FAANG Alternatives: 3 Smaller Moat-Worthy Techs At Multi-Year Lows

Jun. 29, 2022 8:53 AM ETADSK, CRM, DOCU15 Comments6 Likes
Michael Dolen profile picture
Michael Dolen
3.56K Followers

Summary

  • As is typical, they come for the generals last. With the exception of Meta Platforms, the decline in mega tech so far is a fraction of most Nasdaq 100 constituents.
  • Conversely, if you believe tech will rebound in the coming quarters, you might get better returns with the smaller guys.
  • Here are 3 moat-worthy stocks I have been buying. Admittedly DocuSign is the weakest, however, Autodesk and Salesforce are not going anywhere.
  • Salesforce is hovering near its 10-year low for P/S. DocuSign is at its all-time low for the same. Autodesk is at a multi-year low with a unique catalyst, similar to Adobe's transition last decade.

Salesforce Tower entrance, San Francisco

Sundry Photography/iStock Editorial via Getty Images

If you think rates are heading significantly higher, stop reading now. This article is a waste of your time and you will disagree with it.

However if you think the economy is weak, that 3% treasuries surprisingly make mathematical sense with 8% inflation due to debt levels and demographics, and that the FFR is fast approaching its apex regardless of inflation, then keep reading. Just as bonds will rally, so will long duration correlated assets such as tech.

While FAANG, or its new moniker MAMAA, get much of the attention due to their size and must-have services/products, they also come with unique drawbacks.

First and foremost, index weighting. Apple (AAPL) and Microsoft (MSFT) alone make up about 50% of the tech sector (S&P 500 Information Technology):

Market cap weighting of Microsoft and Apple in S&P tech

Yardeni Research, June 24, 2022

Often throughout the 20th century, the largest companies had below average P/E's due to their size, because the law of large numbers comes into play or at least expectations. But that's not what we get with Microsoft and Apple:

Apple and Microsoft Price and PE ratio
Data by YCharts

If you back out those two companies, as well as Amazon (AMZN), Netflix (NFLX), Alphabet (GOOG), and Meta Platforms (META), the remainder of the S&P 500 sits at a 14.9 multiple.

forward PE ratio for S&P 500 with and without FAANG or big tech

Yardeni Research, June 24, 2022

In addition to being higher multiple, most of mega tech also is in the crosshairs of constant political pressure and antitrust threats.

Yes, the latter may actually be beneficial - as breakups often create greater value - but instead of spinoffs, lately we see politicians pushing for restraining divisions of a company. For example, the EU bullying Google to allow rival ad networks to operate on YouTube. That doesn't unlock shareholder value like a spinoff of YouTube would do.

In short, the same strengths of FAANG/MAMAA (size, must-have services) also create weaknesses.

Not to say some of big tech isn't a good buy here but rather as a supplemental investment strategy, you may wish to consider other tech companies which are smaller, don't carry the political/antitrust baggage, yet still provide must-have services which we can't go without.

Here are three I have been buying during this selloff. On one or more valuation metrics, all hover near multi-year lows.

1. DocuSign

DOCU stock chart
Data by YCharts

Since I know the comments will claim I'm crazy for classifying DocuSign (DOCU) as "moat-worthy," I figure it should be addressed first, even though it's not my favorite in this cohort. Yes, it could get chopped in half even from here, but it also could double within a year and it's hard to fathom the other two doing that. This is a higher risk, higher reward pick.

Just as you say Kleenex for tissue and Google for internet search, DocuSign has become the go-to for electronic signatures. The bears make it sound as if DocuSign is merely attaching a signature to a PDF and there's no moat. In some aspects they're right but in others, they're wrong.

For starters, electronic signatures are more complicated than you may think. States have different laws as to what qualifies or even if they qualify and when they do, how and what they qualify for. Time stamped screenshots taken as you scroll through and sign a document, IP address recording, and a number of other identifiers go into these documents on the backend, which you are oblivious to, in order to comply with various state laws and ensure they're legally binding. It's not as basic as uploading a scan of your signature or drawing it with your mouse.

The complexities of creating these different systems on a state-by-state basis though is admittedly, not a moat. The moat comes from the document preparation, storage, and retrieval.

For a local mom 'n pop business who just needs a customer to sign a basic purchase order or contract, admittedly DocuSign may be overkill and overpriced.

