Tech Thoughts Newsletter – 2 December 2022.

Conclusions 

Results reactions show tech is still vulnerable, and macro news continues to drive the sector. The key focus this week has been on software and the general guide down of sales growth into 4Q and 2023. The sales cycles have been lengthening and deals are being scrutinised much more, which is quite natural in an economic downturn. While we acknowledge there will likely be further deceleration of spend, we expect software growth to stay reasonably healthy during 2023 – although some areas and providers clearly healthier than others (which we expand upon below). 

Portfolio changes

We continued to add to our Infineon position during the weakness at the beginning of this week. The two largest negative contributors to our performance this year have been Workday and Salesforce, who both reported this week (comments below). 

Focus next week

The main focus in terms of tech next week will be on the Taiwanese companies (including Foxconn) releasing November sales numbers. Foxconn will be key and should help frame the impact from the China production shutdowns and what that means for the iPhone/Apple supply chain. 

Excitingly, we’ll also see the first tool delivery into the TSMC factory in Arizona on the 6th of December with both President Biden and Tim Cook attending. It will be interesting to follow and see if there are broader comments around US tech sovereignty/CHIPS Act – and any additional details on the fab planned for 3nm which was recently announced. 

Software results this week were mixed 

• The focus and after-hours share price reactions were largely around the magnitude of the deceleration of growth as we look ahead to Q4 (and out to 2023). We also saw a renewed margin focus at many software businesses. 
• It’s no surprise to see some incremental pressure on spend as we look ahead to Q4/2023 (acknowledging typical 9+ months sales cycles which means what we’re seeing in terms of weak results now is really reflecting the sales conversations that started in Q1/Q2 – which likely got tougher in Q3 and Q4..) 
• Key for us are those companies that are able to drive improved margin (mostly through sales efficiency) vs. those that are overly reliant on sales and marketing dollars to drive top line. 
• Over the past few quarters it’s been increasingly clear that many software businesses are hyper dependent on sales costs (including share based comp). For those businesses, increasing margin will be very difficult, and will call into question the sustainability of their sales models. 
• Workday (owned) delivered very solid 3Q results with the key 24-month backlog number growing 21% and guided to grow 19% in Q4. While management did talk of elongation of deal cycles, they also spoke of benefitting from consolidation of spend, which is helping their expansion within existing customers (presumably as they start to replace niche one-product solutions). Medium enterprise was also called out as relatively strong (with large deals in the large enterprise space seeing naturally more scrutiny)
• Importantly for us as we noted above, the margin guidance was raised slightly, placing it firmly on track to their target of 25% non-GAAP operating margin and 35% operating cash flow margin at $10 billion in revenue.
• Salesforce (owned) was slightly more disappointing – in particular around the implied deceleration into Q4, with cRPO decelerating from 15% in Q3 to 10% in Q4 – clearly a bigger delta than Workday. More positively, margins beat in the quarter and there was a clear commitment to its mid term margin targets, with cost cutting programs underway. 
• There was some more management shuffling as co CEO Bret Taylor left leaving Marc Benioff as CEO/Chairman. 
• Salesforce have been under some shareholder pressure, which this set of results won’t have helped. From our perspective, looking at sales productivity metrics across the space, Salesforce stands out as a business which has fallen behind its high quality software peers.
• Nevertheless, we think it remains a best-in-class product solution – and expect it to be able to slim down its sales costs more effectively (or with less topline impact) than peers might be able to. 
• Snowflake (owned – small position) was a similar story of a decent Q3, but a softer Q4, decelerating from 67% growth to 47%. The company commented on weaker consumption in SMB and the APAC region. Financial services was called out as stronger (continuing the trend of the last couple of quarters), and digital advertising weaker. 
• Some of the views we heard from the hyperscalers earlier in reporting season around optimisation of spend were called out on the conference call, with Snowflake also trying to manage this – we’d view this as positive for the whole ecosystem – bill shock around some of these consumption based business models is a broader risk to the cloud transition, so signs that companies are taking action to mitigate that is a positive. 
• Okta – we would characterise as OK results in the context of heavily reduced expectations – raising guidance very slightly. Management commented that the macro environment had deteriorated since the prior quarter, with its pipeline now more weighted to upsells and noting softening demand in the SMB segment in North America. 
• It seems to be shortening contract lengths which for us raises questions around (1) sales productivity headwinds with deals needing to be resigned (noting that it already has one of the worst sales productivity metrics of any business we look at) and (2) the underlying motivations for customers (and the likelihood of churn)
• Veeva (owned – small position) 3Q results were better than expected on both topline and bottom line growing 16% Y/Y.  Guidance for Q4 was slightly below expectations). 
• Interestingly it announced it would move its CRM system in house to its Vault platform and off Salesforce. Its Vault platform is run on AWS – where as we note below functionality is increasing all the time. The primary motivation here appears to be cost, but the risk is clearly that there might be a competitive response from Salesforce into the LifeScience industry. We view this as quite specific to Veeva’s business rather than any indication of a broader shift away from Salesforce. 
• Zscaler cloud security provider beat quite handsomely on topline for the quarter, and is standing out alongside Palo Alto in the cyber space, growing sales by 54% Y/Y with some positive signs of operating leverage too. The company is also raising their 2023 guidance for sales and EPS. They did still acknowledge a tougher macro environment, longer deal cycles (larger deals moving from 9 month to 12 month cycles)
• Crowdstrike was weak – the standout “miss” was new business ARR which is guided to decline 16% in Q4 (after 17% yr/yr growth in Q3), showing a real headwind to signing new customers. Management noted deal cycles lengthening, and spoke of “multi phase subscription start dates” – software speak for delayed, and smaller deals. To us, this looks hyper vulnerable to price competition from Microsoft, which leads us into our AWS Re: Invent comments…  

