WAAAX on WAAAX off
WiseTech, Appen, Afterpay, Altium and Xero (WAAAX) are up just over five-fold over the last two years, pushing the aggregate market cap to over $28 billion. Some of the valuation metrics are now laughable. However... the same thing was also true two years ago before this rally commenced. So where to next? Should it be WAAAX on... or WAAAX off?
With Mr Miyagi out of town, we reached out to the experts at Wilson Asset Management, Investors Mutual and CFSGAM to help answer one of the market's most burning questions. We asked them for their overall view of this basket of stocks, what investors on the other side of the trade are failing to appreciate, and finally for their bull or bear thesis for their pick (or picks) of the bunch.
Read on for their views on some of the most divisive stocks on the ASX.
Valuations have completely lost touch with fundamentals
IT stocks have performed well in sharemarkets around the world, including Australia, led mainly by the US Nasdaq, which has continued to reach new records for much of the past five years.
The US technology sector has been led by what are commonly called the FAANG group of stocks – an acronym for Facebook, Apple, Amazon, Netflix and Google. In the main, these five stocks are hugely profitable, cashed-up, global technology leaders. Other well-established, very profitable, US-listed global tech leaders such as Microsoft, IBM, Cisco Systems, Oracle and Intel.
The Australian technology sector has also performed well in the past year or two, although the truth is that the choice of good quality technology stocks is extremely limited – in fact, it is fair to say that the majority of the larger IT stocks in Australia are very risky propositions, either because they are currently barely profitable or loss-making or because their business models remain largely unproven.
If we look at the profitability of what are now referred to in Australia as the WAAAX stocks (WiseTech, Appen, Afterpay, Altium and Xero), you will see from the table below that not all of the companies are profitable and that they are trading at what we see as extremely high multiples.
Source: FactSet, IML; As at 31 May 2019 *Adjusted for Dec yr-end ^Mar-19 yr-end
We look for a number of characteristics in any stock that goes into an IML portfolio -- characteristics including competitive advantage, recurring earnings, and quality at a reasonable price.
In our view, the WAAAX group valuations have completely lost touch with fundamentals to the point where recent earnings downgrades for WiseTech (WTC), Afterpay (APT) and Appen (APX) appear to have been rewarded with rising share prices instead of a correction to already elevated share prices.
Amongst the WAAAX stocks above are three software players, in particular Altium (ALU), WiseTech and Xero (XRO), and they all trade at significant premiums to global peers.
If we look at WiseTech, we see no compelling reason why a mid-sized company in a relatively niche market with slowing organic growth should be significantly more expensive than much larger ‘category killers’, such as Salesforce (CRM) or ServiceNow (NOW), which are growing organically at a faster pace in much larger markets.
Australian high-growth stocks the most overvalued in the world
As a basket, WiseTech, Appen, Afterpay, Altium and Xero have increased 401% in price over the last two years, and yet only comprises 3.0% of the S&P/ASX All Ordinaries Accumulation Index. In comparison, the FANGs (Facebook, Apple, Netflix and Alphabet owned Google) are up just 39% but comprise more than 20% of the S&P 500 Index.
We have actively traded the WAAAX stocks during their surge, but collectively their valuations are now starting to look stretched. As a result, we have selectively reduced our exposure to the technology sector over the last two months.
Australian high-growth stocks, which the WAAAX stocks are a part of, are now the most overvalued in the world. High-growth stocks are on average trading at a forward price-to-earnings ratio of 38.9x, which is now 65% above the global average, and 25% above the US, the second most expensive growth market.
Australia has the most expensive growth stocks
Assess each stock on its own merits
Many of Australia’s listed technology companies including WiseTech Global, Afterpay Touch Group, Altium Limited, Appen and Xero have seen significant share price performance in recent years, with many investors suggesting that perhaps their valuations have been running ahead of business fundamentals.
For others, these stocks offer significant revenue and profit growth for years to come and may therefore still look attractive.
For us, our disciplined bottom-up process leads us to assess each WAAAX stock on its individual merits.
While most WAAAX stocks have some attractive characteristics, we don’t consider every WAAAX stock an attractive investment. We have invested in the WAAAX companies with long term competitive advantages, sustainable and predictable earnings, excellent management and strong free cash generation.
We take a long term view on value creation, seeking companies that have a disciplined growth strategy and a laser-like focus on their core market. Our process gives us the opportunity to look past the short term valuation metrics if we can have confidence a business has the platform and management team to create a more valuable business on a medium and long term basis.
What we are looking to identify, is a business that might look expensive on short term valuation metrics (like a one year forward PE multiple) but offer value in 3 to 5 years on the back of strong compound revenue and profit growth.
WAAAX stocks susceptible to falls
Martin Hickson, Wilson Asset Management
Each of the stocks in the WAAAX set has been incredibly successful with solid management teams and strong growth. In our view, however, their valuations are now capitalising much of the potential future growth. They are therefore susceptible to large share price falls should another period of volatility return.
