: Okay. No, they shouldn't move on. The setup of the question is absolutely right. At the end of the book, I wrote about these phenomenal stocks. They were last decade, Netflix was the stock of the decade. Literally the best performing S&P 500. I tried to draw all these lessons, but I put this caveat in the very end of the book saying, "Look, I want to be fully cognizant of the fact that I'm drawing lessons from what may be a once in a generation secular trend, like the internet." It's pretty well established now, but that wasn't the case 25 years ago. I'm also trying to draw lessons from what has been an ultra low interest rate environment. Not for the last 25 years, certainly for the last decade since the great financial crisis, and absolutely in '20 and '21.
That has definitely changed. I never want to make permanent calls. I think it's highly unlikely we're going to see an interest rate environment we've seen the last two years. Maybe we'll see it again in our lifetimes, but that was very unusual. Over the last 10 years... We're going to be in a hard money environment. I talk about with clients and investors today focusing on hard money longs, not easy money longs. Hard money longs being those that can work, that have got a lot of earning support on 2023, not adjusted EBITDA support on 2026. There's nothing wrong with these long duration growth assets. This is a chance for public investors to get in on early stage investing. There's nothing wrong with that. In fact, great opportunities, but there's no question that aggressively rising interest rates, they require discount rates to go up.
If your profits are based in the future, that means you're struggling down your profit stream today. There are some hard money longs you can find in tech. This isn't a speculative sector. Apple's not speculative, Microsoft's not speculative. I don't think Amazon is, I don't think Google is. There are a lot of names, though, in tech that are speculative and it's much harder to long those assets in this environment. I completely get that. I'll just end up by saying that, when I look at this group of stocks, I'm very specific on the stuff I'm looking for. I'm looking for signs that inflation is moderating. That's the first tell that interest rates will eventually moderate. The second thing is I'm looking for estimates cuts. Tech had a phenomenal 2020 and '21. There is this reversion to the main theory, which is a reality, that you can't dramatically outperform every year.
That led to the underperformance this year. The sector needed a dramatic derating in multiples that happened as the interest rates went up. A few other things happened on the way to the interest rate farm. You start bringing up interest rates, that means the economy is going to slow down, so that's a negative on demand trends. There's one other funny thing that I don't think I appreciated enough at the beginning. You bring up interest rates and then, all of a sudden, that causes dramatic strength in the dollar. Most of the big tech names are global names, so if half of their revenue has to be translated into lower dollars, it's just another headwind for these names. Yes, you can still buy tech stocks, but the bar is higher now. An aggressively rising rate environment. You have to think about it as an investor and be willing to look out 12 months, 24 months. Then the question is, "In 12 months from now, is inflation likely to be tapering down, moderating?" If you think it is, then the investment horizons and investment environment is going to change on tech.
There's no question at all that year to date it has been a very demanding market for tech, for growth stocks.
Andy: Yeah. Right there at the end, you hit on the big question of the day. Where's inflation going to be 12 months, 24 months from now? The Fed wants to get back to its normal range of 2%. To get there from 8%, 8.1%, that could be painful. You said something at the beginning that really piqued my interest and I think it's the big macro thing here. The idea of a once in a generation trend. That's the big question. We look at the effect of the internet on the macro economy. I've written and talked a lot about the deflationary effects. For the last decade, two decades, the Fed has come in and said, "Listen, we're trying to get inflation here. We're just not getting it." So much of that, at least a piece of that, is because of the internet, the efficiency it's created.
You can go on eBay and likely buy a product at the seller's loss, where you couldn't do that before. Amazon brings the free market totally together in one place. You don't have to go to local mom-and-pop and pay their price. You have a globe of market discovery and pricing. Now the question is, is that done? Has the market squeezed out all that last efficiency and now we're paying for it, now we're into this new normal? That's the question I'm wrestling with, looking at tech. Then, of course, you have the new technology coming in. Technology advancements never stop. They might slow down, a pandemic might slow things down, but are we going to get that next leg up? I think that's where that generational conversation comes in. I definitely think it's slowing. Is that once in a generation opportunity behind us? Not so sure, but there are definitely more question marks there now than two years ago.
