The technology sector is justifiably viewed as a fast-paced, constantly shifting landscape, so unpredictable results should really feel predictable. Still, it was a bit of a jolt to hear over the weekend that IBM (NYSE:IBM) was buying Linux and cloud specialist Red Hat (NYSE:RHT) for $33 billion -- a major outlay that, it hopes, will change the complexion of the cloud business. Also catching investors off guard was Amazon's (NASDAQ:AMZN) outlook for the holiday season -- a forecast may be something of a guess, but Wall Street has gotten used to a bit more revenue from the e-commerce and cloud titan. Finally, it still feels like a happy surprise when Twitter (NYSE:TWTR) keeps delivering quarterly earnings that are in fact real GAAP earnings. But it did last week, and now the shares are getting buoyant.
In this MarketFoolery podcast, host Mac Greer and analysts Emily Flippen and Jason Moser reflect on these companies' various revelations, and consider the questions that investors most need answers to before they add the stocks to their portfolios.
A full transcript follows the video.
This video was recorded on Oct. 29, 2018.
Mac Greer: It's Monday, October 29th. Welcome to Market Foolery! I'm Mac Greer, and joining me in studio, we have Motley Fool analysts, Emily Flippen and Jason Moser. Welcome! How are we feeling?
Emily Flippen: Feeling alright!
Greer: That did not sound very enthusiastic. You have to pump it up!
Jason Moser: I feel good!
Greer: There you go!
Greer: We have a big deal to talk about that we're going to get to. We're going to talk some Amazon and Twitter because we didn't really get to talk about Amazon's earnings or Twitter's earnings last week.
Moser: It was an abbreviated week. You guys were out there in Denver, partying, having fun.
Greer: That's right. We had a great member of in Denver, but it means that we didn't get to talk about some of the big stories from last week.
We're going to begin with a big story this week. IBM making a big deal. On Sunday, IBM agreeing to buy Red Hat for $33 billion or $190 in cash per share. That's a 63% premium to where Red Hat closed on Friday. That sounds like a lot, right?
Flippen: It is.
Moser: It sounds like a lot.
Greer: Not bad. IBM CEO Ginni Rometty says the deal is all about, "resetting the cloud landscape." Emily, I want to get into that here in a minute. The press release announcing the deal describes Red Hat as "the world's leading provider of open source cloud software." When you look at the deal, shares of Red Hat up around 47% today. IBM, down a little. A good deal for IBM?
Flippen: I think it's a necessary deal for IBM. It's an interesting deal for Red Hat. For a little fun fact, this is actually the third largest deal in the U.S. history for tech.
Greer: That's kind of fun.
Flippen: It's a fun fact. That is to say that, you'll notice that Red Hat shares are not exactly at that $190 price. That's attributable to the fact that this will need regulatory and shareholder approval before it moves forward. I would expect that to happen.
It's an exciting deal for IBM. IBM has been posting really stagnant growth over the past few years. They needed to do something. They were losing out horribly to competitors like Amazon and Microsoft in this space. This acquisition for them is an attempt to control every part of the cloud ecosystem for an enterprise. If you're an enterprise, and you have a lot of physical assets, in terms of traditional information storage, and you're looking to move toward a cloud environment, what they do is, they have an inter-between phase where you're operating in a hybrid cloud environment. This deal is going to allow IBM to get in on the hybrid cloud environment space and help companies transition to that cloud environment. They're using Red Hat to do that.
Moser: I think she hit the nail on the head there. It was a necessary deal for IBM. We've been talking about IBM sort of just sitting there doing nothing over the past decade, more or less, as every other tech company we discus seems to be flying right past it. Typically, with big tech companies like this, that are a little bit more based on legacy success, you have to go in there and make a big deal like this. That's why it's such a premium, I think. IBM really wants this. They don't want Red Hat to go shopping around and see if someone wants to up the ante a little bit. So, they're paying a very heavy premium today.
It more than likely goes through. Perhaps there's some scrutiny there. But when I looked at the two companies, I think this really tells you everything you need to know. When you look at the companies, you note the disparity in the research and development line item on their income statements. If you look at R&D as a percentage of revenue, for Red Hat, it's about 20%. They're plowing a lot of the money they make back into the business because they need to keep relevant and keep advancing. IBM's around 7%, and they're basically doing that just to tread water. And that's what they've been doing for a long time now.
To see them make a big deal like this isn't surprising. I think Red Hat's a good business. The fundamentals are sound. Whether IBM actually does anything really good with it remains to be seen.
