Buy Hold Sell: 2 big tech buys and the fundies debate the sector's next steps

It's safe to say that mega-cap tech companies have carried global markets this year, with the NASDAQ 100 returning almost 40% this year. And most of that performance can be attributed to seven behemoths. 

This exuberance around tech has fed across into the Australian market. Year to date, the S&P/ASX All Technology Index has returned over 21%.

Will this run continue or are investors about to hit the brake pedal?

What of the unprofitable hype companies that have characterised the sector through the past decade of free money and growth at any cost?  

In this episode, Sam Koch from Wilson Asset Management and Shane Fitzgerald from Monash Investors pick apart those questions, before providing their thoughts on three local technology companies. As you'll see, it's a stock pickers' market and opinions are divided. 

Finally, they each lay out the investment case for their highest conviction pick from the sector. 

Note: This episode was filmed on Wednesday 28 June 2023. You can watch the video, listen to the podcast, or read an edited transcript below.

Edited Transcript

David Thornton: Hello and welcome to this episode of Buy Hold Sell. I'm David Thornton. Today we're taking a deep dive into the tech sector. US mega-cap tech has carried the S&P 500 this year, and it's taken Aussie Tech along for the ride. For some insights into the sector, we're joined by Sam Koch from Wilson Asset Management and Shane Fitzgerald from Monash Investors. Thanks for joining us, guys.

Can the tech rally continue?

Okay, so the ASX All-Tech Index has lifted nearly 18% year-to-date. Sam, do you see this continuing?

Sam Koch: Great question. In our view, there are actually three drivers that are actually driving the outperformance of the tech sector year-to-date. The first is the fact that the market believes they've got line of sight on the end of the rate-rising cycle. And for the sector as a whole that lifts the prospects of valuation. Secondly, fundamentally a lot of these tech companies have actually cut costs, and so their pathway to profitability is actually a lot narrower, and that's a positive for investors. And then thirdly, the real economy is really suffering. You've seen a raft of downgrades across the retail sector recently. And so when you step back as a portfolio manager and you're looking to allocate capital, where else are you going to put it to actually get growth? We think the tech sector is a viable option.

David Thornton: Pretty mixed appraisal. Shane, what do you think?

Shane Fitzgerald: I concur with most of those points, in fact, all of them. I think the real variable likely to change over the next 12 months or so is the investment time horizon of the market. When you have periods of real uncertainty, like we've had in the last 18 months with backing up of interest rates, high inflation, the market's time horizon really crunches in. And in the tech sector, you have a lot of very long-duration stocks, some of them are not cash flow positive for many years. So when that time period crunches in, the balance sheet becomes at risk. If there's one thing I've learned over all my years of investing, if the balance sheet is at risk, the rest is bullshit. So that's likely behind us now, so I think it's more encouraging for the sector.

Unprofitable tech, will they survive?

David Thornton: Okay. We've seen a real divergence between profitable and unprofitable tech. Sam, what's your outlook for these profitless tech companies?

Sam Koch: It's a great question. From what Shane just mentioned, we have a focus on profitable businesses and profitable tech, or companies that actually have a pathway to profitability in the short term. In our view, it reduces or removes the risk that they need to raise money at a depressed valuation, which is highly dilutionary for shareholders. And I think the market has the same view. You look at companies that cut costs aggressively, their share prices have tended to rally over the last six to 12 months. In our view, profitless companies or unprofitable companies will continue to struggle.

David Thornton: Shane, do you touch profitless companies?

Shane Fitzgerald: From time to time we do but in this market environment, not really. It's all about where the companies need to raise capital, they don't and raising money at the moment is just tough. I think when it comes to the profitless companies, what you are seeing is a lot of them are cutting their costs back. The real question is have they cut into the bone? I want to see a result or two before I get comfort that the cost reductions that we have seen haven't cut to the bone. Tech companies are all about growth, so you've got to see that growth. If they cut too hard too quickly, then that can be problematic.

Earnings season preview

David Thornton: So we've got confession season and earning season coming up. What do you expect to see?

Shane Fitzgerald: The tech sector probably is more diverse than almost any other sector out there. There are companies in a vast range of different industries, different segments, et cetera. So there's no overarching theme going across the sector, but there'll be a focus on the cost line, there'll be focus on the key SaaS metrics. The market at the moment or moving into is a stock picker's market. There's no big themes or trends going on across the equity market. It's all about stock picking. So it really comes down to the execution of the management teams, and how well they do.

David Thornton: Sam, what do you expect to see out of confession and earnings season?

Sam Koch: I agree. Largely idiosyncratic, the sector. Two overarching things that I'm looking for are as these companies have really run aggressive cost-cutting campaigns, have they cut into the bone? Have they really impacted their future growth potential as a result of that cost-cutting? So I'd caution investors to keep that in mind. And then secondly, a lot of these tech stocks aren't necessarily immune to the real economy. Some have exposure to the consumer, some have exposure to the business investment cycle as well. So understanding the end market exposure to those businesses and how that plays through in the results will be key.

Megaport (ASX: MP1)

David Thornton: All right, let's move on to Buy, Hold, Sell. First up is Megaport. It's been beaten up since the end of 2021, but it's up 13% this year. Shane's starting with you, is it a buy, hold or sell?

Shane Fitzgerald (HOLD): We've got a hold on this stock, really on valuation grounds more than anything else. The big drop in the share price really comes back to this, when is the stock going to become cashflow positive? So the company recently took the knife to their cost base, took a tonne of cost out of the business. And on the current projections, it looks like they're going to get that cashflow break even probably in the next 12-18. Does it justify a billion-dollar-plus valuation? No, you need to see the growth coming through. And circling back to what I said a second ago, I want to see where this cutting has impacted the growth. And if you look at the last quarter in particular, and the ones prior to that, the growth metrics haven't been spectacular for this business. So I think they've got some work to do to actually convince the market the valuation that's currently got is appropriate.

