The RiskHedge folks are starting a new newsletter called Disruption Investor, and they’d like you to be a “founding subscriber” ($49/yr) — it looks like this will be one of those technology-focused “entry level” newsletters, helmed by Stephen McBride.
What do I mean by “entry level?” Some publishers call this their “front end” — they’re the lower cost letters that sometimes make a little money but are mostly used to build a list of “people who are willing to pay for investment info,” since those folks are very valuable to marketers and are the best audience for the “upgrade” or “back end” services that cost 20-100X as much and generate most of the profit for many publishers. Pretty much all publishers have a $50ish newsletter that they use to build their mailing lists and funnel subscribers up to their much-more-profitable $1,000 or $5,000 newsletters — and “tech stocks” are often the focus of these letters, since they help attract attention from novice retail investors.
And like so many other newsletters, Disruption Investor is promising to deliver a hot new investing idea as part of their pitch to potential subscribers… and they drop some hints to tantalize us.
So our job, of course, is to go through those hints, identify the stock for you, give you enough info that you can begin to think for yourself about the company… and then, well, you can decide whether or not you want to buy the stock, or whether you want to subscribe to the newsletter — hopefully without all the additional pressure and bias that comes from the heavily pressured marketing language in the ad.
Let’s give you a little taste of the ad, just to get you revved up:
“Netflix’s Worst Nightmare
“It’s NOT Apple, Disney, Amazon, or Hulu…
“Instead, it’s a smaller American company whose stock is set to DOUBLE every 2 ½ years.”
And McBride claims some gravitas because of his prediction that Netflix was going down…
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“Maybe that’s why I hit a sore spot last December…
“That’s when I publicly predicted that, as an investment, Netflix’s best days are behind it.
“Over 2.5 million people stopped by Forbes to read my prediction….
“Sure enough, Netflix’s stock tanked 42% after I warned folks not to buy it.”
I’ve never owned Netflix because I haven’t been able to stomach the valuation, so I’m no wide-eyed bull when it comes to that stock (and my portfolio has been hurt because of it), but that assertion is worthy of a double-check — he did post a negative piece about Netflix, though he did so on December 10 and claimed in that piece that he told his subscribers “Netflix is going to get crushed” back in July, when it was near all-time highs around $400.
I don’t know if that’s true, we don’t have access to his old recommendations, but in that Forbes article he said Netflix is worth $190-200 per share (it was around $275 at the time, during the decline we saw in all tech stocks in the fourth quarter) and that Disney (DIS), soon to be a streaming competitor to Netflix, was “heading for 170”).
So, since he’s claiming great prescience, what have those stocks looked like since he wrote on December 10? Here’s the chart — Netflix in orange, Disney in blue, and the S&P 500 in red:
I own Disney myself, and it’s doing well and I’d obviously choose the stock over Netflix, too, but performance-wise, it’s no Netflix… at least not yet. That doesn’t mean McBride is wrong about the long term, but it serves as a reminder that we shouldn’t take any short-term predictions very seriously, no one is consistently very good at getting them right, no matter what their ads say.
So with that little caveat out of the way, let’s see if we can identify his “Netflix’s Nightmare” stock idea.
“Netflix needs two things to keep up with bandwidth requirements….
“One is data centers to store the content. I just explained how Amazon actually controls those.
“The other thing Netflix needs are networking switches.
“Networking switches are a lot like railroad switches.
“But instead of routing trains, network switches route data.
“They send the right shows and movies to your TV.
“Well, Amazon doesn’t make switches.
“It has to buy them from the ‘Netflix’s worst nightmare’ company I’ve been telling you about.”
So the Netflix connection is that this teased company sells switches for data centers, and Netflix needs more switches to keep expanding its ability to provide content? That makes the word “nightmare” seem a bit misplaced, but let’s get some more clues…
“… if you’re an investor hunting for big, safe profits, it’s this switch company you should pay close attention to.
“It’s crucial to the growth of companies like Netflix and Amazon.
“Which is exactly why, according to my research, this switch company is set to double every 2.5 years for the foreseeable future.”
