MFS Sector Spotlight: Technology - Cloud Play

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  • 10 mins 40 secs
In this Sector Spotlight, we discuss how the MFS Global Research Platform is thinking about the demand for cloud services in the Covid world and investing in that space.

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MFS Investment Management

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- [Indhu Raghavan]
Hello and welcome to this sector spotlight on technology, where we discuss how the MFS global research platform is thinking about the demand for Cloud services in the COVID world and investing in that space. I am Indhu Raghavan from the Investment Solutions Group and I am delighted to be joined today by CV Rao, Equity Research Analyst at MFS who covers technology themes across sectors. CV, thank you for joining us today.

- [CV Rao]
Hey Indhu, nice speaking with you today and I'm hoping to see you and the team in-person one day.

- [Indhu Raghavan]
Like wise. Amidst widespread... I'm going to start again. No, no, no just the question.

- [CV Rao] Okay go ahead.

- [Indhu Raghavan]
Amidst widespread market dislocations precipitated by the COVID-19 pandemic, the technology sector led the market rally from the March lows. We would expect that trends such as social distancing and working from home would be positive for the sector as a whole, and especially for Cloud services. Now, CV could you comment a bit on how the COVID crisis has impacted the demand for Cloud?

- [CV Rao]
Sure. Cloud as we have seen is a multi-decade trend within tech and we are still early pretty in its adoption. Demand has been pretty robust with newer business models being built in the Cloud. Zoom and Netflix are two really good examples of companies and applications that wound up and grew up in the Cloud. Older software applications that are used to run companies to deal with financials, human resources, and so on, which ran in traditional data centers of their own, are now being slowly moved to the Cloud. Something like COVID demonstrates the power of the Cloud model. As more and more folks work from home or with kids came back from college and attending their classes from home, we saw big changes in our day to day consumption patterns in terms of what software we use to do our daily work or what we use for entertainment and when we use it. We are using a lot more virtual meetings, consuming a ton more entertainment and media products at different times during the day than what we were used to, and so on. So when all this happened we saw a need for massive uptick in demand for these Cloud platforms. If we look behind almost all the applications that we use they all one thing they all have in common, they all run in the Cloud. Cloud's ability to ramp, compute, and storage on demand seamlessly helped us get through this massive change and transition with very little pain. If and when we go back to normal, whenever that is and whatever that normal looks like, Cloud can ramp down just as well.

- [Indhu Raghavan]
So, beyond these transitions of say working from home or remote learning that we're all witnessing, are there areas of Cloud demand that are perhaps less obvious?

- [CV Rao]
Yeah, for sure. Moving past the more obvious trends like virtual meetings, at-home entertainment that drove demand for services by companies like Zoom and Netflix. There are less obvious impacts of the crisis that will play out over the longer-term in many sectors and sub-sectors actually. As an example, let's take a look at factory and industrial automation, which was already an ongoing trend before COVID. COVID has been a challenge to global supply chains that were built over the last few decades to take advantage of labor arbitrage, tax regimes and so on. By offshoring extensively, with COVID, plus the ongoing geopolitical changes we could see reversal of this trend as companies try to change their supply chains by bringing them back home in a trend that's called on-shoring. Given much higher labor costs in different markets this might mean lot more automation to drive better cost structure across the board. This could be a nice secular tailwind for automation companies and other software companies that support automation and supply chain optimization. A lot of the newer infrastructure runs in the Cloud. So when you combine all these trends, you see massive structural demand for the Cloud over the next several years. This is the specific automation example is a second or third order impact beyond just the direct impact from the crisis, that we look for as we try to spot investment opportunities more broadly.

- [Indhu Raghavan]
Very interesting. Do you see any risks to this thesis of increased spend for Cloud services?

- [CV Rao]
Sure. Yeah, definitely. We still have to pay attention to the drivers and the fundamentals like we always do. Our processes don't change. We need to think through the duration and size of the uptick in demand, i.e. how sustainable is the current demand we are seeing and for how long? Some of these trends might normalize back to pre-COVID levels while some might stay at a new normal. What that new normal is for us to figure out sector by sector. With these massive swings in demand, keeping supply and demand in sync is very hard to do and this means companies that supply into the Cloud infrastructure market could see cyclicality at some point as that spend slows. But the good news here is that we are still, like I said earlier, pretty early in Cloud adoption which means we have the opportunity to look past some of the nearer term cyclicality as they benefit from the long term secular demand trend.

