China's Effect On The FAANG Stocks

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Includes: AAPL, AMZN, FB, GOOG, GOOGL, NFLX
by: Michael Chandler

Summary

Resolution to the Chinese trade dispute is by far the most important.

Theft of intellectual properties as well as regulation blocking China's markets is at the core of the issue.

US Technology IP is the most sought out by the Chinese Government.

The FAANG stocks are clearly being targeted. In fact, China has created its own version of each of the FAANG companies.

China combined with company fundamentals creates a significant amount of caution for these companies in the near-term.

Who really knows what the current administration is doing regarding foreign trade. I do believe it is evident that the president prefers bilateral agreements. Though there appears to be multiple bilateral negotiations going on simultaneously I can’t help but believe the most pressing is China.

Furthermore, it appears the negotiations, or lack thereof, with China appear to be more about the theft of intellectual properties and regulations that require companies to share their IP with the Chinese government prior to doing any business in the Chinese mainland, then with actual tariffs.

I have mentioned in previous articles that the Chinese practices have been indiscriminate. Not only has China stolen IP from the United States, but pretty much throughout the developed world.

It appears the United States is now building a coalition in its attempt to combat China’s actions.

This week Congress has passed tougher regulations, making it difficult for China to purchase or invest in US technology and other industries having national security concerns. By the way, this may be the first piece of legislation that had bipartisan support.

Many countries of the EU are also considering similar legislation. It appears Germany, the EU’s economic backbone, is one of those closely monitoring Chinese activity.

Seeing how China appears to be in the crosshairs of US foreign trade, I thought it would be interesting as well as prudent to evaluate the exposure the FAANG stocks have to China. It seems to me any negative outcome to the US negotiations could have a significant economic impact on these five companies.

These companies have enjoyed a 35% annualized growth rate for several years now. As a result, some could argue their current market of valuations are getting quite lofty. Recently they have all experienced higher volatility relative to the rest of the market and some of their fundamentals are indicating slower growth going forward. I for one believe that long-term, 5 to 10 years, they are tremendous bargains.

Facebook and the entire social media sector for instance, can expect regulation from Washington regarding their privacy and security. In fact, looking at Facebook’s most recent quarter indications of concerns showed up in both advertising revenues as well as subscriber growth. With a crack in their fundamentals already evident, any exposure to China could create additional unwarranted volatility in their stock performance.

The good news is China does not allow Facebook (NASDAQ:FB), Twitter (NYSE:TWTR), and others to do business in their country. It is however, reported that Facebook is investing in Chinese startups giving suspicion that China may have its own version of social media in the near term. China, not being a big proponent of the First Amendment, would only consider a state-controlled version.

Apple (NASDAQ:AAPL) on the other hand, gets 24% of their revenue from China. Furthermore, 90% of their iPhones are produced there. I suspect this is the reason Apple plans on making an investment of nearly $350 billion in the United States. Having all your eggs in one basket can be a little risky.

Fundamentally Apple continues firing on all cylinders. Once again, its quarter beat the street in both earnings and revenue. It was rewarded by the market yesterday as it became the first company in history to surpass a $1 trillion valuation.

I never thought I’d see the day where a company could sell a phone for $1000. Apple will release its newest product in September and continues to expand its product portfolio to include healthcare and a whole litany of AI products.

The second US company to reach $1 trillion in market capitalization, I suspect, will be Amazon. In fact, many people including myself expected them to beat Apple for the top slot.

Amazon (NASDAQ:AMZN) does not have a physical presence in China, however as a retailer they certainly sell a tremendous amount merchandise manufactured there. Through its marketplace Amazon has become a major distributor for Chinese products. On the other hand, it sells a limited amount of merchandise back into the Chinese mainland. China has developed its own version of an online retailer predicated upon Amazon’s business model.

Therefore, I must conclude there is risk associated with potential tariffs on both Chinese and US products. My guess, tariffs like taxes will be passed through to the consumer. The risk would clearly be one of consumption. Simply put, if prices get too high the consumer simply won’t buy.

With China having nearly double the amount of Internet users than in the US, the growth potential there is certainly substantial. I suspect China will want to support its own online retailers such as Ali Baba.

Fundamentally Amazon continue to operate on all cylinders. Their earnings for the third quarter were up 12-fold from the previous year. They reported 507 million versus an expected 250 million in earnings. The earnings that exceeded estimates was almost entirely from the cloud and advertising revenues.

Revenue grew around 40% over the same quarter last year. It was however a slight miss relative to the market’s expectations.

Amazon’s valuation seems to me to be extremely expensive. At 166 times last year’s earnings and 90 times next year’s earnings it can’t afford to stumble, let alone a significant geopolitical jolt.

Netflix (NASDAQ:NFLX) has minimal exposure to China primarily due to Chinese government regulation making it, for the most part, economically infeasible. Most recently they have been able to sell some of their original produced programs. China clearly has preference to its own version of Netflix called iQiyi, majority owned by the Search Giant Baidu.

Fundamentally it appears Netflix is experiencing a slowdown in its subscriber growth. For the most part this could be saturation of markets. Subscriber growth was some 20% less than what the street was expecting.

For the second quarter, revenue growth once again exceeded 40%. They beat the EPS estimate by one cent.

Like Amazon, Netflix on a price to earnings basis looks quite pricey. It is currently trading at 157 times last year’s earnings and 99 times forward looking earnings. Keep in mind this company is up 75% year to date.

I must admit some of these valuations bring back memories of the dot-com bubble of the 90s.

Finally Google (GOOG) (NASDAQ:GOOGL) shut down its China initiative due to government censorship back in 2010. It has been recently rumored that Google is developing a version for China compliant with their host of regulations. China has since then denied the rumor.

With regards to fundamentals Google appears to be fairly priced. It is currently trading at 33 times last year’s earnings and 28 times next year’s earnings. In the most recent quarter it reported $8.42 in earnings-per-share versus an estimate of $8.04 per share. At the same time, it increased its sales by 21.5%. I would look to add to or initiate positions of Google on any pullback. Once again keep in mind this would be a long-term core position and should be held for the same 5 to 10-year timeframe.

The intent of this article was to review the exposure of each of the FAANG stocks had to China. Secondly, we wanted to evaluate the current fundamentals of each of those companies.

First of all there is substantial exposure to China with Apple and to a lesser degree Amazon. Furthermore, I find it interesting that all five companies that make up the FAANG group have to some degree been duplicated in China.

Baidu is the Chinese version of our Google. Apple being copied by ZTE, Amazon being copied by Ali Baba, Google being copied by Baidu, Netflix being copied by iQiyi, and finally Facebook investing in young startups to develop China’s own version of social media.

When you consider Facebook, Netflix and Google have been blocked due to Chinese government regulations yet all are being duplicated you must conclude unfair trade practices to include theft of IP must be the norm for Chinese trade practices.

Fundamentally I would have to conclude valuations for the group appear to be overvalued at their current prices except for Google. Nonetheless I would look for pullbacks and start building positions in these companies. They are clearly disruptors and will lead the way in artificial intelligence and robotics for many years to come.

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: Investment advisory services offered through World Equity Group, Inc., member FINRA and SIPC, a Registered Investment Adviser. Dogwood Capital Management is not owned or controlled by World Equity Group, Inc.