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2 share ideas to pull through the tech sell off

Rising interest rates are bad news for tech stocks, but some are in a stronger position than others. Here are 2 share ideas that could pull through the tech sell off.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

2022 has been an unfriendly environment for most tech stocks. Pent up demand in a post-covid world and the war in Ukraine has pushed inflation over the top in lots of countries. Central banks have reacted with a sweep of measures to try and keep a lid on rising prices.

In the US, the Federal Reserve (Fed) has raised interest rates to a range of 0.75%-1.0%. It started the process of winding down bond-purchase programmes too, which are usually used to bring down interest rates across the market. It also signalled it intends to reduce the size of its debt, effectively selling bonds back to the market.

We’ve seen the Fed’s balance sheet soar as it tried to stimulate the economy following the financial crisis and pandemic. Buying bonds injects cash into the system and pushes bond yields down, a reversal of that approach has the opposite effect.

Why all shareholders should pay attention to the bond market

In short, reducing the balance sheet while raising interest rates mean future profits for companies are worth less. For tech stocks, that typically trade on high earnings multiples, that’s bad news.

Does this mark the end of tech though? While the dynamics have changed, we don’t think so.

Here’s a look at two companies swept up in the general tech sell-off, with the potential to push on over the long term.

Investing in individual companies isn’t right for everyone – it’s higher risk than investing in funds as your investment is dependent on the fate of that company. If the company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

This article isn’t personal advice. If you’re not sure whether an investment is right for you, seek advice. All investments, including the income from them, can fall as well as rise in value, so you could get back less than you invest.

Masters of Mergers & Acquisitions (M&A)

Semiconductor companies have seen their valuations fall around 20% so far this year. These companies make the electronic chips that allow everything from phones, cars, and washing machines to work.

Broadcom offers a slightly different avenue into the semi space, with a focus on less jazzy end markets that make our everyday lives tick over, like mobile phones and broadband. The diversified product range means the group isn’t as tied to the success of any one industry as some of its peers.

While we see the diverse footprint as a benefit, historically that’s meant earnings haven’t been quite as sought after compared to the sector. That trend’s reined in a touch this year though, as those on higher earnings multiples without the safety net of diversification, have felt a larger pinch.

Broadcom 12 Month Forward Price/Earnings vs Sector

Past performance isn’t a guide to the future. Source: Refinitiv Eikon, 30/05/22.

Aside from the chips it sells, there’s a bigger transformation underway. In 2017, chips made up 99% of the group’s revenue. That’s now 74%, as the group’s expanded into software with several high-profile acquisitions.

In recent weeks, a deal worth just shy of $70bn to acquire software giant VMware was announced. Once complete, revenue’s expected to be split evenly across the business segments.

Acquisitions have helped support steady margin and profit growth since the expansion into software in 2017. Gross margins currently sit just shy of 75% and operating profit’s grown at an annualised rate of 19% per year over that period.

Operating profit ($bn)

Source: Refinitiv Eikon, 30/05/2022. *2022 figure based on estimates provided by Refinitiv.

Expanding into new areas comes with lots of execution risk. But testament to management, they’ve picked good targets and integrated well. But the scale of the VMware deal comes with more risk.

And that brings us nicely on to the balance sheet, which will take on new debt to the tune of $32bn. At last check, it was already around the $30bn mark. That’s considerably higher than peers and highlights one of the main issues with an M&A led strategy, it’s expensive.

Yet, to the groups credit, they’ve shown an ability to quickly de-leverage following previous deals. Free cash flow in the second quarter came in at $4.2bn and VMware is something of a cash generating machine itself. That means there should be plenty in the tank to bring debt down.

With all the news on acquisitions, the chip businesses still needs to push on. This comes from creating new chips and requires large Research & Development (R&D) spending. It’s encouraging to see Broadcom continue to invest in building out the existing business – R&D as a portion of revenue came in at a healthy 17.7% last year.

The tech sell-off means the valuation’s more attractive than it has been for some time, trading on 15 times forward earnings. There’s a prospective dividend yield of 3.0% on offer and a fresh $10bn share buyback programme, following a strong second quarter. Yields are variable and are not a reliable indicator of future income.

Investors need to remember though, the VMware deal still needs to close and be smoothly integrated, both of which carry risk.

Into the clouds

Companies that provide the backbone for economies around the world are few and far between, Microsoft can confidently say it fits the bill. Yet, that doesn’t exclude it from the fate of tech businesses around the globe and its valuation has come under pressure this year.

Looking past external factors though, we think the underlying business is still a growth machine.

Year on Year % change

Source: Microsoft Financial Statement, third quarter 2022.

Since 2017, revenue and operating profit have grown at an impressive, annualised rate of 15% and 25%.

Profit outpacing revenue is the dream for any business, and that’s testament to the software heavy operating model. Each new customer costs very little, so a high proportion of revenue drops through to profit. That helps operating margins too, in at 43% over the first three quarters of 2022.

Cash generation is also monumental, to the order of $56bn last year and $20bn in the quarter just gone. That’s helped fund hefty buybacks. Since the start of 2012, the group’s returned just north of $270bn to shareholders.

It’s also helped offer a dividend, albeit only a 0.9% yield, though anything is rare for a tech giant. Remember, dividend yields are variable, and aren’t guaranteed.

Aside from traditional Microsoft products like Windows, Office and Xbox which remain core to the business, it’s cloud computing that gets the number one spot. Through Azure, Microsoft provides customers with computing power on a pay-as-you-go basis. And it’s been the standout performer since Microsoft started reporting cloud separately in 2015, with over $8bn operating profit in the recent quarter.

Annualised growth: 2015-2021

Past performance is not a guide to the future. Source: Refinitiv Eikon, 31/05/22.

As businesses look to upgrade their tech, increase automation, and cater for at home working, cloud computing is at the heart of it all. That’s a big opportunity and the total addressable market’s estimated to grow from $445bn in 2021 to just shy of $950bn by 2026.

Although, Microsoft’s not the only player and not even the biggest. Amazon leads the way with Google making strides, so competition to capture that growing market is fierce.

Aside from the cloud, Microsoft has its eyes set on expanding its gaming arm. The upcoming acquisition of Activision Blizzard for just shy of $70bn is a sign of intent. Adding Activations host of titles, like Call of Duty, to the existing Microsoft Game Pass is an easy win to boost sought after subscription revenue. There are also several cross-selling opportunities with Azure that the group aims to leverage moving forward.

Demand for Microsoft’s products have so far come relatively unscathed from rising prices. IT budgets and digital transformations often help businesses become more efficient, and so are unlikely to be on the chopping block.

Chinese lockdowns have been a bugbear on supply chains though, and that’s impacted the outlook for a range of products. News that restrictions are easing is welcome, though the pressures are likely to linger.

All in, Microsoft’s transformation into a digital business is yielding some strong results. The group currently trades on 25.6 times forward earnings, which is below the longer-term average, and at the lowest point since 2020. Though, wider economic factors could put more pressure on the valuation in the short term.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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