What We're Watching In 2018

We're just a few weeks off from 2018, and the tech industry is buzzing with potential change.

In this week's episode of Industry Focus: Tech, hosts Dylan Lewis and Dan Kline talk about a few things they're going to be watching out for in 2018. Find out how what tax reform could mean for giant tech companies like Apple (AAPL 0.68%) and Microsoft (MSFT 3.11%), a few new places that the growing niche of esports could branch into next year, how the Disney (DIS -0.40%)-Fox (FOXA) (FOX) deal could change the streaming media landscape, where Netflix (NFLX -1.61%) could find room to grow, why cable companies are going to have to up their game next year in particular, and more.

A full transcript follows the video.

This video was recorded on Dec. 15, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Dec. 15, and we're setting our sights on 2018. I'm your host, Dylan Lewis, and I'm joined on Skype by fool.com's jack of all trades, Dan Kline. Dan, how's it going?

Dan Kline: It's been a bit of a journey this morning, actually. I'm, as you might be able to hear, in a somewhat crowded public workspace, because apparently, it's jackhammer Friday here in West Palm Beach.

Lewis: Yeah, Dan is getting a little bit of work done outside of his house, so he's calling in from a place where a bunch of other people are working. Hopefully that doesn't impact our audio quality.

Kline: Palm Beach Tech, a very lovely space, but it would be impolite for me to ask everyone else to be quiet.

Lewis: We'll just roll with it. Hopefully they're won't be too many major interruptions. I know, actually, when John Maxfield was doing a show a couple of months back, one of his kids came in, and listeners seemed to enjoy that quite a bit. So if any human moments happen during the podcast, that's why.

Kline: Yeah, I can't promise someone won't walk behind me.

Lewis: We're going to be talking about stuff we're watching in 2018 in the tech space. Before we get too far into the discussion of the themes that we're watching and the stories we're watching, when I was talking about the show premise with Austin Morgan beforehand, he thought I meant the shows that we're watching in 2018, so I think it's worth doing a quick roundtable -- Dan, you, me, and Austin -- what shows are we going to try to catch up on? What shows are we going to be watching in 2018?

Kline: It's not so much catch up on, I'm really excited for the new season of Jessica Jones on Netflix. I think those shows, with the exception of Iron Fist, all of the shows in that universe have been fabulous, but Jessica Jones is actually the rare one that my wife will watch with me.

Lewis: Nice. Yeah, it's tough, if you're in a relationship, you have to balance that watch time. I know Vince Shen has the same problem with his wife, where he has shows he really wants to watch and she's not into and vice versa. And being a single guy, I can watch whatever I want, whenever I want.

Kline: Yeah, we have all sorts of complicated rules about shows we both watch, shows just one of us watches. Everything is negotiated in a 20-year marriage.

Lewis: It's the new relationship dynamic in the age of streaming, something we're going to touch on later in the show. Austin, what are you going to be watching in 2018?

Austin Morgan: I'm looking forward to the new season of Westworld, because there was no season this year because of whatever reason.

Lewis: They took an entire year off.

Morgan: Yeah. Basically now, you have Game of Thrones one year and Westworld the next year. Which is brutal. I would much rather have both in the same year.

Kline: But are they coming back for six episodes the way Game of Thrones always does? It's a little bit of a tease.

Morgan: I think it's a full season. I guess we'll see.

Lewis: We'll see. I'm looking to catch up on Silicon Valley, one of my favorite shows. It has fallen on the back burner recently. I think I have a full season, maybe a season and a half, to catch up on there. Obviously somewhat relevant to the tech space, but more of something that I just enjoy for its own entertainment. Switching over to the themes that we're actually looking for this year, Dan, one of the big things that is currently in the news and has an outsize impact on the tech space itself is tax reform. We're getting some hints on what that might look like. I believe that lawmakers will unveil a final bill today, actually, and hopefully vote on legislation sometime next week. We'll see what that picture looks like, and it might be a little bit clearer next week. We're going to be doing some more predictive crystal ball-type conversation today. I guess, to start, Dan, why don't we talk about why this is so important?

