Pie In The Sky?

| About: First Trust (SKYY)

Summary

SKYY is composed of global, industry leading tech sector companies with a large presence in Cloud Computing.

The companies do not fit their sector definitions exactly, however, it doesn’t adversely affect the fund.

The fund has low distributions in spite of good EPS; a possible indication of reinvestment of capital.

"What is the cloud? Where is the cloud? Are we in the cloud now?" are three pertinent questions presented in a PCMag article in April of 2015. PCMag describes the cloud as a metaphor for the internet. Perhaps it's better said that "The Cloud" is a next iteration or evolution of the internet. From very early on, home computers connected to other computers over telephone lines through a modem, through a service provider to another computer.

Anyone remember the old BBS connections? And the phrase "You've Got Mail" became ubiquitous in everyday culture, finding its way into art, humor, literature, TV and cinema. Back then, it was nothing but 'blue skies' for the internet buildout. It was an earth-shaking sea change. Suddenly, tens of millions of ordinary people had access to knowledge and information on a scale not seen since the best days of the ancient Library of Alexandria.

As we all know, the internet didn't stop there. After a bit of a correction, the wireless component of the internet, initially mostly voice, text and cute ringtones offered by mobile communications providers were simply person-to-person communications. Early generation wireless and data transmission speeds enabled some internet access on 'cell phones'; however, those early generation 'smarter' cell phones were clumsy to use and difficult to read.

It must be said that the iPhone and its totally out-of-the-box innovative OS changed everything. The combination of features might best be described as intuitive brilliance and ergonomic genius.

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However, there was also a very unnoticed, equally brilliant innovation working in the shadows, or perhaps better said as 'in the cloud'. As innovative as they were, smartphones were still restricted by technological constraints in particular, memory. This lack of local storage is likely the biggest single reason for the development of the cloud. Many companies began investing capital in large 'server farms' A.K.A. Data Centers.

Without going into some really fascinating details, cloud computing is not simply referring to dedicated network services like, say, the additional storage offered by your mobile carrier provider, (although this is a version of cloud computing). Alphabet's (NASDAQ:GOOG) (NASDAQ:GOOGL) Google Drive is a good example of cloud computing. Essentially, a Google query accesses a shared collection of internet resources on any platform of any 'third party' data centers. It's important to note that data centers need not be within the exclusive domain of brand name carriers. There are many 'carrier-neutral' data centers, which accumulates into 'the cloud'.

In fact, anyone with enough capital resources may establish a data center. However, before you start calling friends, relatives and maxing out your credit cards to start-up a data center in your garage, there's a much better way to get a piece of the cloud in your portfolio. First Trust offers the ISE Cloud Computing Index Fund (NASDAQ:SKYY) in its portfolio of ETF products.

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The fund seems to have come to market at the exact right time to catch the clouding up of the internet: July of 2011. The fund's total net assets are approximately $526.7 million with 17.8 million shares outstanding. The fund has really good liquidity for a specialized fund: a recent volume of 64,750 and a three-month average volume of about 121,000. The fund trades at 3.41 times its book value with a P/E of 25.58, high but not excessively so for technology and also at almost 18 times cash flow.

As one might expect from tech stocks, they're light on dividends and the fund reflects this with a 12-month trailing distribution of 0.44%; the index yields 1.15%. Likewise, the fund is more volatile than the broader market, having a standard deviation from its mean, measuring 14.61% and a Beta of 1.10. This may be compared with the S&P Composite 1500 IT Index at 12.70% deviation from the mean, with a 1.09 beta and lastly, that of the 10.95% S&P standard deviation from its benchmark mean of 1.00. The expense ratio is a slightly above average 0.60%.

Performance

3 Months

Year to Date

1 Year

3 Year

Since 7/5/2011 Inception

ETF Shares

-1.05%

-1.05%

1.57%

11.96%

8.59%

NAV

-1.21%

-1.21%

1.64%

11.88%

8.61%

ISE Cloud Computing Index

-0.98%

-0.98%

-2.42%

12.74%

9.31%

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Data from First Trust

A word or two should be said about the fund's holding, numbering only 34. According to both Seeking Alpha's ETF Hub and ETFdb.com, this seems to be the only such fund. There are other funds focusing on the internet, telecom which are no doubt related but not this specific. Just how specific is SKYY? Since the fund has so few holdings, it's worth taking a closer look beginning with the fund's sector allocations.

Data from First Trust

The fund is heavily weighted in the software sector, although that might be a bit cloudy itself, since companies such as Microsoft (NASDAQ: MSFT), well known for its omnipresent software, also offers 'cloud services'. Companies listed in other sectors are as clear as day. For instance hardware providers, which are more interested in supplying data centers with servers and communications equipment. Lastly, the fund includes a REIT, i.e., a real estate investment trust, which seems to be out of place, but that will be explained a little further down.

