Long-Term Investing Ideas in a Volatile Market
Simon recently spoke with a $35 billion global asset manager about how they're navigating the market volatility. The key takeaways are to think long term, tune out the noise...
7investing CEO Simon Erickson interview's The Technology Letter's Tiernan Ray about several of the most innovative trends in technology.
October 3, 2023 – By Simon Erickson
The tech world moves fast, and it requires companies to constantly be innovating in order to keep up. Investors, too, should always be looking forward when it comes to new trends that are re-shaping the tech landscape.
To help us define those important trends, we’ve brought in an expert. Tiernan Ray is one of the technology industry’s best reporters. He’s covered the tech space for more than two decades – from the early days of the internet and the dotcom boom to the rise of cloud computing and artificial intelligence. Tiernan puts tech progress through a much-needed objective lens, helping investors separate hype from true innovation. He offers daily insights in his Technology Letter publication: www.thetechnologyletter.com.
In the first part of the conversation, Simon and Tiernan discuss the electrification of the industrial world, which will increasingly use electricity to move physical mass. Applications for this already include electric vehicles, though could soon expand to the turbines for power output or even HVAC systems. Tiernan describes how silicon carbide is an important material in this trend and compares ON Semiconductor to Wolfspeed as investment opportunities with different strategic approaches.
The two went on to talk about Intel. Intel has financially struggled in recent years, but now has ambitious of selling its own custom silicon into the data center and also producing merchant silicon in its new foundry division for other chipmakers. Tiernan points out that for the first time, Intel’s foundry division isn’t necessarily tied to producing its own internal demand for its operating companies; that there would now be competition and negotiations for capacity that were based upon economics. That could fundamentally change Intel as a company, especially with Pat Gelsinger now at the helm and his commitment to making Intel one of the largest semiconductor foundries in the world.
Simon and Tiernan then spoke at length about quantum computing. One of the only publicly-traded quantum computing companies, IonQ, is up 87% since our last conversation about quantum computing. Tiernan notes, though, that the stock is currently selling for nearly 100 times next year’s sales –which is extremely expensive and could be difficult to justify forward performance. Tiernan also points out that IonQ’s forward bookings growth has been very strong, but that these often get recognized over a period of several years. The two also discussed what the meaning of “quantum advantage” is and whether it’s still relevant.
They then discussed Cisco Systems’ $28 billion acquisition of Splunk. Enterprise software company valuations were flying-high in the market euphoria of 2021, yet are coming back down-to-Earth in 2023. This has prompted several M&A deals, including New Relic’s recent $6.5 billion buyout by two private equity firms. With longer sales cycles, tech layoffs, and a shift from term to ratable deals, it’s likely that there will be even more M&A in the enterprise software space this year. When Simon asked Tiernan whether he believed GitLab, DataDog, or CrowdStrike would be the most likely company to be acquired next, he responded he thought it would be DataDog.
In the final segment, Tiernan discusses the recent ARM Holdings IPO. ARM is very expensive in the public markets; now even more expensive than NVIDIA. However, ARM’s royalties are declining from the Smartphone market, and their traditional licensing model also faces a new disruptive competitor in the form of open-source solutions like RISC-V.
Publicly-traded companies mentioned in this podcast include AMD, Apple, Applied Materials, ARM Holdings, Axcelis Technologies, CheckPoint Software, Cisco Systems, D-Wave Systems, Dynatrace, Fortinet, Global Foundries, Infineon, Intel, Lucid Motors, New Relic, ON Semiconductor, Palo Alto Networks, Rigetti, Rivian, Samsung, Softbank, Splunk, ST Microelectronics, Taiwan Semiconductor, Texas Instruments, Tesla, Wolfspeed, and ZScaler. 7investing’s advisors and/or its guests may have positions in the companies that are mentioned.
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Simon Erickson 00:06
Hello, everyone, and welcome to this edition of our 7investing podcast where we’re here to empower you to invest in your future, you can learn more about our long term investing approach at 7investing.com and get started with our with our premium membership at 7investing.com/subscribe for just $1. On today’s show, we’re gonna be chatting about innovation and technology. And I’d like to welcome back one of my favorite guests of all time Tiernan Ray. Tiernan has founded the technology letter, which is where you can read articles about technology, and everything that’s going on in the world with that. I’ve been a subscriber since day one of when you started it Tiernan. And I followed you for several decades. It’s always a pleasure having you on the podcast. Thanks for joining me here today for 7investing.
Tiernan Ray 00:47
This is my favorite interview to do, as the target. So thanks for having me Simon.
