Andre Hardy:
Welcome to the Industries in Motion Podcast from RBC Capital Markets, where we'll be exploring what's new and what's next in today's fast-moving markets and industries to help you stay ahead of the curve. Please listen to the end of this podcast for important disclaimers. My name is Andre Hardy, and I am head of Canadian and Asia Pacific Research. Let's get into today's episode.
Andre Hardy:
I'm very pleased to introduce our guest, Paul Treiber. Paul is a Director at RBC Capital Markets and is responsible for our equity research coverage of the Canadian technology sector, which spans nearly everything from hardware to software to services and the internet. Paul has nearly two decades of experience in equity research and has consistently been among the top-ranked analysts in investor surveys in the Canadian technology space. Today, we'll be discussing the state of the technology sector in general, and more specifically technology in Canada.
Andre Hardy:
Paul, over the last 20 years, technology stocks have represented an average of just 4% of the S&P/TSX Composite. Two years ago, you published a report saying that technology was overtaking the S&P/TSX Composite Index, and the sector rose a peak of 12% of the index in November, 2021. Now, technology is back down to just 6% of the index. And this June, you published a report called “Finding opportunities in the sell-off”. What happened over the last two years to drive this rise and fall of the technology in equity markets?
Paul Treiber:
Yeah. Thank you very much, Andre, for having me on. It seems like, when you look back over the last two years, technology definitely experienced some indigestion. In all seriousness, what we experienced over the last two years was nothing short of incredible. There's a massive positive step function increase in technology adoption due to the disruption from COVID. At the same time, risk free rates dropped to generational lows. Now, what this did is lead to valuation multiples on technology stocks, specifically in the S&P 500 technology index, increased about 40% compared to the pre-COVID average. However, for some companies, particularly those that are high growth and unprofitable, the increase was even more substantial. For example, Shopify's trading valuation multiple doubled from immediately prior to its COVID peak to November, 2021. Then in the last six months, we had risk free rates double from 1.5% to 3%.
Paul Treiber:
Plus, we are now facing a possible recession. Technology stocks are long duration assets, and some of the highest growth stocks are unprofitable, so valuations were maximized in a low interest rate environment, and then disproportionately impacted by the rapid rise in risk free rates. We estimate that approximately 60% of the decline in our coverage universe reflects the rise in risk free rates. The remaining 40% of the decline reflects concerns regarding a recession, and valuation multiples for tech stocks have dropped significantly from their highs. For the S&P 500 valuations are now back in line with their pre-COVID multiples. However, for high growth and unprofitable tech stocks, valuation multiples are substantially below their pre-COVID averages. For example, Shopify is now trading 60% below its pre-COVID average.
Andre Hardy:
Inflation, rising interest rates, recession risks, they're all certainly key areas of focus across most sectors at present. But narrowing it to the technology sector, what are the main implications, Paul?
Paul Treiber:
Yeah, good question. So, for most of the technology companies, they sell to businesses, so small/medium businesses and enterprises. And so our view is that while some projects may be delayed in a recessionary environment, we believe that the net revenues for the majority of technology companies would be mostly resilient to recessionary slowdown. The challenge that many of the earlier stage and admittedly fastest growing technologies face is on the cost side. Many of these companies are burning cash or are unprofitable because there's a mentality of growth at all costs over the last several years. For many of these companies, they now need to tighten their belts and cut spending in areas that are the lowest priorities.
Paul Treiber:
And there's been several articles on high profile technology companies, even very large ones, like Google and Facebook, implementing hiring freezes. Smaller companies will need to reduce their cash burn, because at this point they can't rely on external financing through either new equity offerings this year or perhaps next year as well. So, the cash burn of many of these smaller rapidly growing companies, plus the potential of slower, though still positive growth, is leading to a significant risk-off sentiment for technology stocks at the moment.
Andre Hardy:
I hear what you're saying about the impact on valuations from interest rates, but I do want to delve further into your outlook for the resiliency of tech spending. Tech spending didn't look so resilient in the years following the dot-com boom. What's different now?