Software 37.71%

Weighting

Market Cap

Dividend

EPS

Yield

Div/ EPS

P/E

5-Year EPS Growth

Institutional Interest

Oracle Corporation (NYSE: ORCL)

4.28%

$170.81

$0.15

$2.03

1.46%

7.39%

20.32

12.78%

61.43%

Open Text Corporation (NASDAQ: OTEX)

4.14%

$6.28

$0.20

$1.83

1.55%

10.93%

28.23

19.65%

95.31%

SAP AG (NYSE: SAP)

4.06%

$97.94

$1.22

$2.92

1.53%

41.78%

27.34

10.96%

3.56%

Salesforce.com (NYSE: CRM)

3.74%

$50.81

$0.00

-$0.07

0.00%

0.00%

NMF

NMF

87.78%

Red Hat (NYSE: RHT)

3.69%

$13.79

$0.00

$1.08

0.00%

0.00%

70.24

14.26%

96.70%

Zynga (NASDAQ: ZNGA)

3.61%

$1.90

$0.00

-$0.13

0.00%

0.00%

NMF

NMF

86.11%

VMware, Inc. (NYSE: VMW)

3.45%

$22.04

$0.00

$2.34

0.00%

0.00%

22.21

22.62%

66.32%

NetSuite (NYSE: N)

3.36%

$5.54

$0.00

-$1.59

0.00%

0.00%

NMF

NMF

58.22%

Microsoft Corp.

2.55%

$439.52

$0.36

$1.40

2.59%

25.71%

39.57

-6.81%

93.60%

CA, Inc. (NASDAQ: CA)

1.02%

$12.92

$0.25

$1.70

3.23%

14.71%

18.23

4.66%

71.74%

Intuit Inc. (NASDAQ: INTU)

0.97%

$26.89

$0.30

$2.01

1.15%

26.09%

52.04

-3.61%

91.34%

Check Point Software (NASDAQ: CHKP)

0.93%

$15.69

$0.00

$3.74

0.00%

0.00%

23.2

11.92%

77.43%

Adobe Systems (NASDAQ: ADBE)

0.92%

$47.60

$0.00

$1.58

0.00%

0.00%

60.28

-3.37%

89.80%

Activision Blizzard (NASDAQ: ATVI)

0.82%

$25.30

$0.26

$1.20

0.76%

21.67%

28.77

28.91%

72.24%

Averages

2.68%

$66.93

$0.20

$1.43

0.88%

10.59%

39.32

8.57%

75.11%

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Data from Reuters, Yahoo and Company Websites; Market Cap in US Dollar Billions

As noted, MSFT offers its popular cloud service especially for its MS Office users and also its less advertised Microsoft Azure enterprise cloud-computing platform. Oracle, 'the' name in database software also offers enterprise scale cloud services. Similarly, Red Hat a name recognized for being among the first internet 'virtual machine' software, is still mainly software, but also offers cloud services. Some are focused on a particular enterprise customer niche like Salesforce.com providing 'customer relation management'.

In general, the software services sector isn't just software anymore, but now offer a variety of cloud services, which in turn requires, either directly or indirectly, the hardware and communications networks along with it. The investor should note the potential here for spinning off parts of these businesses, or reorganizing as holding companies as Google has done by forming Alphabet.

Internet Software & Services 16.57%

Weighting

Market Cap

Dividend

EPS

Yield

Div/EPS

P/E

5-Year EPS Growth

Institutional Interest

Facebook, Inc. (NASDAQ: FB)

4.35%

$330.34

$0.00

$1.29

0.00%

0.00%

89.98

49.35%

70.02%

Akamai Technologies (NASDAQ: AKAM)

4.18%

$9.75

$0.00

$1.78

0.00%

0.00%

30.99

14.54%

90.24%

Alphabet Inc.

3.96%

$522.95

$0.00

$22.82

0.00%

0.00%

33.73

11.66%

84.18%

Rackspace Hosting (NYSE: RAX)

3.30%

$2.83

$0.00

$0.90

0.00%

0.00%

24.26

20.83%

83.31%

j2 Global (NASDAQ: JCOM)

0.71%

$3.01

$0.32

$2.73

2.10%

11.72%

22.63

8.63%

0.00%

Averages

3.30%

$173.77

$0.06

$5.90

0.42%

2.34%

$40.32

21.00%

65.66%

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Data from Reuters, Yahoo and Company Websites; Market Cap in US Dollar Billions

There seems to be little distinction, then, between the Software Sector and the Internet Software & Services Sector. As noted above, GOOGL has reorganized itself into many smaller 'holdings'. Any one of which may someday be spun-off as an independent company, thus returning value to shareholders. According to Google founder Mr. Larry Page, "... Alphabet is mostly a collection of companies. The largest of which, of course, is Google... ...We are also stoked about growing our investment arms, Ventures and Capital... ...Google will become a wholly-owned subsidiary of Alphabet..."