Simon Erickson 00:53
We have a lot of fun things to chat about. We’re going to talk a little bit about the arm holding IPO that just recently happened. We’re gonna talk a little bit about quantum computing. We’re talking about Cisco acquiring Splunk. But I would like to start with a topic that you and I chatted about briefly last time, which has become even more important as I think other investors are picking up on this, which is the electrification of the world right now. Can you give us an update since we last chatted about this Tiernan? What is going on with silicon carbide? What is going on with the electrification of the world? And then also maybe some thoughts about ON Semiconductor if you have any? You wrote a piece about this back in February of 2022 about Silicon carbide and the impact it’s going to have on a whole bunch of different industries. Specifically, anything that requires energy to move mass is now going more and more in the electrical side ways. We talked about electric vehicles, we talked about wind turbine type based equipments. And you mentioned in the last quarterly results to frame this, that ON Semiconductor, who is one of the players in this space, has now beaten analyst expectations for 13 consecutive quarters. And specifically, one thing that helped them with that was the sales that they had a silicon carbide had quadrupled in year over year sales. And they now have $3 billion of new long term supply in agreements that are in place.
Tiernan Ray 02:15
Yeah, the Tesla Model S was the first car to use silicon carbide for what’s called the traction inverter, Simon. Which converts from DC energy coming out of the battery into AC power going into the motor. And so it’s a very important choke point where you either get more or less of the battery’s potential. And so the traction inverter is a key element of range and performance in electric vehicles. So the Tesla Model three proved that silicon carbide was the future for these kinds of systems. There are many semiconductors that are packaged into a brick that is installed in the car and so it became a race for who’s going to be the supplier for these chips. And the early favorite was Wolfspeed ticker WOLF Wolf, right? Because they had been Cree which was an LED lighting maker, they sold that off to smart global holdings, which is a fun kind of mash up right a keiretsu of different businesses, they took the LED stuff, and we’re focused on we’re going to be a pure play investment in silicon carbide chips. That’s all we’re going to do. And they seemed to have the pole position, Simon, when I wrote that article in February of 22, in saying don’t do this, with old tools. Build a brand new factory, they built a huge factory in upstate New York, and Mohawk Valley to make wafers eight inches in diameter, which would be the only in the world that would be that large, because they’ve conventionally been six inches in diameter. And we’ve seen in past. We saw this with Intel in the 80s moving to eight inch in diameter, that extra number of chips on a single wafer gives tremendous economies of scale. And so the idea would be you build this factory build bigger chips, you’re the only one that could do it, you’re the only one who can empower the makers of the finished systems finished traction inverters to have a better margin because you can bring down costs with more yielding higher yield chips. And so the idea became Wolfspeed is the pure play in Greenfield production. Along comes ON Semiconductor. We have a very smart CEO Hassan El Korrey who had proved himself dynamically at Cypress Semiconductor returned around a decades old business really gave it a new lease on life, improved profitability, improved their focus as one of his strengths is seeing what stuff to get rid of what stuff to focus in on. And so Hassan came in at ON Semiconductor, which was a similar kind of diversified semiconductor maker, not like Wolfspeed. It was not focused only on silicon carbide was focused on many things. And Hassan said we’re going to start to be very strategic and how we talk to car makers, we will give them will compete with Wolfspeed, but we’re going to demand that we get promises of purchases from these car makers and from their system makers up front. And so what he did was he went and bought GT Advanced which is a company that’s been around for decades. You’ve heard of them they tussled with Apple. And one time they were going to develop Ruby, Ruby glass components for the iPhone and it was all kinds of like it’s all drama about this company, long term company just think for decades bought out by on by Hassan according to a lot of skepticism. It was a brownfield approach. So Hassan said, I’m not going to go build a new factory, I’m going to take existing assets, and I’m going to make really good silicon carbide out of this existing plant. Everyone was saying no, the ways Greenfield we both speed not brownfield ON Semi Hassan has proven the doubters wrong starting late last year, but especially when they did the analyst day in New York, and spraying. People started to say, Oh, my God, he’s actually right, they can take these assets, we were skeptical about GT Advanced these old factories, these old furnaces, they could grow these bulls of silicon carbide, they can successfully produce quality material silicon carbide chips in volume wafers, and then chips. And they can get commitments from the carmakers, just like Hassan said he was going to do. And that’s exactly what they’ve done. It led to, as you said 3 billion in multi year agreements of commitments by auto companies, and others to purchase these chips for years of the future, and meanwhile, what’s happening with speed is they’ve been pursuing billions to build out these new factories and the timeframe for when they will get chips out of this Mohawk Valley factory in New York and a second and other factory, their building has slipped repeatedly. And so now they’re in the difficult position of saying we’ve bet the farm on building these things with billions and financing that dilute investors holding and we haven’t yet delivered the goods in terms of coming up with the volume of production. And so it’s a total flip and that’s why you saw that. We’ll see. It’s not been a good performer on it’s been terrific performers because the the the non consensus the Dark Horse bet turned out to be right with ON Semiconductor and Hassan El Quarry. And Wolfspeed turned out to be not yet what had been hoped.