Kline: There's two major things that are going to happen. Assuming this bill passes, and there's some doubt about that at the moment, the corporate tax rate is going to get cut from about 35% to somewhere between 20% and 23%. There's still some negotiation going on there. The other issue that's going to happen is, it's going to cost companies much less to repatriate money. Repatriate means take money that they made overseas, which they don't have to pay taxes on until they bring it back to the U.S., and bring it back to the U.S. They're going to drop that tax rate, again, somewhere in the 20% range from 30% to 20%, though, again, the numbers are not final in any way.

Lewis: Maybe a little bit of a refresher for folks who aren't super-familiar with the corporate tax code: Companies can currently defer paying that income tax, like you mentioned, on money earned abroad until it's brought back to the United States. And because current conditions say that they would be paying a higher tax rate than the current tax rate on those profits, a lot of companies have basically said, "Nope, we're not going to do it. We're just going to keep it offshore, keep it overseas, and wait." And they've been waiting with the hope that they would either get tax reform, in terms of a sweeping tax bill, or maybe a tax holiday. So, presently, it seems like there's roughly $2.5 [trillion]-$3.1 trillion in profits generated by U.S. companies sitting overseas in this limbo.

Kline: The tax code creates sort of a weird disincentive. You have all this money, but it's actually cheaper to borrow money in the United States than it is to bring money that's already yours back. So there has to be some level of reconciling this, because if you have a bunch of money sitting in foreign banks, it makes sense to open foreign factories, to invest in other countries, to spend some of this money. So, however the tax changes go down, ideally there will be either this tax cut or a one-time repatriation deal. Something has to happen, which in theory should be good for investors and probably employees of a lot of tech companies.

Lewis: And the rate that we've seen, or at least I've seen floated in a lot of these reports, for repatriation would be somewhere in the neighborhood of 10%-14% for money held in cash. I've seen that the rate might be a little bit lower if it's held in certain securities. Again, we're speculating a little bit here because we don't know the firm details of the bill at this point. But, the reason this is so relevant to the tech space is because when you look at the heavy hitters that really contribute to that $2.5 [trillion]-$3 trillion in profit overseas, they're all tech firms.

Kline: The big ones are really Apple and Microsoft. Apple has over $250 billion sitting in overseas banks, piggy banks, under some mattresses in a couple of countries. You look at it, Apple has $100 million in debt in the U.S. that they borrowed, sort of what I was talking about before, and $250 million. So in theory, if they brought that back, paid $25 [million]-$50 million in taxes, they could wipe out all of their debt and have $100 billion to play with. To give you a perspective, the recent Disney-Fox deal was a $52 [billion]-$54 billion deal. Apple could buy all of that and still have a lot of money left.

Lewis: And it's funny, because for a long time, we've seen people speculate about, these are the things that Apple could do with its massive cash hoard. It's been these crazy, outsize contextual things. Talking about the number of Ferraris they could buy, or what have you. The point is, there's a lot of money that's been sitting overseas for a lot of these companies. You mentioned Microsoft. They're second right now with just over $100 billion held abroad. Other major tech players, Oracle, Cisco, Alphabet, I think they have roughly $50 billion overseas. But, that money has largely been just sitting there; it hasn't really been put to use. So what you hope to see with a lot of this and what investors will be watching is, if they're able to bring back this money and they're not going to take a huge haircut on it with the taxes they will be paying, what will they do with it? Some folks believe it'll lead to companies investing in growth in the United States, building out jobs, maybe building out factories and things like that. Others think the companies will be using money to buy back shares, possibly raise dividends. You mentioned the possibility of merger-and-acquisition activity. There's so many different things that this amount of capital can enable.

Kline: I think realistically, the biggest impact is going to be increasing dividends and buying back shares. The reality is, if Apple and Microsoft had companies they wanted to purchase, they could make those deals happen. Especially because many of the companies they'd want to purchase, some of that deal could be financed with money that was outside the United States. The other advantage to having all this money is, it makes it very easy to borrow at low rates. Even if you factor in the current tax code, you still have the cash, that makes you the best kind of debt any company could have -- someone who can pay it back but just wants to keep the cash, or for this reason has to keep the cash in another location.

