SILICON VALLEY: BIG TECH PREPARES FOR ITS SECOND ACT

There could hardly be a starker contrast in stock market fortunes. Apple’s shares have perked up this week after a strong earnings report, making it the first company to be worth $1 trillion. One week earlier, Facebook’s stock plummeted on a downbeat forecast, wiping nearly $120 billion from its worth in Wall Street’s eyes — the biggest one-day destruction of value ever for a US company.

The dramatic headlines were partly a reminder of the outsized impact the tech giants have on the wider investment world. Facebook’s reversal reflected the kind of change in perception that often happens when highgrowth companies enter a more uncertain period — it is only the company’s sheer size, its stock market value is still above $500 billion, that made the effect so startling. The bigger they come, the harder they fall.

But the diverging stock market fortunes have highlighted deeper questions. The biggest tech companies have risen together to lead Wall Street inexorably higher over the past five years. So has something fundamental changed? And will their next phase of growth be different from what came before?

From one perspective, it would be a mistake to read too much into the apparent decoupling of the so-called “Faang” stocks — a grouping of tech giants that also includes Amazon, Netflix and Google’s parent, Alphabet. (Many investors throw in Microsoft for good measure.) The designation has been a handy way to sum up a popular theme of stock market investing, but it has yoked together a group of dissimilar companies in a number of markets and at different stages in their development.

Yet there are still important similarities. They have all risen together on the same technology tides. The smartphone boom has turned the iPhone into a business with annual sales of roughly $150 billion, while supplying Google and Facebook with a way of reaching users that now generates more than half of their advertising. And while Amazon does not reveal details, eMarketer estimates that digital retailers worldwide generate nearly 60% of e-commerce revenue from mobile devices.

Some parts of the mobile market are reaching maturity — for instance, in hardware. If Apple can produce another round of strong growth, it won’t just be because “they’re the leader in the smartphone business and smartphones are taking over communications — that’s done,” says Walter Price, a portfolio manager at Allianz Global Investors in San Francisco. The tech giants need new tricks, he adds.

“The industry is evolving,” says Jim Tierney, a growth investor at AllianceBernstein. “If you stand still trying to defend your monopoly, you’re probably going to get run over.”

The core businesses for which they are best known still loom large. Google looks to search advertising for about 70% of its revenues, the iPhone contributed 62% of Apple’s sales last year, and online sales still account for 51% of Amazon’s revenues. But their significance is waning.

“The growth rates are going to continue to decline on a secular basis,” says Mr. Price. “What we’re seeing is the limits to growth for all these companies. The question is, do they have another chapter?”

That has left Wall Street searching for clues about how big these second acts might be, what they will do to the profit-earning potential of some of history’s most successful businesses, and which of the big tech players are best positioned to benefit.

It also raises the possibility of a new era of direct competition between what some analysts regard as monopolistic businesses — though that looks set to take longer to develop than the world’s competition regulators might like.

One message from the stock market divergence of Facebook and Apple in the past week has been the heightened risks — and potential rewards — that come with a period of raised capital spending and R&D.

Apple, for one, is starting to see past investment pay off, contributing to its $1 trillion valuation. Two years ago, when it began to talk more openly with investors about the growth potential in its services business, many on Wall Street saw the move little more than an attempt to divert attention from an iPhone slowdown.

But in the latest quarter, services like the App Store and selling music subscriptions brought in 17% of revenues and grew by 31%. And Wall Street now sees this as one of the key sources of growth for Apple.

Facebook, by contrast, is stuck at an earlier stage, facing higher costs without yet being able to convince investors of the returns that will follow.

“It’s probably where Google was five years ago,” says Mr. Tierney, referring to a period when the stock market soured on the search company’s sharply rising spending. For investors staying with Facebook, he adds: “You have to take a leap of faith.”

Wall Street is divided over how much of Facebook’s “investment” is really about shoring up its core service after recent data scandals, for instance by hiring 20,000 people to moderate content. It is “in between waves of growth” as it both fixes and extends its platform, says Mr. Price. The question is how strongly it will emerge when this period of retooling is over.

The move into new markets is also set to have significant and diverging effects on the groups’ profit profiles. Amazon, for instance, is seeing a profit revival as

it diversifies. Almost anything new the company does “is going to be additive to their margin,” given the relative lack of profitability in the traditional e-commerce arm, says Mr. Tierney.

Amazon has been moving into more profitable areas such as thirdparty sales — taking a 15% cut for selling products for other companies — and cloud computing, where it produces a strong 27% operating margin.

The effects are already apparent. Its operating profit margin reached 5.6% in the latest quarter, eclipsing Wall Street's forecast of 3.2% and its highest level in more than a decade.

That is helping to generate cash for investment in new markets. If Amazon was a widely feared competitor during its years as a margindestroying online retailer, imagine how much more frightening it is set to become as it ploughs surplus cash from its new services back into growth.

The potential for greater competition has complicated the outlook. After earlier attempts to invade each others' turf — like Google's failed efforts to break into social networking — the big tech companies have generally been content to stay away from each other's core markets. But, according to Mary Meeker, a partner at venture capital firm Kleiner Perkins and former Wall Street analyst, that is set to change as they are forced to find new sources of growth.

“Their core product road maps, their conceptual strategic plans, are very different,” says Benedict Evans, a partner at Andreessen Horowitz and longstanding tech industry observer. But that is still leading inevitably to creeping competition as they start to compete more for the same users' attention, he adds.

More direct forms of competition are emerging. Amazon has been pushing brands to spend more on ads to get their products at the top of the search results on its site, in a direct challenge to Google. Sellers say they have little choice but to do so as the volume of items sold on Amazon balloons. And for big brands that are scrutinizing how their marketing expenditure converts into actual sales, Amazon provides hard evidence of a return on investment.

“When people search on Amazon for products, it works,” says Colin Kinsella, chief executive for North America at Havas Media.

Yet even this is likely to have little impact on the balance of power, given the sheer scale of the digital advertising businesses that Google and Facebook have already built. Amazon's advertising revenues will reach $25 billion in 2020, estimates Mark Mahaney of RBC Capital Markets. That is sizeable, but is still projected to leave it a distant third.

Rich Greenfield, an analyst at BTIG, says investors are making “too much” of this apparent competition between digital rivals. Facebook might look like it is treading on the toes of Google-owned YouTube and Netflix with its investments in video content, but it is really seeking a slice of advertisers' TV budgets. Along with Google, he adds, “they are going to feed off the carcasses of legacy media for years to come.”

Observers believe the same could be true of the secular shift to cloud computing. Business worth only around $50 billion of the $1-trillion IT sector has moved to the cloud, estimates Mr. Price. Google and Microsoft may be in hot pursuit of cloud leader Amazon Web Services, but their main rival is the on-premises technology sold by traditional IT suppliers.

None of this means that another sustained period of growth is preordained. There are clear external risks. Asked about the biggest threat, most investors point to potential action from regulators. Silicon Valley's unshakeable belief in the ability of disruptive start-ups to find ways around established tech companies also remains intact, says Mike Volpi, a partner at Index Ventures.

The move into new markets hints at a next phase in the rise of Big Tech. The question about which would be the first to get to $1 trillion has been settled. The race to $2 trillion has barely begun.