Buy Hold Sell: 2 high conviction tech stocks for the next 12 months

Ally Selby: Hello and welcome to Livewire's Buy Hold Sell. I'm Ally Selby, and today we're taking a deep dive into the tech sector. Tech is off to the races in 2024, with investors betting big on artificial intelligence. So, where can you find the next great tech darling? To find out we're joined by Sam Koch from Wilson Asset Management and Andrey Mironenko from Alphinity. Thank you so much for joining us today, guys. 

As I mentioned in the intro, artificial intelligence is all the rage right now, but there's not a lot of exposure on the ASX. Sam, I'm going to start with you. Are you investing in AI locally? And if so, how?

How to get exposure to AI on the ASX

Sam Koch: We do, and we think that there are a lot of ways that you can actually invest in artificial intelligence on the local bourse. As a starting point, there are companies that are leveraging AI to sell more products like Dicker Data (ASX: DDR). There's companies that are leveraging AI to reduce their cost base like Temple & Webster (ASX: TPW). And then, as companies utilise AI, they're effectively increasing their demand for data centre capacity. So, companies like NEXTDC (ASX: NXT), Macquarie Telecom (ASX: MAQ), and GDC (ASX: GDC) which we've got a large holding in, and Megaport (ASX: MP1) as well benefit. And then, lastly, data centre capacity is actually quite capital intensive, and so the whole entire supply chain will ultimately benefit from this demand and we're playing that theme through Southern Cross Electrical (ASX: SXE), which is an electrical contractor. So, it's one sort of trend, but the opportunity is multifaceted.

Ally Selby: There were a lot of names in there. Are you also finding a lot of opportunities on the ASX when it comes to AI?

Andrey Mironenko: There are definitely opportunities. We're investors in Xero (ASX: XRO), which is launching "Just Ask Xero", which is a generative AI co-pilot. Then, of course, the data centre theme, names like Goodman Group (ASX: GMG) provides that exposure. And also, companies like Data#3 (ASX: DTL), which is the largest reseller of Microsoft in Australia, that includes Copilot, and there is significant opportunity for them with services, consulting and implementation around that as well.

The risks you need to be aware of 

Ally Selby: While tech has performed exceptionally well in recent times, it is quite volatile. Are there any risks that you think investors need to be aware of?

Andrey Mironenko: There are always risks, and of course, tech stocks, like any long-duration stocks have exposure to interest rates. Then for the broader thematic of generative AI, I think we still need to see proven use cases that actually scale to prove that demand. For example, for data centre capacity and compute, is it actually sustainable? That comes from inference* and usage of the products, as opposed to just developing the large language models.

Ally Selby: We saw this battle between profitable and unprofitable tech over the last few years. Is profitability still important?

Sam Koch: It's really interesting. As far as the risk is concerned, I think the number one risk that is facing technology investors is actually the sustainability of revenue growth. And I talk about that in the context of profitability as well, because there are macro concerns out there and a lot of these companies cut their costs aggressively during 2022 and 2023 to address profitability. We're all tech growth investors, if a tech company can't sustain revenue growth expectations at the cost of profitability, then I think that's at the risk of derating as a result. So, I think that's a genuine risk.

Factors that will be key to success over the next 12 months

Ally Selby: Looking out over the next 12 months, what key factors do you think will be important to investors, particularly when they're investing in those tech stocks?

Sam Koch: For us, the sector is largely idiosyncratic. It's largely stock-specific. However, having said that, as a sector overall, obviously interest rate expectations are key. So, keeping an eye on that, where's the market? What are your strong views? And then, secondly, it's actually the macro as well, because inversely, in a tougher macro environment, investors are going to be looking for growth elsewhere outside of cyclicals, and potentially interest rates are going to be cut in that environment, so that could boost valuations. So, that's a couple of things that will drive the sector.

Ally Selby: Okay. Over to you. Andrey, do you agree? What key factors do you think will drive success in tech investing over the next 12 months?

