Investors were taken by surprise last week when the US consumer price index rose 5.4% year-over-year in June, the fastest pace seen since August 2008. On a monthly basis, it rose 0.9%. Excluding the volatile food and energy prices, while the Core Consumer Price Index rose 4.5% in June, this was the fastest pace since 1991.
Source: YCharts
There is an argument that the recent rise in inflation is temporary. One prime reason is attributed to the supply constraints due to the pandemic. The sudden rise in used cars and trucks accounted for a major portion of the inflation number, and this was mainly due to the global chip shortage, which reduced the supply of new cars. Used cars and trucks rose 10.5% in June from the previous month, when you compare on a yearly basis, prices rose about 45%.
Last week, we discussed in detail technical signals that suggest the market is not currently concerned with inflation. We see this in the new uptrend in bonds and the collapse of certain economically sensitive commodities. The market is shrugging off inflation fears, for now.
You can read our Portfolio Manager’s July Market Update that discusses this in detail here.
We are prepared to shift our investing thesis if the narrative changes. If inflation is not transitory, this reality will show up in price relations first. For example, if bonds continue down while commodities continue up, this could lead to the FED increasing the Fed Fund rate sooner than expected.
Historically, the rise in interest rates has been negative for equities, which ultimately stops the bull market. Some of the possible reasons are when the discount rate increases the present value of future cash flows will be lower. Another reason is that debt servicing costs for companies with high debt will be higher. The exception will be banking stocks which benefit from rising interest rates.
Even if this happens, history tells us that the time to worry is not when the first rate hike happens, but up to 18 months on average after the yield curve inverts. So, even if rates increase ahead of schedule, history tells us that we still have time for the bull market to run.
It’s important to remember that what causes the cascade of events that leads to a bear market, is the FED reacting to rising inflation. So, the sky-high data regarding inflation is nothing to shrug off completely. If inflation numbers do not subside, the FED will have no choice but to raise rates, and we could be looking to invest in an inflationary environment.
Stocks can make solid investments precisely because they beat inflation in the long-term. On a more granular level, the more traditional thinking here is that dividend stocks are ideal during periods of inflation because of the periodic dividend payouts. Dividends also help to fund your increased expenses due to inflation. While growth appreciation stocks are good in the long term, many institutions will see dividend stocks that have reasonable growth as an important hedge. They will also typically view low debt companies with low debt servicing costs as favorable.
Please note: the I/O Fund is a tech growth portfolio that places an emphasis on growth over profits, and for this reason, the I/O Fund does not currently hold stocks for their dividends. Below, we discuss what inflation trades can look like for a more forward-looking discussion.
Dividend Stocks that Institutions Could Favor for an Inflation Trade
Broadcom Inc. (NASDAQ: AVGO) shares rose 50% in the past year. The company’s revenue growth has been strong as it grew at a compound annual growth rate (CAGR) of 16% in the past five years. It also has a very good profit margin which also plays an important role in the long-term stability of dividend payouts.
The company has a dividend yield of 3.00%. It is comfortably above the US 10-year treasury rate of 1.19%. The company has steadily increased its dividends. The free cash flow from which the dividends are paid is also increasing. In the recent earnings call, the company’s CFO, Kirsten Spears mentioned“Relative to capital allocation, first and foremost, we're dedicated to paying 50% of our free cash flows to our shareholders.” In the recent quarter, it had a free cash flow of $3.4 billion and dividends paid were $1.6 billion.
Intel Corp (NASDAQ: INTC) has a dividend yield of 2.45%. The company raised its dividend in January this year. They increased their quarterly dividend by 5.3% to $0.3475/share. The company had a free cash flow of $1.6 billion in the first quarter of the fiscal year 2022. It also had repurchased $2.4 billion of shares and completed the $20 billion repurchase plan announced in October 2019. The management also assured that they are committed to growing its dividend.
Source: YCharts
Will the rise in interest rates be a concern for the ad-tech industry?
Ad-tech stocks typically have low or no debt. One exception is Magnite, which has a debt-to-equity ratio of 1.13. Magnite accumulated debt when it acquired companies in the past year. More recently it acquired SpotX, a deal that will help to double its CTV business. In the words of Michael Barrett, President and Chief Executive Officer, “We believe the combination is transformative because it immediately gives us critical mass and scale in CTV and more than doubles the size of our CTV business”.
Roku has a debt-to-equity ratio of 0.36. The company’s debt is small and it’s coming down. Interest costs were only $742,000 in the recent quarter when compared to $863,000 in the same period last year. Roku’s revenue in the first quarter grew by 79% year-on-year to $574.2 million. It also added 2.4 million incremental active accounts in the quarter to reach 53.6 million. The company had a net profit of $76.3 million when compared to a net loss of $54.6 million in the same period last year.
Source: YCharts
Looking into the stock returns of the ad tech industry, Roku has been outperforming other companies in the past six months. Recently listed companies like PubMatic and Viant Technology had successful initial trading gains but they have not sustained in the recent months.
Secondary Offerings to Raise Cash
After tech’s historic run last year, many companies have benefited from rising stock prices by tapping secondary offerings. Zoom raised $1.75 billion in January this year by pricing 5.15 million shares at $340 per share. It was able to benefit from the strong share price gains due to the remote working boom. The recent offering was about 10 times its IPO price. Previously the company had issued its shares in the IPO at $36 per share in April 2019. Zoom is a debt-free company.
Shopify raised $1.5 billion by offering 1.18 million shares at $1,315 per share in February this year. The company’s share price grew about 175% during the one-year period before the secondary offering. It had benefitted from the shift to online business during the pandemic.
MongoDB recently raised about $889 million by offering 2.5 million shares at $365 per share. The company has a negative debt-to-equity ratio. Its interest expenses are also high, at $3.7 million in the quarter ending April 30 although down from $13.8 million in the previous year. The stock has a three-year return of 510%.
Source: Ycharts
Conclusion
Many tech companies have low debt right now with many sitting on decent amounts of cash due to raising cash from secondary offerings. The I/O Fund doesn’t own dividend paying stocks as a strategy, per se, yet it’s good to know what kinds of stocks could be favored by institutions should we see inflation haunt the market and consumer spending environment. Specifically, semiconductor companies like Broadcom which continue to have excellent growth and a dividend yield of 3.00% stand out from the list.
Last week, the Portfolio Manager from the I/O Fund spelled out his thoughts regarding inflation fears. In summary, the market’s quiet rotation back into growth stocks and bonds, coupled with the new downtrend in commodities and defensive names, seems to suggest that the market isn’t as concerned with inflation as retail is. You can read this article here.here.
“Hypergrowth” and “renewables” are two words that rarely go together. The infrastructure that is required tends to prevent the rapid growth that we see in cloud or advertising stocks. Most renewables either show the signs of a cyclical industry or they show signs of “growth at any cost.” Plug Power is a growth at any cost company. This has worked many times in tech – to do whatever it takes keep growing – so we won’t want to discount the company based on this tactic. What Plug Power and other renewables require is a different mindset than cloud, ad-tech, consumer tech or crypto investing.
We’ve discussed before that the cost for clean energy is finally competitive with the cost for fossil fuels. This has helped drive the investments in building more infrastructure. However, this isn’t the case for clean hydrogen which complicates Plug’s story. We discuss this more below and why we are interested in Plug despite hydrogen being far behind solar and wind in terms of cost reduction.
Please note: at this time, the I/O Fund has chosen Stem and Plug Power as our two choices for exposure to renewables. This was discussed in the July 2021 Renewables Overview.July 2021 Renewables Overview.
Overview of Hydrogen:
The Paris Agreement of 2016 is widely considered to be the point when global initiatives in renewable energy were kickstarted. The proclamation was signed by 196countries that promised to limit global warming to “below 2-degree Celsius above pre-industrial levels.” This translates to a goal of cutting carbon emissions by 25% by 2030 and to be net zero by 2070.
When we’ve covered renewables in the past, the main takeaway is that the cost to produce energy is dropping to where it’s competitive with fossil fuels. This lower cost to produce solar PV and wind has resulted in more interest in electrolytic hydrogen. The ultimate goal is to use clean energy to produce hydrogen rather than natural gas or coal. This will be accomplished by building electrolyzers near solar fields and wind farms to supply the hydrogen and then transport it where it’s needed. Hydrogen is transported either by pipeline or by liquid form on ships. From there, it’s used to fuel a wide variety of vehicles and buildings.
