Quick Thoughts: Waiting for the Bottom

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SEE LAST PAGE OF THIS REPORT Paul Sagawa / Tejas Raut Dessai

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March 18, 2020

Quick Thoughts: Waiting for the Bottom

  • Portfolio damage from the coronavirus selloff has been seemingly indiscriminate with a few designated “safe havens” such as high dividend telecom carriers and tower companies holding relatively steady.
  • While most companies will suffer from reduced economic activity during the pandemic, some companies bear much greater exposure and risk than others.
  • We see five buckets of risk – 1. Reduced demand, 2. Disruption to sales and distribution, 3. Disruption to operations, 4. Disruption to development, and 5. Idiosyncratic risks (e.g. cybersecurity vulnerability, loss of competitive advantage, etc.)
  • Within TMT, we believe investors have underestimated the implications for hardware manufacturers, in particular, for consumer electronics devices.
  • We also believe that enterprise IT vendors that depend on significant human contact for complex sales and for executing maintenance, implementation and consulting contracts will see lingering negative effects beyond current expectations.
  • In contrast, we believe cloud-based operations will see far less significant disruption and could gain advantage with cost conscious enterprise customers and home-bound consumers. We also expect increased engagement for consumer digital platforms to create longer term advantages.

The coronavirus pandemic is unprecedented. Stern measures in China and other Asian countries froze economic activity for weeks before the deadly virus could be checked, with similar consequences looming ahead for Europe, North America and the rest of the world – or even worse for states with late and/or inadequate responses to the threat. Certainly, the global economy has contracted in February and March, it will probably continue the slide in April, and there is no clear consensus on the prognosis for May and beyond. This is unequivocally bad.

The equity markets, which hate uncertainty, have been hit hard. Over the past month, the S&P500 has fallen 26.4%, the tech elements of that index (which we use as the benchmark for our model portfolio) have fallen 24.8% and those tech stocks in the index that have grown their sales at better than 10% over the past four reported quarters have fallen 30.0%. During this time, the primary safe haven for tech investors have been telecom stocks – carriers, fiber operators, tower companies, and such – prized for their stable revenue base and dividend yields. This is sensible, for now.

At some point, we hope in short weeks but possibly in months, recovery will begin. Businesses will reopen, workers will head back to work, consumers will begin to consume, and investors will begin to invest. Recovery will play out, faster for some companies and slower for others. The crisis may be a catalyst for

Exh 1: Brief summary of disruptions faced by TMT companies

more permanent change – for example working from home and distance learning may be more common. For investors, seeming bargains will abound, but sorting out the real winners will make or break portfolios. To systematically assess the impact of this crisis on the prospects of individual stocks, we break down the risks into five categories (Exhibit 1):

Direct Demand Disruption – Companies have seen meaningful reductions in the demand for their products. As consumers are quarantined or practice social distancing, they are not visiting retail stores. Moreover, the financial uncertainty created by the loss of wages is almost certain to reduce discretionary spending even after restrictions ease. Given the rapid spread of the virus from Asia to Europe and North America, this is a serious impact, particularly for big ticket items like consumer electronics. To a lesser extent, this will also hit enterprises, some of which will scale back capital spending plans in response to the uncertainties in their own businesses.

Sales and Distribution Disruption – This is the flip side of demand disruptions – some willing customers will be unable to make purchases because of retail closures or because enterprise sales reps are not able to close sales face to face. As restrictions on movement ease, these impediments should go away. Product categories with relatively long sales cycles will likely take longer to recover.

Operations Disruption – Factory closures ripple through Just-In-Time supply chains without any buffers to keep production going, and even one lost link in the chain will keep the whole ecosystem stagnant. This will also begin to effect physical distribution as transportation is compromised by governments wary of human movement and by worker shortages related to illness. Worker shortages will also affect fulfillment and delivery elements of e-commerce operations. In the tech world, this will have much greater effect on hardware and consulting services than on software.