David Thornton: Okay, so we've got a hold there. Sam, buy, hold, or sell?

Sam Koch (BUY): For us, Megaport's a buy. We spent a lot of time over the last six to 12 months on really trying to understand whether the underperformance that they've had at the revenue line, and you've seen through the stock price, has actually driven by the product being inadequate or poor execution. In our view, it's been poor execution. Essentially, when they tried to pivot towards the indirect sales channel, they lost focus, sales deteriorated, their costs blew out. And what you've seen now is the founding chairman actually stepped back into the business, cut costs aggressively. They've changed the executive team. They've got a sales executive now running the business, Michael Reid. And they're starting to reinvigorate and reorganise that sales team.

So from our perspective, it's a turnaround story. It will take 12 to 18 months to play out, not a couple of quarters. And it's trading towards the bottom end of its EV/EBITDA valuation range. The catalyst is a re-acceleration of revenue growth and successfully hitting those earnings targets.

Life360 (ASX: 360)

David Thornton: The market loves a turnaround story. Next up, we have Life360. My family actually use the app and love it. But in terms of the stock, is it a buy, hold or sell, Sam?

Sam Koch (BUY): For us, Life360 is a buy. The investment thesis is being progressively de-risked over the next couple of quarters as they continue to add subs ahead of market expectations, whilst putting through a 50% price increase. That really demonstrates the pricing power of this business. Going forward, you've got the integration of the Tile acquisition, which will really help to accelerate subs growth as well because you've got that bundling with the two products together. As it approaches EBITDA and operating cash flow breakeven this year, we think that's a key catalyst to see it continue to rerate.

David Thornton: Shane, it's done 42% this year. Buy, hold or sell, for you?

Shane Fitzgerald (HOLD): Once again, this is another hold for us primarily on valuation grounds. The business growth is great at the moment. I think the price increase they got, in fact that stuck, seems to be really encouraging. What I struggle with is understanding the true total market, the TAM, for this business. I don't believe the numbers they've put out, they make no sense to me whatsoever. And that's true of TAMs that you get from most companies to be fair. But the other thing that I also circle back on is trying to understand what the longer-term competitive dynamic is going to be. I hear you use it, that's great. My family use Find My on the iPhone. That works perfectly okay for us and costs us nothing. If Apple and Google put a competitive product into the marketplace, I don't know, but it could happen. So I want to see how that environment unfolds.

Dicker Data (ASX: DDR)

David Thornton: Next up we have Dicker Data. This was actually a reader request. Shout out to Nathan. Shane, is it a buy, hold, or a sell?

Shane Fitzgerald (SELL): It's a sell for us. When I look at Dicker Data at the moment, it is very dependent on its own customers for its growth and its prospects. And I think in the current, very challenged corporate environment, it's one of the tech stocks that has the most leverage to the broader economy in our estimation in the sector. Given that headwind, it's a sell.

David Thornton: Sam, it's down 23% this year, which has got to hurt. Buy, hold or sell?

Sam Koch (SELL): It's a sell for us as well. If you look at offshore reports recently, TD Synnex (NYSE: SNX) reported overnight, and industry feedback that we're getting, sales of PCs and laptops have really decelerated, really weakened in the last three to six months, and that's a headwind for this company. They're also heading into this environment with an elevated balance sheet. Over two times net debt to EBITDA on a trailing basis, elevated inventory, rising interest costs, and a deteriorating sales environment isn't a good combination. It's trading at 15-16x price-to-earnings ratio. Offshore peers trade at 10x. It's a comfortable sell for us.

David Thornton: We asked our guests to bring along their highest conviction tech pick for the year ahead. Shane, what have you got for us?

Dropsuite (ASX: DSE)

Shane Fitzgerald: We've brought along Dropsuite. For those who don't know, Dropsuite provides cloud backup servers for your email, for your Office 365, for your Quicken Books, et cetera. There are studies out there showing that small businesses, about 84%, of them do not back up their SaaS application data. They just don't do it. So Dropsuite is working with a lot of managed-service providers to provide these servers into those clients. It's got about 2% market share globally of those MSPs, with plenty of runway to grow into that. It's growing at 50% per annum at the moment. Great SaaS metrics across the board, cashflow positive. There's a lot of upside.

David Thornton: That's a bullish thesis. Sam, what have you got?

Smartpay (ASX: SMP)

Sam Koch: Today I've brought Smartpay. Smartpay is a key high-conviction idea from us. We believe it's undervalued, it's undiscovered, and it's a micro-cap story that has earnings and valuation upside. Smartpay operates in the competitive payment terminal market in Australia and New Zealand. Having said that, it's actually quite competitive. They've been able to grow share from 2% back in 2020 to over 6% now of their core market. And we believe that's been driven by a unique product offering and exceptional sales execution. What we think isn't being priced in by the market at the moment though, is a transition in their business model in New Zealand. In New Zealand, they simply do a terminal rental. So they charge on a monthly basis a rental for the terminals that they provide.

As they shift to a merchant-acquiring model like they've got in Australia, it's a far more profitable model. There are some estimates out there, but it's actually quite a considerable and material difference. And this makes up two-thirds of their current terminal fleet. So trading at 0.5 times price-to-earnings-growth ratio, we believe there's plenty of room for Smartpay to continue to rerate as they take share in Australia and they transition that New Zealand model to a far more profitable one.

David Thornton: Well, that's it for today's episode of Buy Hold Sell. If you liked it, please give it a like. And don't forget to subscribe to our YouTube channel. We're uploading great content like that every week. We'll see you next time.