Most importantly, hydrogen is designed for energy storage whereas wind and solar are designed for energy generation, therefore, a hybrid of the two is ideal. Hydrogen allows energy to be stored for weeks — and even up to months — after solar or wind has generated energy. This is important because wind and solar fields are often located too far away from cities to be effective without a storage option
Of all the technologies in existence today, hydrogen has the greatest potential for seasonal energy storage, according to the National Renewable Energy Laboratory (NREL). The major components to hydrogen power is fuel cells, refueling equipment and electrolyzers. Fuel cells use the fuel from hydrogen with the oxidizing effects of oxygen to create electricity. They are made up of an anode, electrolyte of ions and cathode.
Today, the grid is mainly used to produce hydrogen. Currently, natural gas is the primary source of hydrogen production and accounts for 75% of the hydrogen production in the world today, or about 70 million tons. This equates to 6% of the global natural gas use. After natural gas, the second most popular supply source for hydrogen is coal. Grid-based hydrogen is used in oil refining, ammonia production, methanol production and steel production. This is distinct from clean hydrogen.
Renewables: using solar and wind, hydrogen can be produced with water (electrolysis) – considered clean hydrogen (or green hydrogen)
Nuclear: same as renewables, nuclear energy can be used for electrolysis
Steam methane with CCS: proven method with carbon capture, utilization and storage with natural gas, needs to scale – considered blue hydrogen
Steam methane: uses natural gas without carbon capture, utilization and storage, thereby producing carbon emissions. This is the current way hydrogen is produced and produces many emissions as it’s not clean hydrogen production rather it’s gas and coal powered hydrogen – considered gray or brown hydrogen
Fuel costs account for 45% to 75% of production costs. This makes hydrogen fuel cells sensitive to gas prices (for the natural gas production) and this is why it costs more to produce hydrogen in regions like Japan, China and Korea, where natural gas is an import.
To put in perspective how far behind hydrogen development is (and, consequently profitability), consider that in terms of megawatts, hydrogen in 2017 was comparable to solar in 1996 and wind in 1992.
The bull case is that hydrogen can be useful in many industries where is has little to no presence, such as transport, manufacturing, buildings and for power generation. This will be catalyzed by the need for energy storage as it will be impossible to power the world’s energy needs with renewable energy sources on their own. Essentially, the argument here is that world cannot meet its renewable energy goals without energy storage and hydrogen is the best candidate for this.
The decarbonization goals set forth by the Paris Agreement and the decarbonization that commercial industries are seeking on their own (Amazon, Wal-mart, etc) will require a versatile energy carrier. Therefore, a primary bull case is that the decarbonization goals will require hydrogen for energy storage as they simply can’t be met with renewable energy sources alone. The expectation is that governments will be forced to drive down the cost of hydrogen to meet these goals. The driving down of costs for solar and wind with subsidies is cited as an example of how this has been successfully accomplished. For instance, New York has committed $13 million in state tax credits to Plug Power for building its Gigafactory in the Rochester area.
On a similar note, costs to produce hydrogen have halved in the last five years and are at 3% of their 2005 level currently. Another point for the bull case is that hydrogen can use the existing natural gas pipelines and network. Transporting hydrogen through existing pipelines is a lower cost option for delivering larger volumes.
The hybrid method of using hydrogen as an energy converter alongside renewables energy production can save hundreds of billions in Euros, according to a study done on the European Union. In the EU, the goal is to have 32% of the energy demand and 50% of the electricity demand come from renewables by 2070.
Bear Case for Hydrogen:
The bear case is that hydrogen production is cost prohibitive as there is an efficiency loss of up to 70% when converting energy to another form, such as from electricity to hydrogen that is then shipped, stored, and then converted back to a fuel cell. In this scenario, the 70% efficiency loss means hydrogen is more expensive than the electricity or gas used to produce it.
According to the Wall Street Journal and BloombergNEF, hydrogen supplies less than 5% of the world’s energy and could reach nearly a quarter of global energy consumption by 2050 for a total of $2.5 trillion in direct revenue annually.
Admittedly, 2050 seems a ways off with current CAGR at 4.32% through 2027. The global generation market was at $117 billion in 2019 and is estimated to reach $165 billion by 2027. Another source puts the near-term projection at 5.7% CAGR from 2021 to 2028. Steam methane will continue to have the largest share through the forecast period.
This low CAGR and far-off projections add to the bear case around the efficiency loss for hydrogen, which is why we placed the CAGR growth under the cons. Typically, this low CAGR would mean the market is not investable (at least not for growth investors like ourselves).
However, as the bulls point out, this can change quickly if there is enough pressure from legislation and corporate interest.
Plug Power:
Plug Power manufactures fuel cell systems for the industrial sector and manufacturing sector. The company’s line of products include GenKey, GenDrive, GenFuel, GenCare and ProGen. GenKey helps material handling vehicles reduce dependency on lead-acid or lithium-ion batteries. GenDrive offers a proton exchange membrane fuel cell to power material handling vehicles, such as forklifts and hand operated trucks. GenFuel provides a hydrogen fueling system for GenDrive vehicles. ReliOn provides backup power for telecommunications and the utility sector. ProGen offers fuel cell engines for the electric vehicle market to replace batteries. Here’s a good article about ProGen and the partnership with Renault.
By the end of 2022, Plug Power will have two of three plants operational in Georgia, Pennsylvania and New York. The plants will be green hydrogen plants using electrolyzers for hydrogen produced by wind, solar and hydropower. These plants will help Plug achieve the company’s goals of producing 500 tons per day of green hydrogen by 2025 and 1,000 tons by 2028.
New York’s Gigafactory will be where the largest green hydrogen product facility plant will be built in North America. The initial production will be 45 metric tons of green liquid hydrogen to service the NE regions with 120 megawatts of eletrolyzers producing hydrogen.
In Southern Central Pennyslvania, Plug will be leveraging Brookfield Renewables hydroelectric facility to potentially produce 15 tons per day.
Last month, Plug announced plans to build a plant in Georgia with plans to produce 15 tons per day. This plant will be near Home Depot and Southern Company’s headquarters.
This quarter, the company discussed expanding its product line from material handling to expanding more into mobility. This includes various vehicles, such as commercial fleets, airport ground equipment and tuggers for factories. General Motors (GM) was named as the “fourth pedestal” customer for its auto manufacturing facilities. This includes factory tuggers and forklifts. These factory vehicles are loading and unloading heavy equipment everyday which typically requires battery power. The other three pedestal customers for Plug are Amazon, Walmart and Home Depot. We touch more on this below.
The company also released a new product last year called GenSure HP that provides backup power for data centers and energy storage systems with potential deployment in 2021. The backup power solutions compete with generators and backup battery power.
Plug Power acquired United Hydrogen Group and Giner ELX, a leading provider of hydrogen engines and fueling solutions. This acquisition lends itself to Plug Power producing more green hydrogen. At the time of acquisition, United Hydrogen Group was producing 6.4 tons of hydrogen with expertise in hydrogen generation, liquefaction and distribution.
Giner ELX specializes in PEM electrolysis including grid-level storage solutions and also fuel cell vehicle refueling stations. The company uses electrolyzers to turn surplus power into hydrogen. The result is injecting hydrogen into the natural gas network or fueling turbines for peak-time electricity generation. The long-term goal is to have hydrogen fueling stations that look like gas stations.
Partnerships:
Most stock analysts will point towards the partnerships that Plug Power has as either a major benefit or as a customer concentration risk. Both are probably true.
Amazon is Plug’s biggest customer for both fuel cells and electrolyzers. The partnership formed in 2017 when Amazon agreed to a $600 million deal to equip forklifts in Amazon’s warehouses. The incentive to use fuel cells over batteries is partly driven by reducing labor and freeing up physical space. In exchange, Amazon had the right to buy up to 23% of the company through warrants. The warrants vested last year and Amazon took control of 55 million shares at a price of $6. The warrants caused Plug Power to report negative revenue last year with the loss from the warrants being greater than the company’s sales. The more headline-worthy development as of late is that Amazon sold its shares and this can appear like a lack of confidence from one of Plug’s partners. On the other hand, Amazon may have wanted to cash in on the gains as Plug has been trading around $25.
In 2010, Wal-Mart partnered with Plug for the first time, and in 2017, the partnership was expanded with a three-year contract and an opportunity for Wal-Mart to buy 17% of Plug Power. At the time, Wal-Mart made up 34 percent of Plug’s revenue. Plug supplies Wal-Mart with GenDrive fuel cell-powered vehicles in 37 distribution centers. In August of 2020, Plug Power expanded again with Wal-mart to supply their eCommerce network.
