Talking Tech

Talking Tech is produced by the Progressive Tech Team of George O’Connor, Ian Robertson and Gareth Evans. Our aim is to bring you up to date with the tech news cycle each week. We comment via blog and podcast on the slings and arrows of the sector at a time of huge change.

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May 15, 2024

Dreams do come true, if we only wish hard enough.

The ‘Tinkerbell effect’ describes the phenomenon of thinking something exists only because people believe in it. It is named after Tinker Bell who was revived from near death by the belief of the audience. We have an audience in the UK for any pundit ready to bellyache about the dismal fate of the UK markets. The data suggests that the whinging is being played out against an improving backdrop. Join us if you will as we dare to present a contrarian view. Let’s have a look.

The economy. The numbers are neither dramatic nor shattering we had news (10 May) that the UK was officially out of recession. Data showed the economy grew by 0.6% in the first three months of the year. The ONS said the period from January to the end of March marked a return to growth after a recession in H2/2023. Also, this marked the strongest rate of quarterly growth since the end of 2021, and a better performance than expected by economists, who were guessing 0.4% Q1 growth.

Higher for longer (i.e. lower (valuation) for longer) starts to crack. The BoE kept interest rates unchanged at the latest review (9 May) at 5.25%. However, the mood music has changed and there are indications it may begin cutting them from June, and the 10-year has started to nudge better already. The big damper on tech valuation has been the rising cost of capital since 2021, as downward pressure there has an inverse effect on valuation and sentiment. We show the long-term relationship between these variables. Note correlation is mixed as is any more precise cause and effect.

Politics. We are not at Peak Politics, barely at the start. But for Labour an early election helps, for Conservatives a later one please. Our guess is November, but Parliament can run until January. As the economy improves, so too should the fortunes of the Conservatives. A Chancellor in a marginal seat might think about voter friendly policies in a further Autumn Budget.

A strengthening IT spending environment. We note that 17 April, industry analysts Gartner revised IT Spending projections upwards (see below). The analysts now expect worldwide IT spending US$5.06tn in 2024, +8% Y/Y. The prior estimate was +6.8% Y/Y growth. To be sure, forecasts are prone to moving as evidence changes but this is first upward revision by Gartner in several years.

IT Services growth c10% Y/Y. Within the IT market segments, Gartner believe that spend on IT services could grow 9.7% to US$1.52tn. With that this becomes the largest market. From the reported numbers revenue is falling and company guidance falls well short of 10%. However, as we baked in the latest inputs to our IT Professional Services model (Thoughtworks, TCS and Netcompany – see below) the KPIs are moving positively. In addition, participants are picking up incremental AI related work as CIOs say “help” as they look to IT service providers to bringing GenAI capabilities to their existing products, services and implement new use cases being identified by their clients. This will remain the case, and indeed accelerate, until LLMs become less of a ‘black box’ with a tool kit and more of an application stack, i.e. that is not happening any time soon, if ever.

Replacement cycle kicks in. All of the stuff bought for lockdowns is now depreciated and getting ready for the trash. In datacentres cabinets will be replaced by shiny new GPU-based ones. Desktops are already on a refresh cycle and withdrawing support for Windows 10 (14 October 2025) will push the late majority. In addition, the average lifespan for mobile phones is shortening and consumers and enterprises replace mobile phones earlier. This change allows device spending to hit US$688bn during 2024, in 2023 it was US$664bn. The integration of GenAI capabilities in premium and basic phones sustains and drives this change.

The Techmark index recovery. Almost forgotten, the index has recovered this year (see below), and this positions LSE favourably against international comparisons.

Sector TSR is in positive territory. Reversing 2022 and 2023, the 2024YTD sector TSR is +5.7% (see below). Investors are not negatively impacted by favouring the sector.

Tech valuation, as expected by the maco, tech valuation is moving sideways (see below). Positively, this means that shares remain attractively priced. They are a tailwind for any investment case – writing analysts can only argue that share XYZ is cheap and has a plausible supportive argument, as you add in market momentum, the investment case moves on from the ‘dead money for now’ argument.

Tech input pricing remains favourable. There has been a continued drop in offered permanent and contract IT salaries this year (see inside). It is disappointing to see the April spike in tech layoffs (see below) but more favourable on vacancies (see below), but nonetheless it does feed productivity and margin gains. Indeed, this is already featuring in some of our cohort dashboards (below).

So where are the worry beads – (there are always a few)

‘Sell in May’ thinking. Given that most things are cyclical we note following the pre-summer rally, tech has a fondness for ‘Sell in May and go away’ thinking it happened in 13 years since 2003. The follow-on clause ‘don’t come back till St Leger day’ also worked in 13 years. However, the pair trade worked in 8 of those. (Note: this year St Leger is 14 September.) Looking greedily at the pre-summer gains will get folks thinking about banking profit.

Working capital and Capex. A constant theme from calQ1 reporting was the Capex increase to cope with GenAI demand. Note: (i) Amazon flipped US$14.9bn in property and equipment; (ii) Microsoft said that AI demand had boosted sales of Azure cloud by 7 percentage points (iii) Equinix CEO Charles Meyers, commented that the “rapidly evolving AI landscape continues to serve as a catalyst for economic expansion with strong demand from customers across multiple sectors”.) The drivers are increased demand for GenAI services but also, after a pause, there has also been more generic cloud migration. Clearly, this brings with it concerns about potential shortages but these have not surfaced.

The US and ‘we all fall down’. The US market has rallied on the performance of a few tech shares (Magnificent 7). Now  with concerns of ‘bubble valuations’ brings risk of a pull-back. Any pull-back will have a ripple effect through the US market and across to the UK, despite any evidence of either a bubble or without having an domestic UK Magnificent 7.

Not thru the re-structuring grind. The latest Thoughtworks print featured the resignation of the CEO Guo Xiao.

More M&A. Folks get agitated about M&A, and companies leaving the market. The real problem is not exits but the lack of new entrants, tech has had many exists over the years (see below), with more pending at Alpha. The current low levels of valuation whereby ‘higher for longer’ (cost of capital) means lower for longer(valuation) so rational sellers will bide their time and await higher pricing. It is of course short-termist thinking by its nature, but it has ever been thus.

The bubble bursts. We attended a thought-provoking presentation by the noted analyst Dr Richard Windsor this week. Mr Windsor believes that GenAI bubble valuations will retreat and at the heart of his view is over-hyped functionality and business models that fail to deliver the expected unit economics. We agree with Dr Windsor’s views on the problems of hallucinations, and concur that any volt-face could have a ripple effect through the wider sector. This was a very timely meeting, especially as we basked in the reflected joy of the Wayve funding round.

The data

GDP, Tech Spend and Tech valuation

Mirror, mirror on the wall – the indices YTD

Tech valuation changes March to May 2024 via our Valuation heatmap

Tech Sector TSR over time

Gartner improving tech spending outlook

Source: Gartner Group

IT Salary woes continue

IT Layoffs persist as do low levels of vacancies

Sell in May – what is the evidence?

Source: Yahoo Finance, London South East, Analyst (George O’Connor)

The M&A undisturbed price premium, by buyer type

IT Professional Services dashboard

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