Beth Kindig on AI, Semiconductors, and Tech Cycles

Beth Kindig is the lead technology analyst for the I/O Fund. Motley Fool analyst Deidre Woollard caught up with Kindig to discuss:

• Where we are in the cloud adoption cycle.
• A key narrative playing out in semiconductor earnings.
• What to learn from companies that went public too quickly.

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This video was recorded on February 12, 2023.

Beth Kindig: Money could potentially dry up. I am very firm on the fact that the dot-com bust is not what we're looking at because technology today plays a much greater role and a very important role, but I will say that some of the parallels around the private markets are there. 

Chris Hill: I'm Chris Hill and that's Beth Kindig, the lead technology analyst at the I/O Fund. Deidre Woollard caught up with her to talk about how the big macro has changed everything about tech investing, what to watch as semiconductor companies report earnings, and the uses for artificial intelligence that don't get as much attention as they probably should.

Deidre Woollard: You focus mostly on individual companies, but we've got to talk a little bit macro here. How has the macro-environment changed or has it changed any of the ways that you're thinking about investing right now?

Beth Kindig: It has changed everything entirely, I would say.

Deidre Woollard: Interesting. Okay.

Beth Kindig: 180-degree pivot toward how important macro, how important S&P 500 is even for tech investors because the S&P 500 is a culmination of many macro factors represented in one price movement basically. We actually, I would say the best analogy is that macro is in the driver's seat and we like to track the S&P 500 for that in terms of price movements. Bottom line is in the passenger seat and I would say growth is in the trunk of the car. That's how much growth has moved down in terms of importance.

We, at the I/O Fund, everything we do is actually macro-informed and we made that hard pivot back in April and May. If macro and S&P 500 is not participating, for example, we would not enter a stock. If S&P 500 stops participating, we would trim stocks and that's because macro is, like I said, truly in the driver's seat. We see that obviously when the Fed comes out and speaks, but at the same time, there's so much more underlying levels of uncertainty that need to be monitored. I would say the No. 1 would be the consumer actually we think is weaker than the market today is taking into account.

Deidre Woollard: Fascinating. Growth is in the trunk of the car that is a tectonic shift. You're talking about the consumer, but how does that impact some of the tech companies that you're seeing? I'm wondering about things like the cloud in terms of B2B, which then eventually becomes B2C. What are you seeing in terms of that?

Beth Kindig: Yes, that's a great question. In terms of growth being in the trunk, so to speak, we see that actually I think Meta had flat growth or negative growth by single digits and people are looking for that bottom line, etc. I think we've seen some evidence even already, of how little priority growth is being given. But in terms of your question with B2B and B2C, I think it's an excellent question because B2C budgets move faster. You could point toward many things that crashed ad-tech but the umbrella or the one common denominator is that ad budgets were greatly reduced and they are completely every single company doesn't matter if you have 2 billion users or just a couple of hundred million. If you're mobile, desktop, CTV, across the board, they were all penalized greatly due to how much budgets had come down.

Now, we're up against as cloud investors is cloud budgets which the enterprise move slower, They determine these budgets usually in the early part of the year. What I would say is most concerning about the cloud software slowdown is that enterprises were actually pulling budgets, reducing their budgets that they had already set for 2022 for Q4, that's a red flag really. What we could see is some exuberance, which is what we're seeing in the market now, I'm talking not respective to price action. I'm saying underneath the fundamentals are weak enough that eventually price will be adjusted long-term, whether we get an exuberant month or two in the market or not. That would be something to really closely watch, is why were budgets pulled.

The deceleration from Q3 to Q4 last year. I don't think cloud has ever seen that deceleration, not that I can recall. It was nearly a 70 percent deceleration. There should be typically in 2021, 17 percent growth between Q3 and Q4 because it's like a budget flush. You hurry up and use the rest of your budget. There is sequential growth on average across best-of-breed is now five percent, so from 17 to 5 were not negative yet, but that's a substantial deceleration. If we have one or two more of those, quarter to quarter, cloud would be in bigger trouble. We've taken about a 30 percent allocation down to about a 10 percent. We still participate in cloud and this is across various positions, but we're not overweight cloud until we see what's going to happen. Again, we could have one or two, three, four best-of-breeds beat. This is not about getting lucky, this is about being directionally aligned with the fundamentals of not only a vertical such as cloud, but the companies in our portfolio.

Deidre Woollard: Interesting, so of course we're seeing a lot of layoffs, we're seeing a lot of rightsizing and I believe Mark Zuckerberg for Meta, he called it the year of efficiency. Is that something that you're watching for different companies, how well they're trimming those expenses to match expectations?