Similar to Wal-Mart and Amazon, Home Depot is a partner with Plug Power on reducing electricity and battery use by using fuel cell-powered material handling fleets. Most recently, the two companies partnered on a Dallas, Texas facility that is 1.5 million square feet with Plug powering the material handling fleets.
In the Q1 2021 recap, Plug Power also discussed its partnership with General Motors, what the company calls its “fourth pedestal customer” with GM deploying GenKey solutions at multiple plants.
With the Renault partnership, Plug Power will be putting its fuel cells into light commercial trucks in Europe. Road tests will start by early 2022 with a goal of 20,000 trucks on the road by 2025. The two companies have a goal of reaching 1/3 of the market in 2030, when an anticipated 500,000 vehicles will be hydrogen powered. That would represent 7X growth between 2025 and 2030.
Financials:
As the title of this analysis states, Plug Power is a hypergrowth company in renewables. This hypergrowth is priced at a premium with Plug trading at up to a 75 forward P/S. When you adjust Plug Power for a 1-year forward to account for its forward growth compared to renewables peers, it becomes more reasonable. Pictured below, Plug narrows the gap with Enphase from a difference of 14 to a difference of 7 on the 1-year forward.
For the first quarter of 2021, Plug Power reported $72 million in revenue, up 76% year-over-year from $40.8 million. Gross billings were up 71% year-over-year at $73.7 million, compared to $43.0 million in the year-ago quarter. The revenue was a beat as analysts were expecting $69 million in sales but the EPS missed.
The gross product margin was at 38% although the company reported gross losses of ($12 million). Operating losses were at ($48.2 million) with net losses of ($60.8 million). This works out to EPS of ($0.12) with analysts expecting ($0.08). These gross margins are an improvement on a percentage basis from the ($9.7 million) lost in the year-ago quarter on ($40.9 million) in revenue.
The company has raised cash by selling stock for $1.6 billion and also for $1.8 billion. This resulted in $4.4 billion in cash for the company with $330 million in debt despite diluting shareholders. The company has a term loan with a 9% interest rate.
These losses are incurred due to the costs associated with fuel cell systems and related infrastructure, plus the cost to deliver fuel to customers. Growth investors need to understand there is an inherent cost to the renewables sector and get comfortable with losses before a company reaches scale. As discussed in the Hydrogen Overview above, Plug Power is exposed to commodities such as natural gas prices and also natural gas supply.
In regards to this quarter, Plug Power highlighted a few events that negatively impacted their operating margins. Fuel gross margins were negatively impacted due to the escalation of rates from one of their natural gas suppliers and from force-majeure events that caused the price of hydrogen to spike. One of those was the Texas freeze. The company is also exposed to freight costs, which caused a $2 million expense. The company stated in the Investors Letter that they plan to diversify their supply chain to mitigate this moving forward.
The company reaffirmed its targets for 2021 and also for 2024. The company’s goal for 2024 is $1.1 billion in revenue from 50% green hydrogen. The company stated the following regarding 2021 guidance: “Investors should expect $115 million to $120 million of gross billings for the quarter. This is approximately 40% of our target revenue of $475 million for the year. Usually, at this point in the second quarter, we are about 33% of our annual revenue will have been achieved. We are at a run-rate that is higher from both a revenue and growth rate level than we have experienced in the past. We also foresee a very strong third quarter.”
If Plug Power hits the revenue target for 2021 at $480 million and then the gross billings target of $1.2 billion and the revenue target of $1.1 billion in 2024, then that would be 150% growth. This is substantial for a renewables company that faces cost efficiency issues inherent to its industry.
Accounting Issues:
On March 15th, Plug Power announced the company would need to restate three years’ worth of financial statements. At the time, the company stated the restatement would not affect the company’s cash position, business operation or the return from commercial agreements.
The changes were: 2020 net revenue was $7.2 million compared to the previously stated net loss of $100 million and the net revenue of $230 million was an adjusted revenue loss of $300,000. This came after a large EPS miss in the fourth quarter of ($1.12) compared to ($0.11) expected. As previously discussed, the revenue was also negative because of Amazon exercising its warrants which led to a revenue miss in the fourth quarter of $32 million in losses compared to roughly $50 million expected.
The restatements pertained to the accounting for service contracts and classification of certain costs, such as R&D. The overall impact was minimal with a total decrease in EPS of ($0.13) or about a 6% increase in the company’s total loss. The change in reported sales amounted to a 2% decline. There was no change in cash.
Risks:
We’ve reviewed the risks in this analysis. Mainly the concentration of customers and also the cost efficiency of hydrogen as it costs more than the gas to produce it. Competitors are another risk as they range from smaller in size, such as Ballard and FuelCell Energy, to gas companies, like Shell and BP Amoco.
Conclusion:
We understand the challenges around hydrogen yet are willing to take the risk as any progress will be aptly rewarded. Perhaps it will be to our benefit the company’s stock was beaten down over a minor accounting error. We like Plug’s Power ability to post hypergrowth despite the challenges with hydrogen and especially clean hydrogen. We think incremental improvements – whether that’s subsidies, new global partnerships, or a stronger move into mobility – could cause the company to become a renewables leader.
On February 16th, the dynamics of the market shifted as we saw the beginning of a large rotation away from the growth stocks that led us out of the 2020 bear market. Around the same time, the price of copper rose to levels that we haven’t seen since March of 2013, while the yield on the 10-year treasury moved above a key resistance level that has held since February of 2020. In other words, inflation was officially here.
Pictured Above: Copper and Yields broke out on the same day that growth equities topped
Historically, inflation pressures build towards the end of a cycle, resulting in the bond market selling off. The reason for this is because as the FED raises rates to fight inflation, bonds get priced down. Bonds don’t perform well in a rising rate environment; hence a downtrend in bonds usually begins in anticipation of a rate hike. As bonds get sold, rates go up, making the cost for companies to refinance debts more difficult while at the same time harming future projected cash flows for high growth companies. Eventually, stocks catch up to bonds and a bear market begins.
Ultimately, inflation begins the cascade of reactions that leads to a recession, hence the steep selloff in richly valued growth stocks. The real question today is whether the inflation is transitory, as the FED and many economists are claiming, or is it here to stay? If it is truly here to stay, the FED will have no choice but to raise rates, cutting off the bull market. On the other hand, if inflation is transitory, then the recent drawdown in high growth names may have presented a buying opportunity if the bull market resumes.
The popular narrative tends to side with “inflation is here” and “the FED will have no choice but to raise rates soon.” This is backed not only with countless anecdotal claims, but real data. For example, June’s CPI came in at 5.4% YoY which exceeded expectations. This has caused analysts and pundits to point out that the last time we saw a rise this high was in 2007. Just as alarming, housing prices are now exceeding 2007 levels.
This is compelling evidence to support the popular narrative that inflation is here, and likely signals the end of the bull market. However, I believe the markets are a much greater predictor of future economic outcomes. If we monitor the price relations with intermarket analysis (see below), the market is telling us that inflation fears are likely overblown. Even if the trend in inflation continues, we could still see an environment like 1999 where inflation, yields, commodities and equities all advance together.
Intermarket Analysis
On May 12th, the equity markets appear to have hit a significant bottom. Following this low, what we have seen is a quiet rotation out of commodities and value stocks, and back into risk-on assets. Across key sectors, high growth and green tech is up 20% while big tech and cloud is up 15%. Meanwhile, value is up just over 1% while commodities are in negative territory.
Since the May 12th bottom, we have seen beaten down growth stocks take back their leadership role in the market – this is a thesis that we held, positioned for and stated publicly. The I/O Fund has initiated numerous buys since the May 12th bottom, after building a reasonable cash position going into the selloff in February.
Joining growth in a renewed leadership role is bonds. We are seeing bonds in a new uptrend, specifically longer duration treasury (+20 years), which are outperforming the S&P 500 since the May 12th bottom.
If we look a little deeper, copper topped on May 12th, the same day that growth stocks bottomed. Also, on May 12th bonds were confirming their first higher low, which was starting a new uptrend. In short, the bond market was signaling that inflation fears were either overblown, or that they may not be significant enough to force rate hikes.
Pictured Above: The intermarket relationship between copper, bonds and growth stocks from the May 12th bottom
Further evidence that inflation fears may be overblown are found in the recent behavior in lumber. The price of lumber has been the rally cry for investors concerned about inflation. Historically, not a speculative commodity, lumber saw a roughly 180% increase YTD before peaking on May 10th. Since the peak, prices have collapsed by roughly 65%.
