FANGs of Fantasy

Facebook, Amazon, Netflix & Google, the so-called FANG stocks, have stoked bouts of fantasy among investors in recent years, driving up their stock prices phenomenally.

Are they worth the attention? Lets take a quick look.

S.No. Company 5yr Rev Gr ROE Debt-Equity Free Cash Flow 1 Facebook 842% 8% 0 $6B 2 Amazon 214% 4.4% 60% $6.6B 3 Netflix 219% 5.5% >100% -ve 4 Alphabet 155% 10% 4% $16B

The biggest attraction is their stupendous revenue growth.

Facebook — Almost all the $17.9B revenue comes from advertising (online & mobile). R&D and advertising expenses have grown significantly, doubling in FY15 to appox 3% of revenues. Free cash flow is growing.

Amazon — 70% of the $107B revenue comes from electronics & general merchandise, 20% from media (including books), and 10% from the fast growing AWS (cloud services). Low & volatile ROE. R&D and advertising expenses are growing — 15% of revenues in FY15. Free cash flow is growing.

Netflix — 90% of $6.6B revenue is from monthly membership fees from streaming content, the rest from ‘DVD-by-mail’ membership services in the US. Huge debt, in addition to content liabilities (fees & licenses to acquire content). Growing R&D & advertising expenses — 20% of revenues in FY15. Negative free cash flow in the last 3 years.

Google (now Alphabet) — Almost all the $75B revenue is from Google related services (largely advertising — mobile & online), with about 0.5% of revenues from so-called Other Bets (moonshot projects with uncertain returns). Growing R&D and advertising expenses (20% of revenue in FY15), an increasing proportion of which is expected to go into Other Bets. Growing free cash flow.

Netflix doesn’t look good because of its huge debt, negative cash flows, and threat from other online vendors & traditional TV channels. Amazon’s low ROE and growing investments in highly competitive cloud computing is a dampener. Facebook is riding the wave of mobile & online advertising, the durability of which is uncertain. Alphabet looks safe in the short term as its Google services does well, but how well it manages growing investments in Other Bets remains to be seen.

An investor scouting for a strong & durable business which can be held for 5–10 years as a compounding machine may not find these 4 companies appealing. While their growing cash flows are attractive, their ability to reinvest this cash into existing & new projects to earn above average returns is uncertain.

Still, barring Netflix, the other 3 are interesting because of their growth, cash flows, passionate leaders, and investments in ideas which may turn out to be positive black swans. Small bets, at the right price, can possibly lead to asymmetric large returns.

(All 4 companies have significant R&D and advertising expenses, which are expensed the same year they are incurred, an accounting convention which can be misleading. As these expenses are expected to bring future benefits, we could assume they are assets & amortize them over (say) 5 years, which may result in higher current year earnings & slightly better ROE.)