Andrey Mironenko: So, our process at Alphinity is heavily focused on earnings and positive earnings surprises, so profitability is crucial. What I would say has been increasingly important over the last 12 months or so for the market is profitable growth. So, indicators such as the "Rule of 40" continue to be important, but I think there is growing recognition that a percentage point of revenue growth, all things being equal, is more valuable than a percentage point of margin. So, I think what the market wants is earnings upgrades and positive earnings surprises but driven more by sustainable top-line growth as opposed to just purely margin.

Life360 (ASX: 360)

Ally Selby: Okay. Let's get into Buy Hold Sell now. First up today we have Life360. Its share price is up a whopping 114% since the beginning of the year. It helps families track each other and their pets. Andrey, I'm going to start with you. Is it a buy, hold or sell?

Andrey Mironenko (BUY): That's a buy for us. We are excited about the advertising opportunity that they have announced. They have a very high value, large, engaged user base of over 66 million monthly active users skewing to the US and other developed markets. Families are a high-value demographic and are very valuable to advertisers. And they have a rare data set in their location data, which they can monetize in that advertising. In addition, there is a lot of option value for this company to monetize this 66 million monthly active users. They're looking at expanding from just teens to younger kids, pets and the elderly. So, to provide a broader range of services. They've also looked in the past and will continue to look at lead generation, for example, for auto insurance, leveraging their unique driver safety data set. And things like fintech for teens as well. We see the potential for margin expansion through operating leverage over time as advertising comes at a higher margin compared to subscription revenue because of lower take rates from Google and Apple.

Ally Selby: It listed on the Nasdaq in June and it's rated as a strong buy among the brokers. Sam, do you agree and is it a buy, hold or sell?

Sam Koch (BUY): We do agree. It's actually a conviction buy from our perspective. The stock has a really strong customer value proposition. These guys have 66 million monthly active users and 2 million paying circles per month. And they've been able to grow that 20% year-on-year-out despite material price increases. And if you look on the App Store on Apple, you notice that they're ranked quite high as well. The CEO in our opinion is world-class. He's steered the business through a number of crises including TikTok and COVID-19, and has been able to add additional revenue growth drivers within new verticals as you alluded to, but also the Tile acquisition, and now, finally, the marketing opportunity that we're really excited about. It's trading on 30 times EBITDA with over 50% earnings growth forecast. For us, the catalyst for it to continue to re-rate will be addressing those advertising revenue opportunities.

NEXTDC (ASX: NXT)

Ally Selby: Next up we have data centre operator NEXTDC. Its share price has lifted around 28% since the beginning of the year and it's rated as a strong buy among the brokers. Sam, staying with you, is it a buy, hold or sell?

Sam Koch (BUY): It's a buy for us. As we alluded to earlier, the AI thematic is significant. It's driving increased demand for data centre capacity. Couple that with the ongoing drive for cloud computing, and we believe that the demand supply and balance within their target markets is shifting in their favour. You can see that the price per megawatt has actually been increasing and returns have been increasing on capital. So, we're attracted to that thematic. We acknowledge that the valuation is punchy. It's trading near all-time highs in terms of its valuation. But we believe that the recent billion dollars of capital that they raised is indicative of what they believe as far as their contracted demand pipeline is concerned. And so, it can hold its multiple and just grow in line with earnings growth. So, it's a buy for us.

Ally Selby: Andrey, do you agree? Is the valuation justified here and is it a buy, hold or sell?

Andrey Mironenko (HOLD): I think it's a hold. I'm not sure the valuation is fully justified. To me, the stock is discounting continued long-term growth. And notwithstanding the strength of the AI thematic, this growth in compute demand is so far coming very much from training the models. To prove that this demand is sustainable, we actually need to see meaningful demand to come from inference, so from actual usage of the models. And so far, we haven't seen any evidence that there is a use case of a scale of Google search or anything like that that would actually drive this large inference demand.

In addition, the geographic mix. So, I'm not completely convinced that a lot of AI models will be built in Australia. Most gen AI models are built by US companies. You can see demand in China and Europe. It's hard to see, other than the government, who would invest in this at scale in Australia. And even NEXTDC themselves acknowledge that very little of their current demand comes from AI. So far, they're just benefiting from tightening in supply demand in the data centre industry, but how much of the tailwind will actually materialise for them I think is open to debate.