Simon Erickson 07:09
And can we consult the crystal ball here, Tiernan? Can we pull out the crystal ball and say okay, yes, ON Semi has done quite well. Great margin profile, as you mentioned. But Wolfspeed, this isn’t their first rodeo either. Right? You’ve got Gregg Lowe at the helm. CEO of Wolfspeed. He was at TI for decades. You know, he kind of knows this circus and how things go. And he’s not just, you know, throwing money at the wall to see what sticks. But it does seem like they’ve had some missteps, like you said, in Mohawk Valley and New York, you’ve got the other one in North Carolina, I think they’re building a third one in Germany right now. And it’s a little bit harder to scale those up than perhaps the investing community was hoping it would be. Does the crystal ball say that this is still a good strategy for Wolfspeed? You can do everything new and highly automated and get the cost down and you know, increase the labor side. If you think this is going to be successful? Or do you think that it’s just going to be ON Semiconductor who continues to win more and more those supply agreements and wins ultimately, are just industries?
Tiernan Ray 08:03
The problem for Wolfspeed is that this market for you know, Tesla, and Lucid and Rivian. And everyone who with an EV, who needs silicon carbide will absorb lots of capacity. However, in addition to on being very successful, there are very large semiconductor companies such as ST Microelectronics and Infineon which are huge, huge, bottomless pockets for investing. And so I would say now the pressure is to show that as a pure play a company that’s had to go begging for financing can at their scale. As the pure play really carve out enough business for themselves that isn’t taken by on an Infineon or ST? As well as whoever may pop up tomorrow because the chemistry and the physics of developing silicon carbide as a raw material continues to be advanced by outside parties. And so I think the market is a vast one and there will be a lot of business for a lot of players. It’s not clear what kind of slice of pie Wolfspeed will have, as they’ve experienced these delays. If just being new with factories, having Greenfield opportunities will be enough for them to carve enough of a pot size pie that’s meaningful to investors.
Simon Erickson 09:25
Yeah, and the I bring it back up again, you know, your piece from last February of 2022. Great piece by the way, I think that everyone else is really picked up on this since then. But you were early to this and seeing how important silicon carbide was going to be, especially for electric vehicle makers who have committed $500 billion you know half a trillion dollars to the to their new lines of of EVs out there. Most of them using silicon carbide celebrating. As investors, should we be watching for those long term supply agreements? You pointed out that ON Semi has secured $3 billion of more long term agreements and now they’ve got $11 billion and silicon carbide. Good. Is that what we should be watching going forward as we evaluate kind of who’s winning?
Tiernan Ray 10:05
I think that’s a good question, Simon. I think that is the unique acumen of Hassan Al Khorry and the way he runs his company. I don’t think it’s a broad phenomenon. The reason I say that is, when I was interviewing Hassan two years ago, in 2021, when he was first talking about this, before he’d signed the agreements, he was telling me, I’m going to hold these carmakers, and they’re, you know, tier one and two suppliers to the fire and demand long term agreements. But he was saying that in the midst of supply chain crunch, as you recall, was hard to get chips for cars. And so I think some of this is Hassan’s acumen in terms of how he likes to operate. And some of it is, because remember, ON Semi isn’t just selling silicon carbide, he sells other parts, which means he can have another piece of inventory then he can. I would imagine, I don’t know this for a fact, but I would imagine you can say, you’re not getting this chip unless you give me an agreement for the silicon carbide right. You can deal. And I think that’s part of Hassan’s acumen and part of the profile of the portfolio investing in ON. And I also think it was also some of the creation of a supply chain era, when probably customers for chips, were willing to make deals, just to get ahead of the pack to get supply. And now that the world is a little less tight in terms of supply. I don’t know that that is a form of an agreement that persists at every single chip company. I don’t know if they can even get that now.
Simon Erickson 11:35
Yeah, it makes sense. And then maybe if I can sneak in one more question about this, like ask your thoughts about you know, how institutional investors are playing this space that you mentioned? In a couple of your pieces, I believe it is Jed Dorsheimer with Canacor that, you know, it’s kind of early in seeing how OLED lighting was going to replace LEDs and a bunch of other things. He was kind of a you know, an early visionary of seeing this transition to silicon carbide is the rest of the institutional community picking up coverage of the On Semi’s and the Wolfspeeds out there. Are they interested in this trend? Or is it still kind of off their radar?
Tiernan Ray 12:11
I think they are interested in I think they’re now looking beyond Wolfspeed. They’re saying, okay, Hassan el Khorry really showed us with on that it can be done, who else is out there. And they’re looking at ST Micro and Infineon. And they’re looking for other angles to this. You know, I’ve mentioned some in the technology letter, Simon Axcelis Technologies. ACLS is an important tool supplier. Texas Instruments had said, you know, under the former CEO who’s departed now who passed the baton, we’re not as interested in silicon carbide, we’re not chasing fads, but companies like TI are companies that could get into this big time. And also into the cousin chip silicon germanium, which can it can also be attraction inverter approach. And so I think I would imagine people walking everywhere saying, Is there something else like ON Semiconductor that isn’t exotic might not be a pure play. But it’s an interesting window into silicon carbide to invest in, maybe with some less risk, right? Tool tools makers, including Applied Materials are always a way to play. That’s that’s not a pure play. But that’s might be interesting.
