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Tech companies: ‘The big are getting bigger,’ strategist says

Baird Technology Strategist Ted Mortonson joins Yahoo Finance Live to discuss the expectations for the tech space going into 2023, geopolitical headwinds, investor sentiment, how a recession would impact semiconductors, and the outlook for the economy.

Video Transcript

BRAD SMITH: And it's been a wild ride for tech as the industry faces a wave of layoffs, while geopolitical and economic headwinds weigh on investors' minds. And as we look ahead to the new year, our next guest says that a volatile first half is in store for 2023. With more on this, we are joined by Ted Mortonson, Baird Technology strategist. Ted, what particularly within tech do we have to look forward to in 2023?

TED MORTONSON: Well, I think it's as you indicate. And thanks for having me. I think it's going to be somewhat of a tough first half. And the reason why is not only are we facing some geopolitical headwinds, but the Fed with QT, I think that is one of the biggest issues that I think the Street may not be getting their arms around. It's going to be higher for longer. That's number one.

As you look at models out there, whether it be semiconductors or software, they're probably too high going into '23. And I think what has to happen is these managements have to gauge their commentary in the first-- as we go into Q4 reports on really what's happening on the macroeconomic area on reality.

And I think as those models come down, and we actually understand what the earnings outlook is and what the revenues outlook is, we can get to more of a directional valuation that some of the large mutual funds, as well as hedge funds, can get their arms around and see what, really, reality is.

JULIE HYMAN: Well, and sort of on a related front, Ted, in a way, is the tightening cycle sort of helpful for investors? Because it allows them to see where the problem areas are, right? Because it's not as though tightening causes these issues. It sort of reveals them, right?

TED MORTONSON: It does. And in this cycle, I think what you're seeing, as you mentioned, what is being revealed, as in this cycle, the bigger, getting bigger. The cloud titans are now swimming out of their lanes, of their product lanes, and platforms are winning in the marketplace as you pivot to these digital transformation macros, whether it be cloud, 5G, next generation security, and AI. The big is, unfortunately, getting bigger.

And what it is alluding to is the smaller companies that have point solutions in this type of cycle, when you have negative economic headwinds, they become somewhat more at risk. And those models have more downside than some of the cloud titans would.

BRIAN SOZZI: Ted, when did the semiconductor stocks bottom? They have not put up a good, I would say, past six months.

TED MORTONSON: The problem, very simplistically, is '22 was illustrated by just in case inventory. And because we had so many acute supply chain issues, everybody's-- the global 2,000 that needed semiconductors are essentially building so much inventory. It looks as if we have to go through an inventory absorption cycle. And definitely in Q1, inventories are very, very high out there. And as you enter '23, the big worry is that you have a unit recession.

So to guess that the Semiconductor Index is going to come off the bottom in the first half, I don't think that's the right scenario. We really, really need to bleed some inventory here. And then I don't think anybody really has a very clear crystal ball based upon the macroeconomic areas to what degree we have a seasonal second half. So my best guess, to answer the question directly, I think most investors that I'm talking to daily are looking at kind of this reassessment in April, May, or June, to see how much inventory has been degraded.

And then in semiconductors, there's commodity capacity plays, and then there's the innovators. And I think there's much more of a desire to own the innovators, like an AMD, an Nvidia, a name with huge backlog like Avago, or, to even some degree, the big leaders in high performance analog, and that would be an ADI--

BRAD SMITH: Ted, I think--

TED MORTONSON: --with a very strong backlog.

BRAD SMITH: Right, right, right. I think about the cloud-based software plays, software as a service, companies like Salesforce that have just been battered over the course of this year. What would you need to see within the environment for cloud companies, but SaaS or ERP specific companies to see some type of rebound next year?

TED MORTONSON: This goes right back to the model, as I opened up the conversation. We're now in front of what I would call a seat count compression. If you look at big tech, as of last week, we had roughly 90,000 layoffs in the valley from large, medium, and small companies. And as you look at SaaS, Software as a Service, their models are generally driven by seat count additions.

And when you have layoffs, that generally doesn't really point to a lot of these companies outperforming. So for this group also to get going again, the models have to come down on these seat assumptions. Models have to be reset. And then post that, I think as you get realistic valuation, the models have bottomed. Investors will-- when these models are derisked a bit, I think you'll see some actual buyers more in the second half of next year.

BRIAN SOZZI: Ted Mortonson, Baird Technology strategist, great analysis here. Happy holidays.

TED MORTONSON: OK, happy holidays for you.