Beth Kindig: Yes, another great point about cloud is that it tends to be fairly weak on the bottom line so they would have to cut quite a bit in order to improve the health of their bottom line. That's actually unique from one of the worst performing sectors last year was ad-tech. Ad-tech as a whole tends to be cash efficient, but you can pull some levers. Cloud tends to not be cash-efficient so that's yet another headwind. What levers are going to be pulled? What will it result in? Will it ultimately make a best-of-breed weaker to a company like Microsoft, which has more room to pull levers. I love the quote that Satya Nadella had just said and I'll probably mess it up a little bit, but he basically said there's one law of gravity, which is inflation-adjusted growth, which all companies are subject to.

I think that that quote is like the theme of 2023, which I guess Meta repackaged as efficiency, but what I would say is the more that we're in a higher inflation rising rate and environment combined, the harder it will be for companies to grow, the harder is for companies to grow, the worst their bottom lines will be, the worst their bottom lines will be the harder it will be for them to raise money or continue to operate. It's a snowball effect or domino effect, which I think Satya Nadella really put it nicely about that gravity because we all know gravity effects every human and he's basically saying it'll affect every company and there's not going to be too many outliers. I always think there will be a couple of outliers because I'm optimistic, but he's basically saying it's a law rather than something more subjective.

Deidre Woollard: Interesting. Well, I want to talk a little bit about cycles in general. You just talked about cloud. Let's talk a little bit about semiconductors and what's happening there. One of the things that I'm hearing, I heard this from Taiwan Semi or heard this also in the AMD earnings was like they're almost saying Q4 was great. First-half of 2023, don't think about it's going to be terrible and then we're going to be great the second half of 2023, what are you seeing in this semiconductor cycle, both in the short term and the long term?

Beth Kindig: If we're underweight cloud until we see what these companies are capable of with this reduced spending or lower budgets, I would say we're overweight semis and a lot of it is not only some of the visibility that we're getting across a few different companies. I hope Nvidia echoes what AMD and TSM are saying because the more companies that agree on an H2 rebound, the more confident as investors we can be about it, rather than just one siloed comment from a management team. I liked the fact TSM and AMD both lined up on those comments. Secondly, what I would say is that they have better visibility.

In one way, I guess the markets used to be very timid around how they basically run in cycles, but to some extent, Nvidia, AMD, TSM, they have better visibility because these budgets have to be allocated far in advance. That's helpful, especially given the reduced spending we may see from enterprise budgets or consumer budgets or consumer marketing-related budgets, I should say. Ultimately though, we are overweight, not only for the fact that that rebound is nicely timed to the collapse that Nvidia had with crypto mining and AMD had with PCs, that was a Q3 collapse, if you will. Their comps are much easier come the following year, specifically in Q3.

But I also like their AI positioning and as much as you're hearing about things like ChatGPT, the T in that stands for transformer, Nvidia powers that and so what I like is if you're going to give me depressed prices and if you're going to give me a shallow or deep recession, there's is still out on which way it will go, I want to build my AI positions as cheap as possible, and therefore I feel like it's a win-win, where I'm getting to build cheap AI positions given all the deep discounts we have, but I also have some visibility into how it might close out the year of these companies, which presumably will be higher price than where we're starting because of that H2 rebound, which has now been echoed across two management teams. I'd love to get that third in about two weeks from now from Nvidia. So that's what we're looking for.

Deidre Woollard: IPOs have to come back at some point. It's probably not going to be a super robust year for venture capital and for IPOs, but what are you looking for in the long term? Are there lessons that venture capital learned during this time period? Are companies going to wait longer before they IPO. Is there a little more cautious and its now baked into this cycle?

Beth Kindig: Yes, so money could potentially dry up. I am very firm on the fact that the dotcom bust is not what we're looking at because technology today plays a much greater role in a very important role. But I will say that some of the parallels around the private markets are there, which is just this exuberant level of funding. So many companies were able to raise rounds and according to some of the research that we've done, that has not caught up yet to the VC market and it's more likely that it will hurt the VC market this year. What happens is that you're a mid-sized start-up and you're not able to raise more money so you start to go out of business. The more they go out of business, the more zeros VCs have, the harder it is for them to raise their next rounds for funding from their limited partners so it has a domino effect.

It takes longer than the public markets and I think what you saw in the public markets this last year is going to catch up to VCs. It just is going to take a little bit longer of a squeeze, which is start-ups run out of money, they go to raise money, the money is not there, the VCs who funded that angel, that Series A, whatever it is lose that money because there's no more to raise and that is important because almost all of them, the high hyper-growth, new growth companies coming out the gate through a public offering. So the IPOs will slow because fewer Series C, let's just say Series B, Series C rounds are going to happen, which means they'll be fewer that get up to maturity, Series D or F that then will go public and without that, we're going to have far fewer hybrid growth on the market and then that affects tech in general as well.