Hyperscalers still slightly the elephants in the room for software.. 

• Amazon (owned) held its AWS Re:Invent customer conference this week with a number of new product announcements. For us this always creates some nerves that there might be a new product, probably offered for free (or at a very low price) which could compete with some of the businesses we own. 
• There are a number of software areas (databases, cyber) that are large and growing, and these make for attractive segments for the hyperscalers (including Amazon) to go into (at very low incremental cost). We think this competition represents one of the largest existential threats to the third party niche software vendors. 
• AWS CEO gave a keynote speech which focused on the cost savings, noting that moving to cloud can lead to savings of 30% vs on prem. For us the move to cloud is inevitable – and we continue to look for the best possible exposure to the growth (noting too that areas will likely face increased competition over time)
• In terms of product announcements, the pace of innovation at Amazon continues to impress us. While there weren’t any immediate existential threats for third party software providers, there were improvements and additional integrations announced in Redshift (Snowflake competitor); and new products like Amazon Security Lake and Amazon DataZone which could start to encroach on third party vendors. 
• As noted above, Veeva’s decision to migrate off Salesforce effectively onto AWS (with its own in-house system) shows the potential for some share shifts. Of course we acknowledge that for most companies building their own in-house CRM system on top of AWS would make very little sense, but it does perhaps show AWS increasing its product and integration set that allows this sort of transition to happen..

Semicap equipment – incremental China news is a positive 

• ASM International (semicap equipment) gave us a surprise positive profit warning this week, positively preannouncing its Q4 driven by a lower expected impact from China restrictions. 
• Regular readers will remember this is almost same as Applied Materials reported a few weeks ago – noting that China export controls are having less of an impact than anticipated in October. 
• It’s worth noting that the ASMI story was (to us at least) very unfairly reported by the press – the FT’s headline for the day “Dutch chip toolmaker ASMI warns of escalating trade tensions” – in reality, it was really rather the opposite.. 
• We continue to think China are ordering tools at pace and can still very reasonably build themselves into a strategic position within trailing edge nodes, where there is a structural shortage.
• Both China and the structural drivers in semicap drive our belief that the short-term estimates in the space look overly derisked

Semiconductors – still a tail of two end markets

• Somewhat surprisingly, Microchip reaffirmed its guidance for 3Q, which had been initially issued November 3. Their sales expectations are driven by stable end markets and better supply chain.  The company also reiterated its guidance for the March 2023 quarter.
• This is very much inline what we’ve heard from conference season from the other semis players – which we try to pull out the best bits from below. 
• Marvell reported results at the lower end of guidance and guided for Q4 to decline. This is driven by weaker storage and enterprise networking – no surprise given what we’ve seen in the HDD space. Still the key growth areas of cloud, 5G and auto remain robust. Semis remains very much about picking your end-market exposure. 

Retail sales results from the black Friday season were better than expected in the US driven by promotions while Europe demand seems to have been weak

• Adobe reported a 2.3% yr/yr increase in Black Friday spending. Taking 5ppts+ for inflation gets us back to a more sombre figure, and one which should continue to be under pressure.  “With oversupply and a softening consumer spending environment, retailers made the right call this season to drive demand through heavy discounting,” said Vivek Pandya, lead analyst at Adobe Digital Insights. “It spurred online spending to levels that were higher than expected, and reinforced e-commerce as a major channel to drive volume and capture consumer interest.” 
• Shopify’s +17% looks stellar, but is trickier to interpret, given they don’t give lfl store sales
• Similarly Amazon’s “more than $1bn of sales for small businesses in the US” still doesn’t tell us too much. Although Nintendo Switch was called out amongst its best selling items. 
• Salesforce data showed Cyber Week online sales rose +2%y/y with the US up +9%y/y.  “While Salesforce noted weakness in the UK and Europe, which are clearly feeling the pain of an energy crisis

Cloud – demand is still there and we expect a multi year upgrade cycle.. 

