The US “FANGs,” China’s Tencent and Alibaba, Europe’s Prosus and SAP, Canada’s…Shopify?
With broader indices trading below their all-time highs, but the NASDAQ near a complete retracement, tech stocks have garnered a lot of news lately as post-correction darlings. However, here at home, Canada’s tech industry has been historically lacklustre and limited, with investors searching for a star since the falls of Nortel and Blackberry.
Shopify has been Canada’s best shot at the big leagues in quite some time. Unlike roll-up/service firms, such as Constellation Software and Opentext, which are good companies in their own rights but more conservative in strategy, Shopify is growing quickly and heavily reinvesting cashflow in order to capture an outsized opportunity.
Shopify has been widely perceived as the anti-Amazon, arming small businesses with tools to compete in a digital world. This is a great business, but not without its own problems, especially in the shorter term.
The goods provided by these digital small businesses are typically niche purchases which are nice-to-haves (discretionary goods), not need-to-haves (essential items). As unemployment continues to rise and consumers increasingly affected by the coronavirus, shrinking disposable household income drives consumers to shift spending towards groceries and essentials. This creates a major demand problem for the typical Shopify merchant. To make things worse, the average small business has a median cash buffer of just 27 days.
Although we are firm believers in the long-term prospects for Shopify, it is extremely overbought in the current environment. The stock now trades over 30x EV/revenue versus software peers averaging below 10x EV/revenue. From peak to trough over the pullback, Shopify fell 41%, only to surge 95% from its lows over the span of just 25 trading sessions. With Shopify’s prosperity largely dependent on the revenues of its underlying merchants, we find it difficult to justify such a surge in the face of economic headwinds. We believe this rally is due to the lack of viable alternatives in the Canadian market for growth stocks.
The US continues to have a much broader market for growth stocks, particularly in tech. In an environment of uncertainty, we look to two avenues: the stay-at-home portfolio and enterprise software companies trading at more attractive valuations.
The “stay-at-home” trade: Strong prospects in a prolonged retraction
With every great rally emerges new buzz words and acronyms. This time, it’s the “stay-at-home” stocks. The latest and greatest in technology equities have been companies poised to directly benefit from swift social distancing measures. Consumers are staying inside for longer durations of their days and the workforce is shifting to WFH (work from home).
With a prolonged period of social distancing and consumer habits likely to continue this practice well after a “return to normal” (will you rush to be back into an overcrowded concert hall this summer?), the stay-at-home portfolio has strong growth prospects for the remainder of the year. However, in the early days of the sell-off, it seemed investors were more focused on what a company doesrather than what the company is worth.
Combined with investors seeking out somewhere to hide, a rush into this new trend means it is probable several of these companies are and continue to be overbought in the short term, making stock selection paramount. Some of our favorite names are Zoom, Activision, Peloton, Everbridge and Slack. The numbers behind some of these companies are stunning. For example, Zoom downloads surged 14x the weekly average in mid-March, while Slack has increased both total users and paid customers in similar fashion.
Enterprise software will be resilient, but not bulletproof
If you look across software companies today, they have common characteristics of huge net-cash positions, highly scalable business models, mission-critical applications and cost-cutting efficiencies. With the dot-com bubble and the 2008 financial crisis in the rear-view mirror, today’s software companies benefit from more proven business models, a stronger global mandate to digitally transform and a larger role for technology in the global economy.
Within software companies we look for a low average revenue per customer, a high proportion of revenue is recurring (a key feature) and a reasonable EV/sales valuation. A silver lining here is that the pandemic has accelerated digital transformation and software is the greatest beneficiary. We look for software names with large net cash balances, strong free cash flow and defendable moats. This sub-sector makes up roughly 50% of the Purpose Global Innovators Fund and our top picks in the space are Adobe, Atlassian, Everbridge and Crowdstrike.
—Nick Mersch is one of the portfolio managers of Purpose Global Innovators Fund
All data sourced to Bloomberg unless otherwise noted.
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