«There Is No Playbook»
Gavin Baker, founder of Atreides Management, thinks the market operates in uncharted territory. In his view, the earnings power of modern tech companies is underestimated in today’s inflationary environment. Also, he believes that the competitive dynamics among the industry's giants will change significantly.
The jitters continue. The surge in interest rates, the deterioration of the economic outlook and the Federal Reserve’s aggressive campaign to curb inflation are keeping the financial markets on their toes. Tech stocks in particular are under pressure. The Nasdaq 100 has been in a stubborn correction since the beginning of the year. Many smaller stocks have slumped 50 to 80%.
What happens next? That’s what we asked Gavin Baker. The founder and CIO of the Boston based investment boutique Atreides Management is one of the most respected investors in the tech sector and has been professionally involved with the industry for more than two decades.
«There is no precedent, there is no playbook for these business models in a high inflation environment», Mr. Baker says. «In America and Europe, you have never seen how inflation impacts the business models of different software companies. You haven’t seen how it impacts different internet business models,» he adds.
According to his view, this creates opportunities from a contrarian perspective that the consensus underestimates the earnings power of tech companies. In this in-depth interview with The Market/NZZ, Mr. Baker discusses where he sees compelling investment opportunities and why he thinks competition among the tech titans will intensify significantly. He also has a strong opinion on the outlook for the chip sector.
«If you want to compete in the metaverse as a platform, you must have a phone because that is where the processing will happen»: Gavin Baker.
Mr. Baker, you are one of the very few tech investors who lived through the dotcom crash in the year 2000 firsthand and remained active in the sector afterwards. As a battle-hardened industry veteran, how do you assess today’s market environment compared to back then?
Here’s the big thing: A lot of non-profitable tech companies with under $100 billion market capitalization just experienced a similar crash in valuations as we saw in the year 2000. But from a fundamental perspective, I don’t think the burst of the dotcom bubble has many parallels to what’s happening today. At that time, after the bubble burst, the fundamentals of every tech company imploded, they missed their earnings numbers by thirty, forty or fifty percent. Many had significant year-over-year revenue declines, and then their stocks went down more.
And how do things look today?
I do not believe that the fundamentals are going to crash in a similar way. In the year 2000, nobody knew which business models were going to work on the internet. The buildout in telecom equipment, data centers and software was not based on a consumption basis. It was built in anticipation of demand that took much longer than expected to materialize. In fact, we added so much telecom capacity that it took 15 years to absorb the amount of fiber and optical components we put in the ground. Every bank, every retailer and almost every other company was in a huge hurry to go online. They spent all this money to put up a website, but then they were like: «Wow! Why did I do that?» Today, you don’t see that degree of overbuild or excess on the supply side, because it’s all sold on a consumption basis. I promise, if the big cloud hyperscalers stopped spending on CapEx, they would run out of capacity in twelve to eighteen months. It’s a very different environment.
What does this mean for tech stocks?
It creates opportunities because today’s unprofitable tech companies are so much better than the ones back then. Many of them are Software as a Service companies where we know that the business model works. They have immense control over their P&L. You have seen some of them take their free cash flow margins up 80-90% in two quarters. They can be profitable whenever they want. They’re making a conscious trade-off between growth and profitability, and when they tilt towards more profitability, they don’t stop growing, they just grow slower. So it’s wild to me that you’ve had a move comparable to the year 2000 crash in non-profitable tech companies. Their forward multiples have compressed at least as much if not more, but they are great businesses, they’re not missing their numbers.
However, many of these companies were notably highly valued. As interest rates have risen, their shares have now come under pressure.
If you’re unprofitable, you’re essentially a long-duration asset. Hence, it’s natural that you take some pain as interest rates go up. But I think you’ve taken all the pain in the terminal valuation now. I don’t see much more multiple compression. Thoma Bravo, a private equity firm, just took out a software company at 12x forward sales. Today, you can buy a lot of software companies at roughly half that multiple, and they are growing faster with better fundamentals than the asset acquired by Thoma Bravo. So if you’re a software company trading at 6x sales, and an inferior company just got bought out at 12x sales by a very knowledgeable private equity buyer, I think that’s enough of a discount. That’s why I don’t see much more multiple compression. What will drive performance is growth and the relative operational performance of these businesses, and they should do reasonably well in an inflationary environment.
In the United States and Europe, inflation is as high as it has been for decades. How do you generally deal with this surge in prices as an investor?
Until a few months ago, there was a reasonable case to be made that inflation might peak in early 2022 as supply chain issues resolved. But now, we’ve added a massive commodity driven inflation impulse as a result of what happened in Ukraine and Russia. The only way this goes away is a relatively near-term resolution that results in sanctions being dropped, and the world going back to the way it was. That may be possible, but I don’t know if it’s likely. As result, you may have this commodity driven inflation for a while.
What are the implications of this commodity driven inflation?