This puts the growth in lumber prices at negative for the year, which is rare for a commodity because it’s not speculative. This is further backed by the price of copper. After a roughly 35% rise in prices, from its May 10th peak, the price of copper has decreased by 10%.
The collapse in economically-sensitive commodities is also not typically what you’d expect in an inflationary environment. Also, it’s worth pointing out that the 10-year yield is testing the very breakout zone that triggered the growth sell-off.
Pictured Above: bonds, copper and the 10 year yield are almost back where they were before the February 16th rotation began.
As of now, Bonds have broken out above the February 16th resistance with the 10 year yield only 7% away from reclaiming the February 16th region and copper 11% away. If yields and copper follow bonds, and reset the dynamics that lead to the growth rotation, it would suggest that growth stocks could continue their uptrend. As of now, high growth stocks are about 31% below their high.
Correlations and History
I’d also like to suggest that even if the 10-year yield and copper does hold the February 16th breakout zone, and continues to move up, it doesn’t necessarily mean that growth will continue its downtrend. In today’s market, it is now believed that growth stocks simply cannot go up with yields and commodities with inflation on the rise. However, if we look through history, this is simply not the case.
The chart above compares the NASDAQ100 with copper and the yield on the 10 and 20-year government bonds between 1998 through 2000. Red indicates a downtrend and green indicates an uptrend. Note how all four assets participated in an uptrend in unison from February 1999 – December 1999. These assets remained correlated, and this was during a rising rate environment with elevated inflation.
It’s also worth noting that in 1999 copper topped first, then yields, followed by equities. The drop in copper and yields would be considered a boon to equities today, but this was actually a warning in 1999/early 2000. When assets correlate, it’s good to take notice as history tends to rhyme.
Levels to Watch for the NASDAQ100 and S&P500
In our last market report, we identified the 14080 region as a likely breakout zone for the NASDAQ100.
On June 22nd, the breakout was confirmed and we have seen a move up roughly 5%. We’ve also publicly identified that we believe the NASDAQ100 is targeting the 16000 before we’d potentially see a deeper correction.
With the breakdown in the S&P500 on Monday, July 19th, this threatened to end this target earlier than expected. The recovery since has halted the early correction in the broader markets, and setup some clear levels for us to monitor.
The above chart outlines the levels that we are watching. These are the potential outcomes I see playing out:
Even with the strong bounce off the recent lows, we are not out of the woods yet. Until we can reclaim all-time highs, the current bounce could be a corrective bounce in a deeper correction. If we do see another leg lower, I’m expecting the 14200 level to hold, setting up a short correction in a much larger uptrend.
If the bounce continues and we can move past the 14985-14900 region, we can resume our move to the 16000 region before a larger correction unfolds.
The lowest probability scenario is that the current correction breaks down below 14080. If this support breaks, it will signal that we are in the larger correction earlier than expected.
We believe that any correction is part of a much larger uptrend. We expect much higher prices before the secular bull market that started in March of 2009 end, and that the current selloff in growth has provided a remarkable opportunity to buy some of most innovative, and fastest growing companies at a relative bargain.
Regardless of what scenario, or variation of a scenario plays out, the above information provides context so that emotions do not dictate our investments.
On the forum, I stated that Zoom had 90 degrees of the cloud-native communications market with web conferencing and moved to 180 degrees with Zoom Phone. This “half-circle” represents employee communications. When the sales department has a meeting with the marketing department, they’ve been using Zoom for up to 10 years. Prior to this, these departments used Cisco Webex, where Eric Yuan cut his teeth. Ten years ago, when Zoom came on the market, employee communications software and apps were too cumbersome to deliver the speed required for communications. Mobile was especially an issue for legacy products. The beauty of Zoom’s product is it reduced friction entirely from where it used to take minutes to join a call to mere seconds.
Five9 is on the opposite 180-degree side of the enterprise communications circle, which is customer communications. Customer communications is when you go to call your credit card company 1-800 number or health insurance company as a customer. These contact centers are very good in siloed situations yet there is a lot of friction when it comes to aggregating omnichannel touchpoints. Have you ever called your credit card company and discussed an issue for 5-10 minutes only to be transferred to another department where you must repeat the exact same issue for 5-10 minutes? Or, have you ever engaged with a chatbot or live chat and 10 minutes later ended up calling in for help because it was ineffective?
Many of these customer contact centers are quite advanced yet they are not able to connect the pieces in the customer journey to be effective. Wait times have improved yet getting the customer what they need to increase loyalty has not improved.
Here is how Zoom depicts the 360-degree circle:
Here is how Gartner shows the circle – which is actually two circles overlapping:
More on Five9 …
I’ve published volumes on Zoom Video so it makes sense to focus on Five9 for this analysis.
Five9 was not a hypergrowth story like Twilio or Zoom during Covid. In fact, the stock price being up 187% is pretty generous of the market as the company has remained range bound in the 28-40% revenue growth range even during the ideal conditions for a contact center company, which was the work-from-home environment we saw last year.
By my estimation, Five9 has a “bells and whistles” issue and lacks focus. There are too many features and the company tries to do too much. That’s an opinion of mine, although if you visit the website, you’ll probably see what I mean as it’s a bit overwhelming. Essentially, Five9 doesn’t have its cornerstone selling point.
To contrast here is how streamlined Zoom and Twilio are:
Zoom delivers web conferencing and audio for employees. It’s also now a consumer favorite
Twilio simplifies SMS for developers. It’s also becoming an omnichannel marketing solution using first-party data
Despite the fact Five9 lost its way by trying to do too much (evidenced by its lackluster sub-40% growth for many years including during the hypergrowth window of 2020), the product has some chops and ranks competitively across cloud contact centers in the North American region. The company is third for high-volume customer use cases, second for customer engagement use cases, and first place for agile contact center use cases. Agile means it’s quick to deploy for specific use cases (like health care, for instance, needs a customized deployment) and can scale quickly if needed.
The ongoing argument in terms of the shift towards cloud communications is that omnichannel approaches have not resulted in a unified customer experience. The pain point –for both the consumer and the SMB/enterprise – is the sheer number of touchpoints we have today. This includes chat, phone, email, SMS and social media.
Here’s a visual of what Zoom and Five9 will set out to accomplish with multiexperience between employee communications and customer communications. Cisco is one company that has combined Webex with a contact center. As you already know, this is an easy competitor for Zoom to take on. Otherwise, Zoom is primarily taking on competitors in either UCaaS or CCaaS but not both.
In a previous Forbes article, I had stated “Zoom’s ongoing goal will be to disrupt all legacy systems with cloud-native communications – and this means every possible method of communication that is not currently done on the cloud and/or is currently on the cloud but is too cumbersome of a process due to walled gardens.”
Vendor lock-in usually means Microsoft or Google. There is serious vendor lock-in across enterprise companies with 115 million users on Microsoft Teams due to the cross-sell from Office. Google’s walled garden likely destroyed its potential for doing more in communications, as well.
Quick note: I’ve seen some questions about the difference between UCaaS and CCaaS. We can simplify this by calling UCaaS “employee communications” and CCaaS “customer communications.” We know these are cloud-native and we know employee communications is unified. While I’m on the topic, it’s important to note that Zoom made the UCaaS Gartner quadrant for the first-time last year with the addition of Zoom and was immediately named a leader.
Artificial Intelligence
The reason that combining employee communications with customer communications is important is for data integration. One of the most advanced areas for AI is speech and voice recognition. This lends itself well to customer contact centers who speak with customers all day, every day. The AI for enterprise communications will become more effective when CX and EX is combined.
In November of 2019, Google released its Contact Cloud Center AI (CCAI) solution and Five9 was an integration partner for the release. The integration allows Five9’s contact center to send the voice conversation and contextual data to Google’s Cloud CCAI via APIs for real-time transcription and the triggering of knowledge base responses. Salesforce was also a launch partner for the use of CRM to help with custom integrations across a customer base and customer service agents.
The stack in this case (moving forward) would be Zoom for voice/audio/chat for customer contact centers, Salesforce for millions of agent desktops, and Google’s AI voice recognition for accuracy. This is also a great illustration as to why a walled garden like Microsoft isn’t a good reason to discount Zoom. In many ways, you can do more outside of walled gardens and reduce vendor lock-in (or dependency). This is why best-of-breed is becoming popular (reference my Snowflake analysis). In this case, Google likely has the better AI for voice recognition and a company with high customer service volume isn’t stuck with Microsoft for a contact center just because it uses Microsoft for other software products.