Greer: When you look at IBM the stock, it hasn't even been treading water. You look over the last five years. Emily, we were talking about this before the show. Shares are down. You have lost money on IBM over the last five years. That's pretty tough to do in this market.
Moser: Yeah, it had the reputation for the longest time of, if you couldn't really figure out what kind of market it was and how you should be investing, you could always just buy shares of IBM and no one would hold that against you because of its standing in the tech space. But obviously, tech has changed so much in just the recent years, and IBM hasn't really been spearheading that change.
Greer: I want to talk more about this idea of resetting the cloud landscape. IBM's CEO says that big companies have moved around 20% of their work to the cloud. Let's just take that as our starting point. That leaves around 80% that all of these different companies are competing for. IBM and Red Hat can go after that 80%. But we've got a few competitors. Let's just review some of the names in that space. Amazon, Microsoft, and Alphabet.
Flippen: What's interesting about Red Hat is they are focused on open-sourced platforms. When a person goes out uses Red Hat as a provider, they're not actually buying any type of material software. All the code is already out there. If they wanted that, they could quite literally go onto GitHub and copy and paste it. What they're doing is, they're buying Red Hat support -- the technology, the expertise that's needed to implement that. It's going to be really interesting to see how they compete. You'll notice that a lot of their competitors actually use Red Hat.
What IBM is trying to do is saying, "Hey, we're not going to be the big cloud provider that is Amazon Web Services. But, we can at least be the system which Amazon Web Services is operating on." Red Hat's most widely subscribed product is Red Hat Enterprise Linux. It's the operating system that all this technology is running on. What they're trying to do is get in on the base level of that and try to be a player in the space without necessarily directly competing.
We mentioned earlier the culture around IBM, how it's been a slow growth company, not doing much in this space. I think that's where the controversy for this deal comes from. A lot of people see Red Hat as an innovator, completely open-source. Any company that can make $2 billion selling something that's free is a good company in my book.
Moser: [laughs] That's a good point!
Flippen: So, the opportunity there for a cultural disillusion, as this company that's been such an innovator, that's been open-source, moves to this conglomerate, this large, slow tech company, it could be a hard pill to swallow for some employees. But IBM definitely needs the growth.
Greer: The old culture clash. We've heard that story before. I think back to AOL and Time Warner. We will see how the deal shakes out.
Let's talk about one of those competitors. On Friday, shares of Amazon had their worst day in four years, down around 8%. Concerns over slowing growth in the wake up their earnings, Jason. Shares not doing much today. We should add that Amazon is still up around 40% for the year. Perspective is an order. But, what do you make of Amazon?
Moser: Every quarter, when we talk about Amazon earnings, for many of us, the first thing we look to is top line growth. It's less about earnings. We know that typically, they're going to be reinvesting a lot of that money into the business and fulfillment and cloud infrastructure. It's more about top line, less about bottom line.
Taking that into consideration, it makes sense that the market was at least a little bit concerned here. Top line growth was a little bit lighter, perhaps, than what the market was expecting. I think really, the selling is more from the guidance for the holiday quarter. It's difficult for Amazon to go in there and offer a tight window of where they see that top line going. They even made the point in the call that really, most of their money in this holiday quarter is made from this tiny window between the middle of November toward the end of the year, and it's just difficult to predict. They offered a range. That range didn't quite meet up with what the market was hoping for, and you get the sell off.
But it's not to sit there and think, "This is a business in trouble." Clearly, it's not. But it's a business that does a lot of different things. I think one point worth noting is that when you look at the actual retail business, third-party sales now represent 53% of total units sold on the platform. What that means is that Amazon is bringing outside partners in and using their commerce platform to sell their stuff. It's terrific. It's very profitable, but it does play out on the top line number a little bit.
Taking everything into consideration here, I think they're doing a lot of great things. Amazon Web Services continues to grow. It's now a $26 billion run rate. That was $18 billion a year ago. So, let's not get too worked up. I'm going to hang on to my shares for now.
Greer: OK, deep breath. I'll keep my shares, as well. Emily, what do you think?
Flippen: I totally agree. I think the high margin business, which is the Amazon Web Services, is really going to be the main growth driver for Amazon, along with initiatives that the company probably hasn't even thought about yet. This is a blip on the radar.