Hence, the structure of this reorganized company differentiates software and services and everything else. A company like MSFT is still essentially a single integrated software company. Facebook, on the other hand, might be considered a distinctly Internet Software and Service provider. One smaller but no less interesting holding is i2 Global Ltd. and may be best described as software development, system integration engineering and consulting service. Such services, including data analytics, are a vital component improving the efficiency of the cloud.

Communications Equipment 13.44%

Weighting

Market Cap

Dividend

EPS

Yield

Div/EPS

P/E

5-Year EPS Growth

Institutional Interest

Cisco Systems (NASDAQ: CSCO)

4.24%

$144.37

$0.26

$2.02

3.62%

12.87%

14.21

5.61%

77.79%

F5 Networks (NASDAQ: FFIV)

4.23%

$7.30

$0.00

$5.12

0.00%

0.00%

20.63

39.66%

99.16%

Juniper Networks (NASDAQ: JNPR)

3.47%

$9.78

$0.10

$1.60

1.56%

6.25%

15.96

6.69%

90.36%

Polycom (NASDAQ: PLCM)

0.78%

$1.49

$0.00

$0.51

0.00%

0.00%

21.83

NMF

97.64%

NetScout Systems (NASDAQ: NTCT)

0.66%

$2.24

$0.00

$0.35

0.00%

0.00%

64.4

17.15%

0.00%

Averages

2.68%

$33.04

$0.07

$1.92

1.036%

3.824%

27.406

17.28%

72.99%

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Data from Reuters, Yahoo and Company Websites; Market Cap in US Dollar Billions

When it comes to Communications Equipment and Hardware, Cisco Systems is far and away a leader in the field and one of few companies, which envisioned 'the cloud'. CSCO was years ahead of the pack referring to what is now called the cloud as 'the internet of everything'. Once again, there is an overlap. CSCO not only provides 'cloud formation' equipment, but also offers its own cloud services.

Juniper Networks seems to be a better example of a communications equipment only company, providing consulting, design and maintenance services as well as the necessary network components. The interesting holding in the group is NetScout Systems, which provides network monitoring and data analytics. Again, defining sectors here is sometimes a bit unclear. But whether NTCT is a cloud service or cloud hardware provider, isn't really that important. The important thing is that they're in the cloud.

Hardware, Storage, Peripherals 13.25%

Weighting

Market Cap

Dividend

EPS

Yield

Div/EPS

P/E

5-Year EPS Growth

Institutional Interest

EMC Corp. (NYSE: EMC)

4.01%

$52.24

$0.12

$1.02

1.71%

11.77%

26.4

2.77%

82.13%

NetApp (NASDAQ: NTAP)

3.66%

$7.80

$0.18

$1.24

2.67%

14.52%

21.77

9.07%

98.76%

Hewlett Packard Enterprise (NYSE: HPE)

3.12%

$31.59

$0.05

$1.25

1.20%

4.00%

14.73

NMF

81.94%

Apple Inc. (NASDAQ: AAPL)

2.40%

$609.85

$0.52

$9.41

1.89%

5.53%

11.68

33.61%

59.35%

Averages

3.30%

$175.37

$0.22

$3.23

1.868%

8.953%

18.645

15.15%

80.55%

Click to enlarge

Data from Reuters, Yahoo and Company Websites; Market Cap in US Dollar Billions

When it comes to Equipment, Storage and Peripherals, this group has the heavy hitters. EMC was among the first to specialize in data storage peripheral devices, as well as the equally long established NetApp for data storage and management. However, the future of EMC as a publicly owned company may be limited. In October of 2015, privately held Dell Computer announced the acquisition of EMC in exchange for cash and VMware tracking shares, (which had been previously acquired by EMC). Hence, EMC will likely be replaced in the tracking index and thus in the fund. However, the investor should take note of the high potential for consolidation in the industry.

Hewlett Packard Enterprise, does everything the former unified Hewlett-Packard did but less PC and printers. PC and printers are now the domain of Hewlett-Packard Inc. (NYSE: HPQ), and not part of the fund. Lastly, the fund holds Apple Inc. AAPL offers iCloud storage and cloud computing service. Little needs to be said about AAPL products, which are cloud peripherals as well as fabulously popular and fashionable consumer electronic devices. It's important to note that the average market cap for these four holdings is in excess of $175 billion.