Capitalism is amazing at solving supply chain problems in relatively short order. In other words: A lot of supply chain capacity is now being built into the system and supply chain driven inflation likely goes away quickly. But it takes a lot longer to solve commodity price inflation. It’s a lot easier to, say, build a warehouse, hire fulfillment workers or ramp up auto production than it is to bring on-line new mining or energy capacity. That’s a big change, but it’s also very important to be humble when predicting the macro environment because really no one knows.
How does this affect the outlook for the tech sector?
For their research, a lot of people are going back to look at the 70s. That’s a great exercise for energy, materials or restaurant companies where the business models are stable. But it may lead you to terrible conclusions for companies and industries where the business models have drastically changed. That’s why looking at the 70s to understand how tech will do today is absurd. Today’s tech companies are totally different, their business model is completely different. They have much higher ROICs, they are less capital intensive, have much higher margins, more pricing power and more gross profit per employee than tech companies in the 1970s. There is no precedent, there is no playbook for these business models in a high inflation environment. In America and Europe, you have never seen how inflation impacts the business models of different software companies. You haven’t seen how it impacts different internet business models. So from first principles thinking, there is an exciting opportunity to reach very differentiated conclusions and first principles thinking suggests these business models should do well fundamentally in a high inflation environment.
Where do you see opportunities arising against this backdrop?
For example, a lot of internet advertising businesses may be mismodeled. These are high ROIC companies, and they use auction mechanisms to price their ads. It happens in milliseconds every time you click on something, and the way their auctions work perfectly passes on price increases to the advertisers. So theoretically, inflation naturally flows through that auction. But most analysts are not taking inflation into account when they model these businesses.
Are there other segments with appealing perspectives in the current environment with high inflation and a potential slowdown of economic activity?
I’m still bullish on software. Robert Smith, the CEO and founder of Vista Equity Partners, famously said that software contracts are better than first-lien debt: To pay its software contract, a company will miss the interest payment on their first lien. At first, I had some doubts, but COVID broadly proved that actually to be true. I was wrong and he was right. We know now that software companies have massive pricing power with a much higher conviction than we did before. Also, they are very high ROIC businesses, and their recurring revenue streams will help them in a slowing economy.
What kind of companies are you particularly bullish on in the software space?
I have a bias for infrastructure software over application software. Here’s the simple reason: A lot of application software companies are barely software. David Sacks, a co-founder of the venture capital firm Craft Ventures, said it aptly: For around twenty years, all these companies had to do was to take any business process that’s done on Excel or uses a fax machine, create a web or app-based software version of that business process, run it on AWS - and presto: you have a multi-billion software applications company. Obviously there is more to it than this oversimplification, but the point stands that it has become easier to build application software and that world has steadily gotten more and more competitive on a category by category basis.
How are companies that specialize in infrastructure software different?
Infrastructure software for databases, data warehouses, data lakes or enterprise-grade search is real technology. That’s real software. The lock-ins and the barriers of entry are much higher. What’s more, as all of the giant cloud players now start to use their own internal silicon, they are going to compete less with the infrastructure companies because they need them to re-write the software to run on their internal silicon. That competitive dynamic is receding, and that’s very positive from a long-term perspective because those big hyperscalers were a huge threat.
In today’s world, cyberattacks are also occurring more and more often. Does this speak in favor of cybersecurity companies?
During the first twenty years of my career, I was always very negative on cybersecurity because it was one of the very rare industries where scale was a massive disadvantage rather than an advantage. Before the rise of artificial intelligence, human beings were writing software, it was a very manual process. And, as a cybersecurity company got bigger, hackers would start to optimize more and more for hacking that particular cybersecurity company’s software. As a result, the performance of that company would go down and it would lose customers. AI changed all of that because if the AI learns from the attacks, then you get better with scale. So that’s another area I’m excited for. Antonio Gracias, a fantastic thinker, has this great phrase «pro-entropic». To me, cybersecurity companies are pro-entropic. They benefit from rising chaos in the world.
Another long-term trend is that the tech and consumer sectors are becoming increasingly intertwined. Are there any attractive investment opportunities here?
I remain very positive on companies who benefit from the consumer shift from goods to experiences. In the United States, consumer spending on goods is $500 billion above the five-year trend going into COVID. On the other hand, consumer spending on experiences is $500 billion below the five-year trend. And one thing we have learned is that all these things normalize over time; meaning experiences are going to come back to trend, and that is going to be really good for travel.
But the economy seems to be cooling rapidly. Couldn’t that become a problem for the travel industry, which has already suffered badly from the pandemic?
In a recession travel often gets hit pretty hard, but this time might be different. Usually, travel gets hit hard because business travel is an enormous component of travel at very high margins. The first thing literally every CFO does to tighten their belt during a recession is to pull back on business travel. But there is not a lot of business travel today. Hence, if there is a recession, travel will not be hurt by a weakness in business travel to the extent it was in the past. Also, you have a massive pent-up demand impulse from consumers. On top of that, there are a lot of business models within travel that are basically royalty streams, think hotel franchisers or internet marketplaces which will pass on inflation in a very linear way. So even though in a typical recession playbook, you don’t want to own travel, I think travel is a very interesting place to be; particularly if we are going to have a recession with higher-than-normal inflation.