Amanda: Mark, you said that you see some hard long-term plays. What are some of the unique opportunities you're seeing? Who have you talked to that gets you excited about what's to come?
Mark: Let me start off with a stock approach to a stock answer to your question. In both senses of that word. I do think the bar is higher. It absolutely is, if you're investing in growth in tech stocks now. I'm looking for three things. I want stocks that either have very clear valuation support. Meta trading at 10 times gap earnings generating 20 to 30 billion in free cash flow a year. Google with five, 6% free cash flow yield. You need companies that you can say, "There's a valuation floor here on 23... No adjusted earnings on gap earnings or on free cash flow." That's one screen. The second is the market still rewards inflection points in companies, and third, it still rewards catalysts. The stock performance year to date is lousy across tech.
If you look at it since the middle of the year, so we got three months here, there's a couple of dramatic outperformers. Amazon, Netflix, Uber are three of them. They've actually materially outperformed the market by 10 points to 20, to 30 points. Market's off 10% roughly since the middle of the year. Netflix is up 20%. What that tells me is the market is willing to look at fundamentals, thank goodness, because I'm a fundamentals analyst. What's happened with Netflix is you've got this wonderful new catalyst coming out. They just announced it yesterday actually, that they're rolling out an ad supported service. This is huge. In my book I talked about GCIs, growth curve initiatives. When companies have new product launches, new market launches, or innovations in advertising... There are a lot of different things. I throw in a bunch of examples in the book. They cause that revenue growth rate to reaccelerate. Stocks react positively to that.
I see that with a name like Uber. Uber was one of the biggest loss generating assets ever when it went public. They just hit a profitability inflection point, though. They just generated a first positive free cash flow quarter ever in the June quarter and that free cash flow generation is going to start increasing going forward. It's going to do 2 billion in free cash flow next year, we think 4 billion a year after that. The market's noticed and Uber is up approximately 10%, 15% in the back half of '22 versus, again, that market down 10%. I'm looking for the names that got a lot of valuation support. I'm looking for names that have got these fundamental inflection points, like they just hit free cash flow. In a name like Spotify... It's more speculative, absolutely, but I think we're going to have gross margins start going up next year for the first time as a public company. That's a fundamental catalyst.
That last thing I'm looking for... The valuation support, that fundamental inflection point, or give me a catalyst. I got one for you and that's Netflix launching this ad supported business. We can talk about it more or less, whatever you like. Netflix painted itself into this premium price corner that kept raising fees. Looking at survey work, you were starting to see churn increase, because people said, "I can go somewhere else and get content that may not be as good, but it's a lot cheaper." Netflix is painting itself out of that corner by offering this six 99 aggressive, ad supported price service. I think it's going to have better economics than its core business, so it's a huge win all around. Anyway, that's what I'm looking for in stocks. My top three longs here... I try to be long-term oriented about this. With a 12 month outlook, I like Amazon, I like Facebook... Meta, sorry, and I like Netflix.
Andy: On Netflix, I think that is an interesting topic. Over the last, I don't know, 12 months, 18 months, they've gotten a lot of competition. What effect will this new model have on that? You talked about the churn. They've been losing customers-
Mark: Yeah.
Andy: ... people have been spreading out. Do you think this will bring folks back in? Do you think this will lessen? The Peacocks, the Amazons, what are they thinking with this?
Mark: In my book, I highlight Netflix a lot. It really was the single best performing S&P 500 stock last decade. That's last decade. This decade, it's probably one of the worst performing S&P 500 stocks. That's actually not quite true, but since last November, since Squid Games, it's in a handful of the worst performing S&P 500 stocks. It was trading off as much as 80%. Why? Because they hit a growth wall. For the first time ever, had back-to-back consecutive quarters of subscriber declines. Andy, you mentioned one of the reasons. There's just a lot more competition. Absolutely. There is Amazon, HBO, Disney Plus, Peacock. I started joking that everybody's launching a streaming service, I think Pringles has a streaming service. It is a lot of competition, I think they had priced themselves into this premium price box.