If I were to guess the motivating factor behind Zoom’s choice in Five9, it is probably because the company has been working on AI for customer communications. This will save Zoom not only the build for a contact center, but can immediately center Zoom in the trend of AI voice recognition where it’s being rapidly adopted and needed for communications.
Key Points from Investors Call and Investors Presentation:
Five9 stockholders will receive 0.5533 shares of Class A common stock of Zoom Video Communications. This represents a 13% premium at the time of announcement to Five9 for a stock price of $200.28. The transaction value is $14.7 billion and is an all-stock deal. The transaction is expected to close in the first half of 2022. This equates to a 25.3 price-to-sales, which the Five9 CEO pointed out, is the highest M&A P/S paid in the cloud category. On a side note, even though this was stated, I’m not sure this is correct as I believe Slack was bought at a 29 price-to-sales.
According to the Investors Presentation, Zoom will increase the addressable market from $62 billion to $86 billion, for an increase of $24 billion by adding the customer communications. The company points to the cross-sell opportunity, which means not only will Zoom increase its TAM but should capture a higher percentage of the TAM.
Last twelve months revenue for Zoom Video was $3.3 billion compared to Five9’s $478 million. The growth from Zoom was nearly 10X higher at 296% compared to Five9’s 37%. If we look to growth rates prior to Covid, Zoom was growing at higher growth rates of about 3X compared to Five9. My main concern with this acquisition is if we will see slower rates of growth for Zoom. I’ll look to management to make sure the cross-selling re-accelerates the customer communications portion for the growth opportunity that was emphasized in the call.
Management teams have to balance giving away their entire strategy to competitors while also keeping investors happy with enough transparency. According to Zoom’s CEO, they chose Five9 because the two companies had synergy and have landed significant deals in education and retail. He also said that building the solution would take many years and that customers don’t want to wait. As stated, I think it’s because Five9 has been working on the AI-driven automation. At one point, when pressed to state why Five9 specifically, the answer was “look at our video assets and look at their AI.”
According to the Investors Call, Zoom will partner with Five9 competitors, and vice versa, with Five9 continuing to partner with Cisco and Microsoft, for example.
Key Points from Previous Zoom Analysis:
In the August 2020 and April 2021 analysis, I emphasized that the story for Zoom Video was changing and the company was doubling TAM with Zoom Phone. Although I’ve discussed Zoom Phone many times – here is one example:
Last August, I pointed out that Zoom’s hardware-as-a-service products allowed companies to replace legacy systems by consolidating software and hardware for one consistent experience. ServiceNow made headlines last year when they chose Zoom Phone to replace their business phone lines by stating, “Going forward, with the addition of Zoom Phone, we're getting a head start on an even more robust experience with Zoom— one-touch communication and collaboration features, plus Zoom-connected conference rooms.”ServiceNow made headlines last year when they chose Zoom Phone to replace their business phone lines by stating, “Going forward, with the addition of Zoom Phone, we're getting a head start on an even more robust experience with Zoom— one-touch communication and collaboration features, plus Zoom-connected conference rooms.”
This is key because as the CEO of Five9 pointed out, Zoom has the very best technology available today with Zoom Phone. The CEO of Five9 also pointed out that “the opportunity here is the millions, tens of millions, even hundreds of millions of phones, that have to be replaced. When you replace the phone system, you replace the contact center.”
Another key point from our ongoing analysis with entries into Zoom from $62 onward is the international opportunity. The United States is a large land mass with very few telephone providers (we call it a duopoly between AT&T and Verizon). There’s Charter, etcetera, but you get the idea. Many other countries don’t have the reliability that the United States has and/or many countries have close borders and require new country codes when they dial a number 1,000 miles or even 500 miles away. Zoom is all about global and that’s key for investors to understand. This isn’t about the United States.
A Note on Twilio:
There will be customers who overlap between Twilio/Flex and Zoom/Five9 and will evaluate both to ultimately choose one. However, Segment is the main pivot we are interested in for Twilio and the post-IDFA world. It’s the omnichannel marketing path that is most interesting for Twilio as it can eat into advertising budgets rather than IT budgets for a call center (like Five9).
We are seeing nearly the exact same names in the Top 10 list for forward growth after the Q1 earnings reports. The good news is we picked strong companies and we didn’t abandon them when they were called Covid stocks. This is what you want although you won’t get the drama that comes with SPACs or small caps.
We continue to like Zoom, Shopify and Datadog. Of those Zoom has the most room in terms of 1-year and 2-year forward estimates as it’s ranked quite low due to the uncertainty following its banner year last year. If we can get some revisions on those estimates with another quarter of strong reporting, then we could see the company return to all-time highs.
Right now, Zoom is ranked number #6 on current year growth at 51% and is ranked #34 for 1-year forward growth at 20% and then ranked #39 on 2-year forward growth at 17%. That’s quite the gap between current year and 1-year forward on a company that’s reported strong for many years. If the company clears Q2, the uncertainty should start to clear up. You know where we stand – winners keep winning and this product has exceptional product-market fit. We’ve covered this very in-depth on the site across many reports.
Regarding Shopify, I had said that the immense distribution that comes from reaching roughly 4.4 billion social media users across many sites, including TikTok, should not be overlooked in the noise. The combination of a strong product cracking open the pinata on this kind of distribution is what we want in our portfolio for the LTBH positions. Here’s an excerpt from the May update:
“The reason we want to increase our position in Shopify throughout the year is fairly straight forward – Shopify is now reaching billions of consumers through social media. The distribution potential of these partnerships reminds me of an avalanche trigger as Shopify will reach billions with Facebook and Tik Tok and hundreds of millions with Pinterest. Now, they only need to build out the Fulfillment Center and focus on improving their own app; although borrowing these mega size audiences is probably the fastest path to growth for our purposes.”
Datadog is a position that lets us participate in the cloud IaaS growth of Azure and AWS and Google Cloud but through a pureplay. We reviewed this company post-Covid here and also on the 1-Hour LTBH Webinar Update last month.
Twilio’s story hasn’t fully come together yet but we like the Signal acquisition very much. In an effort to get in front of the market, we held a 1- hour LTBH webinar on this company as we like to highlight stocks where the story is not fully known yet our conviction is high.
We’ve also covered Crowdstrike and entered/exited this stock. There is plenty of coverage on Cloudflare on our forum although we have not officially covered this stock. We’ve passed on Palantir due to low commercial account growth. We front run many stocks (technically, we are front running Twilio on the pivot), however, transitioning from government contracts to commercial accounts is tricky in the tech industry. This is because the product was developed and the team built with guaranteed sales and moving into a more “only the strong survive” environment, is a different skillset. We continue to monitor this company.
Notably, we are also pleased that Asana is doing well. It’s the top performing cloud stock this year, up 127% year-to-date with our position up about 100%. I can’t claim credit for this as all of the credit goes to Knox’s technical chops. Atlassian guided for negative growth sequentially and this is being revised upward quite a bit right now with some 60-day revisions up as much as 35%. However, at the roughly 21% growth that management guided for, we like Asana better for now.
Spotlight on Okta and the Auth0 Acquisition
One name that is starting to pop up in my Q1 post-earnings scans is Okta. Okta is a stock we’ve covered in the past yet shied away from during budget constraints in Covid. You can access our prior research here.
Okta
Okta gets an honorable mention for moving back into the top 10 list for both the 1-year and the 2-year forward revenue estimates. In fact, right now it’s estimated to be a percentage point higher than Crowdstrike on the forward estimates. This isn’t organic as it’s due to the Auth0 acquisition, which we discuss in detail below.
Okta: Product Summary
As mentioned, we’ve covered Okta with an in-depth analysis published last year. I’d like to review a few key points from that analysis before we talk about Auth0.
In the previous analysis, we discussed the importance of IAM systems as it allows for the administration of user access across an enterprise and also ensures compliance. This is critical because 60% of data breaches are caused by an organization’s own employees. By having one digital identity for employees and customers, a company can easily modify and monitor a digital identity to allow access to the appropriate assets and in the right context.
IAM became more complicated once employees began to use their own devices and as companies transitioned to the cloud. This is because there was no longer a perimeter. Today there are on-site employees, off-site contractors, hybrid cloud environments, software-as-a-service applications, bring-your-own-device users, UNIX, Windows, Mac, iOS, Android – and soon there will be billions of machine-to-machine connections (internet of things) communicating through APIs.
