Morgans: Tech firms must be earners in high-rate times

Morgans says pressure mounting on tech companies to be cash earners rather than cash burners
Higher interest rates means less access to and higher costs of capital for growth companies
Morgans says investors should consider three factors when investing in a tech stock

As interest rates have risen in recent years, pressure has mounted for tech companies to transition from cash burning to earning with stockbroking and wealth-management firm Morgans saying investors should consider three key factors before investing in a tech stock.

Senior tech analyst Nick Harris says rising interest rates and changing monetary policy by major central banks globally have dramatically changed the landscape for tech companies, which can no longer afford to be staying in the red and be cash burners.

“If you look back a few years, interest rates around the world were at lifetime lows and according to some were going to stay that way for a long time,” he says.

“To give some context, cash rates were at less than 1% back then with 10-year averages closer to 2.5% and today we’re at closer to 4% if you’re looking at 10-year bonds, so there’s been massive movement in monetary policy.”

Time value of money

Harris says low interest rates have big implications for the time value of money and long-dated cash flows for tech and growth stocks, which often don’t generate positive cash flows right away.

To calculate their value, a method called net present value (NPV) is used, which calculates the current worth of future cash flows by discounting them with an interest rate.

“So if interest rates are higher, the NPV of a stock decreases,” he says.

“This means the stock is valued lower because higher interest rates reduce the present value of future cash flows.

“The longer the time to cash flow is, the smaller NPV (or share price) will be and vice versa if interest rates were lower.”

Harris says it all comes back to simple mathematics and if nothing else changes and interest rates go down then the value of future cash flow goes up.

“Theoretically if cash rates lowered by half a percent you might see the value of these cash flows lift by as much as 10% in today’s dollars, so a small change to interest rates can have a big impact on value,” he says.

“When long-term rates were closer to 2.5% and they dropped back to half a percent a few years ago that is what drove those valuations dramatically, sometimes the values of those cash flows mathematically went up 50% because rates were so low.

“Now there is no access to cheap equity and we’re a little more risk averse with people moving to some extent back to bonds and cash so the cost of equity and funding has become more expensive.”

Higher interest rates equals less investors

Harris says the importance of getting from cash burn to cash earn comes back down to the access to capital for tech companies.

He says lower interest rates forced many investors to seek out riskier assets like equity markets, which in turn pushed valuations higher.

“Equity markets are typically considered higher risk so with more capital there was what we term a risk-on trade, which made it easier to raise capital because investors are valuing large future profits at a lot more than small, shorter term profits,” he says.

“The value of a big cashflow in the future was a lot more in a low interest rate environment.”

Harris says in a higher interest rate environment tech companies aim to generate capital, profits and grow organically rather than have to raise capital at very expensive prices.

“A lot of founders don’t want to give away lots of stock in their companies because it’s suddenly very expensive, so if you’re going to fund your business you want to fund it organically,” he says.

“Equity markets can also be pretty brutal so if it’s known you need to raise capital, the share price goes down ahead of the raise because it’s expected to be at a discount so it’s a difficult cycle.”

Three things to look for in a tech stock

1. Value to customer base

Harris says when investing in a tech company it’s important to consider the value they’re adding to their customers.

“The first step is determining if a product adds value to the customer so they want to use the company more,” he says.

“If they’re adding value and there is a big runway for growth, they’re the two things you’re looking for in terms of product with a tech company,” he says.

“Some of the high-quality tech names have spent a lot of time and money building systems, processes and ultimately software that makes the end customer’s life easier and then if that happens they keep coming back, typically paying more.”

2. Capital structure to fund growth

Harris says the second part investors should consider when investing in a tech company is its capital structure to fund growth.

He says investors should consider questions like at what rate can it grow? What do the valuations look like?

“There are many great businesses out there but that isn’t enough and buying them at a reasonable valuation matters,” he says.

“If you can buy them at a discount, that’s the perfect outcome, but typically just buying them at reasonable prices is a good place to start.”

However, Harris says with these great businesses, though, they tend to dictate much higher prices because they are so good.

“You’ve seen the pricing power of some of these tech names in the past 12-24 months where they’ve been able to raise prices quite considerably,” he says.

Harris says if a tech company – like any other business – isn’t adding value to their customer and was raising prices, often they’re likely to lose customers.

“In a perfect world we’d rather they add customers than raise prices but ultimately it’s a trade-off between those two things,” he says.

3. Net revenue retention and low customer churn

Harris says software as a service or SaaS companies often refer to net revenue retention (NRR).

“The ideal benchmark is 115% net-revenue retention so what that would mean in a perfect world is that each year your existing bunch of customers are paying you an extra 15% so say $1 year one, $1.15 year two, a bit over $1.30 year three,” he says.

“That is on a net basis so after losing customers as not everyone sticks around forever so if you have low customer churn it’s easier to grow net revenue quickly and if you have high customer churn you have to grow your gross revenue at a much higher rate to get the same numbers.”

He says with tech companies you aim for that 115% net revenue retention and you also want them to be adding new customers.

“The net revenue retention number shows you those existing customers are paying more each year so if you get a customer taking just one of your products, hopefully you can see over the next decade them buying more of your products to give you revenue growth as well,” he says.

Coming up: Morgans pick of ASX tech stocks going from cash burn to earn

The views, information, or opinions expressed in the interview in this article are solely those of the interviewee and do not represent the views of Stockhead. Stockhead has not provided, endorsed or otherwise assumed responsibility for any financial product advice contained in this article.