Ivana Delevska | Oct 27, 2022 07:00AM ET
Tech giants Microsoft (NASDAQ:MSFT) and Google (NASDAQ:GOOGL) just kicked off the earnings season, after several notable reports and pre-announcements from Snap (NYSE:SNAP), Advanced Micro Devices (NASDAQ:AMD), Micron Technology (NASDAQ:MU) and CarMax (NYSE:KMX).
Demand trends have significantly deteriorated since last quarter and ultimately we expect that every sector will be impacted by the sluggish macro.
With this set up in mind, there are many companies that look very attractive on pullbacks, as we expect that secular trends will overcome their cyclical headwinds over the next several quarters. Within industrial/enterprise technology there is a wide spectrum of business models all providing different risk/reward. On one end of the spectrum are semis/hardware with the most downside, but also the most upside in a recovery, and on the other end of the spectrum are software (SaaS) business models which we expect to be most resilient through the downturn.
Overall, while many risks reman, the share prices of most of the companies in the four categories above have declined 50-80% ytd, presenting what we believe to be attractive opportunities, and manageable risks.
On the contrary, there are many areas where we believe the risks outweigh the potential upside.
Reported earnings are continuing to surprise to the downside, despite expectations declining throughout the quarter. While last quarter we experienced several pockets of weakness (transportation, PCs, semis) this weakness has now broadened to large cap technology companies, that can be viewed as a proxy for the broader economy.
On the positive side, expectations are now re-set significantly lower especially in areas such as cloud (re-set with Microsoft earnings), semiconductors (re-set with AMD and Intel (NASDAQ:INTC)), transportation and logistics (re-set with FedEx (NYSE:FDX)) etc. Consequently, we expect more positive than negative earnings surprises, despite that the earnings cuts trend for the broader market still remains in tact.
h2 Macro Backdrop/h2While downturns follow a pattern, each one is slightly different and caused by a different catalyst.
High risks assets generally sell-off first, which was the case in this downturn, with limited differentiation within business models. This phase is followed by a broad valuation reset, in this case pretty violent and exacerbated by higher discount rates; and lastly, earnings estimates get cut driven by broad macro weakness.
While the last phase is generally the most violent and volatile, there are several factors that differentiate this downturn from others:
We believe that industrial technology can do very well in this scenario once the market stabilizes. Our channel checks indicate that while most companies are looking to optimize their spend, which is weighing on earnings and creating elongated deal cycles, investing in technology will be the only way for companies to stay competitive. We therefore expect a very meaningful tech cycle ahead.
h2 Divergence in Fundamentals/h2While in the first two phases of the downturn there was limited differentiation between companies with solid vs. poor fundamentals, we are just starting to notice some divergence.
As an interesting datapoint, we compare stock price performance of Snowflake and DataDog, both leaders in cloud infrastructure, with Zillow (NASDAQ:Z), an online real estate platform. While these businesses have seemingly not much to do with each other, all three companies have declined roughly the same amount (~50% ytd).
Now turning on to the fundamentals, we compare hiring data provided by Revealera, a company focused on hiring insights in technology. Job openings for both DataDog and Snowflake show a similar, but more recently a slightly diverging trend.
Conversely, job openings for Zillow show a clear deterioration, implying significant divergence in fundamentals. This divergence in fundamentals did not impact the stocks in 1H22, as the sell of was driven by interest rates and consequently valuations, rather than fundamentals.
Interestingly, while fundamentals did not have a meaningful impact on stock prices in the first half of 2022, this changed since the June lows. Many companies traded down to historically low valuations and found a floor, while others with deteriorating earnings fundamentals continue to find new lows.
We noted similar trend for cybersecurity companies, which have continued on a path of consistent growth in hiring. Many of those companies did not reach new lows despite the recent leg down for the market.
Disclosures: Views expressed here are for informational purposes only and are not investment recommendations. SPEAR may, but does not necessarily have investments in the companies mentioned. For a list of holdings click Click here for our Privacy Policy.
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