Okta is an independent IAM provider that allows customers to integrate with any application or scalable platform. Because Okta is best-in-breed, the company can win over Chief Security Officers (CISOs) that want flexibility and who want to avoid vendor lock-in (i.e., Microsoft). IAM allows access to critical assets, ad not only are switching costs high but CISOs will want a vendor that lets them sleep well at night.
The solution Workforce Identity comprises the majority of the business and simplifies the way an organization’s employees, contractors and partners connect to applications and data from any device (as discussed above). You can think of these as internal employee uses. New Products from Okta include FastPass, which allows for password-less login across multiple devices.
The Customer Identity Cloud enables organizations to transform their own customer’s experience making use of API-level access and seamless customer experiences. This is more external. Dynamic Scale helps enterprises handle traffic bursts up to 500,000 authentications per minute.
Here are the six technologies that IAM comprehensively covers:
API security: Allows for single sign-on (SSO) access for B2B ecommerce and API integrations.
Customer identity and access management (CIAM) enables organizations to capture and manage customer identity and profile data
Identity Analytics (IA) creates risk profiles for user behaviors and manages risk profiles.
Identity-as-a-Service (IDaaS) provides single-sign on and identity management as a software service
Identity Management Governance (IMG): Helps to minimize risk of data breaches and improves end user productivity
Risk-based authentication (RBA): Allow for variation of single-sign on and two-factor authentication
Auth0 is in the Identity-as-a-Service space (IDaaS) and offers an identity platform suite that supports single sign-on (SSO) through a centralized authentication server. To illustrate, you use single sign-on when you use the same username and password for the I/O Fund website as the I/O Fund forum. It allows you to be authenticated securely through an API.
The company is able to detect password compromises in real-time by checking against a database of hundreds of millions of breached credentials. The compromised user is then notified by email or text and Auth0 can restrict access until the password is reset. The API authentications are integrated with Microsoft Azure, Facebook, Twitter, WordPress, GitHub and Paypal.
Although there are many competitors in the startup scene, Auth0 can claim it’s prevented millions of malicious attempts with up to 1 billion transactions every day and 4 billion logins per month.
The dashboard for administrators offers control over user account provisioning and deletion, and offers full visibility into history and logs. Auth0 also offers personalized user targeting that enables control over features like social logins and multi-factor authentication. There is also automation through rule builders.
Auth0 and Okta are competitors in the customer identity space and are typically both evaluated by customers. The result will be better pricing power and a stronger product when going up against Microsoft on IAM. Okta’s primary source of revenue has been Workforce Identity. Auth0 acquisition will help strengthen the Customer Identity segment and will diversify Okta across both markets for IAM.
Here's how the two work together. What’s being illustrated is that the Workplace Identity often leads to a cross-sell on Customer Identity with lifetime spend of $17 million.
The last private valuation for Auth0 was $1.9 billion when the company raised a $120 million round. The round was led by Salesforce Ventures likely for the Customer 360 product that Salesforce has, which enables a universal identity and first-party data collection through the sign-on process. From there, audiences can be segmented and personalized experiences can be created (similar to our Twilio discussion on Segment). It would make sense that Okta acquired Auth0 to prevent Salesforce from competing with Okta.
Auth0 is a developer-centric company, similar to Twilio. The company has won over developers with its easy-to-use drop-in identity management solution for authentication APIs. The issue with Okta not being developer-centric and competing more at the Microsoft level is that developers prefer to work with companies that offer more support for the SMB-level. The Auth0 acquisition helps with this quite a bit. Okta is more of a sales-driven culture for the enterprise than a developer-centric focus.
Okta has stated they’d like to court developers for advanced use cases, such as the use of biometrics for authentication. Not only is the use of biometrics very complex but it needs to be properly implemented by developers. The top-down approach Okta uses is not well suited for this, yet the bottoms-up approach from Auth0 is well suited.
Financials
Okta is a $1 billion run rate company with the most recent quarter posting $251 million in revenue. This represents an increase of 37% year-over-year. The remaining performance obligations (RPO) was $1.89 billion, for an increase of 52%, with current RPO expected to be recognized this year up 45% compared to the year-ago quarter. Most bullish analysis will focus on RPO growth.
The adjusted earnings the company reported was EPS of ($0.10) compared to ($0.06) in the year-ago quarter. The bearish side to Okta is the ongoing lack of profitability. The company’s losses are increasing in terms of percentage of revenue on a GAAP basis from 36% to 29% of total revenue. On an adjusted basis, the operating losses were 6% of total revenue, a slight improvement from 7% last year.
These losses steepen with the Auth0 acquisition with adjusted EPS for next quarter of ($0.36) to ($0.35) and for fiscal year 2022 of ($1.16) to ($1.13). Forward guidance includes the Auth0 acquisition with total revenue of $295 million to $297 million, or 47% to 48% year-over-year. Last fiscal year, the adjusted EPS was $0.11
To be fair, the free cash flow margin is at 21% and this has improved. The company has $2.5 billion in cash and cash equivalents. This helps the company to satisfy the Rule of 40, which helps to sift through the many key metrics in the cloud and SaaS vertical to establish what companies have a healthy top line combined with a healthy bottom line. There is a great write-up here from Scale Ventures who has specialized in cloud startups for twenty years. They discuss why this is an important rule for public companies. Here’s an excerpt:
The Rule of 40 states that, at scale, a company's revenue growth rate plus profitability margin should be equal to or greater than 40%. SaaS management teams are often driving towards either rapid growth or increased profitability, and the Rule of 40 has become a construct for framing the balance of these two phenomena. Given that increased investment (whether from external or internal sources) is usually required to drive growth, rapid expansion and strong profitability are usually at odds with each other, and finding the right mix between the two can be tricky. a company's revenue growth rate plus profitability margin should be equal to or greater than 40%. SaaS management teams are often driving towards either rapid growth or increased profitability, and the Rule of 40 has become a construct for framing the balance of these two phenomena. Given that increased investment (whether from external or internal sources) is usually required to drive growth, rapid expansion and strong profitability are usually at odds with each other, and finding the right mix between the two can be tricky.
One of the more interesting slides from Okta’s Auth0 Investor Presentation is the chart showing the 2018 Cohort’s Contribution Margin:
My only concern with the above chart is that Okta has been in business for about twelve years, and therefore, there should be at least ten cohorts with high contribution margins yet the company is still unprofitable.
The company is forecasting a minimum of 35% growth each year through 2026 for revenue of $4 billion. The key drivers will be Customer Identity segment with Auth0, growth in the enterprise customer base, expanding partnerships and international expansion.
We will be keeping Okta on our radar for any re-acceleration in revenue or increased forward guidance as the 35% minimum growth is a solid baseline.
With Auth0, the company is now guiding for fiscal year growth of 45% to 47% year-over-year. There was some criticism from an analyst on the earnings call because Okta did not break up the organic growth in the guidance. The losses are expected to be in the range of adjusted EPS ($1.16) to ($1.13).
Addressable Markets and Valuations
Auth0 was valued at $1.9 billion last July and Okta is paying $6.5 billion, or a 350% increase. The all-stock deal dilutes shareholders by 20%. Notably, Auth0 will be issued shares at $276.21
Okta is known for being downgraded due to valuation concerns. Despite the company having average performance during the 2020 due to Covid, it’s still in the top 10 on forward P/S. By average performance, the 40% range was overshadowed by many other cloud stocks seeing outsized performance. The digital transformation did not show up for Okta in a big way.
Sometimes you can squeeze out a 40 forward P/S but that doesn’t leave too much room in Okta’s current valuation. We will need to see more post-acquisition as we don’t want to front run this right now. If it was in the 20s, we likely would bite.
In the most recent earnings report, Okta stated the identity’s market addressable market was at $80 billion. If we break this down, we find the identity access management (IAM) market was at $12.3 billion in 2020 and will reach $24.1 billion by 2025 for a CAGR of 14.5% during the forecast period of 2021 to 2025. There is another forecast of 13.2% CAGR for IAM between 2018 and 2026 from $9.5 billion to $24.76 billion.
According to Okta in the most recent earnings call, customer identity TAM is $30 billion.
Of the key markets, health care is expected to be the fastest growing market driven by the need to prevent unauthorized users from accessing patient information. Healthcare organizations experience 5 times more attacks than financial institutions.