Development Disruption – Amidst the tumult, productivity will be compromised, and projects will be delayed. Some processes will be more amenable to work at home – software development for example – while physical products face considerable challenges. Prototypes must be built and tested in labs by teams of engineers. Components and subassemblies must be designed and evaluated. Production lines must be tooled and staffed and ramped to full capacity. All of this will be near to impossible until all the partners in the process are back up to speed. Expect new products to be months behind schedule and in short supply.

Idiosyncratic Risk – There are other risks that arise because of the contagion that don’t fall into the general buckets above. For example, the extraordinary rise in work-from-home raises the threat of cybersecurity breaches. Similarly, the disease itself is a threat to key employees who could be incapacitated.

There are areas within TMT that are particularly well positioned to cope with, and even take advantage of the crisis. Companies that facilitate work-from-home such as Microsoft, Google, Slack, Atlassian, Zoom, Okta, LogMeIn, and others could see a long-term boost from this global trial of their technologies. Streaming platforms, such as Netflix, Spotify, and Google’s YouTube should also see substantial increases in engagement. We note that this could be a double edged sword for linear TV media and Pay TV platforms that are also seeing greater viewership, as the cancellation of most live sports removes their biggest point of differentiation and the justification for their substantial price premium, making cord-cutting ever more attractive to financially squeezed consumers. Similarly, video game players, such as Nintendo, Microsoft, Sony, EA, Take Two, Activision, Amazon’s Twitch, and others are already reporting significant increases in online play (Game Streaming: Not Everyone Can Win). Telecom carriers, tower companies and the ilk have held up particularly well through the sell-off, buoyed by their stable revenue base and high dividend yields. We note that we see T-Mobile and Dish Networks as the long-term winners in 5G(5G: Why TMUS Will Win).

Hyperscale datacenter operators, taking on all of this added traffic, would likely remain on track in their aggressive capital spending plans for 2020 – a boon to component suppliers, such as Nvidia, Intel, AMD, Xilinx, Broadcom, Western Digital, Seagate and others. Cybersecurity suppliers, particularly those that help manage threats from external logins, like Okta, CrowdStrike, ZScaler, CyberArk and others, should see new demand. Without government stimulus, we can expect that a pandemic induced recession would see enterprises pulling back on capex, but we believe SaaS applications, which typically promise cost-savings as part of the sales pitch, would be relatively unaffected. Hybrid cloud solutions suppliers, such as VMWare, Nutanix, Cisco, and others, should see near term disruption to their lengthy sales and implementation processes, but should see a healthy rebound as the economy begins its rebound. This pattern would also likely apply to enterprise IT consulting companies like IBM, Accenture, and others. In recovery, we may find that the crisis induces some enterprises to accelerate their move to the cloud and their adoption of new software tech like AI and blockchain. This could prove a meaningful negative for producers of configured datacenter systems and packaged software.

Our biggest concerns are for the consumer electronics ecosystem. Smartphone sales in China were down more than 60% in February, and with dire conditions arising in Western Europe and North America, 1Q20 sales could be off by an unprecedented amount. It is also likely that the economic effects of effectively shutting down retail activity in huge swaths of the world market will linger long after the disease has begun to wane. We do NOT expect a quick rebound for smartphone sales this summer, especially in the premium category, and projections for a 5G driven inflection point in replacement activity are now fantasy. The

Exh 2: Brief updated summary of winners and losers in the current environment

impacts of this will start with the big brands, Apple and Samsung, but will flow down to their suppliers – note that, in 2019, 25% of the world’s semiconductors by value were used in the making smartphones. The pain will go beyond just modems and radio transceivers (Exhibit 2). The relative bright spot in the broader consumer electronics category may be products to facilitate work at home – PCs, WiFi routers, and the like.

We expect that this recovery will see a few false starts before it becomes sustainable, but once underway, the rally will be vigorous. Given the indiscriminate selling, we think that TMT bargains will abound and that good stock picking skills will be extraordinarily valuable. Until then, stay safe.

 

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