Cloud In 2020: Here Is The Bubble

The SaaS/cloud bubble is concentrated in the software application industry.

Fast growth tech plays have strong economic moats embedded in their DNA.

This will make it tough separating innovators from the rest.

The outlook for the broad market is strong, however, a well-diversified portfolio remains the best way to avoid irredeemable losses.

Welcome to 2020.

Source: Medium

The cloud/SaaS space recorded a mild correction last year. However, a careful analysis of key tech industries reveals that a possible bubble in 2020 would be triggered by a handful of fast growth bets in the software application industry with a perceived economic moat. These bets are based on businesses generating tons of data to drive customer value and growth using inbuilt machine learning and artificial intelligence models. However, any softness in global demand for tech stocks could cause a revision of reality and potential that investors attribute to these fast SaaS stocks. A growth deceleration has hit other industries due to the US-China trade war. Their margins have also been impacted by the demand from enterprises for improved TCO (total cost of ownership) in their tech purchases. This has favored companies with platforms that can reduce the number of physical devices needed to help tech companies set up their stack. This involves leveraging the public cloud, private cloud, hybrid cloud, virtualization, and HCI (hyper-converged infrastructure) to optimize I.T. interoperability and cost.

At the macro level, demand for semiconductors and electronics is expected to pick up driven by the release of a new wave of 5G enabled devices. The entire tech sector continues to provide platforms and infrastructure for other sectors to drive growth and efficiency. A lot of the increase in innovation in the tech space will be harvested in other sectors like communications, finance, manufacturing, and healthcare. This is a win-win for the tech space as strong economic growth and macro outlook mean less volatility in the near term.

Most investors are familiar with these fast-growth stocks. However, as earlier explained, two things could be attributed to their lofty valuation: their economic moat, which gains from the network effect, and their acquisition protection factor.

The acquisition protection factor is an observation of mine that struck me after researching a lot about SaaS stocks. The idea is that for a company to achieve its true potential, its valuation has to lead growth. This leads to massive multiples expansion, which protects it from getting acquired by more prominent tech players in their effort to curb competition. Imagine if Instagram was already worth billion when Facebook (FB) came knocking, it will have been passed on by the social media giant. Snap (SNAP) and Twitter (TWTR) are two examples of companies that have built this acquisition protection factor due to their big size. Another case study is Square (SQ) in the payment space.

However, the downside is often grave as overvaluation typically leads to corrections and selloffs if the company doesn't achieve its true potential.

There is a paradigm shift in value creation, and this is obvious in the profitability and growth skew across tech industries. Semiconductors were the first platforms, which gave way to communications equipment. The computer hardware industry ushered in the second generation of platforms, which are PC and server-based. These, in turn, ceded control to software infrastructure platforms that are OS virtualization-based. Today, a new platform is emerging around cloud, AR (augmented reality), software services, and mobile devices. This explains the fast growth of software application stocks. The lack of profitability in the software space can be attributed to the conviction that for sustainable growth to be achieved, margins have to be sacrificed for market share gain in the quest to stay competitive.

These bets will only be valid if competition doesn't kill pricing power and if the macro environment remains favorable. Across most software application sub-industries, there is only room for a couple of winners. Smaller players and challengers will eventually have to be acquired by their bigger peers.

Industry focus

Software Application

The application software industry has the highest trailing P/E of all tech industries. However, compared to the software infrastructure industry, the growth generated in this space isn't superior. This might signal a wide gap between valuation and growth. Valuation leading growth is good as it indicates positive economic sentiments from investors, and it gives management the confidence to execute on their capital allocation strategy. However, the data suggests software infrastructure companies aren't done profiting from the network effect derived from their platforms. This means they will continue to occasionally fight for attractive acquisition targets with emerging software application plays.

Software Infrastructure

Alongside the software application industry, there have been massive gains in size and value due to the networking effect, globalization, and worldwide migration to cloud platforms. Cloud platforms make capital intensive business models simple. As a result, entrepreneurs can successfully execute and act on their erstwhile impossible ideas. This makes it easy for them to make their business case to VCs, who, in turn, reward their capital-light business models with huge valuation multiples.

This is the second most expensive industry, with smaller players trading at questionable valuation ratios. However, the healthy growth and superior margins of top plays in this industry makes it attractive. Players like VMware (VMW) and Synopsys have been able to record strong growth and profitability ratios, which is a tough attribute for software companies.

Computer Hardware

The computer hardware space has witnessed decelerating growth in recent quarters. This is driven by little advantage that is derived from the global cloud migration as most enterprises prefer to rent cloud hardware solutions versus buy inhouse. The US/China trade war has also impacted this industry. HCI and virtualization players with a focus on AI and cloud-enabled deployments have been the only ones recording growth. Going forward, I expect favorable macro tailwinds and renewed demand as players adjust to the demand from enterprises for hybrid cloud storage and HCI solutions.

Semiconductors

The semiconductor space will experience favorable comps this year as demand for 5G enabled devices picks up. This will benefit electronic component manufactures like Quorvo (QRVO) and Skyworks (SWKS). Last year was partly affect by memory and inventory overbuild in addition to the US/China trade war. Advancements in robotics and the proliferation of IoT devices, particularly in the automotive sector in the area of driver assistance, will fuel demand.

Going forward, I expect the semiconductor space to remain the tripod upon which other tech industries rest.

Communications Equipment

When Cisco (CSCO) coughs, the communication industry develops a full-blown fever. Cisco's recent deceleration has impacted sentiments in the communications space. Also, the deceleration in the growth of traditional network security vendors and the emergence of a new wave of cloud security plays suggests the migration to cloud platforms is impacting the demand in the communications equipment space. Again, the narrative is straightforward, the new wave of enterprises and SMBs will instead rent their cloud services, and network devices than own them. From network devices, databases, storage solutions to security appliances, everything can now be offered as a service. This will continue to impact the demand for communications equipment.

Electronic & Scientific Instruments

This industry will benefit from the upcoming console refresh cycle. Apple (AAPL) is set to release 5G iPhones this year. Also, the latest console reference will continue to drive demand for electronics components.

The IPC electronics trade association found businesses have seen a 31 percent increase on the dollars they spend on imported products. Twenty-five percent said more than half the dollars they spend are facing higher tariffs.

Going forward, I expect the impact from the trade war to wane as demand for key electronic components picks up.

Information Technology Services

The information technology space will continue to cede space to software and communication companies who hire data scientists and machine learning experts to build intelligent systems to automate key business decisions. Developing actionable insights used to be the specialty of information technology service providers. Though they still play a significant role across enterprises that need expert advice, product review, system integration, and recommendation services during IT spending, upgrade, and optimization seasons. However, critical data analytics skills are increasingly getting automated by software companies with threat intelligence modules. These threat intelligence modules can provide real-time actionable insights to systems analysts and execs. This will continue to impact the rate of consulting engagement and services needed by traditional enterprises. I am projecting tough comps in this space in 2020.

Conclusion

While macro sentiments are improving, the lofty valuation of cloud plays coupled with intense competition for market share in the software application and infrastructure space will lead to a petri dish of valuation volatility. Companies with a healthy balance of growth and profitability with ample cash position will be able to take advantage of the possible correction that will be triggered. As a result, companies trading at lofty valuations will become cheap as the SaaS market consolidates.

Investors should make sure they aren't overexposed to any industry, and a balanced portfolio of growth, value, momentum, and profitability remains the best investment strategy in the near term.

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Disclosure: I am/we are long TWTR, SQ, NOK, AMD, JMIA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.