IT Services 7.85%

Weighting

Market Cap

Dividend

EPS

Yield

Div/EPS

P/E

5-Year EPS Growth

Institutional Interest

Teradata Corp. (NYSE: TDC)

3.78%

$3.31

$0.00

-$1.54

0.00%

0.00%

NMF

NMF

0.00%

IBM (NYSE: IBM)

2.81%

$146.55

$1.30

$13.62

3.41%

9.54%

11.2

3.37%

60.29%

Wipro Ltd. (NYSE: WIT)

0.96%

$20.93

$0.07

$0.55

1.43%

12.73%

23.25

13.38%

2.29%

Averages

2.52%

$56.93

$0.46

$4.21

1.613%

7.424%

17.225

8.38%

20.86%

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Data from Reuters, Yahoo and Company Websites; Market Cap in US Dollar Billions

Once again, there's a lot of overlap here, but it's not such a bad thing in this case. For example, Teradata Corp. focuses almost exclusively on data analytics, but then again, so does 'big blue' IBM. In brief, IBM does just about everything in the tech sector, including state-of-the-art R&D projects exemplified by Watson, a supercomputer able to match wits with people by simulating abstract thinking.

The point is that IBM does provide data analytics plus many other technology related services, whereas Teradata is much more focused. Just a quick note about IT services provider Wipro Ltd.: their strategy includes growth via acquisition in order to gain quick access into new business sectors. Its most recent acquisition was HealthPlan Services, a company which provides IT services for the Healthcare Insurance sector.

Internet Catalog & Retail 6.99%

Weighting

Market Cap

Dividend

EPS

Yield

Div/EPS

P/E

5 Year EPS Growth

Institutional Interest

Amazon.com (NASDAQ: AMZN)

3.61%

$287.80

$0.00

$1.24

0.00%

0.00%

482.61

-13.13%

67.26%

Netflix (NASDAQ: NFLX)

3.35%

$45.25

$0.00

$0.28

0.00%

0.00%

376.44

-7.86%

84.94%

Averages

3.48%

$166.52

$0.00

$0.76

0.000%

0.000%

429.525

-10.50%

76.10%

Click to enlarge

Data from Reuters, Yahoo and Company Websites

Netflix is a next generation entertainment provider, streaming content to any device. Although Amazon is well known for its seemingly infinite consumer retail services, Amazon also manages a formidable webhosting and cloud services, (featured on 60 Minutes News Magazine in 2013). This cloud service is used by NFLX as well as the CIA! So true, AMZN is a premier world-class retailer, but also a world-class provider of cloud computing services.

REITS 4.46%

Weighting

Market Cap

Dividend

EPS

Yield

Div/EPS

P/E

5 Year EPS Growth

Institutional Interest

Equinix (NASDAQ: EQIX)

4.44%

$32.77

$1.75

$3.18

2.12%

55.03%

103.64

38.28%

0.00%

Click to enlarge

Data from Reuters, Yahoo and Company Websites

The most curious holding in the group is a REIT, Equinix. Indeed it might be considered a REIT as it holds over 145 'carrier-neutral' data centers hosting over 500 cloud service providers in 40 cities in 15 countries, distributed over five continents. The company also maintains "colocation center" locations, which is the sought after domain of high-frequency trading.

Equinix was the vision of two former Digital Equipment Corp. employees, Al Avery and Jay Adelson, who realized the growing demand for data centers far outstripped the supply. Although more closely related to the IT Service Sector, the company was reorganized as a REIT for tax and accounting reasons. (This, then, technically makes the cloud hot real estate).

The puzzling array and overlaps of the sector labeling should be completely ignored. Perhaps the fund should be viewed as a subset of the collection of all services provided by all the fund's holdings. Very appropriately named, 'the Cloud Technology Sector' has yet to solidify into a more accurately defined sector with subsectors. What shouldn't be ignored is that the potential for rapid growth, M&A, and particularly, companies spun-off from rapidly growing Cloud Services divisions.

The probability for a high capital appreciation storm is increasing. It's also important to point out that the larger diversified holdings in the fund may perform well via their other divisions even if cloud service does not, hence stabilizing the fund's volatility. It's also important to note the very low dividend to EPS ratios. These companies are still reinvesting capital for expansion, or have large cash holdings, hence the potential exists for high distributions over time. Activist shareholders have been demanding high dividend payout and do sometimes succeed in returning value to the shareholder.

Cloud Computing as an economic sector is still in its early stages, and this fund seems to be the only fund covering the sector, even if it's not entirely composed of pure-play cloud service companies. It may be well worth venturing a small portion of capital into this fund instead of just one or two big cap individual holdings. It might actually be an opportunity to get a slice of the pie in the sky.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: CFDs, spread-betting and FX can result in losses exceeding your initial deposit. They are not suitable for everyone, so please ensure you understand the risks. Seek independent financial advice if necessary. Nothing in this article should be considered a personal recommendation. It does not account for your personal circumstances or appetite for risk.