I will just add, though, that I think a lot of concern is coming from the growth of Prime subscribers, and the question of whether or not the market has been tapped out for people who are going to pay a premium of $119 a year for a Prime subscription, especially when you have a lot of people who have one account per family. Is the growth there really maxed out? And did they achieve the Prime customer growth that they were hoping to when they acquired Whole Foods, and started doing the discounts for Amazon Prime members at Whole Foods? Was that a better deal for Whole Foods than it was for Amazon Prime? I think that's to be determined. Either way, I think it's going to be concerning for a lot of people, seeing the growth of Prime subscribers starting to slow down as the market begins to get tapped out.
Moser: We're faced with the conundrum of Prime or Costco, Mac. Which way do you go?
Greer: Oh, my gosh!
Moser: Is it one or the other?
Greer: That's Sophie's Choice. That's a totally offensive analogy and I apologize, but I never want to be left with that. I would probably choose Amazon over Costco, if I had to say that and please do not repeat that to Jim Sinegal. But I don't have to. I don't have to. This morning, we ordered something on Amazon, and it's coming later today. My question is, do they have a distribution center in our front yard now? I mean, how?! That's voodoo magic. I don't understand it.
Moser: The past couple of years, they've spent a little bit more on fulfillment than they had historically. They have made the point here that this holiday season, they're going to be spending a little bit less, because they've spent so much in the preceding couple of years. That could play out on the bottom line favorably for them. Whether it does or not, I don't know that it really matters. But it's worth noting. They continue to invest a lot in fulfillment.
Bottom line is, much like Costco, Amazon is looking to provide low prices and awesome customer service. There was a quote on the call. For me, this was the best quote of the call, and it's the best quote I've heard from them in some time. It came from Dave Fildes, the director of investor relations. He said, "It's easy lower prices, but it's much harder to be able to afford to lower prices." That, to me, tells you everything you need to know. That really, I think, is the crux of the competitive advantage. Anybody can lower prices, but can you afford to do it? And for a while, it didn't look like Amazon really could, until they could.
Greer: That makes a lot of sense. I'm thinking back to your question again, and I don't like my answer, so I'm going to modify it and say that I don't want to give up Amazon or Costco. Costco has the treasure hunt. Amazon will never, in my humble opinion, be able to replicate that treasure hunt mentality. That's a wonderful thing. And, they don't have the free samples. You're not getting free samples on Amazon.
Moser: It's a fair statement!
Greer: OK, so, lay off Costco. Let's wrap up by talking Twitter. Jason, I know this is a company near -- I'm not sure it's dear to your heart, but I think it is near to your heart. I want to talk about the changing narrative. It seems like the narrative is changing a bit. Last Thursday, Twitter reported better than expected earnings. Shares up around 20% since they reported earnings.
I use Twitter. I like the service, but I had kind of written off the business. Should I give it a second look?
Moser: A second look... I'm going to get back to that. I'm not terribly convicted one way or the other there. It's funny to see that what has been held against the business for so long has now become more or less a passing concern. What I mean by that is the monthly user growth. For the longest time, the question was, how big can they grow that user base, they need to grow that user base as big as you can so you can monetize it.
I think we've hit the point, as investors, you need to look at this and say, "Twitter's basically maxed out its user base." It's not going to get much bigger than it already is. It's somewhere around 326 million monthly active users. That was 335 million a year ago. From 335 to 326, and that's going to go lower this coming quarter, as well, they've already guided. The market buying the stock was a little bit odd, but I think it makes some sense. What we're seeing now is, at least they've proven there is a business there.
To put some numbers around that, if you look at the trailing 12 months, Twitter actually has an E to go in the price to earnings ratio. The P/E ratio is not very helpful if there's no E.
Greer: The E has arrived!
Moser: For the longest time, there was no E! But over the trailing 12 months, they've recorded $0.47 in earnings per share. Real GAAP profitability there. That makes a difference. I'm not sitting here telling you the stock is dirt cheap, but at least we know there's a business there. I think that's where investors can start to say, "Maybe there's a way to leverage this platform." They're doing some good things on the video side. Advertisers are saying good things. They're realizing some return there. It's proven itself to be pretty resilient as a platform for the purpose that it serves.
I think there's a lot of trouble that still comes with a lot of these social networks, and we're seeing a lot of the downside of this so-called connected world. But it's good to see them changing the discussion a little bit, for sure.
Greer: Emily, what do you think of Twitter?
Flippen: Since I'm not a Twitter shareholder and I'm not a Twitter user, I would just say to the extent that it plays into my life, Twitter could have posted earnings of $100 per share and it probably wouldn't have changed the needle for me at all. Social networking sites are, in my opinion, very faddy. To me, it's hard to predict where a market goes in that direction, monetizing what I consider to be a relative fad.