Simon Erickson 13:26
It’s kind of a great segue to the next topic I wanted to chat about, which is Intel. Speaking of chip providers, Intel has got a lot of ambitions and things that they’re going after. One they just abandoned actually was kind of related to silicon carbide. They dropped their acquisition of Tower Semiconductor here recently. But Intel, you pointed out that they just had their innovation conference at Intel innovation 2023. And one of the things that they were really interested in was the dev cloud, which would be using Intel’s custom silicon. So again, if you want to do cloud computing, if you want to do if you’re a developer, you want to do some fine tuning large language models or other things like prompt engineering, you can now use Intel silicon carbide to be doing that. I guess my question is just is this going to work? Tiernan? I mean, Intel has been getting killed in the datacenter for a long time. A lot of that, you know, due to AMD replacing their CPUs that run those servers. This is a little bit slightly different than that. But what do you think about Intel’s new ambitions? Is it something investors should be excited about?
Tiernan Ray 14:25
The stock trades for three times revenue, so it’s incredibly cheap. But the margins dipped below 40% for the first time. And since anyone can read probably the company’s first time in the company’s history in the first quarter of this year, the gross profit margin dipped below 40%. It’s a stunningly low level. So it couldn’t get worse from a financial perspective. They cut the dividend which is never a good sign. So it’s a beaten down financial model at the moment. It’s a company with a lot of moving parts specifically they’ve said they’re splitting their historic sort of organic whole of have of designing chips and running their factories. Traditionally, the factories just took orders from the operating units, you know, we’re gonna make this new Intel Xeon. And that was the chip making the factory guys job to go and produce it and volume. And now they said no, we’re gonna do this new arrangement where they both operate as profitable businesses, and they negotiate. And so it’s a big change, total change in the history of Intel to say, one half of the business is going to contract but the other half, it hasn’t been proven it can work effectively. And you know, it’s a big change for something that is such a complex operation is producing something with billions of transistors. So there’s a lot of moving parts. There’s a beaten down valuation, there’s a financial model that’s at the moment, really injured in terms of margin if not broken. And there is goal to get to back to supremacy and chipmaking by 2025. When they come to that sort of one manufacturing step that CEO Pat Gelsinger has said now will regain the lead. I mean, it’s so cheap, that it’s an optional and do any of these things worked out? Well. And I think there’s so many things that he could say, you know, maybe for only four or five have to work out. Well, they have to match NVIDIA in performance with their Intel Habana Labs Gaudi2 chip and start to take back business from Nvidia in AI while regaining some Xeon market share from AMD’s EPYC line. They have to regain manufacturing prowess in 2025. They have to prove a new business model between operating units and factory. And, they have to suddenly — as they’ve never been able to in the past — demonstrate that they can be a merchant semiconductor manufacturer for all comers, including Nvidia, maybe who want to go to them for fab capacity. These are let’s say there were five only five challenges for Intel. Will four of those lead to the resuscitation of gross profit margin anywhere near Intel’s historic margin of 64% Gross profit margin? Three bucks, maybe that’s your bet is that four or five, maybe three or five could lead to you know, resuscitation. Maybe that’s what you’re paying $3 in forward revenue for.
Simon Erickson 17:32
So Pat Gelsinger goes way back, right? He worked with Gordon Moore. That Gordon Moore. There Moore’s law, you know, founder of Intel. Andy Grove. Yeah, right. And Andy Grove. Exactly. So Gordon Moore has done this for a long time. Like he seems like this is incredibly complicated. And Intel’s got a lot of irons in the fire like you said. It’s really only five things. But those are really big things. You think about the foundry, you know, designing their own chips and the operating relationships. On a report card of A to F, I mean, what what do you give Pat Gelsinger on Intel’s strategy going forward? Is this something that a plus investor should be really excited about because he’s doing all the right things? But then, like you said, you know, maybe a turn off that he cut the dividend and the margins are following. How should we evaluate how he’s doing so well?
Tiernan Ray 18:14
You have to try and figure out. I’m not sure what the answer is Simon. But what is his focus. Because companies that have come back have been about focus when Steve Jobs came to Apple in the late 90s. And Apple was almost bankrupt. He cut lines of business, he said we’re not going to do that we’re not going to sell a thing called a Newton. Get rid of that. And we got rid of a lot of things. He focused on resuscitating the Mac line, and he did so with Johnny Ives so brilliantly. So focus, focus focus. When Lisa Su came to AMD many years ago, when it was sort of on the downslope and Intel was dominant CPUs, she cut lines of business. She got rid of just whole lines of business that had been brought in preceding her joining. And so focus focus focus is what helps the rare business come back and it is rare too. To, to my mind to meet deadlines and meet customer commitments again, where you have stumbled and you failed. Intel before Gelsinger failed multiple times to get chips out the door on time. Simply couldn’t produce chips anymore on time. It’s a stunning. It’s a stunning place to end up when you were the best chip maker in the world. So maybe instead of all these things that they’re doing, Gelsinger has regained a focus on let’s say simply turning out chips on time. And it does seem that so far, the Xeon Sapphire that came out this year, there’s the big server offering was on time and it does seem like some other roadmap chip efforts are ahead of schedule. And so if you want to believe that somewhere in all these five things I just enumerated there’s focus, focus, focus, that he’s focused, then that would be the thing that I would say that no one has grasped. Let’s say that’s the book argument is focus, which gets a company back to meeting commitments and meeting deadlines, which is always, as far as I can see has been the key to the rare comebacks like Apple and AMD.