Lewis: Yeah. No one has any problems buying up bonds from the likes of Apple because they know there's all this money sitting overseas. So even though they have that $100 billion in term debt, they've had coupons between 3.5%-4.5% to maintain their capital return program, pay those dividends and buy back shares, and they haven't had any trouble raising that money because the assumption has been they're going to be able to bring that money back eventually.

Kline: I think what you're not going to see is massive investment in U.S. factories. All of the economics that make that not work -- the cost of workers, all of those negatives -- if you could make those numbers make sense, they would be doing it now. You might see an increase in research and development. This makes it easier for Apple to spend a few billion dollars on driverless cars or whatever their next fancy might be, spaceships, who knows, but that's not going to result in tens of thousands of jobs.

Lewis: I mentioned before, we're looking at preliminary reports of the bill. We'll find out more in the coming days. I think one thing that's particularly worth watching is what the bill dictates about future foreign profits. I've seen some reports that the repatriation tax would apply to past profits only. I've seen other reports that the 10% tax or roughly 12% tax, whatever it winds up being, would apply to foreign profits moving forward under certain circumstances. That's something that will largely determine how companies treat their foreign profits going forward. If it's something that it doesn't really matter how they bring things back, what they're taxed at, that's going to dramatically change what balance sheets look like.

Kline: It's a moving target, and not to get too into the politics, but even the bill we see this afternoon, there's still only the thinnest of Republican majority in the Senate. So, exactly what we see on Friday and what gets voted on next week or the week after or whenever it gets voted on, that could all look very different.

Lewis: And the reason I specifically mentioned that future-looking element of foreign profits is, that's kind of the situation that got us here. The reason that all these companies were stockpiling cash abroad was, they hoped that at a certain point, they could force policymakers' hands and say, "We want to have some sort of cash repatriation, or we want some sort of tax reform that allows us to bring it back at a rate that makes sense for us." For the longest time, Tim Cook has said, it's irresponsible for me to my shareholders to bring it back at the rate it would currently be taxed at. So if there's wiggle room in whatever they set up for the tax code, it would not shock me to see tech companies go about building up the same war chests, again, overseas. So it's all about what policymakers decide to create.

Kline: I think the best thing for shareholders is stability. If you really look at this, and they come out and it's a one-time deal, that'll have a nice benefit over the next couple of years in spending, and give back some dividends. But the reality is, if they do set a lower long-term rate, even if it's not as low as 10%-14%, as long as it seems stable and it doesn't look like you're going to have Congress, the Senate, and the presidency flip to the Democrats. So, whatever gets voted on is almost certainly going to be in place for a while. That makes it a lot easier for a company to plan long-term investment.

Lewis: That's what you want to be able to see, is this understanding of where things are going.

Kline: Yeah. When your tax rate could change by 20%, that's not a small number.

Lewis: Yeah. Switching gears over to another story that we have our eyes on, Dan, it's the continued rise of esports. This is something that I think maybe I'm a little more bullish on than you.

Kline: We've been talking about this, not just you and I, at the Fool for five years. Every year, esports is the next big thing; it's going to break out. And I know the numbers have gone up, but I question with the ceiling for it is. It's not that I'm not bullish on growth; I just don't know that it's going to become the next NFL, or frankly, even the next NHL.

Lewis: I don't know that it needs to, though. I think maybe that's the important thing. I've been an esports skeptic for a long time. Going back a couple of years ago, I changed my outlook on this trend, specifically looking at the performance of the gaming sector, and also just understanding all the investments that are being made to support it. And I see these little stamps of validation left and right. You look at the top-paid individual YouTubers; four out of the six are online personalities that game and do game walk-throughs or group plays or things like that. I see that Westwood One, a major radio station, is launching a nationally syndicated esports talk show. Dan, you sent me a link the other day about this reality TV show based on a season of Madden.

