Date : 10/10/2020

Tech Sector

The tech revolution in Australia is imminent – it is just a question of when. Innovation will drive change and businesses will adapt to the new norm or be left behind. The tech boom had begun, and adoption was growing. Covid19 has accelerated that adoption by 4-5 years. Most consumer facing businesses are forced to leverage and adopt technology to continue their business operations. Their survival depends on it as we move towards a digital economy where technology is disrupting industries.

Innovation and technological advancement in a market has to start from the bottom. Education drives innovation, we see more start-ups. As more start-ups pop-up, the availability of risky capital in the economy increase – venture capital and private equity players emerge. These start-ups turn into disruptors with the enablement of their technology. The availability of risky capital has not changed much due to Covid19. Global markets were slaughtered during March, however start-ups with sound business models were thriving and have been raising money during one of the worst financial crises seen by man.

Tech Rally a bubble?

Tech stocks have rallied since the downturn in March and people have not shied away from expressing their opinions about technology stocks being overvalued. When we adopt a data driven approach to see what has really happened during this crisis, technology stocks have rallied for a reason and we believe the market has priced them right. Before dwelling into the tech stocks, we need to take a look at how this financial crisis is different from the ones in the past:

  • In this crisis, economies were put on a halt for known periods of time. The stock market tumbled much after the halting of the economy. This has never happened before. During the GFC for example, the market crashed and the repercussions on the economy followed.
  • The halting of economic activity meant only businesses that were already digitally enabled benefitted. If you were a restaurant that only took online order and delivered food, you probably survived.
  • Liquidity is king in a crisis. The firms that have very little debt and lots of cash will come out of the crisis stronger because their competitors will suffer. To put this into perspective, Apple has enough cash to pay all its employees for ever a year without selling a single product.
  • Few industries will face irreversible change. Business travel for example have been driving sales in airline and hotel industry, this will change as the world gets more comfortable with online tools to conduct business.

These are some of the reasons why the buy-now-pay-later firms such as Afterpay have surged. They are a flexible business with low debt levels. They can change their business model if an unforeseen event occurs. Banks on the other hand have huge levels of debt on their balance sheet. Their performance depends on the firms who have borrowed these banks being able to pay their interest payments. The risks associated is hence much larger with Banks due to the inflexibility in their business model.

Airports and airline stocks for instance are adversely affected. Some airliners will unfortunately go under during the crisis. Government stimulus will help few of these firm make it through the crisis. But technology firms such as Zoom have changed consumer behaviour forever. Businesses will no longer pay $5000 to fly their employee to London for a meeting that lasts one hour even once Covid19 passes completely. The technology sector is gaining more market share, and these are coming at the expense of different sectors.

E-commerce has not taken off in Australia yet compared to other developed economies. The ability to order groceries, and everything else on Amazon without having to leave your seat at home is a luxury that the USA, China, Europe, and most of Asia already has access to. We fully expect this revolution to be underway as the millennials demand it. E-commerce will see a major growth in the years to come.

The FAANG stocks in the USA account for over 40% of the NASDAQ 100 Index, and over 20% of the S&P 500 index. These are the biggest companies in the world. Amazon is probably the biggest Covid proof companies there is. These stocks will emerge out of the crisis stronger than they were ever before. The valuations of these firms have benefitted not just from their incredible performance. But they have also benefitted from the markets slashing valuations from their competitors (Amazon will surely emerge out of the crisis stronger than Bed, Bath & Beyond).


Source: Tradingview.com

The chart above compares the ASX 200 index against the S&P 500 and NASDAQ 100. The higher the weights of technology sector, the greater has been the recovery after the March market crash.

It is a similar story in global markets. FinTech innovation has resulted in a lot more people having access to stock markets for zero-brokerage fees. They are disrupting the stock brokerage industry with solutions that are more affordable and consumer focussed than ever before. The shift in consumer behaviour has to be monitored every step of the way. Stake and eToro have seen a lot more traction in Australia, and more people are investing in the US stock market. These firms have gained more market share at the expense of CBA’s commsec and the likes.

The hype and surge are real, technology is the future. The minerals sector will decline when there is a scarcity of minerals. However, Tesla will become more powerful as the shift to solar power and electric cars becomes much more prominent in the future. Macro-economic factors have enabled the growth of technology firms.

Breaking the myths of valuations!