Simon Erickson 20:15
And speaking of that have deadlines and customer commitments. Intel Foundry has been such a big focus, like has said specifically, you know, he wants to go out and make those merchants silicon chips for other companies that are not named Intel for their own needs. Do you think that Intel will wrestle market share away from either Taiwan Semiconductor, the largest foundry in the world, or Samsung, the second largest foundry in the world? Do you think that Intel is going to actually win some big customer contracts from them? Or is this just something that they’re going to be a distant third for quite a while?
Tiernan Ray 20:45
I don’t believe it. And I believe it because historically Intel could never devote its factories to things that weren’t Intel’s product. So to the earlier point that they’ve split. Now the relationship internally, maybe Gelsinger did that saying if the factory has to survive on an operating profit basis, on its own merits, maybe there’ll be finally incentivized to say no to internal projects or not, no, but Okay, wait, because we’re gonna get this thing from Nvidia. And we’re gonna fab that maybe, I don’t know. But historically, they haven’t been able to do this. It remains to be seen at this new internal arrangement propels that, and it remains to be seen whether they can come back in 2025 to the manufacturing lead, and in the two years to go until they would say reach that, does anyone care about going to Intel for extra capacity, when Taiwan Semi is at the top of its game and Samsung is certainly a very good company. And Tower Semi is a good company. And Global Foundries is a good company. There’s many factories to go and have stuff made. And it’s not clear to me that more factories is strictly the limiting factor for what needs to be done today, right. And for the hardest chips to manufacture. There’s lots of stuff going into watches that are older technology for which you can go to an existing factory, such as Taiwan Semi, or Samsung, or Global Foundries or Tower Semi that has depreciated fully depreciate equipment to make older circuitry. And so I don’t see the market justification for it. And I don’t see the historical, you know, will at Intel, and those are the things that make me skeptical.
Simon Erickson 22:31
Let’s chat next about one of the sexiest types of computing out there that everyone else is catching on to now, which is quantum computing. And this was this is the topic that you and I chatted about in our last podcast conversation, which was also in 2022. In the time since we talked about it back then, which was still very, very early, everyone was just trying to figure out quantum, I pulled some numbers. IONQ, which has kind of become the poster child of the publicly traded quantum computing stock out there, is up 87%. Since we last spoke, and they just landed a new $25 million deal with the Air Force with the Air Force’s research and development department. To frame how big of a deal $25 million is for IONQ, total revenue in 2021 was $2 million. And then in 2022, it was $11 million. This one deal is essentially doubling all of their last year total revenues, as it seems like some companies are really interested in pursuing this. Is this the quantum leap that quantum computing has been waiting for the inflection point or is it still way too early to make any kind of conclusions or even invest in this space?
Tiernan Ray 23:39
It’s very early. If you invest you have you’re paying extraordinary valuation, the actual revenue Street consensus for next year is about 36 million. So the stock’s worth a little over $3 billion, which means that if you’re buying it now you’re paying 100 times next year’s revenue. Which is an unheard of multiple. And that’s growing from, you know, let’s say 20 million this year. So it is growing at a fast clip from a small base, right. So from a small base growing at a fast clip is whether you think it’s impressive or not. It’s debatable. But the point is, you’re paying 100 times multiple sales for a company that will lose 100 million on an EBITDA basis, maybe less if you adjust it for stock options, being an extraordinary multiple and the question is can this company grow into that. As you point out Simon, they have bookings now that are far above revenue. The projected I think Street consensus for bookings for next year is 106 million. The important thing you got to realize Simon is bookings is one of these non GAAP numbers that is contract value and what what where the rubber meets the road is when the contract value is realized as reported revenue. And in the case of the systems to was my understanding the case of the Air Force system and a similar system sale with Quantum Basil which is a sort of research lab in Switzerland. These are contracts that have been paid out in hundreds of 1000s or millions of dollars, let’s say per quarter over years. So the actual time to realize as revenue, these contracts is a long time. So one thing is if you buy for either 100 times next year’s Street consensus, projected revenue, or let’s say 10 times next year Street consensus, projected bookings, you’re waiting a long time for the cash flows from that to be realized, as an investor. So it’s it’s very expensive bet on these things. And I think from the business standpoint, a funny thing happened on the way to analyst day last week. You know, they held an analyst day on the 19th, in which the company’s talent talked about the outlook. It was funny, because you and I have been talking about quantum advantage for a while now, this is the term that took over from quantum supremacy. Quantum advantage was supposed to mean that it’s kind of it was kind of a binary threshold, when you reach it, all other computers are irrelevant, and you have the best computer in the world. Peter Chapman, the CEO last week said, we no longer talk about quantum advantage. That’s an academic debate. The reason this struck me is well, then you do away with quantum advantage. What exactly is the point of your computer? The point, he said, is to do business problems better? But then the question becomes, if it’s not a quantum leap, if it’s not a binary situation where all other forms are irrelevant, if you’re simply better, how much better are you? Then let’s say a billion dollar system packed with Nvidia GPUs, right? Because you can do some of the same problems that Peter Chapman and his team are talking about or optimization problems, right. So they gave an example of they worked with Airbus on an example problem of how do you pack bags most efficiently into bins on a flight, you can do this with other forms of high performance computing supercomputing, you could do this potentially with deep learning forms of AI using NVIDIA GPUs. So it now becomes less clear to me what exactly is supposed to be the threshold at which it’s so much better doing it on a quantum computer that you would spend any amount of money to buy these systems from IONQ, because you just don’t want to take the risk of doing them. Right fear of missing out by running them on your old computer, your Nvidia GPU ingredient keeps getting better and better, and Taiwan Semi keeps getting better and better making NVIDIA GPUs. It’s no longer clear to me what exactly is supposed to be the threshold at which IONQ is in which it makes no sense not to buy on cue machines, because you don’t want to run it, other than on a quantum system.
