Magnificent 7: the rally continues while heading in a different way

Recent Earning results(Q3)

YTD Return Perspective:

Reasons behind the rally:

Previous events and policies: 2022 was a difficult year for the US stocks in general. Investors were worried about the high inflation after the generous stimulus during the Covid years and the global supply chains were disrupted by the pandemic and the war in Ukraine. Thus, the Fed did not have any other option but to take a more hawkish stance on rates, imminently affecting the valuations in a negative way. This led the valuations of the US stocks to enter a rather attractive territory.

AI mania: The current magnificent seven stocks were the ones that led the trend. These companies were able to take advantage because of their dominant market position, solid balance sheets and abundance of cash and technological know-how. Therefore, all these macro factors, solid business model and attractive valuation provided the right foundation for M7 to skyrocket.

The rally was further boosted once the inflation and the hawkish Fed tone reached their peak and investors started to consider potential rate cuts.

Divergence: Even if we put the same label for all these seven stocks, we need to be aware that they operate in a very different way from each other and they also derive their revenues in different ways also. For instance, GOOGL and META are mostly making money from advertising, MSFT from software and cloud, AAPL from phone sales, AMZN from ecommerce, NVDA from data centers and TSLA from cars.  Thus, we should not expect them to continue to go the same direction in the future. As can be seen from the YTD data this year, TSLA is roughly flat due to weak first half of the year (mostly because of intense competition among EVs), MSFT is also underperforming, NVDA and META are still rallying strongly.

GOOG

Revenue and EPS: both strong and above consensus

Stellar performance: Cloud revenue was the main driver here with 35% growth YoY. Among the three cloud service providers (AMZN, MSFT, GOOGL), this was the fastest growth for the quarter.

Advertising business was also solid with 10% growth YoY, mainly driven by Search and YouTube at 12% YoY.

Profitability and margins inched higher, as the high margin nature of Cloud improved the overall operating margin for the quarter to 32% (from 28% in 2023Q3). However, along with the dynamic growth of revenue and margins, capex is also expected to ramp up. The recent legal challenges related to anti-trust practices can lead to extra general and administrative costs. 

Currently GOOGL is traded at 23x PE ratio, which is the lowest of all the magnificent seven stocks. There is a possibility that investors do not want to flock into GOOGL because of the legal challenges related to its monopoly status, however if there is certain clarity related to this, the stock has the potential to re-rate.

AMZN

Amazon also reported revenue and earnings that beat the expectations with $158.88bn and $1.43 – 11% and 52% growth YoY, respectively. The official guidance was $157.2bn and $1.14, respectively.

Cloud services grew by 19% YoY, accelerating from one year ago when the growth was 12%, however this is still slower than GOOG and MSFT, showing that as a market leader in cloud business AMZN needs to defend its market share.

Source: Needham & Company, Company Financials

Advertising-wise: the sales grew 19%(potential tailwinds in the coming quarters for advertising are the deals with the NFL and NBA).

56% Growth in OI: significant efforts into trimming costs;

Non-revenue generating ventures investments(LT):18% down on a  YoY basis;

Corporate managers cut:15% ;

In the near future, AMZN will focus more resources on the services revenue (cloud, advertising, GenAI, streaming) rather than the pure ecommerce business. This will lead the margins to further expand, as services margins are far larger. Currently the reported margins for the recent quarter were 10% vs 6% for one year ago. 

Source: Needham & Company, Company Financials

AMZN is traded at 45x PE ratio with dominant position in ecommerce and cloud and due to its ability to expand margins quickly. However, the multiple is higher than advertising peers (META at 29x), cloud peers (MSFT at 34x) and retail peers (10-20x).  

AAPL

For the quarter, Apple revenue was $94.9bn (+6% YoY) while the EPS was $0.97 (-33% YoY). The drop in the profitability was due to $10.2bn charge over tax issues in the EU. If there was no such charge, the EPS would be $1.64 (+12% YoY). The initial consensus was $94.58bn for revenue and $1.60 for EPS.

iPhone sales: the main revenue generator for the firm, also rose by 6%.

Wariness: Revenue from Grater China also did not meet the initial expectations - $15bn vs $15.8bn due to strong competition from Xiaomi and Huawei.

Gross margin: in line with expectations – 46.2% vs 45.2% one year ago. 

Source: Company Financials

Currently AAPL is traded at 34x PE ratio, which is a rather rich valuation. Buffet slashed his stake of AAPL in Berkshire Hathaway, which can serve as a good indicator of the limited potential in the stock.

META

The parent of Facebook and Instagram grew its revenue by 19% YoY to $40.59bn, in line with the estimates ($40.29bn). The net income was up with 35% YoY to $16bn ($6.03 EPS), which was 15% ahead of consensus ($5.25), thanks to effective managing of the operating costs.

Source: Company Financials

Revenue guidance: 12-20% YoY, in line with the previous estimates.

Ad revenue: driven mostly by pricing (11% growth) rather than by increased impression (7%). ---Meta is currently working on enhancing its video player.