On the other hand, if you are an enterprise client, such as a national insurance company like Farmers (who uses it), or a large realty firm, there is a lot of back-end automated document creation and management going on that you as the customer don't see.

You do get a taste of it if you've bought or sold a house, as you will sign various auto-populated documents, counter-offers, and supplemental documents in a specified order. Far more complicated than signing a basic PDF. On a related note, even if you are bearish on home prices, it doesn't change pricing on the transactional documents which must be signed.

As is typical with enterprise software, the more ingrained an organization becomes in it, the more of a hassle it is to switch, even if they can save a few bucks elsewhere.

DOCU stock price and PS ratio
Data by YCharts

The share price would suggest that business is terrible, but as you can see, sales have never been better and the stock has never been cheaper. All of the COVID bubble premium has evaporated, and then some.

The share-based compensation (SBC) sounds scary, when you hear things like it's 60% of FCF, but this is a bit misleading, such as the fact that FCF is generally low for high growth companies due to investments in growth. As such, most things will seem high relative to FCF.

Also, a silver lining of the tech wreck for not just DocuSign but the whole tech sector is that all of this non-cash compensation doled out in recent years is now worth a fraction of what the executives had perceived its value to be. That actually benefits shareholders, as they paid these execs using inflated shares instead of cash.

While I do not advocate buying anything on takeover speculation, it's worth noting that at its $13B EV, the Kleenex of electronic signatures and document management is small enough to be a bite-sized acquisition for a number of potential suitors, including Microsoft, who they recently expanded a partnership with. Buyouts often happen when the C-suite is in disarray and CEO Dan Springer was just ousted.

2. Autodesk

While the moat of DocuSign can be legitimately disputed, it's hard to dispute the moat of Autodesk (ADSK). Think of its flagship computer-aided design (CAD) software as a mandatory tax on construction. Starter homes and similar basics may forgo its necessity, but not large commercial projects. It's also used for the design of vehicles, aircraft, parts, and much more.

If you look at the last 5 years, they look cheap on a P/S basis:

AutoDesk price and PS ratio
Data by YCharts

However if you go back further, the multiple looks average at best:

ADSK price and PS ratio
Data by YCharts

So what are you to make of this? Well for one, their business model has and is evolving. What was a one-time software license is now turning into a subscription. Adobe (ADBE) went through this transition several years ago and Autodesk is just in the first innings of it. Similar to what we saw with Adobe in the latter half of last decade, Autodesk should continue to generate higher FCF on each dollar of sales moving forward.

ADSK price to free cash flow
Data by YCharts

A multiple of 26x for FCF and 25x for OCF may not be cheap, but it's the same that Adobe is at right now, after its transition to subscriptions:

Adobe price to free cash flow
Data by YCharts

I like Adobe too and in fact, have added 900 shares this year, but I would argue growth over the next 3-7 years should be greater for Autodesk.

For one, the transition to a subscription model, which Adobe has already done. Yes, I refuse to use their Creative Cloud and keep transferring my Photoshop CS2 license from computer to computer, but I am in the tiny, tiny minority. Like the equivalent of using Windows XP in 2022.

Second, moat. Yes, Adobe has an incredibly powerful moat but that is getting eroded, particularly at the lower end. Canva is, or at least was, valued at $40B and has 60 million active users in 190 countries. The capabilities are primitive relative to Photoshop but as image manipulation technology progresses, many of the most advanced (manually applied) features of Photoshop are becoming less of a necessity, as Canva and others have created automated ways to apply them. This also expands the customer base, as novices using Canva can accomplish many of the same things which Photoshop experts have taken a decade to master.

Going back to Autodesk, it's a fine company back to being at a fair price. Its $43B EV means its unlikely to be acquired, but it also means there's plenty of room to grow. New avenues of revenue, such as extended reality (XR), have the potential to move the needle.

Lastly, as I discussed in my recent piece about Amazon AWS, software in general does very well in an inflationary environment. Rather than explain it here, you can read that to understand why.

3. Salesforce

Similar to Autodesk, their moat is strong. While I've long owned some Salesforce (CRM) before this tech wreck, this quarter I increased my position 10-fold when its P/S hit a 10-year low:

CRM price and PS ratio
Data by YCharts

Customer relationship management software is a highly competitive industry, yet Salesforce is the undisputed leader:

Salesforce market share vs. CRM competitors

Salesforce

Salesforce is actually an ecosystem, as there are many applications built entirely on top of their CRM. Take Veeva Systems (VEEV) as one example. They are a $32B market cap company serving pharma and life sciences. Without Salesforce, they couldn't operate.

