Cloud disruption, Cloudflare investor day, and growth stocks joining the value club

We’ve created a new Weekly Insights series where we share our latest thoughts on current themes and hot topics across the Industrial Technology landscape. This week we focus on cloud disruption, Cloudflare investor day, growth stocks trading below BV, inflation and noteworthy earnings reports.

CONTENTS

Stocks and Focus Areas

  • Cloud disruption and Cloudflare Investor Day
  • Growth stocks are joining the value club

Macro Datapoints

  • Inflation may have peaked but commodities continue to put upward pressure
  • Panic selling creates set-up for upside earnings surprises and short squeezes

STOCKS AND FOCUS AREAS

Cloudflare investor day — innovators getting disrupted

We attended Cloudflare investor day where the company outlined several initiatives aimed at disrupting traditional cloud vendors (e.g., AWS), and compete with innovative cybersecurity companies (e.g., Zscaler).

As background, Cloudflare is a leading content delivery network (CDN) and DDoS mitigation company (acts as a reverse proxy between a website’s visitor and the customer’s hosting provider). The company has built a network of 270 points of presence (POPs) across more than 100 countries globally offering a low-latency edge network, connecting thousands of globally-disbursed servers across these POPs into a single, unified network that intelligently routes traffic. Cloudflare operates at a massive scale with 4 million non-paying customers and 132,000 paying customer.

The unique aspect of Cloudflare’s story is that this massive network can be used to continue to add new products that make use of the same infrastructure without having to add meaningful incremental cost. As an example, Cloudflare has been successfully expending in Zero Trust cybersecurity services (essentially copying Zscaler’s business model), and more recently introduced products that are going after the cloud vendors (AWS, Azure, GCP) and attack their pricing (e.g., data egress).

Data egress fees are charges that customers need to pay for taking their data out of the cloud and are one of the cloud’s biggest hidden costs, costing enterprises and small businesses thousands of dollars per year. The reason why Cloudflare can offer this service for free is because the company already has excess capacity on its servers. The company uses existing capacity depending on where there is excess, vs. with a traditional cloud vendor (e.g., AWS) customers rent a server that will be always there for them. At the investor day, Cloudflare announced a full offering of Compute + Object Storage (R2) available in open beta + SQL Database (D1) beta test June 2022. While these products are in the early innings we are paying close attention to the developments.

Growth stocks are joining the value club

As we are approaching new lows we have noted some valuation support for companies trading close to Book Value. While there are no guarantees of a floor and stocks can trade at a discount to BV for an extended period of time, growth stocks trading at cash and/or BV is a noteworthy topic.

Typical profile of these companies is: (1) pre-revenue or small revenue bases, (2) no proven business model or unit economics (3) large cash balance on their BS from a capital raise at an insane valuations.

The risk: there is no guarantee that investors will see the cash from the balance sheet as the company will continue to invest it in the business (i.e “burn money”).

Examples include Rivian ($16bn of cash vs. $24bn market cap), Plug Power ($4bn of cash vs. $8.7bn market cap) and Joby Aviation ($1.2bn vs. market cap $3.2bn).

MACRO DATAPOINTS

Inflation was the big topic last week with April CPI at 8.3% and core CPI (ex. food and energy) at 6.5%. While this was lower compared to last month, both core and total inflation remain at historic highs.

Investors have been focused on the Fed and the potential to now have to raise rates even further, but we are missing the fact that the most inflation categories that surprised to the upside were due to elevated commodity prices.

Even for categories within core inflation (ex food and energy), commodities were the underlying driver for the price increases (e.g. airline fares increased by a record 18.6% reflecting higher jet fuel pricing). We believe this is important to note as more aggressive Fed will not necessarily alleviate commodity driven inflation, especially in the near-term. In fact, oil prices could further accelerate in 2H22 as the impact of the incremental oil from US Strategic Petroleum Reserved dissipates.

Moreover, market volatility and rates uncertainty may have the opposite effect as companies are starting to re-evaluate capex investment decisions (reported by several industrial companies). Limited incremental supply means commodity prices stay higher for longer.

Consequently, our base case assumption is steady rate increases and 10Y ~3%. But headlines continue to be volatile and we believe it will be very difficult for investors to get comfortable with growth stocks on a sustainable basis until there is some more clarity on the appropriate assumptions.

In last weeks Weekly Insights we talked about increasing correlations and potential for peak panic selling. During the week there we several large hedge fund liquidations that resulted in outsized idiosyncratic moves to the downside in many stocks (that coincided with the reported holdings of these funds). We had several holdings that had 3 consecutive days of -10% moves with no stock specific news. As stocks approached over-sold levels, the set up on earnings changed to “squeezes on in-line earnings” from “sharp sell-offs on inline earnings”.

Earnings highlights:

  • Earnings squeeze’s from Thursday/Friday with stocks up >20%+ (non-exhaustive list based on companies we follow)
  • Roblox — revenue of $537mn (+39% y/y) missed the Street by 5%. Adj. EBITDA of ~$68mn missed the Street’s by >30%. RBLX up 45% from lows
  • Rivian — inline earnings; reaffirmed 2022 production guidance of 25K, Adj. EBITDA -$4.75B & capex of $2.6B. RIVN up 35% from lows
  • Unity — brought guidance down early in the week based on a company specific hiccup. U up 35% from lows
  • Many more: Cloudflare, Upstart, SoFi, RobinHood etc.

Short squeezes and peak panic selling do not necessarily mean that we are out of the woods. In fact the average decline for the Nasdaq over the past 15+ bear markets was 35% vs. thus far the Nasdaq is down 30%.

On the flip side, these pull backs offer many opportunities to acquire technology leaders at discounted prices as during sell-offs the market doesn’t distinguish between good companies and bad ones (trading is mostly based on factors rather than fundamentals).

For more research visit out website spear-invest.com

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