Technology stocks have experienced some of the deepest routs of all shares since inflation and interest rate rises started spooking markets. The ASX All Tech index is down 12.68% for the month and down by 39.89% year-to-date, versus the All Ordinaries index, which is down 9.69% over the month and down by 15.21% year-to-date. Cutely-termed ‘pre-revenue’ stocks have been badly beaten up as their discount rates have taken a battering. But there are still opportunities to invest in tech stocks that do return a profit.
The discount rate is the interest rate used to calculate a company’s discounted cash flows, which is a way of estimating an investment’s value based on projected cash flow. When the official cash rate rises, so too does the discount rate and the value of the asset falls. This is what happened to a slew of listed technology stocks that had not yet produced a profit. The local bourse is littered with examples, with unprofitable buy-now-pay-later companies some of the worst-affected. For instance, listed BNPL Afterpay challenger Sezzle’s investors have watched its share price plummet by 96.0% year-on-year and its sector stablemate Zip has seen its share price retreat by 93.5% over the same period.
It’s worth noting the market became enamoured with tech stocks during the pandemic, with share prices appreciating at pace for a range of reasons. Suddenly we needed technology to work from home, streaming became our main form of entertainment and meeting in-person switched to video conferencing. Businesses in these tech sub-sectors and more benefitted as a result. But global economics has shifted as the pandemic’s restrictions have eased and the investment thesis for pre-revenue tech firms has changed.
Equity Story analyst Peter Kopetz agrees there’s been a shellacking of tech stocks since the risk-off rerate. “There are the haves and the have nots, meaning there are some profitable tech stocks that are generally less risky, which have outperformed the non-profitable ones. The profitable line-up is very small and dominated by tech mainstays that have a strong business and dominant market position here in Australia.” He points to Carsales, Pro Medicus, realestate.com.au, Seek, WiseTech and Xero as tech names generating a return.
“We have taken a magnifying glass to these stories and have picked out two stocks that still have a strong business, a rosy long-term outlook and are trading at prices not seen for three years. We call it the ‘2019 run out sale’ for those that like to grab a bargain and hold it for a five-year-plus period. These kinds of sales are the mother of all opportunities if you pick the right stocks.” Kopetz names Xero and Seek as his two favourites of his group of profitable tech stocks.
Xero is also in Morningstar’s analyst Gareth James’ sights, albeit with a number of qualifications. It’s the largest provider of accounting software-as-a-service across Australasia and James expects the company to springboard from this position to take market share in the UK and US. “The capital light business model should enable returns on invested capital to comfortably exceed weighted average cost of capital in the long-term,” he advised clients in a note.
Nevertheless, lower returns are expected from Xero in the near-term, reflecting management’s strategy to reinvest revenue into software development and marketing, with higher revenues anticipated over time. James notes subscriber numbers were up by 19% to 3.3 million in fiscal 2022 and revenue grew 31% to NZ$1 billion.
James also likes WiseTech Global, which turned in a strong fiscal 2021 result, while highlighting the supply chain software leader’s improved disclosures. In a note to clients, James said the company had significantly alleviated Morningstar’s concerns about its accounting policies and earnings quality. “Its first half results still exceeded our expectations and management has increased fiscal 2022 EBITDA guidance by 5%.” Further, James says despite WiseTech’s high, one-year, forward P/E ratio of around 100 and macro-economic challenges, the business is still considered to be significantly undervalued.
Prime Value Asset Management’s equities portfolio manager Mike Younger has two stock picks in the profitable tech category. The first is global financial services software IRESS. “The company was established more than 20 years ago and has been highly profitable throughout the journey,” he explains. “It has a very high market share in equities market data and trading and wealth management, with customers comprising investment banks, fund managers and wealth advisers.”
Younger says although IRESS is well known in the investment community, the company is under-appreciated, largely due to its historical bottom-line growth under-performing market expectations. “With a reset in focus to organic growth and management KPIs linked to EPS growth, we see solid medium-term growth ahead at a reasonable valuation.”
His second pick is Hansen Technologies, which is a founder-led, highly profitable, global provider of billing software to the utilities and communications industries, also established more than 20 years ago. He says organic growth is mild but relatively predictable and driven by growth in its client’s customer bases, as well as regulatory and product changes that open new markets such as energy and water deregulation.
Another profitable tech stock worth a look is Pushpay, according to Benjamin Mellody, equities analyst at Prime Value Asset Management. The business provides management software and payments processing for more than 14,000 US churches in the US. It has a market leading position in medium-sized and larger churches, benefits from high customer switching costs and generates significant cash flow.
“Pushpay is looking to grow organically, with a planned expansion into the Catholic market, as well as continuing to make accretive acquisitions to build its capabilities in adjacent markets, such as digital streaming. Pushpay is an example of a profitable listed technology company and is currently trading on a reasonable multiple. Notably, it has also recently received takeover interest from multiple parties, including private equity firm BGH Capital.”
With life likely to remain tough for unprofitable tech businesses in the immediate term, this smaller group of shares that are in the black are likely to pique the interest of investors that want exposure to tech but don’t want these assets dragging down portfolio returns over time.