Inflation and favorable setup for industrial technology in 2H22, earnings from Nvidia, Micron, Datadog, Cloudflare and more

IIn this Weekly Insights, we provide thoughts on inflation and the favorable setup for industrial technology in 2H22, as well as earnings for key companies in our coverage universe.

macro backdrop

Low gains, but in the rearview mirror

  • Low earnings of semiconductors (Nvidia, Micron); relatively better business software (Datadog, Cloudflare)
  • Customer quality is paramount – focus on Cloudflare

MACRO-CONTEXT

Implementation favorable to industrial technology in 2 hours

Consumer prices (CPI) rose 8.5% year-on-year in July, compared to 9.1% in June. Although this was better than expected and consequently caused a favorable stock market reaction, we warn investors that inflation could stay higher for longer as progress has been very limited in reducing structural inflation. .

The drivers of lower inflation in July were energy prices (down 4.6% m/m), while food prices were still up 1% m/m (10 .9% YoY) and Housing up 0.5% YoY (5.7% YoY), both very sticky categories. It is important for investors to keep in mind that the decline in fuels (commodities in the broad sense) is caused by the “self-induced” recession that occurred when interest rates (10-year ) reached 3.5%. If the economy recovers, this decline could be short-lived.

However, before getting too negative, it’s important to bear in mind that companies in our hedging universe are already pricing in a 3.5%+ risk-free rate, around 100bp higher than the 10 years from today. With inflation below expectations and the Fed moving away from previously aggressive inflation-fighting language (see our report last week), rates significantly above these levels are not an option (at least for now). We estimate that every 100 basis point drop in the discount rate generates around a 20% rise in valuation, which is why equities are easily able to weather weak earnings reports in the current environment. .

Additionally, while we expect commodity inflation to be volatile, wage inflation is here to stay out of a deep recession. We believe that improving productivity is the only sustainable way to fight core inflation. Although this is a longer-term thesis, businesses are undergoing a digital transformation with areas such as cloud spend, vertical and horizontal enterprise software seeing strong growth in their turnover (20-30% +) despite a difficult macro.

In summary, while we expect more volatility as July’s positive inflation report may only provide temporary relief, there have only been 5-6 investment opportunities like this. over the past century, let alone for tech stocks. Despite the recent price decline, many high-quality industrial technology companies continue to generate positive FCF and have stock prices down more than 40% year-to-date.

There have been very few positive surprises this earnings season, except for stock price reactions. The spectrum within industrial tech has been relatively broad with semiconductors, which are the most cyclical and economically sensitive, surprising significantly on the downside (stock prices are only down ~MSD% ); and enterprise software (cloud, cybersecurity), the strongest, which aligns with the best (stock prices up 20-30%).

Weak semiconductors compared to relatively better enterprise software

In the semis, Nvidia revised its 2Q22 revenue outlook to $6.7 billion (from $8.1 billion), down 19% year-on-year and up 3% year-on-year. This is a significant reduction, but the stock was only down about 6% at the time of the announcement. Gaming was the main driver of the decline, down 44% QoQ (vs. a 15% decline). Data center, which is now the largest segment, was up 1% year-on-year, although below expectations, with an increase of 6%. Automotive (a relatively smaller segment) did well – up 59% qoq (more on Nvidia’s long-term opportunity in autonomous driving here).

Micron, pre-announced negatively, is now at the lower end of the disappointing guidance range provided only about 6 weeks ago (revenues of $7.2 billion ± $400 million; -17% YoY and – 13% YoY at the midpoint). The stock fell

Enterprise software revenue was relatively better, although guidance beats were hard to come by.

Datadog reported higher revenue with 74% year-over-year revenue growth (compared to expectations for the mid-1960s), but provided a weak forecast for the company’s revenue. financial year 22 only increased by +56 to 58% year-on-year. The company cited weak spending habits among some large customers, particularly in the consumer discretionary sector, leading to lower billings, a forward-looking indicator. Billings reached +47% y/y vs. +103% y/y in 1Q22. The stock traded down about 10% pre-market, but rallied on report day.

Cloudflare was one of the few companies that beat and grew, with revenue up 54% YoY (~3% above forecast) and billing growth of 57%. Management raised FY22 revenue guidance to $968-972 million (+47-48% year-over-year), up from the previous range of $955-959 million. Management noted that although it was difficult to win new customers, the company was able to generate higher revenue from existing customers. The stock rose more than 25% on the report, which many investors found surprising. More thoughts below.

Focus on Cloudflare (NET)

We believe Cloudflare is one of the most misunderstood companies in our coverage universe and a battleground among investors.

As a backdrop, Cloudflare is a leading content delivery network (CDN) and DDoS mitigation company (acts as a reverse proxy between a website visitor and the customer’s hosting provider). The company has built a network of 270 points of presence (POPs) in more than 100 countries around the world, providing a low latency network. Cloudflare operates at scale with over 4 million non-paying customers and 151,000 paying customers.

Cloudflare has a unique business model where the core product is application services (CDN and DDoS mitigation), but the company can use its current infrastructure and customer base to expand into other areas such as Zero Trust and Services network (SD-WAN) and compete with leading providers such as Zscaler and Palo Alto Networks. While application services are a relatively mature market (and therefore many investors dismiss Cloudflare as an attractive investment opportunity), other areas such as Zero Trust and Network Services are high-growth end markets and Cloudflare is starting from a very small base with compelling products. . Therefore, each of the opportunities below can scale to a size similar to the company’s current market cap (~22 billion), if the products prove successful.

The most misunderstood part of Cloudflare is the quality and size of the company’s customer base. Cloudflare has millions of customers, including many small businesses and start-ups, but many of them are yet to pay customers. In addition, large customers represent only about 1-2% of total paying customers (1.7k out of 151,000 paying customers). The interesting angle is that although large paying customers are few in number, they generate more than 50% of the company’s revenue. Customer quality has become paramount throughout this downturn as many industries and start-ups have struggled. Further logo weakness is to be expected, but will only be implemented for easy comps as the market recovers next year.

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For more research, visit the spear-invest.com website.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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