OK, so that’s actually a fairly rational forecast — at least in the context of newsletter promos. They often promise 1,000% returns or life-changing profits, so “double every 2.5 years” sounds almost reasonable. That’s only a compound annual growth rate (CAGR) of about 32% a year… which is REALLY, REALLY GOOD and enough to really goose your portfolio if you can compound those kinds of earnings for a long enough time, but 30% a year is not usually the stuff of daydreams — more often we’re sold on the idea of a winning lottery ticket and a Ferrari in the driveway.
Other clues? We’re told about a few of the other big customers of this switch company:
“… it’s not just Netflix and Amazon…
“Google and Microsoft also need this company’s switches to keep growing.
“Keep in mind, Microsoft, Amazon, and Google are 3 of the 4 richest companies on earth.
“But as big as they are, these three giants only account for about 40% of this company’s revenue.
“5,000 other customers buy their switches too.
“Including the Pentagon, which recently placed a $100-million switch order.”
OK, that’s almost enough to start guessing… but we’ll keep going. What else are we told about this company and its prospects?
Here’s a bit:
“The company I’m talking about has a key competitive advantage.
“It has a toll booth position….
“Its toll booth position is secure for at least 5 more years, through 2024.”
From what I gather, this “toll booth” he’s talking about is not at all literal, he seems to be referring to their “competitive advantage” as a toll booth — so presumably they have a technology that’s better than others and is, as the title of the newsletter indicates, a “disruptor” in the industry. A technological advantage or “lead” is pretty much the only competitive advantage that matters for technology companies that are already large and selling at a pretty meaningful scale (as this one must be, if Amazon, Google and Microsoft are close to 40% of their revenues).
He compares this company to an early Cisco (CSCO), and that always gets peoples’ attention — especially when you’re able to include that Cisco stock chart from about 1990 to 2000, when its shares returned about 100,000% (no one ever includes the post-2000 period in their tantalizing CSCO charts, mostly because the dot-com crash was so dramatic, and the 2000 overvaluation for CSCO so absurd, that the stock, despite continuing to lead the industry for decades and paying a strong dividend, has still not yet gotten back to that peak price… though thanks to strong performance over the past couple years, it’s finally getting close).
That comparison is not just to stock price potential, though, since Cisco is in part a switch company… more from the ad:
“Cisco makes networking equipment.
“It made the equipment that allowed computers to connect via networks.
“And one of the key pieces of equipment Cisco sold was networking switches…
“Just like the other company I’ve been telling you about.
“That’s what took Cisco from nothing to a market cap of over $550 billion, making it the biggest company in the world in the year 2000.”
And now, apparently, this “Disruptor” steps in…
“Cisco’s networking switches have fallen out of favor.
“And companies like Amazon, Google, and Microsoft are replacing them with this company’s switches instead.
“In other words, this company could go on the same kind of tear that Cisco did 20 years ago, selling a similar but superior product.
“Now, I’m not telling you this new networking switch maker will grow as much as Cisco did in the ‘90s.
“For one, Cisco was an 8-cent stock at the time. And the company I’m telling you about is no penny stock.
“In fact, it’s a $24-billion company already.
“Still, though, it’s eerily similar. So much so that I call this company the next Cisco.”
So what is different about this company? More from McBride…
“… it figured out how to turn a hardware switch into a software switch….
“The switches that this company makes are much faster and easier to use than Cisco’s.”
And apparently there’s a lot of growth potential:
“… today, the network switch market is worth about $4 billion.
“Right now, Cisco enjoys almost HALF of that business.
“Meanwhile, the company I’m telling you about only has about 16% of the market.
“That means it sells $640 million in networking switches per year.
“I expect those numbers to flip, though. Fast.”
And that’s enough for us to feed to the Thinkolator… so what’s the stock?
This is, interestingly enough, a company that has been teased by the Motley Fool for almost two years now (we last covered one of those pitches about this as Tom Gardner’s top 2019 pick here, though they’re still circulating today), and a stock that I also own a small position in: Arista Networks (ANET)
Arista is indeed primarily a maker of software-based switching systems for networks in data centers and large enterprises (think: corporate campus with 1,000 employees), they use fairly generic chips from providers like Broadcom (AVGO) and build customizable and programmable switches around that silicon as a “newer, better, faster, cheaper” product than competitors like Cisco were selling. And yes, if you’re checking the clues, they did get awarded a Pentagon contract last Fall, taking some business away from Cisco ( Cisco reportedly protested, I don’t know if or how that was resolved) — and that could be $100 million over multiple years, though that’s still not a massive driver of returns for a company that’s expected to report more than $2.5 billion in revenue this year.
