Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
For the longest time, investors have been told to invest in the "FANG" stocks trading on the Nasdaq -- Facebook (NASDAQ: FB), Amazon, Netflix, and Google -- and it's been good advice. Over the past year, equally weighted investments in these four red-hot tech stocks would have returned an average 75% profit -- six times the return of the S&P 500. But no plan works forever.
As investment banker Nomura argues in a series of new recommendations released last night after close of trading, it's time to tweak the famous FANG formula. Over the next year, Nomura says you shouldn't buy FANG, but buy "FAS" instead -- Facebook, Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL), and Spotify Technology (NYSE: SPOT) -- if you want to truly maximize your profits on internet stocks.
Here's what you need to know.
There are a lot of internet stocks out there. Which three are the best? Image source: Getty Images.
Tweaking the formula
Nomura stormed into the internet sector last night. As reported by TheFly.com, the analyst issued new recommendations for most of the stocks named above, arguing that if growth prospects elsewhere may be getting played out, there is "still some room for growth in digital advertising for the foreseeable future" -- but these growth prospects are not equally distributed.
Twitter, for example, got initiated with a reduce rating (i.e., sell). Netflix, Snap, Trade Desk, Criteo, and Pandora received only neutral ratings from Nomura. Instead of any of these six stocks, Nomura argued that it sees the strongest prospects for shares of Facebook, Alphabet, and Spotify. Now let's look at why.
The most obvious holdover from the old FANG grouping, Nomura endorses Facebook stock with a buy rating and a $228 price target that's 12% above where Facebook trades today.
Nomura argues that "advertisers are likely to continue spending on Facebook's properties" despite recent controversies dogging the company regarding misuse of its platform by Russian government agents, and data miners besides. As Nomura explains further in a note covered by StreetInsider.com, "[T]here are few companies better equipped ... to tackle these industry-wide problems head on."
Nomura is especially excited about Facebook's ability to grow advertising on WhatsApp and Instagram, and in particular to capitalize on video advertising, which the analyst believes could grow into an $80 billion market by 2020 -- a market nearly twice as big as Facebook's entire existing revenue stream.
Google isn't quite Google anymore
A second holdover from the old FANG paradigm, Nomura also likes Alphabet stock -- which still owns Google, and used to be called Google officially.
"Alphabet's share of online search and video advertising and the reach of its brand and platform provide a moat that distances the company from its competitors," argues Nomura. With a revenue stream nearly three times as big as Facebook's already, and a market cap more than one-third greater than Facebook's, some investors might worry that Alphabet is facing the law of large numbers, and will find it difficult to maintain strong growth rates as it gets bigger -- but not Nomura.
To the contrary, Nomura sees Alphabet's size (it calls the company a "search advertising juggernaut" as an advantage that "enables the company to adopt long-term horizons for attractive opportunities in its disparate portfolio of businesses," taking its time and enabling it to grow over long time spans. Nomura gives Alphabet a buy rating as well, and a $1,400 price target, implying 19% upside to today's stock price.
Retaining Facebook and Alphabet, Nomura replaces Amazon and Netflix in the FANG list with new IPO Spotify.
While new to the public markets, notes Nomura, Spotify is already "the largest music streaming provider in the world," and dominates this market that Nomura sees growing to $53 billion by 2020 (excluding China). Given that Spotify's annual revenue stream is less than 1/10th of that currently ($5 billion), Spotify arguably has even more room to grow in its chosen marketplace than Facebook has to grow in video advertising.
And Spotify is growing, "with growth that has exceeded expectations as the company goes toe to toe with several of the largest tech giants in the world," points out Nomura.
What investors need to remember
The question investors need to keep in mind, however, is whether Spotify is growing fast enough to justify its valuation -- or indeed, whether any of these three companies are?
Unprofitable at present, Spotify does at least generate significant free cash flow -- $159 million over the past 12 months, according to data from S&P Global Market Intelligence. At a market capitalization of $32.2 billion, that means that Spotify stock is selling for more than 200 times trailing free cash flow, which is quite a high price. Granted, trailing-12-month FCF is more than twice what Spotify generated in 2016. But over the next five years, analysts on average predict Spotify will settle down into a more sustainable growth rate of 20% annually.
Nomura may be comfortable paying 200 times FCF for 20% growth, but I am not.
The situations with Alphabet and Facebook are similar, if not quite so extreme. Crunching data from S&P Global, it appears that Alphabet stock has run up to about 38 times trailing FCF, and has a projected growth rate of 19% annualized over the next five years. Facebook sells for a slightly more palatable 31.5 times FCF, and boasts the best growth rate of the three stocks Nomura has recommended -- 24% projected over the next five years.
Of the three internet stocks Nomura likes, Facebook has the closest to a buyable price -- but none of them looks particularly cheap. Nomura's recommendation notwithstanding, I don't think I'll be putting new money into any of them today.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Rich Smith owns shares of Alphabet (C shares). The Motley Fool owns shares of and recommends Alphabet (A and C shares), AMZN, Facebook, NFLX, P, TTD, and TWTR. The Motley Fool recommends CRTO. The Motley Fool has a disclosure policy.