There's no question there was a pull forward of demand to Netflix, because of the COVID crisis. In the first half of 2020, they added something like 35 million subscribers. That's more than they added in full years prior. For good reasons. We all got stuck so, "Let's Netflix and thrill," or, "Netflix and chill." That's what people did. Anyway, created these really tough comps for the company. I also thought the company got somewhat mature too. 60 to 70% of the US broadband households were Netflix subs. Yeah, that's going to limit your growth, because there's only so many more subs you can get. All of that set up Netflix at the beginning of this year, growth hit a wall, I downgraded the stock. Did I get the top? No, but I downgraded the stock, because I thought growth had hit a wall. Then they started talking about advertising.
I thought they should have done it a year or two ago, but that's the past. It's all about the future always. It's always the next play. Those Coach K fans out there, "It's always the next play," when it comes to thinking about stocks. They started rolling out this... They're talking about this ad supported service and there were three simple points for me. I know, based on survey work, that users of Netflix have become more price sensitive as prices have gone up. Sure, it has increased. Second, I looked at what the other streaming companies were already generating in terms of ad revenue per user. It was like five bucks. The light bulb for me was, "Wait a second. Netflix can come out, cut their price by three bucks a month, and then layer in five bucks a month in ad revenue per user."
It's better economics. Instead of getting nine, 99 in subscription revenue per sub for the basic plan, they'll get six, 99... This is what they're doing right now, literally what they're doing, and then they'll get ad revenue on top of that. It could be $5, it could be more than that. All in, they're going to be generating $11 and 99 cents. You don't see this too often in business, where somebody's rolling out a plan that broadens their value proposition. IE, the more price sensitive customers, they don't have to churn over to somebody else, they can go to the lower price plan. You reduce churn and then you get better economics on that? You rarely see that. I just thought this was such a great move by the company. Belated, but great move by the company. I didn't think it was in estimates and I didn't think it was in valuation.
Yeah. I'm on Netflix's bull again. When you get these turns, these things can play out for quite some time. To a positive and a negative. Anyway, that's one of the reasons I'm so bullish on Netflix today. Valuation... Sorry, last thing. You could never have bought Netflix at 17 times gap earnings. The first year in it's 25 year history that you could... It's been a public stock for, I don't know, 22 years or something. The first time you could ever have bought it at close to a market earnings multiple was 2022. First time ever. This is what happens. Andy, you know this history just as well as I do. You get the big multiples, big growth names, and then often gravity brings down everybody. Those growth rates come down, the multiples come down, and you get another chance to look at it more from a value perspective, more from a GARP perspective. That's the sweet alley, sweet spot, whatever it is, that you can find Netflix in now.
Andy: Yeah. I like that. You made me feel old, though. I remember when Netflix IPO'd and I was writing about it. Yeah, it's been a while. You mentioned, again, going back to the macro idea, the pull forward.
Mark: Yes.
Andy: If you look at charts in the market right now, we're basically back to 2019. 2020 and 2021 disappeared, because so much of the... Not demographic, but the economic trends have gone back. We've erased the COVID bump and people aren't working from home. They're not sitting at home and they're traveling again. What effect do you think that's going to have? It's less a technology question and more of a macro stock question, but it ties into technology. What effect do you think that's going to have? Do you think we've gone back to the 2019, that's the big reset, we've gone down to the mean, and here we go, we're resetting it and moving forward? Or do you think there there's more to it than that?
Mark: You're raising $100 billion question, Andy. I'll tell you, this is what I've witnessed over the last three years. Year prior to COVID and COVID years. This was a once in a generation. I hope it was a once in a generation event, I hope I don't see this again. It had dramatic impacts on everything. On politics, on culture, on lifestyles, on economies, on technology. Everything. Zoom is permanent feature now, because of COVID. We could go through a lot of other examples. When it comes to the stocks, that was one of the biggest, fastest corrections we've all ever seen. Go back, Andy. That February to March, that was 30% correction across the entire freaking market in a month. That's 1930... I forget the exact date of Black Friday. The markets have gotten faster and we just corrected dramatically.