The stock was an incredible performer in 2016 and 2017, though has been more volatile since and has lost that steady upward momentum (at around $250, the price today is very close to where it was in January of 2018, though it has been both above $300 and below $200 in the months in between). It’s also pretty big — it’s no longer a $24 billion company, that was two weeks ago, before their disappointing earnings report of May 2… it’s now just below $20 billion.
Arista falls into that scary category of stocks, which includes a lot of the tech world right now, that is counting on a narrative of, “early and mid 2019 will be weak, but things are going to get a lot better late in 2019 and 2020” — that same story is being told about a huge number of companies, mostly because of the data center spending and 5G investment.
The big cloud companies reportedly pulled back a bit on spending and had overbought equipment late last year and early this year, like switches, including the big Chinese companies who probably overbuilt their inventory because of tariff threats, and forecasters are expecting a “bounce back” … and the 5G-exposed equipment companies are waiting for the major telecom providers to go beyond the initial testing and limited rollouts and place huge orders for aggressive nationwide (and international) buildout of 5G networks. Those narratives both make sense, but the fact that this huge swathe of the tech investing world, including almost all the hardware companies that I can think of, is in “just wait’ll the second half of the year!” mode means there’s probably a lot of risk — anything that these companies say about delays or slower demand or lowering forecasts or guidance could clobber a whole lot of stocks (a lot of these stories and forecasts are already known for this quarter, but not all of them — we’ll get one more indication later today, when NVIDIA (NVDA) reports, since they also are dependent on growing spend in data centers).
So that’s the risk, that we’re likely to have a volatile second half of the year for data center and 5G companies thanks to high expectations… even if big events or trade war tweets don’t put a huge scare into the market. For Arista specifically, I’ll share with you what I wrote to the Irregulars after their earnings report a couple weeks ago (when I also added a little bit to my position on the dip, though it has dipped further still)… this is an excerpt from the May 3 Friday File:
Arista Networks (ANET) is one of the purest “big data center” plays out there, and has been whipsawed a few times by the wave of bullish and bearish sentiment over how much big players like Microsoft and Facebook are spending on building and upgrading their data centers (both are very large ANET customers)… all tied in with the stories of the major chip suppliers to the data center, many of whom have gone through a couple panic/party phases during just the past year as worries about that market go up and down.
I don’t have a handle on exactly where we’re going, but ANET got clobbered after reporting “just fine” earnings, and it was mostly because their second quarter revenue guidance was way below what Wall Street was projecting (~5-8% below), and that almost entirely because of the surprise “pause” in orders from one of the “Cloud Titan” customers starting in mid-March — most likely Microsoft, their largest customer, but it could have been one of the other biggies (they’re not saying). That drove the shares down about 15-20% and, to jump to the conclusion, I bought a bit more.
It’s an expensive stock by most measures, at almost 10X revenue, and it trades at a rich premium both because of the rapid growth they’ve seen and because of the next cycle of growth expected by investors, especially the upgrade that we should start to see soon to 400G data center connections, though they and others have also spent the past six months cautioning investors that the 400G upgrade cycle is going to be long and probably slow, at least in part because fiber optic connections are not available yet to upgrade to 400G at scale.
So… Arista is seeing pretty much the same story as all the other suppliers that you can lump into either “data center” or “5G”, there is building up a huge expectation that the first half of 2019 is going to be weak but the business will rebound in the second half of the year. 5G and data center cycles aren’t specifically connected or correlated, that’s mostly just a coincidence, but it’s worrisome that so much hope is now being placed on the second half of this year across a really broad swathe of the technology sector.