In the September to December period when global equity markets experienced high levels of volatility, the WAAAX stocks as a group fell by 26.5%. If we were to experience a similar situation, in our opinion this sector is again likely to underperform the market.
Four out of five of the WAAAX stocks are in the S&P/ASX Small Ordinaries Industrials Index and represent 145% of the movement in the Index this financial year to date.
Therefore fund managers who have avoided these stocks or have been underweight are likely to have struggled to perform over the last 12 months, but will likely experience a better period during any equity market instability.
Performance of high-growth stocks over the last 12 months
Don’t overlook the importance of compound profit growth
Dawn Kanelleas and Michael Joukhador, CFSGAM
While high performance, high growth stocks are attractive to investors, the large multiples these names trade on can be unappetising. We believe investors often fail to appreciate the ability of an exceptional business run by exceptional people to continue to create long term value. Companies that are the market leaders within a sector can often leverage that market leadership, strong free cash flow, strong intellectual property (including staff) and pricing power to further grow market share. Operating leverage (and therefore profit margins) as revenues grow can often be underestimated.
In our view, the market can often overlook the importance of compound profit growth and how quickly the compounding of growth can lead to a change in company valuation metrics. To demonstrate, it’s worth observing that a company that can grow its earnings at a compound rate at 20% for 6 years will be 300% more profitable at the end of that period. If that same company was trading on a PE of 30 today, at year 6 it would be trading on a PE of 10.
Of course, growth is often not free and comes with risk and also often requires significant capital deployment. For all of the upside, there is significant downside for investors if these companies fail to execute.
It’s, for this reason, we continue to stress the importance of a disciplined investment process that carefully assesses risk. The objective is to identify those few great companies that offer the predictable long-term growth that can justify the short term valuation measures.
‘Total addressable markets’ seem to get bigger at every presentation
Lucas Goode, Investors Mutual
While the Nasdaq has continued to reach record highs, there are some clear signs that the market is reaching euphoric levels, particularly when it comes to many of the more speculative parts.
To illustrate, the chart below shows the percentage of new listings on the US market over a number of years. One can see that the percentage of US IPOs - which are mainly technology companies - being listed with negative earnings is now at over 80% - a level not seen since 2000 – just before the last tech ‘crash’ in 2001.
As mentioned at the start of this article, while the US has some great technology companies, the positive sentiment around these companies is now spilling over into a frenzy of floats of many loss-making tech companies at valuations that are very hard to justify. It is also our view that this euphoria is largely the reason many Australian-listed IT stocks are trading at grossly overvalued levels.
Looking specifically at the WAAAX stocks as a group, they are being valued on very subjective – and in our view often fantastical – total addressable market (TAM) sizes (the maximum market a company could capture) in lieu of traditional growth metrics. In some cases, the TAMs seem to get bigger with every presentation that we attend.
For example, Afterpay (APT) has a great consumer product and has had phenomenal top-line growth but it appears to us that there are no real barriers to entry, other than brand recognition, in terms of replicating what APT has done. In our view, if new entrants come in and offer retailers’ fees below those of APT, there is every chance that APT face a choice between losing merchants or thinner margins. This compares with the hockey stick margin expansion in outer years that seems to be factored into the company’s current share price.
Looking briefly at Appen (APX), while the company is positively exposed to the growth in investment into machine learning and artificial intelligence (AI), it is effectively a labour-hire business. There is very little revenue visibility and APX is heavily reliant on a small number of large customers, all of whom could probably bring the data-crunching that APX does in-house if they chose to do so.
While many remain excited about the company’s prospects, APX’s lack of recurring revenue and poor visibility is an issue for us. Despite the growth, we struggle to see Appen as a high-quality business and are unable to justify the current valuation of more than $3 billion.
Despite the shortcomings of many of these companies, the PEs of the WAAAX stocks have expanded dramatically over the last couple of years – as shown in the chart below:
Source: FactSet, Note: XRO has been lossmaking since IPO and thus has not been included in this chart.
While it is clear that many investors are extremely excited about the IT sector’s prospects, they are failing to recognise, in our view, the sector’s very high risks. The WAAAX stocks are trading on lofty valuations as many investors and speculators incorporate a great deal of blue-sky potential into their share prices.
The case for Altium and Xero
Dawn Kanelleas and Michael Joukhador, CFSGAM:
Two high-performance growth stocks that we have identified as having long term competitive advantages, sustainable and predictable earnings, excellent management and predictable cash generation include Altium and Xero.
We believe Altium, the world leader in software that designs circuit boards, has an exceptional management team and a laser-like focus on its core market. There are very few businesses as well positioned to benefit from the explosion of growth in connected devices and artificial intelligence as Altium. For every traditional device that is redesigned to talk to other devices – and for every new device brought to market – there sits an engineer heavily reliant on Altium (or competing software).