Kline: Here's the thing. I'm not saying esports isn't poker at its height but with more long-term viability. My son will sit and watch YouTube videos. I think the challenge is, aside from the three or four biggest video game companies monetizing this with in-game sales, with tournaments, with building up a very long life cycle for some of these game titles, I don't see the ability for bigger media to do more than nibble at the ends of this. Yeah, ESPN will have a show at 3 in the morning, and TBS has a show, and there's a few things out there. But aside from Twitch, there really isn't a big monetization play outsize of EA and Blizzard and some of the big gaming companies.

Lewis: Which is why I continue to like Activision, Take-Two, and Electronic Arts. These are three companies that have been incredible performers so far in 2017. Activision Blizzard is up 75%. Take-Two is up 120%. And EA is up 33%. They've all crushed the market's return of 18% this year. They've also been multibaggers over the last five years. And I look at a couple of trends with this space, and some projections for where things might be going. The esports audience is estimated to grow by 50% between now and 2020, and it's believed that the market will double in revenue to roughly $1.5 billion in that year. Those are some big wins pushing the sales up.

Kline: And it's model-changing for these companies. If you look at what the video game model was a few years ago, it was very much movies. You put out a title; you hoped it sold a lot; maybe there were sequels. Now, if you look at a game like OverWatch that has a huge esports community around it, you buy the game, and there's additional spending and advertising and all sorts of opportunities within that game. And that's a life cycle that goes on theoretically for decades. There will be new versions of the game, but it becomes like football or soccer or any other sport, where your business is no longer selling the one-time sale and maybe a sequel. Your business becomes, people are just playing, and there's money to be made doing that. 

Lewis: Something that blew my mind with esports was, I believe the purse for the 2016 DotA [Defense of the Ancients] championships -- DotA is a very popular online game -- was $20 million. And that was split between a team of six or seven.

Kline: That's slightly better than the pretzel that was a prize for the Ms. Pac-Man tournament that I played back in 1985.

Lewis: Yeah, you got into the wrong line of work there. But the idea that that much money is being put out as prize for one game's championship speaks to, I saw some article put it in the context of, the players on that team each took home as much as the person that won the Masters last year.

Kline: This is also going to tie into what we talk about next, with the changing face of television. As you have younger people who are cutting the cord, they're looking for other types of programming. If you play DotA or OverWatch, or, my son plays Star Wars Battlefront, one of the ways to feed your gameplay is to watch other people play. You and I can't watch the NFL and go, "We'll be as good as Tom Brady because we saw him, or, we'll get better because we saw him play." But if I see somebody show me how to get Batman to solve a puzzle in one of the Arkham games, I can actually apply that. There's a much more useful level. And that's an area that I think could grow. I think the social-media aspect of this could eventually be an even bigger driver.

Lewis: Dan, you teed up TV disruption. Why don't we start talking about that? In the past decade, the way people consume content has radically changed, I think it's pretty safe to say. You spend a ton of time covering cable and streaming tech, and this is one space that you think is going to be a major focus for the next year.

Kline: The cable universe, as we've talked about endlessly for the last four years, has gotten smaller. And the pace of that is accelerating. That means that people who used to buy a traditional cable bundle are now cutting the cord or never opting to have cable, or they're going with alternative services. And as more and more services come out, that becomes more likely. If you look, we have a second home, and our second home, instead of cable, we have Netflix, we have Sling, we have Hulu, we have an antenna. So we got a little bit of live programming through Sling, can you get a couple of channels over the antenna, there's everything you can watch on Netflix, everything you can watch on Hulu. I have Amazon (AMZN 3.00%) Prime, although aside from The Tick I don't think I've used it. And this is a space where there's five or six other players, the most interesting one being T-Mobile, that are going to come into it in the coming year.

Lewis: I'm with you, Dan. I'm someone that has high-speed internet. I recently moved. I have high-speed internet, I have Netflix, Amazon Prime, and my roommate has HBO Go. And between those three, we cover a lot of the programming that we want to watch. So I don't think that you and I are alone in that. In this space, what are the players that you're most interested in? You mentioned T-Mobile. Why specifically them?

