FAGMA is the new FAANG

Cramer: ‘We gotta get Netflix the hell out of FAANG’

CNBC’s Jim Cramer, who popularized the acronym FAANG, said on CNBC’s “Squawk on the Street” that it’s time to take out Netflix and replace it with Microsoft.

Though he did not invent the FAANG acronym, the “Mad Money” host popularized the term that encompasses the internet stocks of Facebook, Apple, Amazon, Netflix, and Google-parent Alphabet.

“We gotta get Netflix the hell out of FAANG,” Cramer said in an appearance on “Squawk on the Street.” “I tell you that right now. I don’t know how to do it.” Just the day before, the show host told viewers not to buy or short the Netflix stock — just sell it out of your portfolio.

Why do I, Goldman Sachs, and Jim Cramer think it's time for FAANG to retire?

When the acronym FANG was created and later extended to FAANG, technology investing was dominated by mobile, advertising (led by mobile), over-the-top streaming, and e-commerce. Today, tech stock investors would be remiss to not have the cloud in their tech portfolio as the category has proven to be secular and insulated from economic drawdowns.

Netflix is considered one of the superstars of big tech, but that status should be determined by more than an impressive valuation and growth charts. Netflix is in trouble. Superficially, Netflix does seem to fit in, with a $145 billion market cap and 27% year-over-year revenue growth from September 2018 to 2019. Despite competition from Amazon Prime and Hulu, and the threatening rise of Disney+, Apple TV+, and WarnerMedia’s HBO Max, Netflix boasts a base of 158 million subscribers globally.

But a deeper analysis of FAANG reveals that one of these companies is not like the others. Netflix’s core business fails to take advantage of platform dynamics. FAGMA, on the other hand, swaps out Netflix for Microsoft, a true platform conglomerate with strong network effects in several of its businesses, from its Windows operating system and its Azure developer ecosystem to LinkedIn and the new video game live streaming platform Mixer. That makes FAGMA a better picture of companies positioned to stay on top for years to come.

Where has Netflix gone wrong?

Its major challenge is the lack of supply-side network effects. Other streaming video challengers like Disney face a similar challenge. But Netflix, as the biggest of them all, could fall the hardest.

For all its outstanding performance over the past decade, Netflix has been hounded by the dark cloud of negative cash flow for far too long. The company has reached $12.43 billion in long-term debt with no surefire plan to get on the road to positive cash flow.

Netflix is spending more and more to acquire premium content in the face of diminishing returns. Its content spend has reached $15 billion for 2019, far exceeding that of competitors. Not only are big media companies like Disney and WarnerMedia entering the streaming wars and shelling out hundreds of millions to lock down top production talent, but extremely popular TV series like The Office and Friends are being reclaimed or snatched away from Netflix by the highest bidder. While Netflix has invested billions in its own original content, its most popular shows were still these major licensed properties. Netflix is losing the very licensed content that has driven most of the viewership, which is forcing the streaming giant to ramp up spending on in-house production even more.

The big problem hurting Netflix’s defensibility and profitability is a lack of network effects on the supply side. Content producers cannot sign on to the service organically. The demand is there. But Netflix doesn’t provide an ecosystem to attract a growing network of content creators who can, in turn, freely create and connect with viewers.

Rather, Netflix either buys licenses to content or pours money into making original shows and movies. The only way the current model allows the service to compete is to grow the library of exclusive, premium content, which only continues to add red ink to the balance sheet.

This would be temporarily OK, if there were a solid plan to escape the cash flow freefall. In light of this, Netflix has been making strides in international expansion. But while the 98 million-and-growing non-US subscriber base is helping Netflix show growth, many customers in new markets such as India and Malaysia are not going to pay as much as American subscribers will. That puts a cap on profits. At the same time, domestic subscriber growth is slowing, with Netflix missing on domestic subscriber growth in the most recent quarter.

As long as the fundamentals are bad and Netflix stubbornly sticks to its guns in the content arms race, going international won’t work to secure long-term profitability. A plan based simply on the hope that scale will outpace costs is a flimsy one at best.

The lack of network effects isn’t only a problem faced by Netflix. With an average churn (subscriber loss) rate of around 18% across the industry, all the big players crowding the streaming space will likely find themselves on the same hamster wheel, constantly pouring huge sums of capital into content and customer acquisition.