Business models have shifted in recent years. Especially in the technology sector. A lot more firms have moved to a subscription-as-a-service model. The valuation has therefore been affected as a result of the new models. The Subscription model does not show high revenues initially, such as is the case when a firm sells a contract with a buyer for a huge amount. The beauty about subscriptions is that it ensures stable and sustainable revenues. It focusses on constant recurring revenues from a client over a sustained period of time, rather than a big money contract that may not be extended the following year. Unit economic metrics such as customer acquisition cost, churn, retention, etc. are what drives value for tech stocks. Subscription business model comes with a lot of benefits:

  • Subscription enables business to be flexible. Companies will not be bound to offer the same service due to contractual obligations.
  • Firms build stronger relationships with its customers. This is probably the most important feature as firms such as Afterpay and Xero are able to retain almost all of their customers. This results in constant and stable revenues.

The flexibility and concentration on subscribers ultimately change the metrics that determine the valuation of these technology firms. Most of the assets of Google for instance will be off the balance sheet due to the intangible nature of its data centres. Our reports on SaaS businesses such as Xero employ these new metrics to determine intrinsic value. The popularity of subscription has been extended to a variety of businesses.

Global SaaS market is estimated to be around US$150 billion. The forecasts suggest a 11% compounded annual growth rate with the industry set to be valued over US$300 billion by 2026. The growth is mainly driven by cloud services and enterprise software industries. Nextdc have also adopted the business model and SaaS in Australia has seen massive growth in cloud services. Reports suggest over 50% of Australian organisations adopting a SaaS model.

Cloud Services has taken off!

Data Centres are like Digital Real Estate. It is the most essential requirement to operate a business over the internet. For technology firms, data centre costs are one of the biggest operating costs. Since in-house data centres are too expensive, businesses outsource to providers of these digital infrastructures to host on their servers.

Cloud services is the first step in a tech revolution. It enables other businesses to become digitised. The coronavirus has only increased the shift to a digital economy as more and more businesses are moving to online to continue operations by abiding by restriction that have been imposed. The shift to online also drastically reduces operating expenses. New trends such as work-from-home, remote learning and teaching, online shopping, etc only fortify businesses that are in the data centre business.

Cloud services is a high growth industry which has been growing at 14% compounded annual growth rate. It is forecasted to grow at the same pace for the next few years as we move towards a much more digitised economy. Gartner Research suggests the cloud services industry sits at over $250b in 2020. By 2022, over 60% of organisations are expected to use external cloud services for their operations. The Australian cloud services market is forecasted to reach $11 billion by the end of 2022. These estimates show that Australia’s cloud service is still in its early stage and we believe the growth here would be mainly driven by the SaaS market.

Large cap Firms such as Xero and Altium deliver software solutions to their clients over the cloud. We estimate the market for software as a service to grow further in Australia. The gig economy has increased globally with more freelancer service providers. Start-up ecosystems are surging as well in all developing markets. These are growth defining drivers for the SaaS industry and ultimately the Cloud services industry.

This is very promising for established firms like Nextdc in Australia. A firm that has performed consistently well in the past and also has low debt levels in its balance sheet. Our report on Nextdc will give investors an idea as to how the firm has taken advantage of the growing demand in the industry and the incredibly strong unit economics that it has. We have a buy recommendation on Nextdc for our members looking at growth stocks.

FinTech has a lot of tailwind!

The global FinTech sector is vast. It is still in its very nascent stage, yet it is valued close to $200b at the moment. The industry is forecasted to hit $300b by 2022. Such is the immense growth of the industry. The age-old financial industry is being disrupted both in the B2B and B2C space. Big data and artificial intelligence are fuelling this much needed change.

Digital payments is a space that is very popular among the millennials. A smartphone is all you need to make payments of any kind, anywhere. This has taken off in huge consumer markets such as China, India, and the USA.

In Australia, the industry is in its very early stage compared to the global fintech space. It is led by the of buy-now-pay-later firms such as Afterpay and other players. There has been an emergence of FinTech start-ups that are offering banking and stock trading services. The opportunities for innovation are higher than ever before, as risky capital is readily available than ever before.

The buy-now-pay-later (BNPL) industry is where payment solutions are provided to consumers and merchants, allowing the consumers to purchase goods and services immediately. However, interest free instalment payments can be made to cover the cost of the good or service. BNPL is already a crowded space with a number of players offering similar services.

At the end of 2019, the global BNPL market was valued at over $7 billion. It is forecasted to grow at 21% annually into a $33 billion market by 2027.

Operators in the BNPL industry are characterised by low losses, high re-investment, and low margins in the early and growth stage of the corporate life cycle. These firms with high-growth potential invest heavily (increasing costs) initially to penetrate markets and grow their users. Retention of these users and the expansion revenue each user brings are a couple of the key metrics that the industry tracks to measure performance and attach values to the firms.