Greer: Jason, how about one person I should follow on Twitter? I don't want anything political. I get enough politics. Just someone I should follow on Twitter, whether it's going to make me smarter or happier or it's just going to be worth following. Present company excluded.
Moser: This is going to hurt, Mac, but given the results of this past weekend, I think you need to give the Boston Red Sox a follow.
Greer: Oh, you had to mention that?
Moser: I mean, they ran one hell of a feed all year long. It was the dream season.
Greer: They crushed my beloved Astros.
Moser: It'll bring a smile to your face. At least you'll say, "You know what? I was pulling for the Astros, but these guys keep me smiling." I think that's what you'll say.
Greer: You need to enjoy your one-year run, because a year from now, it's going to be the Astros' return to greatness. I feel it. Which means the Red Sox will win again, because I predicted the Astros would sweep the Red Sox.
Moser: It was a pretty phenomenal year for them, for sure.
Greer: Incredible, incredible year! Great players! It's an easy team to like, and I say that as an Astros fan. The Red Sox are an easy team to like.
Moser: No Manny Machado's on that team.
Greer: Oh, God! For those of you not following the World Series, Manny Machado, here's what you need to know. He's a great baseball player who, basically, hustling is not his thing. There's a situation where he hits what he thinks, I guess, is a home run. It's not even close to a home run, by the way. It bounces off the bottom of the wall. And he's walking to first base. You have to do better. I don't care if you're a baseball player, I don't care what you do in life, you have to hustle. You can't just show up, you have to hustle.
Moser: You have to put it out there, man!
Moser: In all seriousness, I hope you're following Industry Focus' Twitter feed, Mac. That's a universe of information there that will benefit any investor. Any and all.
Greer: I'm not going to answer that question right now, but I think that sounds like a good idea if I weren't already following it, which I may not be.
OK, desert island poll, let's end with that. Once again, you're on a desert island. It's a totally unfair, never-invest-this-way, arbitrary question. I'm going to give you some stocks and you need to tell me, if you're going to buy one of these stocks for the next five years -- I'm going to make this interesting. I'm going to throw in some of the competition for IBM in the cloud space. We've got IBM, Microsoft, Alphabet, Amazon or Twitter.
Flippen: I'm torn, throwing those out there. I love Amazon's business model. I think over the next five years, Amazon might have some struggles with their employee base. That problem has been festering for a while. I also like Microsoft. I like Microsoft a lot. I think they're doing a lot to compete in the cloud computer space, much better than a lot of people predicted. So, I'm torn between those two, possibly leaning toward Microsoft. But I will add that if IBM hadn't acquired Red Hat, if I was looking at Red Hat on Thursday or Friday last week, like I was, I would easily pick Red Hat out of those two. I loved the open-source nature of the company.
Moser: Yeah, I think that's good. That's fundamentally a very good business. I'm going to surprise you, I think I probably would actually go with Microsoft. I think Alphabet is really going to be dealing with some privacy issues in the coming years. That ad business is a difficult one to keep on knocking out of the park.
I tell you, Microsoft, Satya Nadella has done a great job of turning this thing around, changing the discussion toward the cloud services they offer, really growing that business out there. A tremendous cash machine. And they'll keep raising the dividend, buying back shares, and staying relevant.
Greer: Thanks, and we will see how it shakes out. Jason, Emily, thanks for joining us!
Moser: Thank you!
Flippen: Thank you!
Greer: I want to give a shout out to our listeners who I met in Denver. We had a great listener meetup. We had a great member event. I've said this before, and this gets a little a little hokey, so indulge me here for a minute. It is a joy and a privilege to do the show. We know you have a lot of listening options. Jason and Emily, I know, sometimes we're in this studio, and it's hard to really see how the show's being received. Then you talk to people, and they're like, "I listen on my way to work!", "I listen when I walk the dog!" And I'm like, "You do? You're the one?" I really, really appreciate all the conversations I got to have with our listeners. Most of all, we appreciate our listeners giving us their time, because that's an incredibly valuable thing. As always, we will try to hold up our end of the bargain. I'll try to hold up my end of the bargain. And when I don't, here's what I can tell you. There's a very good chance that Chris will be hosting the next day anyway, so just move right along.
Moser: Hang in there!
Greer: Hang in there! One day does not a show make. With that in mind, you can always email us at firstname.lastname@example.org with your questions and your comments. As always, people on the show may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Mac Greer. Thanks for listening! We will see you tomorrow!