At the end of the day, Netflix is a traditional content creation business with a digital distribution mechanism. All of the important questions about Netflix’s business are the same ones that have faced traditional content businesses for decades. It hasn’t fundamentally changed the economics of the business. And unless it does so, it’s not clear that its business model can be sustainable, especially as it faces real competition for the first time.

Enter FAGMA

Outside of the streaming wars, we see something the other FAANG companies are doing that actually does bode well for growth and profitability. They all own platforms with strong network effects, and they all leverage user-generated content (UGC) to some degree.

That UGC comes in many forms. Facebook, through its core platform and Instagram, allows users to crank out content for free consumption by others. In addition to its content platform in Google Search, Alphabet has YouTube, which boasts 1 billion+ hours of video watched every day. And with its huge demand base, YouTube can now look at sourcing premium video to add even more value for users.

Like the other FAANG giants outside of Netflix, Apple is a platform conglomerate. As it runs the hugely successful iOS development platform and App Store, it’s building out the ecosystem around the iPhone and Apple Watch and seeding network effects in electronic health records (EHR) and other areas.

Then, there are Amazon’s and Microsoft’s forays into the world of videogame live streaming. Amazon’s Twitch is dominant in the space, slated to hit $1.65 billion in revenue by 2021 according to NewZoo. And while Twitch holds the title for viewership, Microsoft’s Mixer saw explosive 149% year-over-year growth in 2019, second only to the growth of Facebook Gaming among the big players that year.

Outside of content, Amazon’s Marketplace, which accounted for 60% of sales in 2019, has strong network effects that attract millions of third-party sellers with hundreds of millions of products. Microsoft, of course, also has LinkedIn as well as a large ecosystem of third-party developers around Windows and Azure.

So, if we subtract Netflix from FAANG, we see that Facebook, Google, Apple, and Amazon all have strong network effects that provide real defensibility. And, where content is the main unit of value, the user-generated content doesn’t sit on their balance sheets, as it does for Netflix.

The tech giants are building sustainable scale by leveraging the consistent value exchange between their user groups. Netflix is chugging along based on how much it can spend, but at some point, the bottom has to drop out.

Netflix’s international expansion helps on paper and with growth in the short term, but it fails to solve the underlying problem of gigantic capital expenditures with no end in sight.

What would make for a solid plan? Embracing platform thinking, and building network effects on the strength of user-generated content.

There are many forms this could take, from viewer commentary to interactive, behind-the-scenes content from creators that engages loyal fans of certain shows. But however it's done, given the diseconomies of scale that plague the industry, it seems inevitable that the big linear streaming companies will leverage UGC and try to harness network effects at some point in order to make a profit. All of Netflix’s profitable platform content competitors have done so. Yet the streaming company stubbornly has not.

Microsoft is the most valuable publicly-traded company, with a market cap of over $1 trillion, making it more than eight times bigger than Netflix.

FAANG, coined in 2013, originally didn’t include Apple and was intended as a nickname for high-growth internet companies. The following year, Satya Nadella became Microsoft’s CEO and sparked a massive turnaround at the software maker.

“At that point we didn’t know how great Satya was going to be,” Cramer said. “It was pre-Satya. I came up with it pre-Satya.”

The FAGMA Portfolio

In assessing the rest of the FAANG class, Cramer said Facebook is a “very undervalued stock” but warned that it could also get kicked out of the group if the U.S. government forces the social media giant to spin off the Instagram and WhatsApp platforms.

Apple is the “north star” of the market, Cramer added. The host said he thinks Wall Street may be “concerned” about Amazon’s spending habits. The e-commerce giant earlier this year earmarked $7 billion for video and music content in 2019.

While Amazon also faces some calls to be broken up, Cramer is convinced that Alphabet could benefit by separating its search, cloud services, and self-driving car program, Waymo, into separate businesses.

As for Microsoft, it is one of two companies that have a market value of more than $1 trillion, according to FactSet. Apple has nearly $1.07 trillion market value to Microsoft’s almost $1.06 trillion, as of Friday’s close.

With Microsoft, FAGMA would be made up of the five most valuable companies on the S&P 500. Facebook, the youngest company of the five, has the smallest market value at $530 billion.

Approximately 3,000 companies (mostly tech companies) trade on the NASDAQ, and the Nasdaq Composite Index, which indicates how the tech sector is faring in the economy. Facebook (FB), Amazon (AMZN), Apple (AAPL), Microsoft (MSFT), and Alphabet (GOOG) accounted for 55% of the NASDAQ’s year-to-date (YTD) gains as of June 9, 2017.

