Monday, April 15, 2024

Looking at the Magnificent 7

The "Magnificent 7" companies have replaced the "FAANG" stocks, which means that Netflix has been dropped from the growthy-tech investor zeitgeist and Microsoft, Nvidia, and Tesla have been added. The combined market capitalization of the Mag 7 is $14 trillion, which is equal to one-third of the total market capitalization of the S&P 500 companies ($43 trillion). 

That is a very high level of concentration in the top index picks, which means that the returns for the float adjusted, market capitalization weighted index that most index investors buy (SPY) will likely be meaningfully different than the returns on the equally weighted index (e.g. RSP). (The equal weight RSP is trading for 19x earnings versus 21.5x for the SPY.)

Since we are generalists at CBS, it is "our business to know" what is going on with everything, even the frothy Magnificent 7. I thought that we should take a look at the cash generation power of these businesses. What do you get for $14 trillion? How are the free cash flow conversion margins - are these actually good businesses - and what is the valuation (FCF/EV)?

Before I did that, I wrote down my subjective view of business quality or moat for each, on a one to five scale. I am a customer of five of the seven (i.e. all of them except Nvidia and Tesla). How hard would it be for me to fire them? How hard do I think it would be for a team of well-funded 10x engineers to disrupt them? 

Based on that framework, I think that Tesla is 1/5; clearly the worst. (It now has the smallest market capitalization by a significant margin, while it was once larger than Facebook.) I think that Apple is clearly the best, 5/5. I gave Nvidia 4/5 although I am not very familiar with the company or its products. I think that Microsoft, Amazon, and Google are 3s and Facebook is a 2. (Without Instagram, Facebook would be a 1.)

How did my subjective view line up with the numbers? Surprisingly well. Click the table below to enlarge:

Some observations that stand out:

Microsoft blew an entire quarter's revenue, $65 billion, on the acquisition of Activision. But even adding that back, Apple generated almost as much free cash flow ($34.5 billion) as the other six companies combined ($46 billion).

Apple has the second highest free cash flow margin (29% of revenue) of the Mag 7. Nvidia's was 46%, a tobacco-like margin. We know that Amazon is a low margin retail business, Tesla is a joke of course, but Microsoft and Google have very lackluster free cash flow conversion.

Google's stock based compensation (SBC) in the most recent quarter was equal to 30% of cash from operations, and capital expenditures were equal to 58% of cash from operations. (Or 6% of revenue and 9% of revenue, respectively, if you want to look at it that way.)

Apple spent only 8% of cash from operations on SBC in the most recent quarter (3% of revenue), and only 6% of CFO on capital expenditure (2% of revenue), leaving much more free cash flow.

We know that Google is an inferior business to Apple because Google pays a gigantic tithe to Apple. But notice that Apple's most recent quarter cash flow was running at a 5% yield on the enterprise value. That is much more attractive than the other companies in the Mag 7 (which otherwise seem quite expensive).

Apple seems to have the best combination of moat and valuation. If you had to own one of the Mag 7, Apple would be our choice, hands-down, based on business quality and valuation. (Maybe you do have to own one. How far from the S&P 500 index and its performance are you allowed to stray?)

Berkshire has $156 billion of Apple stock, just over a quarter of its own market capitalization. We do not like Buffett's energy pick, but we do like his tech pick.

1 comment:

CP said...

Apple's iPhone sales were down 10.5%, services were up 14%, and total revenue was down 4.3% (all year-over-year).

They generated $63 billion of cash from operations over the past six months, less $6 billion of stock based compensation and $4.4 billion of capital expenditure gives $52 billion of adjusted FCF (up 3% y/y).

Annualized, that is a 3.9% yield on the $2.67 trillion market cap. They bought back $43 billion of stock and paid $7.5 billion of dividends.