In this Weekly Insights we provide a recession playbook, 2Q22 earnings insights, and the long term case for industrial technology.

• Technology: low expectations drove outperformance for some (Netflix, Tesla), but not all (SNAP)
• Airlines: struggling to deliver with peak demand — what happens when demand turns down?
• Banks: strong consumer spending, but reducing exposure, canceling buybacks
• Retail: bellwether, Walmart, cutting guidance …again!
• Recession playbook: what to focus on vs. avoid?

• Productivity improvement the only sustainable way to fight inflation
• Industrial technology to lead the next tech cycle

Earnings expectations are low, but not out of the woods just yet

We expect that the weakening macro environment evident since March, will start getting reflected into earnings this quarter. Expectations are relatively low going into earnings season, but expect volatility and outsized moves in both directions. Our earnings models indicate that there could be on average ~10% downside to earnings estimates across the board for our space, with consumer related businesses (e.g., consumer discretionary, housing, consumer tech) on the higher-end of that and industrial/enterprise technology one the lower-end (e.g., cybersecurity).

Technology:

The most significant report last week was Snap, which pulled the entire tech sector down and particularly hit the advertising stocks such as Meta, Google, Unity.

The company had already warned that 2Q results will be below the low-end of the guidance. But not only was growth in 2Q lower than the original guidance, 3Q commentary was very disappointing, sending the stock down ~40%, after already being down ~40% on the warning. The company cited challenging macro and increased competition, in addition to Apple privacy changes. Results summary:

• 2Q growth +13% vs. originally guiding to +20–25%yoy — disappointing, but expected after the warning
• 3Q QTD trending flat yoy which implies that the full quarter could be down yoy. The company is no longer providing guidance due to low visibility

Is this an overreaction? Maybe. But it is never good when growth slows for a technology company, and even worse when it turns negative. While the sharp reaction can be attributed to the fact that Snap has been a consensus long due to the company’s younger demographic, investors may have underappreciated its exposure to more volatile advertisers compared to peers (young growth companies, crypto, online brokerage etc). While there appear to be many company specific issues in this report, increased competition is something to be mindful of for the remaining earnings reports.

On a more positive note, both Tesla and Netflix were able to exceed low expectations. But before investors get too excited, here is the data:

Netflix results summary:

• Netflix lost 970K subscribers in 2Q, better than the 2MM loss the company guided to, but largest loss Netflix has ever reported
• 20% Operating Margin was down sharply Y/Y and Q/Q
• On the positive side, Netflix expects positive FCF going forward and substantial FCF growth in 2023 vs. 2022. The driver for this will be less spending on original content. Moreover, the company will be offering a lower-end ad-supported tier in an attempt to broaden its audience

In summary, Netflix goal is to accelerate revenue growth, while moderating content investment at a time when competition is increasing, both from competing streaming platforms (e.g., Disney, Paramount) and independent content creators (e.g., YouTube). Possible, but certainly not easy. Netflix already has 60% penetration of US households, adding the 30% affected by password sharing brings the total to a very mature levels.

Tesla results summary:

• 2Q22 automotive gross margin of 26.2% was better than expectations of 25.4% BUT down -380 bps sequentially (vs. 1Q at 30%). Margins were ~flattish yoy despite +27% higher unit sales and +42% higher revenue y/y, reflecting higher costs.
• Price increases ($10K price hike) will benefit 3Q and consequently, the company expects to recover some of the margin decline.

It is important for investors to keep in mind that Tesla is expected to exit FY22 at almost 2 million vehicles annualized sales run-rate (globally). As a comparison, the entire US market in light vehicle unit sales in 2021 was ~15 million. With that scale, the company is much more exposed to cyclical downturns (similar to other automakers), compared to previous cycles where the secular drivers outweighed the cyclical slowdowns.

In summary, thus far not many positive surprises are evident outside of low expectations. The common theme is that while 2Q was weak, companies are addressing the challenges by taking actions such as cutting spending (Netflix, Snap), increasing prices (Tesla) etc. While these may be the appropriate actions to take, we find it difficult to imagine that companies will be able to realize improving demand in a recessionary environment with higher prices (Tesla) and less content (Netflix).

Airlines

Both Delta and United Airlines reported earnings last week that missed Street estimates on higher than expected fuel costs. Both companies noted strong demand:

• Delta: robust leisure and corporate demand trends — September international travel is already booked to 60% at attractive price points
• United: UAL’s corporate business continued to recover in 2Q with corporate volumes/revenues now 75%/80% recovered. United did note that the rate of corporate improvement slowed in the last few weeks

We believe that this summer travel season benefited from post pandemic pent-up demand. In our base case, we are assuming a mild recession in the US and are therefore avoiding airlines at these levels. Airlines are high fixed costs businesses and small changes in demand can result in significant earnings downside.

Banks

Several large banks reported earnings and while most highlighted that the US consumer remains strong, some (e.g. JPMorgan) noted some early signs of trouble emerging among lower-income consumers (cash buffers declining and delinquency increasing). As a result, JPMorgan is more selective with regards to balance sheet growth (e.g. plans to “substantially” reduce mortgage loans) and suspended its buyback plan.

