National Bank/RBC National Bank Financial analyst Richard Tse and John Shao see the potential for slowing momentum in the Canadian technology sector entering the earnings season after a strong start to 2023.
“If you follow our research you’ll recall in our 2023 Year Ahead (Get Ready) we made it a point of emphasizing that avoiding the Technology sector given the big pullback in 2022 was a potential detriment to missing outsized returns, at least in the short term,” they said. “A big part of that was based on what we’ve seen historically, and as recently as the middle of 2022, when the idea of moderating rates pushed the group higher. That bottom-fishing had the S&P/TSX Info Tech index up 26.5 per cent vs the 4.6-per-cent return on the TSX in Q1 (March).
“But what do you do now? Given that early year run, we think inertia is setting in as valuations have crept back up again to their historical averages against growing risk for a softening economic backdrop. For investors looking ahead, we see our defensive technology names (CSU, GIB.a, OTEX) outperforming at this point with an opportunity to build positions in our OP-rated growth names that continue to consistently execute (AIF, DCBO, KXS, NVEI, SHOP, TCS, TIXT).”
In a research report released Friday, the analysts see increased potential for earnings disappointments heading into reporting season following a change in sentiment on the Street through the first four months of the year.
“While earnings had been moderating earlier this year, that declining trend has recently turned based on a shifting focus towards cost controls with many names taking on restructuring over the past 12 months,” they said. “We think that’s led to a slight uptick in expectations, and it’s that higher bar that’s also set up increased risk going into this Q1 earnings season as those cost improvements are likely temporary pickups under moderating top-line growth.”
“From a macro perspective, the narrative in the first quarter of 2023 for Tech was largely driven by potential implications following the SVB (Silicon Valley Bank) collapse. No doubt, that amplified the notion of liquidity when it comes to our coverage group from tighter financial conditions, particularly for many of our ‘newer’ names and especially the unprofitable ones burning cash. In light of that, we’ve updated our cash burn analysis to assess which of our (NBF) coverage names have potential liquidity risk. The analysis underscores that most of our coverage names are in sound financial positions with low liquidity risk.”
The duo named four companies with the “potential upside from calendar Q1 results.” They are: CGI Inc. (GIB.A-T, “outperform”), Nuvei Corp. (NVEI-T, “outperform”), Shopify Inc.(SHOP-T, “outperform”) and Tecsys Inc. (TCS-T, “outperform”).
Conversely, they think Farmers Edge Inc. (FDGE-T, “sector perform”) and Real Matters Inc. (REAL-T, “sector “perform”) have downside risk.
With their updated forecast, they made these target adjustments:
* CGI Inc. (GIB.A-T) to $160 from $140 with an “outperform” recommendation. The average on the Street is $136.46.
“We’re expecting solid FQ2 (CQ1) results for CGI given the follow through in digital transformation projects post-COVID combined with a pick-up in cost savings/efficiency offerings under the current and expected economic market backdrop,” said Mr. Tse.
* Constellation Software Inc. (CSU-T) to $3,000 from $2,700 with an “outperform” rating. The average is $2,854.31.
“We’re expecting solid in-line results for Constellation in FQ1,” said Mr. Tise. “If you’ve been following our research, you’d know that we’ve been calling for more potential spinoffs looking ahead as a way of surfacing value following the successful spinoff of Topicus and more recently the Lumine Group. While it’s still too early to assess that potential untapped value from the Lumine Group, we’d note that Topicus has seen its market capitalization expand by $3.3-billion since it began trading as a publicly-traded entity.”
“All in, we continue to like CSU for its defensive attributes (recurring revenue and cash flow) and heightened growth profile given the accelerated pace of capital deployment.”
* Lightspeed Commerce Inc. (LSPD-N, LSPD-T) to US$20 from US$30 with an “outperform” rating. The average is US$27.21.
“Given a recent shift in strategy to target ‘higher value’ merchants (i.e., more than $500k in annual GTV [gross transaction value]) care of the improved unit economics associated with the group, the Company is refining its target market,” said Mr. Tse. “For reference, those merchants (higher value) have 2.5x – 4.5 times greater ARPU [average revenue per user] than smaller merchants (those with less than $200k in annual GTV) and represent 63 per cent of total GTV despite only representing 15 per cent of the total market. Beyond that shift (in strategy), on January 17, 2023, Lightspeed announced the elimination of 10 per cent of headcount-related operating expenditures (300 employees) with half of those cost reductions coming from management layers. All in, Management expects the salary and related benefits from the eliminated roles to save $25-million annually. While those savings are meaningful, the Company has made operating leverage gains with software margins up 110 basis points year-over-year (FQ3). And with the forward focus on only two core (flagship) products, Lightspeed Retail and Lightspeed Restaurant by yearend (post-acquisition integrations), we think the path to profitability looking into F24 appears reasonable.”
* Q4 Inc. (QFOR-T) to $5 from $3.50 with an “outperform” rating. The average is $3.38.
“We’re expecting an in-line quarter for Q4 in FQ1,” said Mr. Tse. “A notable growth driver for Q4 is IPO deal flow as it presents greenfield opportunities to onboard new customers at a low cost given its partnership with NYSE. IPO deal flow was soft in calendar Q1, but has recovered from the lows of 2022, up 44 per cent year-over-year and 271 per cent quarter-over-quarter. That said, declines in valuations have the potential to fuel M&A/de-listings. The above factors have reigned in growth expectations to 10-15 per cent in F23.”
Elsewhere, in a research note, RBC Dominion Securities’ Paul Treiber said valuations for tech stocks remain below historical levels heading into earnings season.
“With the decline in risk-free rates and improving sentiment, tech valuations have rebounded over the last several months,” he said. “However, macro uncertainty persists, with some markets resilient and others seeing signs of softening. In this environment, we see outperformance in Canadian tech dependent on individual stock selection. The stocks that we expect to rally through Q1 results will be those that are able to avoid the near-term impact from elongating sales cycles and deliver growth or profitability ahead of expectations. In our coverage, we believe several secular growth stories like SHOP, KXS, and NVEI are likely to report solid Q1 results. We also view the consolidators as attractive holdings in this environment. Consolidators are counter-cyclical and are likely to deploy additional capital in periods of uncertainty.”