Asia Pacific is the region expected to drive the most growth with North America holding the largest share.
Conclusion:
Okta is firmly back on radar. What we want to see from this company is increased guidance following the Auth0 acquisition. The baseline of 35% forward growth is an excellent baseline to work from as any increase from here will help the stock quite a bit. There is strategic value to diversification and cross-selling in your customer base. For Okta, the acquisition adds developers plus strengthens their fastest growing segment (customer identity).
For now, the company get honorable mention, and if we see the right set-up, we will take it, but only if we see the right setup. Taking the number two position on 1-year and 2-year forward is a key reason as to why Okta is back on our radar. To be candid, the bottom line is a bit ugly for a company this age and at these growth levels (i.e., not hyper growth), so let’s see if the cross-selling improves this.
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Over the past fifteen years, there has been a marked shift in the world’s most valuable industry. Oil dominated the top 10 in the prior decade and technology dominates in the current decade. However, what will happen when these two dominant industries merge into renewables and combine the addressable market of fossil fuels with the disruptive nature of technology?
It’s a big question to ask as many renewables companies look like moonshots, or they’ve operated for some time and have cyclical financials. There are many highs and lows in their financials due to the level of infrastructure required for renewables and the dependency on cyclical supply chains. To put it plainly, the financials in the renewables sector are what most growth investors try to avoid. First Solar is a great example as the company rotates between 100% growth in some quarters and negative growth in others. Cyclical issues are the norm and not the exception. We discuss this more towards the end of the report as we identify a handful of companies we are keeping a close eye on.
Our first report on renewables highlighted a study from the College of UC Berkeley claiming that by 2035 the U.S. could see up to 90% of U.S. energy consumption come from renewable energy sources. This report assumes favorable subsidies and legislation that should facilitate this transition and acknowledges that government assistance is not a guarantee. Without government support, the report claims the U.S. could see up to 55% of its energy consumption come from renewable sources by 2035.
Since year-end 2020, we’ve seen even higher growth reported than previously estimated with worldwide capacity growing by 45%. This is the largest annual growth rate since 1999. The growth was driven by a 90% rise in wind power and a 23% expansion in new solar power installations. Most importantly, the IEA is predicting that large capacity gains in renewable energy becomes the “new normal” in 2021 and 2022 with gains in capacity similar to 2020.
The key point to renewables is that the levelized cost of energy (LCOE) for utility-scale solar photovoltaic (PV) has plummeted 400% in the past five years. I covered this for MarketWatch with the image below to depict how competitive solar has become compared to other energy sources. This is important because the industry has seen a change in the story and (generally speaking) is why the renewables’ financials were deep in the red over the last couple of years.
This has led to hockey stick growth. According to the report, wind is growing the fastest (50%) within the renewables category yet solar (26%) is expected to overtake wind power.
The reason for this growth is that the technology is being developed for and marketed to individual consumers whereas wind is designed primarily for a region’s electricity grid. As the efficiency and storage continue to increase, and the cost continues to go down, more people will likely migrate to having a home that is independent of the grid predominantly due to a reduction in personal expenditures, which will also align with the desire to become greener.
More importantly, the cost to produce 1 kilowatt of solar electricity is now competitive with wind, and is the cheapest form of electricity available when taking into account utility-scale systems installed in locations that receive full sun.
If we use the metric of levelized cost of energy (LCOE), solar is more expensive to build upfront, but much cheaper to maintain, compared to a natural gas power plant that is less costly to build but has significant and on-going costs to maintain. As stated, the LCOE for solar has plummeted as much as 400% in the past five years, making the economic incentive a real driver for municipalities and business to develop on a large scale.
Global Addressable Market
Renewable energy companies have global addressable markets, which makes it an attractive industry for investment. In any given region – China, the United States or Europe, energy accounts for 15-18% of the country’s GDP. According to Brookfield Renewable Partners, one of the world’s largest investors in renewable energy, $5 to $10 trillion will be invested in renewable energy worldwide by 2030.
We’ve covered why we are keen on China for electric vehicles specifically. In a similar vein to the country having a need for electric vehicles due to a lack of oil, China is also the biggest manufacturer of solar photovoltaics and the largest producer of solar-generated electricity. According to Wood Mackenzie, China will exceed the United States on solar power through 2024.
Last year, China accounted for 50% of the world’s growth in renewable energy capacity. In Q4 of 2020, China added 3X gigawatts in capacity compared to Q4 2019.
The country’s global share is at 22.9% with a 10-year annual growth rate of 33.4%. Compare that to the United States with a similar global share of 20.1% yet with a 10-year annual growth rate of 10.1%.
India is forecast to become a growth market, as well, with ambitions to reach 225 gigawatts of power by 2022 compared to 10 gigawatts of power in 2019.
India and the United Kingdom are tied for the second highest 10-year annual growth rate in the 17% range after China’s 33%.
With that said, the United States is a key market with 5% of the world’s population yet accounts for 17% of the world’s energy. The daily per capita energy consumption in the United States is 2.6 gallons of oil, 9.7 pounds of coal, and 255 cubic feet of natural gas. Residential consumption is 11.8 kilowatts (KWh) per person.
Even though the growth rate is much lower in the United States, on a per capita basis, the country is in a wide lead for both fossil fuels and renewables. In Q4 of 2020, the United States added 19 gigawatts compared to 13.7 in the year-ago quarter compared to the 3X growth China reported.
Constraints to Renewables:
Renewable energy’s capacity factor is more fixed due to the elements. Solar has a capacity factor of 25%, while wind has a capacity factor of 35%. These numbers are based on the rotation of the sun and other weather patterns. Advancements within this field must come from an acceleration of efficiency during the restricted time that it can produce energy.
The average size of natural gas power plants in the U.S. is 820 megawatts. The average current capacity factor for natural gas in the U.S. is 58%. This means that the average natural gas power plant produces 4,166,256 MWh/year.
Compare this with one of the more advanced on-shore wind turbines, which is about 810 ft high with a blade diameter with a 518 ft diameter. One turbine has a 5 MW size, with a capacity factor of 35%. Therefore, one turbine equals 15,330 MWh/year. In order to have the equivalent energy output of the average natural gas power plant, you would need 272 of these turbines.
There are now off shore wind farms where the capacity factor is an impressive 63%. Furthermore, General Electric has developed an off shore turbine called the Haliade-X that can produce 12 MW. So, one of these turbines produces 66,225 MWh/year. Even with such improvements, you would still need 63 of these turbines, which seems more plausible.
The scalability issue becomes even more exacerbated with solar. For example, the United States is in the process of beginning to build one of the more advanced solar farms in the world, called the Gemini Solar Project in Nevada. When completed, the generation facility will have a size of 690 MWs, and the total land mass it will take to build this array is roughly 7100 acres. For perspective, Central Park in NYC is about 840 acres. So, the size of the Gemini Solar Project is the size of about 8.5 Central Parks.
With a capacity factor of 25%, the total MWh/year comes out to 1,511,100 MWh/year. Thus, you would need nearly three Gemini Solar Projects to equal the average energy output of the average natural gas power plant.
We have seen huge improvements in renewable energy tech; however, total scalability of the U.S. energy grid is not feasible (yet).
Impact from Covid
Due to COVID-19, the energy sector as a whole saw the largest drop in investments in history. The sector as a whole experienced a roughly 20% decline in investments, which includes renewable energy projects. Many believe this is a temporary setback, and preliminary earnings reports seem to agree in some cases while other companies are still reporting negative revenue growth.
Stocks We are Watching
Renewable energy companies that generate free cash flow and have strong balance sheets have a competitive advantage over financially weaker rivals, since they have greater access to the capital needed to finance growth. That's why investors should focus their attention on financially strong clean energy companies.
Although this is not an extensive list, we spell out our thoughts on why a couple of names make our watchlist and why others don’t. We are providing this in case it’s helpful as renewables often have quarters with negative revenue growth, etcetera, so more depth into why we ignore this in some cases and not others may be helpful.
Plug Power:
Plug Power is a high growth company within renewables, and thus has attracted a very high valuation. As we covered before, management is expecting high growth over the next several years, believing that in 2024 it will earn $200 million in operating profit and record gross billings of $1.2 billion (gross billings will be $325M-$330M in FY’20).
Per our previous coverage, HC Wainwright projected Plug's revenues in 2024 will be about $1.1 billion — more than four times the company's trailing revenues currently. Current consensus is projecting Plug to grow revenue 40% next year in FY 2021.