One thing I would characterize about the dotcom bust, let's say is you did have an Amazon and a Netflix, but they were just very few hyper-growth companies coming onto the market not only because of some of the macro backdrop but because the IPO market had gone bust and the venture world had gone entirely bust. It ruined people. We like to talk a lot about how the public markets ruined people from the dot-com bust, but the venture world was ruined as well so a lot of people lost a lot of money. That's coming probably and I follow some people on Twitter and I have to think about their names right now. I have to get back to you on that, but some of them are really very interesting data points on it that I've been following so tech investors should keep an eye on that.

Deidre Woollard: For some of the companies that maybe IPO'd too fast or that are grossly unprofitable at this point, do you think we're going to see more mergers and acquisitions? We've already seen a little bit starting to happen this year, certain companies being taken private other companies being folded in, how much are you watching that aspect of what might unfold?

Beth Kindig: That's a great question. I don't think enough people are asking what will happen if the previous Wall Street darlings don't survive or run out of money and valuations remain low for a long time, which makes it harder to raise money. Overall, what I would say is that in verticals like Cloud consolidation is coming but actually let me back up. The weird part right now is nobody knows how deep or shallow the recession is.

Deidre Woollard: Yes.

Beth Kindig: Yeah, we're in a really strange moment here. On the positive side, it would be early 2024 when we come out of the recession. There are certainly some analysts' estimates predicting that if you look at, for instance, Facebook's return to growth supposedly they're going to return to growth back half of 2023 and into 2024. That's for every company almost that I've tracked, far majority, let's say 80 percent. Anyways, let's say it's a shallow recession then M&A may not happen at the level that you would normally think it would. Let's say it's a deep recession which would swipe out 2023, 2024. We go all through 2024 with these low valuations, tech out of favor, M&A will really pick up and it'll be survival of the fittest.

The public markets haven't been through this for so long that people probably think I'm talking doom and gloom but I'm not because it's actually just a pretty natural process where these VCs, actually, speaking of VCs, they will fund a lot of start-ups, push them off into the public markets. They actually get an exit from that. They get paid pretty well if they go public, but can those companies survive long-term? That's not even a question they care to answer. It's not important to some of the insiders or the VCs. It's imperative though for public investors to figure that piece out. Can the company that did so great as a hyper-growth start-up, are they able to have a strong bottom line to get through in a time when cash is scarce? It's not going to be able to raise like you were when you were a start-up so basically that's the big question mark.

In that case, mergers and acquisitions would really pick up, the strongest would pick up the weakest if they're lucky, and the rest would go out of business if they're not lucky so you can expect a percentage of the public markets, companies, stocks, former Wall Street darlings to go out of business or have to sell, be eaten up by the strongest companies with the biggest cash levels and that would all greatly depend on how deep the recession is, but it's a pretty natural process this is not a doom and gloom. It's actually just how tech operates and it goes through that about every 10-15 years and we're far long due since the great financial crisis for it. Mobile actually had a bust cycle. Already, gaming how-to-bust cycle. Zynga is a great example. It was a darling that I think they are still around but they're not valued for worth much so near-zero at that point.

Deidre Woollard: Want to ask you because I was really looking forward to talking to you about generative AI and the buzz that we're right in the middle of now with OpenAI and ChatGPT and we've got the AI art trend. Everyone is so excited about generative AI right now. What should investors be thinking about with that? Is it focused on Microsoft or what do you thinking?

Beth Kindig: ChatGPT was a nice catalyst or a nice headline around AI. There'll be so many AI tools, AI apps, even image generation tools, things like that thousands basically, over the next 5-10 years. ChatGPT happens to be one of the first that is getting widespread attention, which is great. Beneath all of that though, you do have Microsoft and you also have Nvidia and I would look for those companies that are going to participate, no matter what the OpenAI called mainly R&D firm or company no matter where it's coming out of or who's making the app or company.

We obviously have a lot of big players that are going to look to pivot and bring those apps to the market. I also like the enterprise side, although there will need to be some consumer participation, AI is going to be expensive to adopt and I think the most likely first adopters will actually be the enterprise, which is another reason I like Microsoft. Microsoft has really strong relationships with the Fortune 500 and the Fortune 2000. I think that's going to be some early adopters because the goal of AI is to drive down costs and unfortunately, as you've probably heard, to reduce headcount, who's going to want that more than the Fortune 500? I like that about Microsoft where it lands with the consumer is probably harder for an investor to predict.

We've seen that with the metaverse, despite there being a lot of industrial applications for the metaverse, such as training autonomous systems. The consumers have pushed back. They're not necessarily wanting their kids living in the metaverse or themselves with headsets so I think consumers can always be a little harder to predict whereas enterprise with AI, to me, makes a lot of sense and so Microsoft is right there so I would look at it broader too not just with ChatGPT, super popular, but who's really going to propel AI/ML forward? I believe it will come from the enterprise.

Chris Hill: As always, people on the program may have interests in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.