Simon Erickson 27:46
I share that perspective Tiernan. You know, I’ll be going next week to MIT again, I’ve been at least two times a year for seven years. And they always talk about quantum computing. And it’s always this chicken or the egg conversations the exact same conversation every single year. They’re saying, you know, the commercial interest is there. But they’ve got to have the computer that’s cost economical. Compared to the other options they have. I just can’t get past that right now. These machines are 10s of millions of dollars apiece. And it seems like the available market for them, which are problems that are unsolvable by what’s out there is still very linear. It’s almost a consulting project rather than something like cloud computing. Which is using all the sexy chips that you know and videos making out there.
Tiernan Ray 28:26
I’m sorry, I was gonna say sounds a good point. That’s why most of the revenue IONQ is not through AWS, they have machines at AWS that you can go to use, right, but most of the businesses direct with IONQ where you go to contract directly. And one of the reasons for that, as the CFO said, is because there’s a lot of hand holding that needs to be done just to run something on these things. It’s very early in the development of running problems on these gigantic expensive machines.
Simon Erickson 28:59
We mentioned IONQ That’s one of the publicly traded companies. It’s a $3 billion mark capsule largest quantum computing company, at least in the public markets. There’s some other options to Rigetti RGTI as a ticker on that one also D wave systems QBTS they’re actually making a little bit slightly different quantum annealer is not a traditional quantum computer. Are you interested in any of these Tiernan? You mentioned 100 times revenue, it still seems super early but what do you think about these as investment ideas?
Tiernan Ray 29:26
Well, the reason that Rigetti and D wave last night look they’re trailing is because IONQ was early in selling systems. So as you remember Simon when they came these guys came to market the model was cloud based, you know quantum as a service, where they have the the expense of setting up the machine meaning the vendor meaning IONQ Rigetti or D wave. And then you lease runtime really cycles like old time shared computing, just like a cloud model. And but the streets were excited about these large booking, use of multimillion dollar multi tentatively known as a deals. And so IONQ is the one that was first to show that someone would step up and buy these machines to run on prem. And that’s why they have the lead at least in press releases. I’m you know, if IONQ is a long bit than the two most mirrors, competitors, D wave and Rigetti, who haven’t yet had the momentum in press releases in bookings of IONQ seem like less interesting, because they all have interesting technological approaches. But at this point, the only thing that the Street cares about is can you show me bookings, of system sales. So these other guys are kind of, you know, they would have to catch up in system sales to be at least as interesting, I think, to most investors, is IONQ.
Simon Erickson 30:51
Absolutely. And then one final thought on this one before we jump to another topic, but I think that the ecosystem is going to be as important if not even more important than the systems themselves. Just like Nvidia made CUDA, you know, to get developers understanding how to use GPUs for whatever software application they want to do, you’ve got to define the quantum computers capabilities in a way that makes sense for whatever problem you’re trying to solve. And that’s why these companies like Strongeworks, and you know, Quantinuum, which is going to be coming public here shortly. Very interesting to keep an eye on I think, as investors should we consider this part of it, which we haven’t even talked about really yet.
Tiernan Ray 31:27
Very, very good point, Simon. It has been around for over a decade, it’s only in recent years that it became a phenomenon that has created a software story for Nvidia. If, you know, Ion Q has been developing software tools for a few years, do they have 6-7-8 more years potentially, of having to build a software ecosystem before it has the momentum with developers to even make a $25 million computer useful. It’s a real issue of software tools, software tool availability and maturity, adoption by developer community before the systems or anything other than interesting science projects.