That’s risky, of course, because no one really knows what will happen. Microsoft and Google and Amazon might take longer to digest their huge investments in new data centers and stay “paused” or “slowed” in building out new capacity… big telecom companies might slow down on their data center upgrades even more as they decide how to allocate capital expenditure budgets… or they might double down, no one knows.
That’s reason to keep these positions smallish as we wade through the uncertainty, but I do still like Arista’s exposure to the next wave of data center upgrades, and I like what they said on the call about prioritizing their spending to focus on selling and building up their enterprise and campus businesses, which are higher margin but also harder sells than the “cloud titan” businesses, and I like their continued R&D leadership in routing and switching, and their focus on building better software to manage these products. They also co-developed some new equipment with Facebook, which is showing no signs of slowing down on its expansion as far as I can tell, so not every huge customer is “paused.”
I’m not going “all in” on this position today, but I had targeted the $260-270 range as a reasonable buying opportunity earlier this year, based on the expectation that they should be seeing earnings of $10+ in 2020, with 15-20% earnings growth after that (meaning you’ve got a forward PE of about 25 and earnings growth of 15-20%, which is a decent value in this market), and I still think that makes sense for the long term — I still like the company, the addressable market is massive, and I think they could well reignite growth after this “clout titan” slowdown, and we have not yet hit the stop loss trigger of about $235 that would indicate a real shift in sentiment (though we might, of course). I increased my position by about 20% at $264.
There’s clearly some uncertainty about whether the second half of the year is strong or weak when it comes to their big customers and the CapEx cycle, but they are still winning business, presumably from Cisco, and still see a multi-year 400G upgrade cycle as likely (though really starting next year, not this year). It’s still a fast-growing company, we’re just not sure how fast it will grow in the next 6-12 months.
I expect we’ll see the news digested over the next week or two, but that analysts will be hesitant to make many predictions about the second half of the year until the company gets some more clarity on its order flow (the “pause” in orders in mid-March obviously came as a big surprise to them) — the next news on that front should come at Arista’s June Analyst Day, and they said on the conference call that they’re being cautious about projecting what the second half of the year will look like until then. Patience is easier with relatively small positions, and ANET is now roughly a 1% position with an average cost of about $242/share… and I’ll be watching what they say about that big customer and the second half of 2019 at the analyst day next month, they could easily send the stock down below $200 or up to $400 with a few choice words about the future.
Here’s the summary of one analyst response from Briefing.com this morning… I imagine we’ll have some more changes to the forecast in the days to come as analysts digest:
“Needham notes Arista reported another solid quarter of strong growth against the last of the tough 50% Revenue growth comparisons. They also sustained their rich Margins at 64.5% GMs and 37.5% Operating Margins. But that’s where the good news ends. Arista offered a soft guide for the June quarter citing a halt in purchases at one large Web 2.0 Titan and slow demand at two others. The Revenue guidance of $600-$610 is below Street estimates of $639 million and represents only a 16%-17% growth rate at the mid-point, well below the nromal mid-20’s growth. Arista stated business slowed sharply in late March and persisted through April leading to the lowered outlook. Arista stated they didnt know how long it would last as they didn’t have enough data. They think its likely a temporary lull. With ANET indicating down 15% to $260, they are a buyer on this weakness.”
And, well, the analyst meeting and any possible adjustment to their forecast are probably at least a couple weeks away — I haven’t seen a date for the analyst meeting they talked about, though they do have their actual Annual Meeting on May 28 and they’re presenting at a few investment bank conferences in the first couple weeks of June. My opinion hasn’t changed.
My opinion also doesn’t matter that much, though — it’s your money, so it’s your thinking that counts. Are you feeling confident in Arista’s growth? Expect a strong end of the year? Worried about them being steamrolled by the much-larger Cisco in the next product cycle? Let us know with a comment below.
P.S. Readers always want to know what you think about newsletters you’ve subscribed to — so if you’re one of those “founding subscribers” to McBride’s Disruption Investor and you like it or loathe it, please click here to share your opinion with your fellow investors.
Disclosure: Of the stocks mentioned above, I own shares in Disney, Alphabet, Facebook, Amazon, NVIDIA and Arista Networks. I will not buy or sell any covered stock for at least three days, per Stock Gumshoe’s trading rules.