In addition, FAGMA stocks accounted for 37% of the returns of the S&P 500 index, which tracks the market capitalization of 500 large companies across various industries trading on the NYSE and NASDAQ.

Each of the stocks in the FAGMA class is in the top 10, by market capitalization, of the S&P 500 index. Although the five stocks are only 1% of the 500 companies in the index, they make up 13% of the market value weighting in the S&P 500.

Since the S&P 500 has widely been accepted as the best representation of the US economy, it follows that a collective upward (or downward) movement in the stock performance of FAGMA will most likely lead to a similar movement in the index and the market.

For example, on June 9, 2017, shares of FAGMA companies slumped following a report from Goldman Sachs cautioning investors not to use these stocks as safe-havens. FB, AMZN, AAPL, MSFT, and GOOG fell by 3.3%, 3.2%, 3.9%, 2.3%, and 3.4%, respectively, by the end of the trading day. In turn, the NASDAQ fell almost 2%, and the S&P 500 was down 0.08%.

FAGMA are termed growth stocks, mostly due to their year-over-year (YOY) steady and consistent increase in the earnings they generate, which translates into increasing stock prices. Retail and institutional investors buy into these stocks directly or indirectly through mutual funds, hedge funds, or exchange-traded funds (ETFs) in a bid to make a profit when the share prices of the tech firms go up.

As of June 9, 2017, while the S&P 500 had gained by 8.5% YTD, the worth of each company that composes FAGMA increased by over 30%, except for MSFT and GOOG, which were up 16.7% and 24% YTD, respectively, beating the market benchmark index. The 13-F filings for the first quarter of 2017 saw notable hedge fund managers increase their holdings in FAGMA. Since FAGMA stocks have consistently beaten the market over the years, adding these stocks to a fund’s portfolio could increase the chances of generating a high alpha for the fund.

FAGMA has been likened to the tech stocks that were prevalent in the market before the 2000 tech bubble burst. Historically, growth stocks have higher volatility than the market due to their risky ventures.

However, FAGMA stocks have a valuation with unusually low volatility, which is reminiscent of the pre-dotcom crash tech stocks. While analysts, notably from Goldman Sachs and UBS, have expressed doubt in the continued low volatility of the tech giants, they agree that these tech stocks in the digital era still have plenty of room to grow as they delve into new technology ventures in machine learning, big data, cloud computing, social media, video streaming, artificial intelligence (AI), blockchain and e-commerce systems.

Essentially, FAGMA represents the U.S.'s technology leaders whose products span mobile and desktop systems, hosting services, online operations, and software products. The five FAGMA companies have a joint market capitalization of around $4.5 trillion and are all within the top 10 companies in the US according to market capitalization as of March 31, 2020.

Among FAGMA stocks, the oldest company to list on the stock exchange is Apple which had its initial public offering (IPO) in 1980, followed by Microsoft in 1986, Amazon in 1997, Google in 2004, and Facebook in 2012.

Conclusion

The new variation of the biggest tech companies should include Microsoft and not Netflix because of the relatively small market capitalization of Netflix as compared to the other five companies in FAGMA.

Thus, FAGMA is the new FAANG!

References:

1. https://www.investopedia.com/terms/f/faamg-stocks.asp

2. https://www.cnbc.com/2019/10/03/cramer-we-gotta-get-netflix-the-hell-out-of-faang.html

3. https://www.cnbc.com/2019/10/18/lets-swap-netflix-for-microsoft-jim-cramer-says-in-faang-audit.html

4. https://en.wikipedia.org/wiki/Big_Tech

5. https://www.forbes.com/sites/bethkindig/2020/06/26/wheres-the-m-in-faang-heres-why-2020-belongs-to-microsoft/?sh=6de3bea36a52

6. https://www.applicoinc.com/blog/faang-is-out-famga-is-in-why-netflix-should-be-swapped-for-microsoft/

7. https://www.teamblind.com/post/Why-is-Netflix-part-of-FAANG-and-not-Microsoft-zfKX7aYX

8. https://news.ycombinator.com/item?id=22165118

9. https://www.reddit.com/r/stocks/comments/91klvo/why_is_msft_not_in_faang/

10. https://www.quora.com/Why-is-Microsoft-left-out-of-FAANG#:~:text=Google%20is%20into%20OS%20market,It%20changed%20the%20whole%20industry.&text=Of%20course%20FAANG%20acronym%20is%20related%20to%20stock%20markets.