Paul Treiber:
Yeah, really good question, Andre. So, back in dot-com days, many companies were very early stage. In some cases, these companies didn't have revenues even. Many were just concept companies, and they didn't have the luxury of time to see many of these concepts to fruition. But ultimately, many of these concepts did emerge. Look at e-commerce, for example. Back in 1999, US e-commerce was only $150 billion market, or just 5% of retail sales. Last year in the US, e-commerce rose to $1.2 trillion, or almost 10 times the size, or the equivalent of 18% of retail sales. Another fundamental difference is the nature of revenue. So, back in the early 2000s and late nineties, the majority technology was sold on a one time basis. So, hardware and software were purchased outright and the buyer managed it themselves.
Paul Treiber:
Often, the replacement cycle was several years, so sales were quite cyclical. In comparison, the majority of software deployments are now hosted in the cloud and sold on a SaaS basis. SaaS stands for software as a service, and buyers sign a contract and pay on a monthly basis to use the software, much like a cellphone. While the upfront revenue to vendors is less on this model, it provides a steady stream of cash flows while the customer’s using the software. So, the break-even is typically three years. However, unlike the old model, this model greatly reduces cyclicality and smooths revenue over multiple years. Now, you might ask, well, what if customers cancel the contracts and leave? Well, that is always a potential risk. I think that's partly what the market fears here. If the economy gets really bad, it's not just say growth slows, but that customers may leave outright, or perhaps even go bankrupt.
Paul Treiber:
Our view is that is a potential risk, but I think the reality is that the risk is relatively low. So inherently, software is quite sticky after you deploy it. Companies deploy software to address a specific business process. It is more cost efficient and effective to address business processes using software than using manual processes. So realistically, unless companies go bankrupt, we think that they are unlikely to stop using software that they have already deployed.
Andre Hardy:
Well, those are pretty important differences. Thanks for going through that. I do want to switch gears a little bit. And perhaps if we focus on the Canadian technology sector specifically, where do you see Canada in the global tech ecosystem?
Paul Treiber:
Yeah, it's interesting. The technology in Canada has always been very idiosyncratic. We've had three very large technology companies in Canada over the last 20, 30 years. That's Nortel, BlackBerry, and Shopify. However, probably one of the bigger changes is that we've had hundreds and perhaps thousands of smaller technology companies, and probably more so in recent years. In many cases, these smaller companies were innovative, but had difficulty scaling, and part of that reflects the risk adverse mentality of Canadians. We tend to focus on profitability, as opposed to making big, perhaps riskier bets. So as a result, we end up with far fewer large companies than what you see perhaps in the US. However, what's interesting is that it seems we're getting better each generation. We're seeing more and more Canadian tech companies. And part of that reflects the increasing size of global tech markets, but also the fact now that you don't need a lot of scale to start a software or a cloud company.
Andre Hardy:
You mentioned BlackBerry. That's a company that you covered through significant changes in its business strategy and in the relative popularity of its devices. What can we learn about the evolution of the industry from looking at the BlackBerry story?
Paul Treiber:
Yeah, we think BlackBerry is a great example, and it really illustrates how the market has changed over time. So, BlackBerry was, when it started, predominantly a hardware company called RIM, or Research in Motion, and it sold smartphones. As everyone knows, you own a phone for two or three years, and then you buy a new one. Now, there were some aspects of BlackBerry that were somewhat sticky, like BBM or BlackBerry Messenger, but overall in that era, there was very low switching costs. You can switch from one phone to another phone, and there wasn't an ecosystem where customers were locked into the device. So when something better came along, when another device was better than a BlackBerry, customers switched. Now, what's interesting is that the downfall of BlackBerry from the rise of the iPhone is completely aligned with the philosophy of one of the books and authors, Clayton Christensen’s book, Innovator's Dilemma.