Now even though they're at a 10 year low for P/S, their P/FCF is still 31 and P/OCF at 28. These are high, with the latter even higher than Amazon in recent quarters. However, they're not high relative to CRM's history. Similar to Amazon, they constantly re-invest in growth.

So far, these investments have delivered, despite their large ones being controversial at the time - e.g. MuleSoft for $5.7B in 2018 and Tableau for $15.7B in 2019.

CRM revenue
Data by YCharts

Their $27.7B acquisition of Slack, announced in 2020 and closed in 2021, was their biggest to date. While CEO Marc Benioff claims to be satisfied with the results so far, Wall Street remains skeptical and I do too. Though given his track record of successful acquisitions, we should hold off on a verdict for now.

FAANG/MAMAA vs. the other Nasdaq 100

Just as DOCU, ADSK, and CRM have declined a higher percentage than most of the mega tech cohort, there's a good chance they outperform on any major rebound, if you believe such is in store. The same holds true for many of the Nasdaq 100 constituents and I have been buying many others, too.

To reiterate, DocuSign is the highest risk out of these three. While it currently sits at $65, it's not unthinkable to see it hitting $40 or $130 in the next 12 months. You should view it as a much more speculative play.

This article was written by

Michael Dolen profile picture
3.56K Followers
I prefer to buy long term winners when they have short term problems. You may call them falling knives, I call them being on sale. Most of what I buy is with the mindset of never selling, or at the very least, holding several years. With a long to very long term horizon, volatility doesn't bother me too much. I've been investing for over 20 years now, through 3 major bubbles (dot com, GFC, and the present). I saved up $500, the minimum deposit required to open an UTMA brokerage account, in middle school. I convinced my grandpa to co-sign the account, despite the fact that he nor anyone else in my family owned stocks or any other investments (aside from CDs). Investing has been my foremost interest for as long as I can remember. While classmates may be reading Harry Potter, I was into Security Analysis and the like. Although I grew up trying to emulate the Buffett style, I morphed into more of a Munger mindset. Today, probably Mohnish Pabrai would best reflect my philosophy of favoring undervalued, while not outright ignoring generational growth opportunities. I have been self-employed my entire life and for the last several years, have been investing full time. Prior to that, for 6 years I ran an online business in the credit card space. I started it the same month Bear Stearns went under and despite my poor timing and the fact that all my customers (banks) were in trouble, I maintained profitability every quarter and never took any outside investments or loans. Eventually I sold it to a publicly traded internet company.  While running that business, the cash flow coming from it afforded me the opportunity to make high risk, high reward investments in private biotech companies. Two went public. Life sciences is a great interest/hobby of mine but because it evolves so rapidly and requires immense amounts of continuous due diligence, it is something I now only do on the peripheral of my portfolio. While the vast majority of what I buy may be considered boring, I do make investments in some highly speculative stocks.  Lastly, while I mostly agree that you generally lose more money preparing for a crash than you do in an actual crash, I like to keep a healthy cash allocation on hand for those opportunities when everyone else is panicking. For those funds I prefer munis and in fact, have been betting on long duration for nearly a decade now. Contrary to the prevailing mindset this last decade, there's far too much debt to sustain higher rates for any meaningful amount of time. I have been on Seeking Alpha for at least a decade but did not start writing on here until 2020, due to boredom during covid. Even more than parking, I despise paying for investment research. As such, I will only write about one article on here every 30 days, which is the minimum required to maintain SA Premium access. I would rather slit my wrists than charge you for my content, so you won't see a marketplace service from me. Raised in Michigan, live in Manhattan Beach, CA.
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Disclosure: I/we have a beneficial long position in the shares of ADSK, CRM, DOCU, AMZN, GOOG, VEEV, ADBE, META, NFLX either through stock ownership, options, or other derivatives. 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: I am not a financial advisor. This article is general information and for entertainment purposes only. It should not be misconstrued as being investment advice. Please do you own due diligence regarding any security directly or indirectly mentioned in this article. You should also seek advice from a financial advisor before making any investment decisions.

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