• HPE remained steady in 4Q and sales and earnings beat on better supply. HPE sales climbed 12% Y/Y on a constant currency basis to USD7.9bn, which was above their outlook as supply constraints eased. Sales would have been even higher if a Frontier deal had not slipped. Orders remained steady too, driven across high interest in edge cloud solutions. The company closed the year with a significantly larger order book than it had in the beginning of the year.  Sales and orders for the Compute and Intelligent Edge businesses were particularly strong, the HPE GreenLake platform (Hybrid cloud solution). The large order book contributes to their guidance for sales growth of 2-4% in 2023.
• Services around their GreenLake solution are growing fast. Total as-a-service orders again increased more than 30% from a year ago during the quarter, leaving the service order growth of around 68% by year end. In the final quarter of the fiscal year as-a-service orders represented approximately 12% of the total company bookings.

Gaming – still very title driven

• CD Projekt reported its strongest quarter YTD although 3Q normally its weakest quarter of the year, sales totaled PLN245mn up 70% Y/Y.  The quarter was driven by sales of the new upgrade to Cyberpunk.
• The results show the dependence of the key title Cyberpunk and its upgrades. The company is now working on a major expansion to Cyberpunk 2077 titled Phantom Liberty, which will debut in 2023.  On December 14th, the company plans to release an update to The Witcher 3: Wild Hunt. 

Overheard in tech… 

It’s also been the end of year conference season with companies out giving their views into the year end – a good time to contemplate and in some cases give a longer-term perspective than we hear on quarterly results calls.. As the Palo Alto CEO Nikesh Arora commented, “Everybody tells me they’re a long-term investor, but they want to know what’s going to happen next quarter”... 

We thought it might be most helpful to pull out some key quotes from some of the companies we listened to this week:

LAM Research – $1trn semis market 

• “McKinsey published a study about where the semiconductor industry is headed by the end of the decade. And they suggested that they see a path towards a $1 trillion industry. I believe that. We at Lam believe that. Industry revenue this year is probably about 600 maybe a little shy of 600. So that is a very bright future for this industry. In order for this industry to generate that much revenue, there’s a lot of equipment purchases that are going to need to occur. So WFE is going to be meaningfully higher than it was this year in support of that”

Applied Materials – structurally higher capex intensity across both leading and trailing nodes

• “Now you see companies are actually having to build a new plant and buy new equipment. And so the intensity in the more mature nodes has gone up to approach the leading edge logic type of intensity. So when you do that across the whole ecosystem, intensity levels are rising.”

ServiceNow – software as a cost saving/productivity benefit driving demand

• “So whenever we can articulate hard dollar savings, doesn’t matter what the industry or geography is, that automation and productivity is what is resonating for ServiceNow.”..

Palo Alto – summing up software cycles

• “I’m pretty sure you’re going to hear this from every enterprise CEO because we’re currently not as much in fashion as we were about one year ago. We’re all going to have to work harder. We’re all going to have to scrutinize our pipelines. We’re all going to have to get ahead of the deals and talk to our customers much sooner, and we’re going to have to pay attention to opportunities out there. There probably will be more discounting and there’ll be probably more street rolls out there between people who are competing with each other for business, which is fine.”

Microsoft  – optimisation part of the cycle

• “Well, I think optimization is not a new thing. If you think about the cycle, particularly in cloud-based workloads, you migrate them, you optimize them, and then you reinvest in new workloads. That’s a normal cycle.”

Autodesk – same impact, different problems facing US and European customers

• “Because if you – talk to customer anywhere, especially in the U.S. hiring is a problem materials are a problem. So they need to be more efficient and productive in all these things. You talk to a European customer you get a very different conversation. They’re concerned about energy costs. They’re concerned about material costs. They’re much more – cautious as we’ve talked about earlier, customers are much less willing to pay for multiyear deals upfront which we’re completely okay with.”

Cloudflare – more deal scrutiny, new customers harder to sign

• “So what has certainly become a theme over the last two or three quarters is that new logo acquisitions have become significantly more difficult that the more ACV is under negotiation, the longer it takes people measured twice before they sign. We’ve seen that. And we have not seen many changes to the better over the last two quarters to be very honest. Where we see hope, especially unique to us, is when it comes to security and the threat landscape has not – has become more relentless.” 

Twilio – hurt by a consumption business model

• “I think our business is particularly sensitive to what ends up happening with end consumers. And so we have been really paying very close attention to like what retail is doing, what happened over the most recent holiday period, obviously. And as those things have played out, I would say, in an increasingly worse way that’s had some impact on our business as well.”