Paul Treiber:
So, what happened to BlackBerry was, it was listening to its customers at the time, who were predominantly the telcos and enterprises. Carriers wanted an anti-iPhone, something that was light on the network. Enterprises wanted a long battery life and security. And at that time, the iPhone was a complete opposite. So, BlackBerry was giving the customers, the telcos and the enterprises, exactly what they wanted. Now, in terms of execution, because BlackBerry felt that it was differentiated, it never tried to match the innovations of the iPhone until it was too late. Also, at the same time, bring your own device really impacted the usage of BlackBerry among many enterprises and professional consumers. So, execution was incredibly important for the rise of the iPhone and the downfall of BlackBerry. Execution also explains the success of Android, which did capture a lot of share along with the iPhone.
Paul Treiber:
So when iPhone was launched, Android was actually emulating the design of BlackBerry, but Android very quickly pivoted to touch screens to match the iPhone. As a result, iPhone and Android now dominate the smartphone market. What's even more interesting, we think, is that BlackBerry still exists today as a software company. The market structure for software is far more attractive than hardware. So with enterprise software, customers switch far less frequently, and so Blackberry had time to pivot its business to support multiple devices, and this really illustrates the attractiveness of software as a business model that I described earlier.
Andre Hardy:
Interesting. Now, shifting gears again, COVID has been a tremendous accelerator for the adoption of new technologies in Canada and globally. Now, do you fear this was just a one off event due to unique circumstances?
Paul Treiber:
Definitely COVID was a driver of adoptions of all sorts of technologies. Video conferencing is the best way to address your question. Video conferencing has probably existed, in some form or another, for the last 20 years, but it was very difficult to use, so rarely anyone used it. Corporations had these special hundred thousand dollar video conferencing rooms, but they'd only communicate with other similar proprietary systems. And so it was fine within the same company, but you couldn't reach anyone outside that. In the year’s right before COVID, we began to see some innovations in video conferencing, like FaceTime for consumers, or Zoom for consumers and businesses. And what really helped Zoom here is that anyone could video conference with anyone else using a web browser. And then with COVID, usage skyrocketed. All in person meetings were basically canceled and had to switch to video conferencing, and usage probably went from less than 1% to nearly a hundred percent of all meetings.
Paul Treiber:
Now, I think what's probably more important for adoption than the actual technology is that business practices changed. So, industry regulations were changed to accommodate video conferencing across multiple industries. Great example is doctor appointments were, during COVID, and it looks like it's even persisting, are now permitted to be conducted virtually. So, addressing your question, will that remain permanent going forward? In some cases, I can see businesses and others moving back to in-person meetings. We, as humans, long for personal relationships and are admittedly difficult to establish through virtual means, however, for many other meetings where there's logistical challenges or where relationships have already been established, video conferencing will persist. Will usage remain at a hundred percent? Probably not. However, it's likely to remain a key communication means for many people. The efficiency gains from video conferencing are just too great to ignore, and the business practices are already now in place.
Andre Hardy:
So, video conferencing is a good example where usage went to nearly a hundred percent during the peak of the COVID social distancing measures. What about other technologies where adoption increased, but usage is still well below a hundred percent? And how do you see the adoption of these technologies progressing?
Paul Treiber:
There are two great examples of what you describe. The first is eCommerce, and the second is the cloud. Let's start first with eCommerce. In the last several years ahead of COVID, eCommerce penetration in the US was growing at about a hundred basis points per annum. In 1999, eCommerce penetration was 14% of total retail sales in the US. It jumped to 18% in 2020 and 2021. So, it was basically four years of penetration in a single year. Now, does it go back to our lower level of penetration? We believe that's unlikely. You look at the June quarter, the data this year, US e-commerce sales are up basically 9% year-over-year. Total retail sales are up about 8.5% year-over-year. So, even though there's a full quarter of reopening, e-commerce is still, one, increasing year over year, and two, growing slightly faster than retail sales, and that implies rising penetration. Why is that?