In such an environment, how do you rate the prospects for big tech? With the exception of Facebook, other industry giants like Apple and Google have held up quite well in the recent market turmoil.
It’s exciting: Not only are we in an environment where there is no playbook from a macro perspective for a lot of these new business models, but I also think we’re going to see the competitive intensity between these mega cap tech companies go up. A lot of that is driven by the fact that one of the large platform owners chose to exercise their platform power which - in the short-term - negatively impacted the fundamentals particularly of some social media companies that depended upon that platform owner for targeting, measurement, attribution, essentially everything. So if you are a giant tech company and you don’t own a platform, you now fully understand that you are at the mercy of those platform companies. That’s why I think you are going to have more competition.
In which areas do you think competition among the tech titans is going to intensify?
If you want to compete in the metaverse as a platform, you must have a phone because that is where the processing will happen. The metaverse is not just augmented, virtual or mixed reality, it’s also ambient always-on computing. In the future, it seems highly likely that we will all have a miniaturized version of air pods which will always listen and we can always talk to. Additionally, we will have some sort of wearable tech on our wrist, and the two of those in combination will do a lot for health. Then, we will have glasses that we can kind of superimpose digital images on, augmented or extended reality. The computing for all of that will be powered by the phone. So anyone who wants to compete there, will develop a phone and a phone operating system - or at least they are going to try.
And what are the implications?
Similarly, as these platforms go from coopetition to more competition, you’ll see new players enter search. If you are a platform, and you have a vast amount of data, and you believe that assistance - applications like Siri - are important, it will be really hard to succeed without a digital assistant. Over the years, that digital assistant becomes our on-board, always-on personal AI we can access through ambient computing and that kind of gives us superpowers as humans. Against this backdrop, it’s very hard to succeed within digital assistance without being really good at search. Consequentially, we are going to see more outright competition in what had been a reasonably stable coopetitive dynamic for a long time.
What does this mean for investors looking at big tech?
For investors, there was a playbook that worked very well for around ten years. For many of these mega tech companies there were essentially minimal competitive threats. They were basically levered royalties on global GDP with a very high ROIC, and they were perpetually underpriced. But that playbook is changing. As that stable coopetitive environment becomes more intensely competitive, there are going to be more opportunities for investors, more opportunities for stock picking and to differentiate.
Significant changes are also taking place in the semiconductor industry. The largest chip manufacturers are ramping up spending by the billions as demand booms. What’s your take on semis?
Generally, I’m negative on semiconductors on a short-term basis. Nassim Nicholas Taleb said it best: «I’ve seen gluts not followed by shortages, but I’ve never seen a shortage not followed by a glut». We haven’t seen a true semiconductor capacity cycle in more than twenty years. The last time you had this kind of ramp in semiconductor capital expenditures, their stocks imploded. It was not until 2015, that semiconductor wafer fab equipment spending reached its 2000 peak. What’s more, government subsidies like the Chips Act are geopolitically very important for America and Europe. But by definition, when supply in any industry goes up for geopolitical rather than economic reasons, it’s very negative for the supply and demand balance in that industry.
So what should investors look out for?
As we discussed in our previous interview, Artificial Intelligence is shifting upward the semiconductor intensity of global GDP. Therefore, semis are a great place to be in the long-term, but we have to get past the inventory cycle first, and then we have to get past the capacity cycle. Then, it will be a great time to buy semiconductor stocks.
When do you think the current inventory cycle will turn?
We will be starting to see a lot of signs that the inventory cycle is beginning to loosen up. In addition to that, there is a recession or a slowdown that will further help the semiconductor cycle loosen up, and that will hurt the stocks. On top of that, the shift in consumer spending from goods to experiences will not be good for semiconductor demand. That’s why I think there are a lot of high-level reasons to be cautious on semiconductor demand in the near-term.
Where do you think signs of a slowdown will show up first?
There are beginning to be a lot of signs that PC demand is slowing - and PC, along with cloud, is still one of the biggest consumers of silicon. The way semiconductors work is when one area loosens up, it spreads to other areas. So when the PC chip manufacturers start asking for less wafers from a foundry, that foundry will have more wafers available for other sectors.
TSMC, Samsung Electronics and Intel are currently engaged in a breakneck race for the leading processing technology. What will happen next in this area of the semiconductor industry?
At the leading edge, it’s generally easier for a company to be a follower than the leader. If you’re a leader, you have all sorts of advantages: You’re solving the problems first, so you’re on to the next node first. But at the same time, if you’re two years behind the leader, it’s probably relatively easier to go from being two years behind to being six months behind because all of the equipment companies are helping you, and someone else already made the breakthroughs - and going from a distant number two to a very close number two creates a lot of value.
Gavin Baker