Texas Instruments – cost benefits of in house 300mm production

• “So since then our excitement, our confidence in our plan has grown. It is a big debt. It’s a big spend to build a 300-millimeter wafer fab. It’s not an easy investment. But again, the secular growth of what the market will do and our position in these markets and our ability to control our supply plan I think will pay dividends in the long-term.” 

Analog Devices – cycle stabilising

• “…in the third quarter, we were, sort of, at the top of the roller-coaster looking down. We didn’t know how far it was going to go. And now, we’ve had eight weeks of kind of flattening out, and that is — that’s kind of the situation. So the spirit of our management team has always been to be very transparent, so we’re telling you like it is. Not trying to read, not trying to guide you in any direction, but just letting you know what we’re seeing.”

NXP – long term EV driver around increased semi content 

• “I think the speed of conversion to electric drive trains in automotive is a surprise. Had you asked me a year ago at the Analyst Day, I would not have forecasted that electric and hybrid electric cars would be I think it’s now 27% of the total this year, it’s going to be 34% next year. So as I say a solid third of the car production is electric. I would not have forecasted that. So that speed is a positive surprise is a big, big tailwind for NXP because we are over indexed to electric cars, which is not just the drive train. I mean, we shouldn’t forget that electric cars have a higher electronic feature content across the board. So it’s not just the drive train, which was more semi. But they also tend to have more ADAS features and more convenience features because the classic — the buyer of an electric car expects more tech in a way.”

On Semi – still supply constrained in auto 

• “Our ability to supply is not going to match the demand. We are still going to be supply constrained in automotive in 2023. So even if the demand kind of fluctuates, it’s not the supply boundary and that supply that we are — as the semiconductor industry, we are going to be shipping into 2023 is higher than what we shipped in 2022.”

Cisco – ML/AI increasing network requirements

• “And then on the web scalers, it’s just driven by the continued incredible growth in that segment, and we are seeing new builds of AI and ML networks that are even more sort of network intensive and that’s contributing to our growth there.”

Arista – cloud upgrades driving growth

• “So you have to invest in that network and infrastructure and upgrade no matter what, which is what many enterprises are doing as well.”

Nvidia – Hopper architecture driving datacentre

• “Our data center business is now coming forth with our H100 architecture. That’s a great opportunity to really take advantage of a lot of the innovation that we put in to focus on large language models… And the overall performance improvement, the efficiencies, the total TCO that you get from H100 is there… The H100 in terms of its performance improvement, depending on the type of workloads, can be more than 6x what we see with A100… They’re still in that very early days of AI. But large language models and the size of large language models and the influence of natural language processing within that is very front and center”.

Micron – unprecedented PC/Smartphone weakness vs. Data Centre strength

• “On the on the PC and smartphone side, still very weak, I think we are expecting PC to contract again this year and smartphone to be single – basically flattish in ‘23. So – and they were both off 15% versus earlier in ‘22 expectations. So, they – I think which was unprecedented in those spaces. So, it’s been very severe, and they remain weak. And I think that’s probably also the macro backdrop in consumer getting more cautious in spending. Data center, as the end demand, we believe, is still strong, and you see that I was reading a report on a company today or said their growth in data center was 35% plus as I could see going out.”

Intel – CHIPS Act needed to drive cost parity with Asia

• “..when you look at the cost differential just in terms of differences in labor costs, construction costs and so forth, there is a meaningful, obviously, premium in the U.S. to build a fab relative to what you see in Asia. And Asia also provides incentives. So in order to get that to an equilibrium state, their incentives are going to be necessary. I think Pat did an amazing job getting the CHIPS Act or helping to get the CHIPS Act across the finish line with the U.S. government. He also did probably underappreciated an amazing job at getting the CHIPS Act in Europe over the finish line. And when – as we get those funds that will definitely get us to a level where we’re on – assuming our assumptions are correct in terms of what the investment tax credit, plus the CHIPS money gives us, that should get us to a reasonable parity in terms of cost.”

AMD – Genoa leading from a cost/performance product perspective – and a product refresh cycle underway

• “And so with Genoa, it really delivers that and it delivers it in a timely way because when you look at the server fleets out there – there’s a major refresh cycle coming. And so if you look at IT operators, from hyperscale across enterprise, they’re looking to really improve their total cost of ownership. What Genoa does is it leverages the fact that we took the CPU complex and moved it from 7-nanometer to 5-nanometer. So it’s on the cutting edge, TSMC 5-nanometer. Remember what I said earlier, the new transistors are still giving you more density and more performance per watt. So we combine 5-nanometer on the CPU with our design techniques, we partnered very closely from a design and technology standpoint with TSMC, and we improved 48% on the efficiency of computing. So it’s a huge generational gain on performance per watt.”

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