Paul Treiber:
I think it's so easy to buy online now. For me personally, I'm frankly just accustomed to buying things on my phone, and then waiting a day or two for them to show up at my front door. I find it much easier than going to a store. Now, it's not a hundred percent because there are always things that you need right away, and it's easier to go out to a store. In addition to changing behaviors, the other element is that e-commerce innovation continues. The ordering process now is far smoother. A good example of that is your credit card information is now saved. Shipping is generally pretty good in most regions, typically one to two days later. And then even things like returns, which have always been a struggle, are getting better. Additionally, when you look at e-commerce, it is really good at capturing conversions, and conversions is really important for digital advertising. You know what this is, is ads on Facebook and Instagram are really convincing and drive exposure to new brands. There's many of these out there, but the best examples are probably brands like Allbirds or Kylie Cosmetics.
Paul Treiber:
And it also has driving a number of impulse buys. Here's a question for you, Andre. Andre, have you ever purchased anything online as an impulse?
Andre Hardy:
The timing of that question is pretty funny. I had a quiet morning Saturday, and yes is the answer to your question. I just purchased golf shoes totally on an impulse just this Saturday morning.
Paul Treiber:
Yeah, so that's a great example. I mean, it's just another one of those things where you wouldn't think you'd be buying it a couple years ago online, but you now are. And this also leads into another conversation just on the emergence of new direct to consumer brands that have been largely enabled through e-commerce in online advertising. Anyhow, we think e-commerce is... Adoption is still very early. 18% penetration implies that there's a lot of retail sales that aren't made online, and we think there's good long term growth there. The second example that I mentioned is cloud software. This is referring to enterprise software that is deployed in the cloud. The vast majority of software that we use at... Using a large bank, for example, RBC, is on premise, meaning we're running it on a server, and then we access through our PCs or through a client. And this is what's called client server.
Paul Treiber:
This is... The technology has been deployed over the last 20, 30 years. We have a handful of applications that are entirely cloud based that we access through a web browser. In 2018, McKinsey wrote a report that indicated that just 40% of companies have moved more than 10% of their workloads to the public cloud, and 80% planned to move more than 10% over the next three years. Now through COVID, cloud adoption has increased, and the reason is that obviously accessing the software through web browser is much easier, or it's a necessity, when you're working remotely. According to McKinsey, again, in a 2021 survey, 65% of surveyed organizations increased cloud budgets through COVID, and 55% moved more workloads to the cloud than they initially planned.
Paul Treiber:
Additionally, 40% of companies expect to increase their pace of deployments going forward. By 2024, surveyed respondents aspire to have cloud spend account for 80% of their total hosting costs. And for the cloud, the benefits are usability and lower costs. And the cloud is very easy to deploy, and probably more importantly, to scale. Organizations don't need to worry about managing hardware and the infrastructure like they did in the past with servers that they did in house. Additionally, it is very easy to support a diverse and virtual workforce using cloud software. So, adoption is likely to continue to rise going forward.
Andre Hardy:
We spent a lot of time discussing specific trends that were accelerated through COVID. If we take a step back and try to forget about COVID, which obviously is impossible to do, but if we try to do that, from a high level, what are the drivers for continued technology adoption over the long term? And what gives you confidence in that outlook?
Paul Treiber:
Yeah, this is a great question. I'd say, first, look at the historical trends. So since 1980, US GDP has increased 5% per annum on average. In comparison, US investment in intellectual property, and that includes technology, rose 6% per annum over the same timeframe. So, technology spending is growing faster than the broader economy. Technology investments have increased from 2% of US GDP in 1980 to 5% last year. Now, the fundamental driver of technology spending is productivity. Organizations deploy technology to enable improved productivity. ERP systems, for example, automate the recording of transactions and accounting related to that. Now, you could say that some forms of technology don't drive productivity improvements, something like a smartphone. However, I think the opposite is the case. Consumers are far more in touch and effectively productive using a smartphone.
