Why we think we are in the early stages of a technology recovery

IIn this report, we focus on why we think technology company earnings have bottomed out and why we expect them to continue rising.

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• What gives us confidence in the technology recovery in the second half of 2023
• Q1 2023 earnings takeaway: Hardware bottoms out, software follows suit

Reasons to be confident about recovery in the second half of the year

Recessions follow a typical pattern, with valuations first being hit, followed by widespread economic weakness, which impacts earnings for most sectors and companies. Although it typically takes several quarters for earnings estimates to reset, we believe technology sector earnings bottomed out in the first half of 2023.

Valuations have bottomed out this year as interest rates have stabilized (in the 10-year range of 3.5% to 4%). Despite many tech companies plummeting from their lows and media noise about a “new bubble,” the average software multiple is only ~6x EV/NTM revenue (last year’s bottom was 5x, the highest ever (approximately 8 times) 10 years) average.

This is in line with our expectations, as interest rates are higher than historical averages (4% vs. 2%) and NTM growth forecasts are lower (NTM 15% vs. 10-year median of 25%). We don’t expect rates to rise significantly in the near term, as we assume rates will remain high for an extended period of time, but we do believe that our earnings outlook is around the corner.

Hardware revenue bottomed out in Q1 2023.Software to follow

Semiconductors are considered the “canary in the coal mine” due to the fast-cycle nature of the business. As soon as there were signs of economic downturn in May 2022, distributors began reducing inventory, further exacerbating the impact of weak demand. Nvidia reported dismal financial results for his second quarter, writing off over $1 billion in inventory (April/August 22). Consumer-facing semi-companies such as AMD felt the impact early, while data center-focused companies such as Marvell felt the impact a little later.

As we enter the second half of 2023, competitions will become much easier and companies are starting to be able to exceed lowered expectations. In addition to the cyclical upturn, investment in artificial intelligence (AI) is expected to significantly increase demand. This is not just his one-quarter hype, but a multi-year investment cycle. Nvidia says it has 1 trillion pieces of unaccelerated data center hardware that must be upgraded to support AI workloads.

Q1 2023 Earnings Highlights:

Most semiconductor stocks reported (AMD, Marvell, Broadcom) expressed confidence in recovery in the second half of 2023 (AMD, Marvell, Broadcom), with the strongest (fundamental) performance of the quarter Nvidia has a market share of over 80% in data center GPUs and has a unique position in the AI ​​field. Highlights of reported earnings include:

• Nvidia projected second quarter 2024 (August 23) earnings as follows: 50% More than consensus. Analysts have raised their future forecasts for this year and next by 40%. The company noted that production capacity will increase significantly in the second half of 2023.
• Marvel reported the inline results, but was guided as follows: AI revenue to double in 2024 and 2025; AI sales in 2023 were $200 million. In 2024, he will make more than $400 million. Starting in 2025, he will make more than $800 million (run rate of about $5 billion).

Interestingly, despite Nvidia’s best results (so far), it wasn’t the best performer in our May coverage (it wasn’t even in the top five). This is because the idea of ​​bottoming out in semiconductors has set rock bottom prices for the rest of the technologies, resulting in investors rushing into technology areas that could boost the next step.

However, if we take a step back, NVIDIA is the only company whose estimates have increased commensurate with the stock’s price movement (+50%), which we believe provides solid fundamental support, and therefore the outlook for the future. continues to be a top idea in industrial technology with huge potential for profits (our report Nvidia: One-Stop AI Shop).

Software (Enterprise + Cloud + Cybersecurity)

Software revenue typically lags quarterly by six months. There are different areas of software that bottom out at different times, depending on the end market and business model (pay-as-you-go versus subscription-based).

Our software sector revenue estimates continue to decline, with the median NTM growth estimate currently at just 15%, compared to the 10-year average of approximately 25%. Hyper-growth companies are now growing only around 30%, whereas previously they were over 70%. Companies continue to cite longer sales cycles, smaller and staggered deals, and execution challenges. Reported profits aren’t great, with many companies reporting negative net new ARR 😱.

However, an interesting development was that relatively small surprises were bought aggressively and large failures were able to recoup losses. This is usually a sign of a bottom, as investors want to look beyond this quarter if they are sure we are at the bottom.

Powerful results:

• Zscaler – Had a difficult last quarter, reporting 40% increase in billings amid challenging macro environment
• GitLab – Aims for +27-28% revenue growth, above consensus +25%, following +15% decline last quarter
• MongoDB – Outperformed/raised very conservative guide (+17% to +19%)

Weak results were ignored, with Cloudflare, Snowflake, and SentinelOne citing stricter macros than originally expected. Cloudflare and Snowflake were able to retrace their losses. SentinelOne remains undecided, but has rebounded significantly from its lows.

Commemorating Q3/Q4 2022 when we started experiencing fundamental weakness, comps in 2H 2023 are becoming significantly easier. Additionally, businesses have been postponing spending for several quarters in anticipation of a recession, creating pent-up demand.

But what about recession?

Most of the companies we cover experienced significant declines in profits in anticipation of the recession. Therefore, we do not believe that small changes in economic growth (+/-1%) will make a material difference to technology companies’ returns.

However, the severity and duration of the recession (if it comes at all) could influence the slope of the recovery. Therefore, we look to invest in well-capitalized businesses with strong fundamentals.

For more research, visit spear-invest.com.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.