Then it created this dramatic mother of all, father of all bull markets for the next two years. What happened in that, and this won't shock anybody, we over extrapolated. The market's never completely... It's rational long-term, but it's human nature short-term. We get overexcited and underexcited. We had this dramatic rerating in the supposed COVID winners. Too many companies were thrown into that COVID winners camp. Peloton, permanent winner. Turned out not to be the case. Netflix, permanent winner. I think it actually was a winner, just not by as much as the stock implied. You had a good number of these companies that... The average multiple doubled for the stocks that I look at. They went from 15... Almost doubled. Went from 15 times 40 EBITDA to 25 times a year in 2021.
One of the reasons the sector has corrected so much this year is that the market said, "Wait a second, they can't all be permanent winners. We're going to derate this sector." Then you had these tough comps, because June of '20 was a terrible quarter. That was the worst COVID quarter for ad names like Google and Facebook. The revenues declined year over year, which meant June of '21, monster quarters in terms of year over year revenue growth. I can tell you what the headlines were, because I read them and I wrote some of them too.
Andy: Mm-hmm.
Mark: Google just had its fastest revenue growth quarter in 15 years. What happens then in June of '22? It has its slowest revenue. It's like it's a comps issue. You had all these funky COVID comps you had to work through. I think these investors, you had to really think hard about, "Yeah, this was a major event." There clearly were some real long-term winners from it. They may have been overpriced, but there were some, and some of the ones that were treated as long-term winners weren't long-term winners. You had to sort through all that. I've gotten off on a little bit of a tangent, Andy, because you asked a question that I'm really passionate about. I think there were some permanent societal impacts from COVID. What we're doing, where we all are now, this remote working, remote living, for good or for bad... I worry about these Bowling Alone trends. For good or for bad, that's part of how we're all going to be living and working in the future. Not permanent, but there's going to be some sort of element to that. That has to have business model implications, positive and negative, for assets.
I spent a lot of time thinking through those. My guess is that we've gone through this hype, disappointment, and there's a reality that comes out of that. We way overstated the COVID impact and now we treat as if there was no COVID impact, but there was an impact. I'm looking for those names. I think Amazon actually is a structural winner from the COVID crisis. I think Airbnb is a structural winner from the COVID crisis. If you want to price it as if they're the biggest long-term winner ever, I can't buy that. If you want to price it as if there was no impact, I'll buy that. That's where you are on some of these names like Amazon.
Andy: Yeah. The other caveat in there is all the money we printed, we have to digest-
Mark: Yes.
Andy: ... all of that. That's the big variable the markets are really having to struggle with. Especially right now with all this interest rate and inflation talk. For our viewers, the key here are those extremes. We talked about reverting to the mean, but we're hardly ever at the mean. We're at one side or the other. We just need to grasp how fast and far things move. We went from a two week shutdown to here we are, several years out of it, still dealing with the ramifications of it all. I don't think we're done with it, because we did such monstrously large things to combat this. Namely printing trillions of dollars.
Mark: Yes.
Andy: Still handing it out. We're going to be fighting that for a while. It's good news for guys like you and I, Mark. We've got plenty to talk about.
Mark: It's also just a reminder of the law of unintended consequences or the laws of consequences. You do major things and... You print a lot of money, you may well have needed to do that for a period of time, and we can debate whether what was too much or what was too little, but that's going to have a consequence. We're seeing it today. Getting back to the very first question you asked. If we get it back to growth and tech stocks, aggressively rising interest rates are not good for long duration assets and there's need for a reset. That's what we've gone through. It's been very painful. NASDAQ is off over 30% year to date. The tech stocks that I looked at, the internet sector is off 50% year to date. Again, they had monster years in '20 and '21, so there always is a reversion. Anyway, we have to think through... These stocks never trade in a vacuum and you have to be able to put that macro cap on them. I've become an inflation analyst in addition to being an internet analyst.