Simon Erickson 32:14
Speaking of software, another topic I wanted to chat with you about was the $28 billion acquisition of Splunk by Cisco Systems that just got announced that was about a 30% premium to Splunk previous training price in the public markets. This is generally regarded as kind of Cisco’s growing interest in DevOps and observability, as you pointed out on the technology lead in the article you wrote for your own site there that, you know, this is kind of something that a lot of companies have been more and more interested in. And perhaps it’s because finally the pricing is right, for a lot of these software companies that were just ridiculously expensive and 2021 settling down a little bit now, in the in the public markets. What’s your take on the Cisco acquisition of Splunk? And you think this is a prompt for anything further?
Tiernan Ray 33:00
Well, I think it is a prompt for for a lot more dealmaking. The, the market has been highly fragmented, meaning the market for what you call DevOps, or dev SEC ops, or observability, has been highly fragmented. And you’ve had companies like data dog and Dynatrace, and New Relic which is being bought out by private equity, and Splunk going after this for years. And it does feel like it has to consolidate at some point. And I would imagine this can be a spur to that the takeout price for Splunk. Around I think seven times projected revenue or there abouts was a nice level above what I think New Relic got only about four and a half or five times revenue. So it was a nice, sort of higher takeout price. This market that all of these companies serve as I understand from talking with the companies is still vastly an area of internally built tools Simon so IT departments build their own homebrew brew tools to manage the application lifecycle from development to serving to putting into production. And so I think Cisco looks at it and what they say probably is a huge fragmented market that is mostly still bespoke internal development looks like a market that we a giants such as Cisco come into and rationalize with a strong sales force, you know, a meat and potatoes raw red meat sales team, we go in and we get we drive sales quarter after quarter and we capture that market opportunity better than these little companies can and I think there’s some argument to that. It may be that that kind of horsepower of that kind of selling of a company like Cisco starts to make the management of these other companies look to to protect themselves with a larger require as well.
Simon Erickson 35:00
It makes sense. I’m glad you brought up New Relic too. And the valuations piece because software sales is kind of transitioning, right? Like you, we’ve seen that it’s longer sales cycles, it’s harder to close deals, we saw a lot of tech layoffs in Silicon Valley anyway. And you mentioned seven times sales. That seems like a reasonable offer, considering a lot of these companies were 20 or even 30 times sales, and the not so distant past here. New Relic got bought by a private equity company or go to private equity companies together for six and a half billion dollars. And of course, there was also an all cash deal for Splunk. Certainly the attractive the evaluations are more attractive now. But it also seems like it’s getting harder to sell for a lot of these companies that maybe some of them are just putting their hands up and saying, look, take care of it. Cisco, you’ve got the sales team, you’ve got the relationships, it’s too hard for us out there. What’s your take on that?
Tiernan Ray 35:52
They might, here’s the countervailing factors, Simon: riches. We just came through an IPO season in 2019, and 20. And even into 2021, to an extent where companies got extraordinary valuations at IPO. What that meant was they banked unbelievable sums of money. So if you look through any of these companies, one thing you’ll notice you wouldn’t have seen in prior eras, with small software companies is just extraordinary balance sheets. And so some of these companies, the management can go the distance, and they can demand a pretty substantial premium, because they can say, you know, we know that this market needs to consolidate. At the same time, we’re not in a cash burn situation where we’re in trouble. We don’t need to tap equity markets, we are generating profit increasingly, because now we’ve committed ourselves by cutting employee count, and we’ve been we’ve reduced expenses. And so we’re either near profitability or profitable on a cash flow basis for many of them. Our our trouble, as you mentioned, was selling has now stabilized to the point where, you know, estimates have come down, sales have gotten sales growth has come down from let’s say, 30% to 15%. But it’s now maintainable. And so all these companies are saying, Okay, well, maybe this is the new normal is we go along and 15% growth, it’s not as ambitious as it was when our stock was valued, you know, at 30 times revenue, but we can, we can do this, we can maintain this quarter after quarter, and we have the balance sheet to keep going. And so then you get a situation, which is interesting, which is you never had this kind of bargaining leverage by small companies to say we don’t need your money, we have enough of a balance sheet to keep going.
Simon Erickson 37:40
I’m going to have some fun with this Tiernan. And you know, you mentioned that there’s some other companies out there that might be of interest for those with deep pockets, especially in these kinds of trends. I’m gonna get, I’m gonna spot you up with three. I’d like you to either pick one of these three to be the most likely to be acquired next, or you can take the field and say it’s none of those three, it’s gonna be someone else. But I think that these three at least have been mentioned as potential m&a candidates. The first is GitLab, for software applications, kind of organizing a lot of those working out same DevOps space. The second is Datadog, and observability platform for cloud computing. And then the third in cybersecurity is CrowdStrike. So GitLab, Datadog, or CrowdStrike. Or someone else. Who’s most likely to get acquired next?