Paul Treiber:
Checking Instagram, for example, is far easier using an app on your phone than sitting down at a computer. You get a notification immediately if something changes. That ease of use ultimately has resulted in far increased usage, which implies better productivity. However, it does admittedly consume a lot of time for some people. And for some organizations, smartphones have improved productivity, even more so when companies have cloud applications where employees can access through apps on their phones. Another driver is digital transformation. The vast majority of companies have not made meaningful investments in transforming their fundamental business processes. For example, when you look at automotive, Tesla's ordering process is entirely through the cloud. The initial car purchase is through the cloud, or you're using a web browser.
Paul Treiber:
The deposit is made on a website using a credit card. When the final payment happens, it happens through a wire transfer at a bank, and that is effectively in the cloud from Tesla's point of view. In comparison, using another example, looking at signing up for a credit card or completing a mortgage application, or even making that wire transfer for a car, that, for the most part, it's done in person at banks across Canada. So, you can say that technology usage and deployment is still early stages for the vast majority of companies. When you look at the driver of that, technology is driven by new entrants. So, the ease of use due to technology ultimately becomes industry standard. The laggards in the industry either catch up or they lose share. This is what gives rise to the expression, "Software is eating the world." Technology, or effectively software, disrupt and improve industries for the better.
Paul Treiber:
And this is ultimately what gives us confidence in long term technology adoption. Market forces will continue to drive the adoption of new technologies from a competitive or a cost point of view. It has happened in the past, and we think there's a long way for future adoption.
Andre Hardy:
You have a unique perspective where you get to see fairly early, or get an early heads up on a lot of technologies that are being developed. So, right now, what new technologies are getting you excited? What's on the bleeding edge of technology adoption right now?
Paul Treiber:
Yeah, I would say I wouldn't be a technology analyst if I didn't mention blockchain. So, we think blockchain is searching for its soul somewhat. It needs a killer use case. Bitcoin and the various digital currencies out there have their fans, but it's a little bit outside of my realm in terms of thinking about enterprises deploying software. I do think though an interesting use case for blockchain, and also NFTs, is something called token-gated commerce. And this is where an organization can sell special access through a token, but because it is a token, a secondary market can emerge. We think this is a really interesting opportunity. And the best example or use case I can think currently is the secondary market for the right to become a season ticket holder. In that case, you are reliant on a third party validating that you indeed are buying or selling a right that is legitimate.
Paul Treiber:
However, season tickets are well established and there's a fairly large secondary market. But hypothetically, with token-gated commerce, a secondary market could emerge for all sorts of memberships. Additionally, I think another interesting possibility is the metaverse. I think it's still a ways out there, but it's possible that people could engage in a completely alternative reality. And you see it somewhat with various video games that are out there. You can also say that TikTok or social media is also an alternative reality. Now for the metaverse, it's still very early. We think we need to see more enabling hardware technologies, like augmented reality or virtual reality. And that's somewhat similar to smartphones. Smartphones existed for 10 years before the iPhone came around, but it was really the iPhone and multitouch that led to mass market adoption. So, if everyone starts using the metaverse, you get the enabling technology. At a certain point in the future, you could see commercialization and monetization within the metaverse.
Andre Hardy:
Well, Paul, that was a really interesting discussion. I like how you highlighted how we're still early in the adoption of many technologies and why technology could play an increasingly larger role in the Canadian public markets in the future. So, thank you very much for your insight into how the significant structural changes in the sector are impacting us. What else lies ahead in today's ever evolving markets and industries? We'll be keeping track right here on Industries in Motion. Until then, thank you for joining us on this episode recorded on July 25th, 2022. And please make sure you subscribe to Industries in Motion wherever you listen to your podcasts. If you'd like to continue this conversation or you're interested in more information, please contact your RBC representative directly, or visit our website at www.rbccm.com/industriesinmotion. Thank you very much.
Speaker 3:
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