Andy: With inflation rising interest rates. Rates are still historically low. Again, it depends what we call, "Historic." Again, if you draw on average between the '50s to here, we have the '80s throwing everything out and an average rate 7% or so. Can a Netflix, can a Google still grow when borrowing costs are six, 7%, something like that? Sure, that slows things down, but what do you see as the neutral limit or the fair price for rates? When we really start to see, "This is the thing that's going to slow us down." Not just the overall trend, but where's that line that creates some actual contraction?
Mark: You're much smarter at that than I am, Andy. I'll sidestep that question a little bit, but I'll make two points. One is that I just want to be clear, rates have no impact on the fundamentals for Google. Google's got a 100 billion plus in cash and they should be paying a dividend. They don't have to worry about borrowing costs. Apple can take on debt, because they want to, not because they need to. Same thing with Microsoft. It's wonderful to be those companies, they can weather any storm. It's more for the speculative assets where the valuation is based on future cash flow. You have to run the DCF models. You can't buy it on this year's free cash flow or next year's free cash flow. That's what the market penalizes the most. Then there's the other thing, which we've also touched on, which is rising inflation has this... Aggressively rising inflation, which the Fed now has to... We're probably too late to combat and that does have economic consequences.
It will lead to a softening consumer. They have to put the breaks on the economy, so that does crimp demand. None of these stocks are insulated from crimping of demand. If the economy's going to slow down, Google's revenue growth is going to slow down. If the economy's going to slow down, Amazon's growth is going to slow down. Interest rates don't impact their P&L or their balance sheet. For the biggest tech companies, I'm talking about. Rising interest rates, to the extent of the slow business activity they do, will slow down their end demand. I spend a lot of time looking at all the stocks I cover, or what we should do as investors and say, "Nothing's recession resistant, but what's more recession proof? Which of these companies is more recession resilient than others?" I think about relatively inexpensive subscription models for entertainment. That's Netflix.
That probably holds up better. Whereas names that are mostly discretionary like a Peloton, fashion apparel companies, luxury goods... Travel's the funny one, Andy, because we just had the summer of travel love. This was the strongest travel year we've had in decades, because it was so much pent up demand. Even yesterday, Delta Airlines is talking about really strong results that are continuing. Travel, we all know, is discretionary. When times get tough, you're going to cut back on that trip. We had so much pent up demand that it remains strong this year and you got to wonder that that shoe has not fallen yet. That shoe is super high. Retail, we've seen some signs of softness. Advertising, we've seen signs of softness. We haven't seen it in travel. We should all think about... That's probably going to be weak next year. You're going to have tough comps. Yeah, that's one sector I want to be cautious about. I like Airbnb as a long term asset. I think what they're doing is really innovative. They generate a lot of cash flow, it's a great business model. I love these innovative founder-led companies.
Airbnb is a stock for years one through four, not necessarily for months one through 12.
Andy: Sure. I echo your comments on the airline industry and travel. Airlines especially. You look at some of the earnings out in the last couple of days and weeks... Valuations are certainly high and the excitement is high, but you also have to add in rising energy prices and energy volatility. There's hedging involved with that. That's part of it, but then you look at lots of companies... Who was it today that was laying off 16% of their workforce? Thousands of people. Those people aren't going to be traveling. As people worry about their jobs, travel is going to wane. That's probably the next really big leg, the employment conversation.
Mark: Yeah.
Andy: Employment's been red hot, but there are signs of that weakening. It has to. To get from 8% inflation to 2%, if that's still the goal, somebody's going to have to lose a job. A lot of somebodies are likely to and that's not good for the travel industry, for sure.
Mark: I agree.
Amanda: It sounds like that's - not a great note to end on, but a note to end on. Definitely given us and our readers a lot to think about, some things to look forward to, and things to look out for. If anyone who's watching has any questions about what was talked about today, be sure to send us an email. That's mailbag at Manward Press dot com. Mark, thank you so much for joining us and we look forward to talking to you again. Thank you, Andy, for taking some time out of a busy Friday to talk to us as well. From all of us here at Manward, thanks for watching. Take care.
Mark: Thank you.
Thanks, Andy. Thanks, Amanda.