Retail

Walmart, a bellwether for the US consumer, negatively pre-announced and noted that food and fuel inflation is impacting spend elsewhere in the store and specifically called out apparel. Consequently, operating income is expected to decline 11–13% for the year (vs. ~1% decline previously).

While our base case is a mild US recession, and consequently we expect downside risk to all sectors, we believe that this summer will end up being a great entry point for many investment opportunities. Per Bank of America Fund Manager Survey, equity allocation vs. cash is lower than during the peak of the pandemic, and at similar to levels during the 08/09 recession. This suggest that either fund managers have gotten smarter by keeping more cash, or everyone is going to get caught underinvested.

While we expect downside to earnings across the board, some sectors, such as industrial technology, have been already hard hit on higher interest rates, while fundamentals have not materially deteriorated (see the industrial technology section below).

In a recession, enterprise spending will come down, and depending on the business model some sub-sectors have more downside than others. Cloud spending, as an example, is consumption based which means that reduced consumption will result in less revenues. Cybersecurity spending, on the other hand, is relatively less discretionary, but nevertheless, shrinking economy means less customers.

On the positive, compared to consumer technology, industrial technology is in earlier-innings of adoption which means more white space and less competition. Companies in most end-markets have 1–2 competitors and addressable markets that are multiples of current revenues. As a result, while companies may be facing a weak macro environment over the next 1–2 quarters, the secular growth drivers are likely to provide an offset.

In summary, we would avoid economically sensitive areas (e.g. housing, autos, durable goods, leisure/travel); we are very selective in other areas such as consumer tech where we believe many companies will have to re-invent themselves and some may not be able to; and we find many opportunities in industrial tech as we believe that we are in very early innings of adoption.

Companies are undergoing end-to-end digital transformation enabled by several technologies that are reaching scale at the same time (e.g., cloud migration, innovation in the software stack, improving compute speeds, connectivity (5G), and edge computing). Companies are able to improve their topline, by introducing better products and optimizing sales processes, and the bottom line, by efficiently managing their operations thus lowering their costs.

We believe that productivity improvement is the only sustainable way to fight inflation and consequently expect that the outlook for industrial technology will remain relatively stronger despite weaker macro.

We have identified the following four areas of opportunity:

• Horizontal software — across industries (e.g., CRM, Procurement, HR, etc.)
• Vertical software — industry and application specific (e.g. design software, simulation)
• Cybersecurity software and hardware (e.g., cloud security, endpoint, identity management)
• Artificial Intelligence software and hardware (e.g., GPUs, CUDA)

Horizontal Software

Sales processes were one of the first functions to be automated and Salesforce was one of the first ones to offer a cloud CRM (“Customer Relationship Management”) solution in 1999 targeting small/medium sized businesses. The functionality of the CRM system has evolved from digitizing a rolodex to much more (incorporating social media data, chatbots etc). Moreover, in addition to just being a database, today companies are using tools and analytics to generate sales leads, analyze sales cycles, etc. This process requires an entire ecosystem of providers from cloud vendors (AWS, Azure, GCP) to data warehousing and compute companies (e.g. Snowflake) to visualization tools (e.g. Microsoft’s Power BI and Salesforce’s Tableau).

The digitalization over the past several years has continued to expand to other areas beyond sales such as workflow management (ServiceNow), procurement (e.g., Coupa, Jagger), HR/talent management (Workday). These software solutions are sometimes referred to as horizontal software as they work across different industries.

Vertical Software

In addition to optimizing processes with horizontal software, there has been significant innovation in vertical software. This would include software that is industry and application specific such as simulation and design (e.g., Autodesk, Ansys, PTC, etc.). With improving compute speeds, companies are now able to innovate at a rapid pace and introduce simulation much earlier (i.e. in the “ideation” phase rather than the “design” process), and sometime even eliminate the prototyping phase which can be costly. The result is better products at significantly lower costs with higher return on R&D investment.

Cybersecurity

As companies are adopting cloud based software platforms, and are transitioning to public, hybrid, and multi-cloud environments, there is a need for entirely different cybersecurity solutions as the traditional network perimetar solutions are inadequate. This need has resulted in rapid innovation in cybersecurity with several “next-gen” cybersecurity companies establishing themselves as leaders. For more info refer to our Cybersecurity Primer.

Artificial Intelligence (AI)

Until recently AI was a buzzword with no meaningful applications at scale. Today every successful consumer internet company is likely using AI (e.g., Paypal, Pinterest, Snap, Twitter), although some more successfully than others. We are at the cusp of AI gaining broader adoption in many traditional industrial products (e.g. automotive) and applications (e.g., predictive maintenance etc). For more details refer to our report Nvidia: the one stop AI shop.

We will dive deeper in each of our focus areas in our subsequent Weekly Insights. For more research visit out website spear-invest.com.