Capex ramp up:  strategic investments such as GenAI and the related infrastructure.( a possible slowdown in margin while LT benefits would be seen in the coming years)

Currently META is traded at 29x PE ratio, which is lower among most of the M7 stocks. However, we should bear in mind that META is almost entirely reliant on ad revenue, unlike GOOGL or AMZN which also have advertising business, but also very established and profitable cloud businesses.

MSFT

For the quarter, Microsoft revenue was $65.59bn (+16% YoY), slightly higher than consensus of $64.51bn, while the EPS comfortably beat the guidance - $3.30 vs $3.10 expected (+10% YoY). If we exclude the effect of the acquisition of Activision Blizzard in October 2023, the growth is 13%.

For the following quarterly results, MSFT guided 10-11% revenue growth in the range of $68.10-$69.10, below the previous estimate of $69.83bn

Productivity and Business Processes: grew 12% YoY to $28.3bn (ahead of forecast), driven by M365 Commercial, notably Copilot adoption, while Intelligent Cloud revenue was $24.1 (20.4% YoY).

Cloud business: the conservative guidance due to capacity constraints and third-party deliveries - $68.1bn revenue for the current quarter vs. $69.83bn previously expected, driving the stock price down by 4%.

Source: appeconomyinsights.com

Currently MSFT is traded at 34x PE ratio, which is in the middle between lower GOOGL and the higher valued AMZN.

TSLA

Tesla reported $25.2bn revenue, which is +8% YoY increase (in line with the consensus). The net income for the quarter was $2.18bn (16% YoY). On an EPS basis, the profit was $0.72 vs $0.58 expected.

The company produced 470k vehicles (+9% YoY) and delivered 463k (6% YoY). The deliveries slightly miss the guideline of 464k cars. Thus, auto sales were $19bn which is just 1% YoY. Growth mostly comes from the global expansion of the Model 3/Y platform.

Full-service drive: a big boost with $326mln but with 90% margin, this almost entirely goes down the profit line.

Ambitious guidance: potential 20-30% growth in vehicle sales (from the previous consensus of 14%) for 2025, driving the stock market price up by 20%.

The potential release of Model Q: a cheaper model that can compete with the large Chinese EV makers.

TSLA adjusted GPM was 17.1%, up 2.5pp from 14.6% in Q2. This improvement happened mostly due to cost savings and a higher portion of the energy and services-related revenue, despite the ASP being down 1.6% from the previous quarter.  COGS per vehicle were lower due to the economy of scale, lower material and freight costs.

Source: appeconomyinsights.com

Currently TSLA is traded at 69x PE ratio – the highest multiple among the M7 companies that reported so far. TSLA does have a bold vision of the future but with this high valuation there are too many risks involved.

What do we see ?

At a first glance, we can conclude that for the quarter ending on September 30^th, all of the six companies from M7 (apart from NVDA which still have not released results) reported revenues in line with or better than the estimates. What’s more, they all comfortably beat the EPS guidelines (apart from AAPL). This certainly implies how the companies from M7 have the capabilities to optimize their efficiency and control costs.

The market loved TSLA results, liked GOOGL and AMZN results, but didn’t react well on MSFT, META and APPL. The negative reaction was mostly due to more conservative guidance on growth and plans for more aggressive AI spending.

AI-related investments: Investors are slightly concerned about this due to 1) the potential increase in capex and operating costs, which itself may lead to dragged margins; 2) uncertain outcome when it comes to AI-related ROI.

However, AI-spending should be seen as more of a necessity rather than luxury, as this is the way these companies will maintain their competitive edge. For instance, AMZN and MSFT do need AI for providing better cloud and enterprise services, while META needs it for providing better content for users (same can be said for GOOGL’s YouTube). Not only will these companies be able to provide more customized products with the help of AI tools, but also, the churn rate for clients will become lower, as it will be harder for the latter to move to a different platform with entirely different infrastructure.

Eventually, the biggest winner from the AI-related spending will be NVDIA, which has all of them as the largest clients. We are yet to learn how NVDA would look like, but from what we see in this set of results, we could feel less worried about the growth prospects of NVDA, as companies would continue to spend heavily on AI infrastructure. NVDA, having more superior products, will perhaps be the main beneficiary.

Recommendations

GOOGL seems to be the most attractively valued out of all the six companies. Not only is it traded at just 23x earnings, but also it holds a dominant market share in the search business and outperforms competitors in the fast-growing cloud business which will continue to expand margins. Currently the low valuation is mostly due to legal concerns, not related to the soundness of the business operations.

Another attractive stock out of these six is META with a price equaling to 29x earnings. With Facebook and Instagram, the grip on the social media market is really strong, and with the large cash position, META can focus entirely on improving the algorithm and the user engagement with more AI investments. Thus, the concerns regarding the near-term softer engagement metrics and the overreliance on advertising seem overstated. META also has a historically successful record in investment decisions, thus there is more confidence that the ROI of their AI-related investments will be justified.