The technology sector’s long-term growth potential remains intact.
The technology sector has suffered a severe correction in recent months, mainly due to the acceleration of inflation, a rotation from growth stocks to value stocks, the drop in consumer demand and disruptions in supply chains. But, contrary to this bleak picture painted by the market, the sources of long-term growth in the technology sector remain intact.
Among the main themes discussed during this tour were the intensification of demand for digitalization and automation, the long-term growth drivers for semiconductors, the emergence of new technologies aimed at promote the transition to the cloud and the growing desire of companies to preserve their profitability through their pricing power.
Demand still strong despite recent volatility
This tour demonstrated that Covid-19 and supply chain disruptions have, in fact, become catalysts for technology adoption, particularly in the areas of digitalization, automation and hybrid working solutions. Businesses need to invest in technology to maintain a competitive edge in hybrid work environments and automate processes to reduce procurement risk. The main industries set to benefit are cloud, security, data analytics and hardware companies providing hybrid working technologies. For example, Amazon, through its AWS division specializing in cloud services for businesses and individuals, is optimistic about cloud computing. The company believes the benefits of the cloud are finding even more expression in hybrid working, a trend that is set to continue post-pandemic.
Despite macro headwinds, spending on data centers and cloud computing is holding up. Our meeting with Marvell Technology, which designs and manufactures semiconductors, revolved around the strategic refocusing of its portfolio away from the consumer segment towards data centers. This reorientation allows it to limit its exposure to cyclical consumption and the winning of several contracts in the field of chips should help boost its turnover.
Within semiconductors, companies see electric vehicles (EVs) as a key long-term source of chip demand. Only around 10% of global car sales were EVs in 2021, four times the market share of 2019 (IEA, May 2022). This situation suggests significant growth potential as the rest of the global vehicle fleet converts. Within the other sectors, the discussions confirmed that recommendation engines based on artificial intelligence (AI) should also guarantee a substantial return on investment for Internet companies.
Some segments show a cyclical slowdown
Nonetheless, we are seeing some signs of waning consumer demand. Emerging from the Covid-19 pandemic, companies benefiting from “containment” are thus victims of a reversal of the trend, marked by a slowdown in the growth of Zoom, e-commerce and subscriptions to streaming content after having reached historic heights. This is mainly due to the shift in spending from tech goods related to working from home and e-commerce towards services that promote business and customer experience. Consumer electronics companies have also started cutting orders due to weak demand. After having increased very sharply during the pandemic, this demand is marking time.
New technologies are emerging for better management of bandwidth and computational complexity
Several discussions served to illustrate the fact that we are at the beginning of the transition to the cloud due to network bandwidth constraints. The Intel group is convinced of the interest of Compute Express Link (CXL) technology, a new standard for interconnecting memories that could significantly increase server bandwidth (boding well for chip memory and cloud services) and computing capabilities (boding well for data center operators who will be able to offer new and more powerful propositions to their customers). The technology also works on existing physical interfaces, which should facilitate and accelerate its adoption by customers in the coming years.
Supply chains still facing challenges, but a long-term backdrop that remains positive
On the supply side, the conversations during the tour focused on the short-term difficulties, but also on the fact that the long-term overall situation remains unchanged. Supply chain issues are particularly prevalent in the semiconductor industry and have led TMSC to significantly reduce its order volume.
Nevertheless, these short-term headwinds are not going to affect the long-term outlook in any way. For example, LAM Research shares the view that the semiconductor industry should see its weight reach 1000 billion dollars by the end of the decade insofar as capital intensity is not expected to decrease due to the increased complexity of the chips required.
Profits and pricing power
Pricing power and strong balance sheets are essential in highly inflationary and volatile environments. The discussions focused on companies that preserve their margins and profitability thanks to their pricing power, which is prevalent in the technology sector. Since semiconductors are essential components of most of the most innovative technologies, groups in this area enjoy strong pricing power. Software publishers often have contracts that provide for adjustments based on changes in the consumer price index (CPI). Also, many tech platforms charge a nominal percentage on all the products and services they sell. They can therefore pass on inflation to their customers and benefit from an increase in their nominal turnover.
Given the market’s correction and overreaction to the current short-term headwinds, active investors with a bottom-up approach are presented with excellent opportunities to generate Alpha. Valuations are attractive and leading technology companies are now trading at low multiples, but their long-term growth profiles have not changed. Through my conversations in Silicon Valley with companies such as Zoom (video conferencing platform) and Zendesk (customer service software company), I solidified my belief in growing software solutions. There are opportunities among companies with leading software that are still in the early stages of their market launch with endless opportunities, with multiples at their lowest, and which have not benefited from demand. exaggeratedly high under the effect of the pandemic. I expect M&A activity to increase in this sector, as many smaller companies with attractive assets are now much cheaper following the recent downturn in the sector.
In summary, trading in Silicon Valley has been positive and the technology sector’s long-term demand supports remain intact. The adoption and use of technology is an integral part of the activities and practices of households, businesses and the public sector – and this is a fact that can no longer be questioned. People always need technology because it has real utility: efficiency, decision making, supply chain planning, entertainment and many more. Additionally, many tech business models come with recurring revenue, strong pricing power, and strong balance sheets – all essential to weathering a volatile environment. Looking at the adoption curve for the next 3-5 years, the main opportunities will remain in the cloud, data analytics, security, electric vehicles and industrial automation. Meeting the managers of companies potentially in the portfolio or already included in it is an essential component of my investment process. This allows me to collect valuable information on the achievements, the projects of the companies, as well as their point of view on the dynamics in their sector. Our 9th Silicon Valley Research Tour was no exception and I consider it a great success.