Data#3 (ASX: DTL) 

Ally Selby: Okay, next up today we have IT services provider Data#3, its share price has fallen around 3% year-to-date. Andrey, last one for you. Is it a buy, hold or sell?

Andrey Mironenko (BUY): It's a buy for us. It's one of the genuine beneficiaries of AI thematic in Australia. As I mentioned, they're the largest reseller of Microsoft in Australia, so they're well-positioned both to resell Microsoft Copilot and Microsoft AI-enabled Surface PCs as well. But then, more importantly, they are positioned to sell services around that. They're now in the process of conducting a number of AI readiness audits for government and private sector organisations, some of which we expect to convert into larger implementation programmes and drive services revenue. In addition, it's a very high-quality business. It's very cash-generative. It has been growing double-digit earnings consistently without needing almost any capital, which we see as a high-quality business.

Ally Selby: That said, it is quite expensive. It trades on a P/E of around 30.6 times, but it was recently upgraded by both Morgan Stanley and Evans and Partners. Sam, last one for you. Is it a buy, hold or sell

Sam Koch (SELL) Data#3 is a sell for us. Whilst, we acknowledge AI is definitely a benefit to Data#3, longer term, we think that potentially it's going to take a little bit longer than the sell side is suggesting within their models. In the shorter term, you've got the potential risk of a macroeconomic softness weighing on demand from their corporate and government clients, and that's something that we're a bit mindful of in the short term. It is trading on, as you said, over 30 times PE, which is about 80% higher than pre-COVID levels. It's a consensus buy to your point as well. So, from our perspective, there are probably better places to allocate capital.

Ally Selby: Okay. We asked our guests to name their top pick within the tech sector today. Sam, I'm going to start with you. What's your favourite tech stock?

EML Payments (ASX: EML)

Sam Koch (HIGH CONVICTION BUY): I've come with EML Payments. So, EML is a conviction buy from our perspective. There's evidence that the turnaround in that business is actually happening. You've got the old CEO or the old management team that has divested and sold a number of underperforming divisions, plus the previous hurdles around their growth rates or attracting new customers within their UK business have recently been lifted. So, from our perspective, that's evidence that they're doing the right things, both from a shareholder and a regulatory perspective.

That's then enabling them to focus on their core business - reloadable, gift and digital cards. And this is a business that the market is familiar with and actually has been quite attracted to in the past. The stock's trading on sub six times EBITDA. We believe the stock can double just based on that valuation alone. What's interesting, is it is trading at about 90 cents today. The new CEO who came in earlier this month has an incentive package, which if he's successful, strikes at about $1.50 a share. So, we think there's a lot of opportunity there for the market to start to get more comfortable with that business.

Ally Selby: Okay. Over to you, Andrey. Your time in the hot seat. What's your favourite tech stock right now, and why?

Xero (ASX: XRO)

Andrey Mironenko (HIGH CONVICTION BUY): My favourite tech stock right now is Xero. They have a world-class management team now, with experience from Google, Uber, Okta, and other top tech firms. They have dramatically accelerated their product velocity. They're launching that generative AI co-pilot, but also improving core products in the UK and the US around payroll and payments. They're also conducting early marketing experiments, which can help them re-accelerate the growth of their top line as well. 

I've just come back from the UK from Xerocon, their flagship conference, and the feedback from the accounting partners is overwhelmingly positive for those product enhancements. And the structural trends are in their favour in the UK market. So, the UK accounting market is going through a private equity-driven consolidation. And those large accounting firms who are acting as the consolidators choose to standardise on Xero as opposed to their competitors, which is accretive to their market share. 

At the same time, the smaller end of the accounting firms are increasingly finding products like tax and payments and eventually payroll fit for purpose for their needs. So, Xero can increase its share of wallet with those accounting firms as they expand from just using core accounting to using more of the Xero product suite, while the middle is disappearing as it's being acquired by the larger players.

Ally Selby: Okay. Well, I hope you enjoyed that episode of Buy Hold Sell as much as I did. If you did, why not give it a like? Remember to subscribe to our YouTube channel. We're adding so much great content just like this every single week.

*Inference: Andrey uses this word to describe the "use of artificial intelligence".