Kline: There's two big changes that are coming. The first one is the Disney-Fox deal. The Disney-Fox deal will give Disney a controlling interest in Hulu. That could absolutely change due to regulatory concerns. They could have to cede control or agree to a split board. It's hard to know exactly what will happen. But Hulu offers live streaming, much like Sling TV, and its Netflix-like archival and original series. That will give Disney a platform to add to its own planned sports and entertainment offerings that will have live streaming TV. So really, you might be able to buy a $30 or $40 package from Disney that, it won't replace everything you have in cable, but it'll hit all the ages. You'll get the adult Marvel Disney shows, you'll get the kids' stuff with the Pixar, you'll get the live streaming stuff with the sports. So that's potentially the first package that a family can look at and say, "Wow, I don't need cable because I'm hitting all ages." And with Netflix, we don't know exactly what they're going to do. They just bought a company called Layer3. Layer3 was an alternative cable provider. It's an interface that allows you to have one log-in for Netflix, Hulu, all the different services, along with your cable properties. It's a premium property. In theory, T-Mobile will offer that both on a digital streaming basis over its phone network and as a wired service. What that's going to look like, what the prices are, it's hard to know. But when you look at what T-Mobile has done in the wireless carrier space, you can assume it's going to be very consumer-friendly. And their ability to market to their customer base could instantly get them up to speed.

Lewis: So, a lot of that centered on the domestic market. I look at Amazon and Netflix specifically in the streaming space, and it seems to me like with Netflix's users and Amazon Prime's users, they're inching closer and closer to saturation with paying members domestically. Looking broadly internationally, is that where the growth is going to be for these guys?

Kline: I think for Netflix, absolutely. Netflix has a huge first-mover advantage. There are a lot of markets where simply the concept of streaming television has not been fully embraced. In Japan, people are not paying for this content in the same fashion, so Netflix has some education to do. When you look at Amazon Prime, I think their issue is different. I think the best majority of people who buy Amazon Prime do not buy it for video. So, if they're hoping to grow with video, they still need their killer content. You look at a show like Transparent that won all sorts of awards and got all sorts of acclaim -- most reports said it was only watched by about a million people. That doesn't compare to, a hit show on a network might do 15 [million]-17 million. So, yes, there's absolutely growth potential with video as a driver for Amazon outside the U.S. And for Netflix at 50-something million in the U.S., yeah, they're going to need to keep growing in some new markets, and that's expensive, but clearly, it's been working so far.

Lewis: And, for Netflix, that means bespoke content, it means creating content specifically for certain geographies.

Kline: And even simply translating. House of Cards might be interesting, or Jessica Jones, as we talked about before, which has a lot of action, that works in any language, but you're probably going to want to watch it in your language, not with subtitles, and probably not in English.

Lewis: Dan, anything else with the cable space or the streaming space that you're looking at for 2018?

Kline: I'd be worried about big cable. Obviously, Comcast and Verizon and some of the other players have made up for cable losses with selling broadband internet, because you need broadband internet to get these cord-cutting services. The problem with that is, there could be an innovation that allows some other method of delivery. Whether it's Google blimps or Facebook comes up with something, there absolutely could be a disruptor there. But I don't like any of the begrudging skinny bundle offers that are being put out by Comcast or Charter. They clearly are married to an old model, just like they were married to a monopoly model, and I don't think they're going to move fast enough. Obviously, it's only a portion of Comcast's revenue, but I would be very worried about Charter as more and more people leave the traditional cable space.

Lewis: A lot of fun stuff to look forward to in 2018. Thanks for hopping on, Dan!

Kline: Thanks for having me!

Lewis: Listeners, that does it for this episode of Industry Focus. If you have any questions, or you just want to reach out and say hey, you can shoot us an email at [email protected], or you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes, or check out the Fool's family of shows over at fool.com/podcasts. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Shout out to Austin Morgan for all his work behind the glass. For Dan Kline, I'm Dylan Lewis. Thanks for listening, and Fool on!