In Plug’s most recent earnings report, the company “reaffirm(ed) the recently raised gross billings targets for 2021 and 2024.” Plug Power’s accounting issues have also been cleared up with minimal impact on the overall financial outlook of the company. The company reported 76% growth in revenue year-over-year for $72 million in revenue which was less than analyst expectations at $77 million. There was also a EPS miss at ($0.12) compared to ($0.08) expected.
Why has the stock done well despite a weaker-than-expected earnings report? My guess is because Plug Power is the fastest growing company within the renewables sector and the underlying key metrics are stronger than the surface-level ER reveals. Although profitability is an issue, Plug Power’s fuel cell systems segment is growing rapidly and this is the company’s most profitable segment.
Gross billings are also very healthy. Here is what the CEO said in the last earnings call:
“Investors should expect $115 million to $120 million of gross billings for the quarter. This is approximately 40% of our target revenue of $475 million for the year. Usually, at this point in the second quarter, […] 33% of our annual revenue will have been achieved. We are at a run rate that is higher from both a revenue and growth rate level than we have experienced in the past.”
Plug Power is at the top of our list right now for renewables.
Enphase:
Enphase has done well because it’s a safer choice than many other renewables as the company has been consistently profitable for many quarters (9 out of the last 10). The company has an adjusted gross margin of 41% with adjusted EPS in the most recent quarter of $0.56.
Not only is Enphase consistently profitable yet the company has maintained industry-leading growth. The most recent quarter reported 46% growth year-over-year and 14% sequentially. In 2019, Enphase was in the 75%-100% growth range. This is important because the company is very consistent where other solar stocks are not.
During Covid, there was a brief pause in revenue growth in Q3 and Q2 of 2020. The company reported flat growth in Q3 2020 and -6% growth in Q2 2020. For this industry, that is not bad at all and is actually a sign of strength that Enphase bounced back faster than it’s peers.
The company has a cash balance of $1.48 billion. In March, the company issued convertible notes due 2024 and 2025 for net proceeds of $1.19 billion.
For the second quarter, Enphase management guided for $300 million to $320 million, or 140% growth. Again, this is due to the weaker quarters the company had last year during Covid, which were flat to negative. It’s better to look at the growth on an annual basis, which is expected to be 70% growth for FY 2021 with analysts expecting $1.32 billion this year, up from $774.4 million.
Enphase is at the top of our list for renewables.
SolarEdge:
SolarEdge competes with Enphase yet does not have the same consistency as the company has reported flat to negative growth for four quarters. The company reported revenue of $405.5 million, or (6%) year-over-year yet up 13% sequentially.
Adjusted gross margins are at 36.5%. The company has $515 million in cash.
Looking forward, SolarEdge is expecting $445 million to $465 million in revenue, or an increase of 37% for the upcoming quarter. The annual growth for FY2021 is expected to be around 29% with the year after at 25.3%.
We will keep an eye on SolarEdge for improving financials.
Blink and ChargePoint:
ChargePoint operates the largest online network of independently owned EV charging stations operating in 14 countries. The adjusted gross margins are in the 20-25% range.
We like this company for its strong cash position and steady forward growth. Revenue increased 24% year-over-year to $40.5 million with management guiding for $46 to $51 million in revenue next quarter. The company also confirmed its revenue outlook of $195 to $205 million for FY 2022 ending in January. This represents 37% growth year-over-year. The company has cash and cash equivalents of $610 million after exercising warrants worth $73.8 million.
Blink is a fast-growing company with revenue growing 72% year-over-year and charging stations growing 370% year-over-year. However, the company has very little revenue to speak of with $2.2 million in the first quarter. It’s easier to put up triple digit numbers with a low revenue base. The company also losses of $7.4 million that have gotten steeper as the company grows, up from losses of $3 million in the previous year.
We wanted to highlight these two to show why we prefer Stem as our high beta play. Not only is Stem growing faster but plans to be profitable this year. Notably, we also have exposure to EVs through Xpeng and Nio. We’ve owned Tesla and Lucid Motors in the past.
Stem:
Stem has over 900 systems operating on its Athena AI software in over 200 cities worldwide. Athena AI optimizes time-of-use and demand charges, resulting in 10% – 30% monthly electricity bill reductions.
The company is still in its infancy with $33M in net revenue for the FY 2020. Revenue is projected to grow 348% YoY in 2021 to $147M. With the way the company recognizes its sales, 88% of its forecasted 2021 revenues are from contracts that have already been executed. This means there is minimal risk that the company will fall short of its 2021 revenue target of $147M. Notably, the company has a pipeline of $1.43 billion.
The company reaffirmed its 2021 financial guidance for $147 million in the latest earnings report on May 17th. The company also outlined they expect nearly half of the annual revenue to come in Q4.
Revenue came in at $15.4 million in revenue compared to $4 million in the year, up nearly 275%. Adjusted gross margins were at 19% compared to 1% a year ago.
The company expects to reach adjusted EBITDA profitability in 2022 and turn FCF positive in 2023. Gross margins are expected to improve to 38% by 2025. The gross margin improvement will be driven by Stem’s increasing software revenue, which is the highest margin portion of their business (~80%)
Stem is a newer company that must prove itself. On that note, we are very bullish on this company for the exposure to software within the renewables sector that this particular investment provides. Notably, Stem is the one renewables stock and the only SPAC we remained with during the sell-off. Please reference our Stem position on the portfolio and our past research here.
iSun:
iSun offers solar, energy and data solutions. The company is a “deSPAC” or basically SPAC post-merger that has very low gross margins. In the most recent quarter, the company reported $7.26 million in revenue yet had only $119,000 in gross profit. This nearly $0 in gross profit is a pattern in previous quarters, as well. We see this company as too high risk for an entry at this time. The margins would need to improve substantially for consideration.
Bloom Energy:
Bloom Energy has revenue of $194 million per quarter, an increase of 23.8% year-over-year. The adjusted gross margins are at 29% with adjusted EPS of ($0.07). The company has negative operating margins of (7.4%) in the first quarter of 2021 which is an improvement from the (29.6%) operating margin in the first quarter of 2020.
The company has cash of $365.7 million and debt of $522.2 million.
Management guided for forward revenue of $950 million to $1 billion for FY 2021, or 25.7% growth. The company was flat last year and saw very low growth the year prior.
Overall, this company is not high growth enough for our portfolio.
Conclusion:
One reason why the renewables sector is at a starting point (and we are not seeing the full picture yet in terms of financials) is that Moore’s Law applies to renewable tech. For example, the cost per watt in solar has gone from $22 in the 1980s, to $3 in 2011, and is now about $2.90 per watt. In fact, MIT released a report explaining how close we are to $0.20 per watt, which will make the economic benefit of transitioning to solar a real driver for both individuals, businesses and municipalities.
Right now, we rate Plug Power slightly higher than Enphase in terms of positions we want to build. We are also reiterating our conviction on Stem compared to other high beta plays in this sector. We believe these are the top three choices – Plug Power for growth, Enphase as a market leader and Stem for its position with the Athena AI software and strong revenue growth out the gate.
Asana is the best performing cloud stock this year. The I/O Fund discusses how they identified this opportunity by using a blend of fundamentals and technicals to remain with the stock through the growth selloff. I/O Fund also added to the position in May for an 85% gain in under a month.
In February, the I/O Fund entered Asana (ASAN) and we held this position through the growth rotation, On May 20, we added to Asana (at $33.25) as a momentum play and held a webinar explaining our entry.
It was confirmed that Asana was outlining a common uptrend pattern that we see with tech growth.
Others, such as Roku, Datadog, Nvidia (overlapping uptrends), have followed this pattern as well.
We saw some significant bullish patterns within the volume, which typically leads a breakout. We were getting evidence that “smart money” was accumulating shares at these levels.
On top of our entry at $33.25, and identifying another buying opportunity at $34.50, we alerted subscribers that a breakout above the all-time high ($44.00) would also be a good entry point.
On June 18, we trimmed a third of our Asana position at $55, since our first target was met. That’s a solid 65% return in under a month.
Knox Ridley is the Portfolio Manager of I/O Fund. He uses a blend of technical analysis and risk management to achieve some of the best returns on Wall Street. He holds weekly webinars to discuss his trades setups. When he enters and exits stocks, he also sends real-time trade notifications to subscribers on the premium site.some of the best returns on Wall Street. He holds weekly webinars to discuss his trades setups. When he enters and exits stocks, he also sends real-time trade notifications to subscribers on the premium site.