The industry is forecasted to grow into with the growth of e-commerce across the world. Another complementing data point is the decrease in the use of credit cards and increase in the use of BNPL.
The RBA reports that the BNPL market now leads the market for credit cards by approximately $400m. The flexibility that BNPL provided and the high adoption rates seen in consumers forecast these numbers to not go anywhere but higher.

Afterpay is arguably the biggest player in this space. They have expanded globally and are positioned perfectly to enter new markets and drive growth. Currently, Afterpay is the world’s most valuable buy-now-pay-later firm. In the B2C space, customer acquisition and retention is king. The total addressable market for APT has kept going up as it enters new markets with populations greater than that of ANZ, resulting in sky-high valuations.

We hold Afterpay and Splitit in our growth portfolio. The opportunity for FinTech to boom in Australia is greater than ever before. Digital payments is here to stay. The big 4 banks of Australia are already on a declining trend, with frustrations growing among users. The younger generation will drive the migration to solutions that are user-friendly and a lot more trustworthy. It sure will be interesting to watch new disruptors coming into different segments of the FinTech space.

Emerging Technology Segments

While the tech stocks in Australia are led by the likes of Afterpay, Xero, Nextdc, etc. There are a number of emerging technologies arising out of Australia. Artificial Intelligence, Machine Learning, Drones, Robotics, IoT are all in its nascent stage with a number of small-cap firms creating breakthroughs in innovation.

The number of devices a person interacts with everyday has been increasing. By 2025, research estimates reveal that an average person will interact with 4 devices every day. These devices are only getting smarter and in order to get smarter, they should be capable of storing more data, delivering it at higher speeds, reduce volatility of the data, and of course consume less power.

Artificial Intelligence works through analysing large amounts of data that has been gathered on a subject to find patterns and successfully make predictions based on what has been learnt in the past. This processing of data happens at data centres due to the demands of size, density, and power required to carry out the tasks. The goal has always been to move the processing to the place where the data is created. This will allow the technology to be quicker and more efficient to perform tasks just as a human would. This processing of information and analytics at the source is known an Edge AI.

The potential for Edge AI is ridiculously high. In 2018, Edge AI device shipments were about 160m units, and it is forecasted to reach about 2.6b by 2025, according to Tractica’s research. The revenues from the Edge AI industry is forecasted to reach US$ 52 billion by 2025 as it grows at a 41% compounded annual growth rate. We estimate APAC to deliver most of this growth as China and other South East Asian countries are ahead of the curve when it comes to technology revolutionising the economy.

Such a technology enables machine learning and artificial intelligence at the source. Brianchip has developed a chip that mimics a human brain. Our detailed report on Brainchip talks about its applications and the potential that lies within its product.

A disruption in the memory industry maybe underway as well. DRAM is a high speed and highly volatile memory. In a nutshell, high volatility means the chips lose the data as soon as power is cut off. The chips are associated with high power consumption and high costs per every gigabyte of memory. The data is limited to 2D density.
Flash however is quite the opposite. Its costs have been decreasing every passing year. It comes with speed much lower than DRAM, but it has 3D density capabilities (meaning, more data can be stored), and very low volatility & power consumption.

4DS and Weebit Nano are both trying to disrupt the industry with innovative products in this space. The market size for DRAM at the end of 2019 was US$ 45 billion. While that of Flash memory is about US$ 60 billion. The demand in the industry is at levels that we have never seen before as storage requirements are growing at 2x year-on-year.

Robotics will improve efficiencies and reduce costs in the manufacturing industry. The use of robotics in the construction industry is still in the infant stage. Construction Robots are now slowly realizing commercial potential as automation procedures are becoming easier with better technologies.

We believe this disruption of the industry will happen in due course as more companies develop and enable technologies in this space. FBR Limited looks to be doing just that. The firm’s Hadrian X robot has recently completed construction of a display home in Perth.


Source: FBR Limited

Summing-Up

The technology sector in Australia is at the early stage. With government support and education increasing the capabilities for innovation, Australia is positioned well to drive the change to a digital economy and reduce its reliance on the energy sector.

The metrics that determine valuations of tech firms are different, and investors are required to skill-up and invest or be left behind during the imminent big boom.

The emerging industries with firms like BrainChip, FBR, Weebit Nano, etc. are a good starting point to understand the innovations being made down under. Blue chips such as Afterpay, Xero, and Nextdc have already showed the capabilities of a truly globalised and interconnected world we live in. They are able to enter new markets and capture them – increasing their potential and justifying sky-high valuations.

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