- [Indhu Raghavan]
So it seems like on balance there is likely to be a sustained secular demand for Cloud services that has been accelerated by the COVID crisis. From an investment standpoint, how do you think about the ecosystem of beneficiaries from this trend?

- [CV Rao]
Sure. Companies and stocks that have benefited from recent events, they already reflect pretty high expectations and their trading at pretty rich multiples. With these more obvious beneficiaries there is likely a decent amount of risk to the downside actually as in, when things normalize and these companies are all well understood; given our global presence and breadth of coverage we can look for opportunities further afield in less obvious sectors, sub-sectors and in other geographies. So taking a look at Cloud ecosystem, it's pretty large. We can start with Pure Cloud providers who build and sell Cloud services; we move onto Software companies that benefit from the Cloud or actually provide a service or software that is critical for Cloud migration and enablement. Semiconductor companies which make the chips that go into servers and switches that actually power the Cloud and if we go one step deeper we get to semiconductor capital equipment manufacturers, that make equipment that helps make the chips and so on. There also other sub-sectors like data center companies which provide real estate for Cloud. And of course IT services companies that help with this transition to the Cloud. This is a continuous process; looking at the sectors the whole time, and being able to work with colleagues around the globe helps us cover more ground and be ready when opportunities arise and also it helps us to spot risks when they arise.

- [Indhu Raghavan]
So looking ahead, could you share your thoughts on how companies within say one of these sub-sectors that you mentioned might differentiate themselves making them potentially good investment opportunities?

 

- [CV Rao]
Sure. Let's take a look at one areas that we actually just mentioned - semiconductor capital equipment. These companies make large machines that could cost a few million dollars all the way up to 150 million dollars for one of them. These machines are used by semiconductor companies and sit in large manufacturing facilities called fabs to make semiconductor chips that go into servers and switches. The industry, this particular industry, was traditionally considered highly cyclical but the industry has consolidated over the last decade or so, and we are now down to a very small number of companies.  80% of all semiconductor factories, its been this year,  actually benefits just 5 of these companies, all of them are effectively monopolies or duopolies in their own area of specialization, and semi companies cannot really build semiconductors without their tools; they are absolutely essential. And on top of that, China wants to stand up its own semi supply chain which also benefits these companies. As Cloud build up continues these companies will see, I think, strong demand for their products. We've identified opportunities in this sub-sector here in the US as well as Europe and in Asia in the recent past.

- [Indhu Raghavan]
So they have dominant market positions providing an essential product in the value chain. Could you guys comment on another sub-sector with slightly different investment dynamics?

- [CV Rao]
Sure. Let's also take a quick look at software that enables a lot of complicated online transactions. Companies in this space we're already seeing a nice increase in demand and were riding a steady adoption curve even pre-COVID, and I think this will be true post-COVID actually. But COVID has definitely brought what they do to the fore and I think accelerated their adoption. So, just to kind of make a point, let's look at real estate which has radically changed how it works as COVID shutdown took hold. Agents, virtual agents, now rely on virtual visits, virtual closings and so on. They rely on zoom and other virtual visit technology and rely a lot on e-signatures etc. to streamline new workflows. These are for more video closings, title insurance, showings, so on, so on, so on. In these areas we look for companies that can get to scale and become de-facto standards for each of these industries like real estate, for example, there might be many companies that can help with streamlining workflow for particular industries but picking winners requires understanding market dynamics competition win rates, switching costs and substitution risk and so on. Along with getting to know management teams and their execution traffic. So we've actually been able to find investment opportunities related to these themes in the recent past as well.

- [Indhu Raghavan]
So, each sub-sector within the Cloud ecosystem that you described seems to have its own dynamic and decision criteria for identifying opportunities over the long term. CV, thank you so much for sharing these insights with us today, and we look forward to continuing the conversation at a later date.

- [CV Rao]
Thanks, Indhu.

 

The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.

 

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