We like Altium because:
- It has quietly grown to become the market leader in the space and continues to drive significant market share gains.
- It has leveraged its strong market share and strong free cash flow into product development to drive further share gains and price growth.
- It has demonstrated a disciplined approach to investment to deliver excellent margin growth (highlighting the available operating margin as the revenue increases).
The first half result, as a good example, demonstrated 24% revenue growth, margin expansion and 58% profit growth. While many investors would baulk at the PE multiple, we have been able to look through this short term valuation measure and focus on the significant value creation opportunity for the business over the coming 3 to 5 years.
June year end. Source: CFSGAM. Forecast data as at 4 June 2019. Shown in AUD terms.
We hold a long term position in cloud-based accounting software provider Xero because they offer a strong management team prepared to invest for the long term.
The business has built a globally scalable software that is the most compelling offering in the markets in which it operates. Xero is in the enviable position of being able to leverage a recurring revenue base to cement its competitive advantage by driving investment in product development harder every year.
We would expect the Xero software suite to evolve over coming years to take full advantage of the Artificial Intelligence and Data Analytic macro trends. As an open platform, it will be also be able to leverage third party applications to cement its competitive advantage. While it is very difficult to specifically articulate how and when such products might be commercialised. What we can do is identify the fact that Xero have the platform, the management and the vision to crystallise the available opportunity as it presents itself.
March year end. Source: Factset consensus. Forecast data as at 4 June 2019. Shown in AUD terms.
Xero is in an excellent positon to offer investors both free cash flow generation and continued strong double digit revenue growth across the globe. The total addressable market is significant and good execution offers investors significantly larger margins and profit over the longer term. By example, Xero leveraged what started out as an ANZ business into the UK. It is now the dominant accounting platform in the UK (a market 3 times larger than the ANZ) and has delivered 48% subscriber growth over the last 6 months. Once again, focusing on short term valuation measures can distract from the significant value creation opportunity ahead for the business.
The case for Afterpay and Appen
Martin Hickson, Wilson Asset Management
Our catalyst to invest in Afterpay Touch Group Limited (ASX: APT) came from the strong momentum the business was having in signing new clients in the United States, with a number of large retailers such as Steve Madden and Urban Outfitters publically endorsing APT.
We believe Afterpay will likely continue to sign large marque brands and successfully penetrate the US market. A key risk we are watching closely would be the potential of Australia and the United States experiencing a significant bad debt cycle, which Afterpay’s model has yet to encounter.
We first invested in Appen (ASX: APX) due to continued strong demand from its large customers, a belief that a weaker AUD would be supportive of earnings and that the outperformance of its Leapforce acquisition would drive increased profitability.
The company delivered its full year results in February, exceeding expectations with revenue of $364 million and underlying earnings before interest, tax, depreciation and amortization (EBITDA) of $71 million, up 119% and 153% respectively, on the prior corresponding period.
They are currently generating five times the revenue from the customers they acquired four years ago, and so as they continuously keep adding new customers their revenue should continue to grow exponentially over the coming years.
Why we are a bear on WiseTech (WTC) over the next 3-5 years
Lucas Goode, Investors Mutual
WiseTech is a 25-year-old company that has been profitable for several years thanks to its CargoWise One software system and its predecessors. Given that WTC has been around a while, its current PE of well over 100x seems to us to have little basis other than “it’s a tech stock”.
WiseTech listed in 2016 with a market capitalisation of $1 billion – this in itself looked fairly hefty at the time, given the company was projecting sales of $135 million and earnings before interest, tax, depreciation and amortisation (EBITDA) of $48 million.
Since its IPO, the organic growth of the company’s core Cargowise One software system has actually declined. However, investors appear to have become extremely excited thanks to the company’s ambition to become the world’s leading logistics software provider.
The company is attempting to do this through an aggressive acquisition programme. In fact, since 2016 the company has amazingly spent almost $600 million on an acquisition spree buying what appears to us more than 30 disparate businesses in 18 countries around the world - including places like Uruguay, Argentina, the Republic of Ireland and Taiwan. The strategy behind this seemingly limitless expansion is to look to establish an integrated global software package.
As anyone who has been involved with any IT systems integrations would know, integrating two software systems into one can often be an incredibly complicated task. The mind boggles with the integration issues the company is likely to face as it attempts to integrate 30 companies across almost 20 countries!
With the company now trading at well over 100x earnings, it appears to us that WTC investors are clearly convinced that management has the expertise to successfully extract synergies and blend a grab bag of rapidly acquired and far-flung businesses into a finely tuned global player.
In our opinion, WiseTech is not an investment for the faint-hearted and certainly does not come close to fulfilling our stock-selection criteria.
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