Tiernan Ray 38:24
Off top my head, I would say Data dog, because to me, it’s a function. It’s not a full business. It’s a function. And it’s a barely a very good function, but it’s a component of someone else’s toolkit. But I think those are all excellent suggestions. I mean, security. CrowdStrike seems to have a defensible franchise, but I can imagine roll ups in security as well. I can imagine someone putting together the various pieces because there’s lots of these interesting ones ZScalars and other great security franchise. There’s obviously these great security franchises out there. Makes you wonder, okay, we’ve got Palo Alto, CrowdStrike, Zscaler. You know, and you’ve got Fortinet and then you’ve got older things like Checkpoint does some of this rationalize the same kind of thing you wonder does this market rationalize itself insecurity get lab again, huge balance sheet, I think they think they can be the number two to Microsoft GitHub. I don’t know if that’s true, but I think I feel like they feel they have this opportunity to resist being bought and to go the distance maybe they will prove me you know, too idealistic in that sense, but if they would be to my mind was likely to sell I think I think Data dog is a good pic, of something that feels like, like it wants to be inside of some other you know, larger offering.
Simon Erickson 39:49
Okay, Tiernan’s money is on Data dog. You can you can submit your own bets on which one you think is most likely: Datadog DDOG, GitLab GTLB, CrowdStrike CRWD, or something else? Let us know at email@example.com. If you have a pick out of those. You mentioned IPOs. You mentioned bringing money into the balance sheet and well capitalized software companies. Let’s talk about a recent IPO for the second time around its ARM Holdings. I say for the second time around because this was one that was actually taken out of the public markets a few years ago by SoftBank. They brought on private at a $32 billion valuation in 2016. They’ve now spun it back out at a $55 billion valuation and sell publicly traded again, A R M is the ticker for this one. I mean, this is a company that, you know, Softbank kind of took out of the public markets out there spinning it back, and they made a pretty good payday on this. And and what’s your thoughts on the IPO for Arm here?
Tiernan Ray 40:49
It’s way too expensive. It trades for 15 times next year’s revenue 17 times this year’s revenue. And as I understand from some of the reports from for example, Pierre Farrar Gu of new Street researchers as an analyst who’s done a lot of good work. Peer notes that recurring revenue is what people care about. So there’s two kinds of revenue Simon license and recurring licenses a big thing that you sign what say once every several years with a company like Apple signs a license so that they can play with the instructions of the arm design and make their own thing and make the A Series processor royalties or what just come month after month from all these devices now using actual chips built with Arm technology and royalties what people care about on a recurring royalty basis. So some subset of total revenue stock is more like 30 times forward revenue, which is extraordinarily expensive. I look at this Simon and I say to myself, number one, when Masayoshi Son the chairman of SoftBank bought arm in 2016, the stock got a 40% premium, what’s proceeded to happen was growth slowed and margins were reduced. So you’re now paying asked by Softbank to pay they’re gonna still own 90% of the of the stock, you’re all asked to take a minority position at a price that is inflated by the takeout price Masayoshi Son paid in 2016 for business with less desirable financials. And by the way, for business whose market main market most of arm designs the vast majority is not interested in collecting royalties from the smartphone market, a market that is a lot less attractive now than it was seven years ago when Softbank bought the company. So when I look at this as NVIDIA, okay, so they’ve got high high gross profit margin. Is there a company that has similarly high maybe not as high but high gross profit margin is in a market that’s expanding not contracting or in static? And is a tremendous operating history? And is it similar valuation multiples? Well, it turns out based on next year’s revenue and NVIDIA trades for a little over 13 times revenue below 15 times for arm, so Nvidia is cheaper based on next year’s revenue and NVIDIA has incredible margin structure and Nvidia has an expanding data center. Ai training and inference market for its chips that is growing is putting it mildly, versus the smartphone market for arms. And so far, Nvidia has no competition whatsoever. I mean, they’re cleaning up the floor with Intel and AMD and all the startups that compete with them. Arm has competition from not only the existing entrenched products, but also this movement of RISC five, which is an open source. instruction set architecture for chips that is gaining momentum will soon produce a new probably stunningly promising IPO in the form of sci fi, the startup that is sort of a middleman it brokers the open source, it’s kind of like what Red Hat was for Linux, sci fi is going to be what? You know how RISC five finds its way to the commercial business market for investors. So I’d rather keep my powder dry and wait for the inevitable Sci-five IPO, which will probably be cheaper and more exciting than the RMI IPO. And in the meantime, which is rather by NVIDIA is a better franchise that’s slightly less on a forward revenue basis.
Simon Erickson 44:19
But you read my mind, I’m glad you brought up, you know, RISC five, because it for I mean, to think about this Arm has been around for a long time, but it’s publicly traded since 1998. Like you said, it’s got kind of like this lock on the smartphone market, which is still important, but you know, perhaps less exciting, since it’s so ubiquitous. Now, RISC five like you said, Open Source architecture, you know, telling the chips, how to do what they’re intended to do or whatever you want them to do. Do you think that this is disruptive to what arm offers in the license for chip makers? Or is this still something that it’s going to have its place, you know, techies are still going to want to do this but the majority of the market is still going to be kind of more stuck into traditional licenses.
Tiernan Ray 45:02
I think that the open source stuff was going to eat the chip market, just the way Linux eight, Linux and the whole Apache stack ate the whole internet software world. Everywhere you look, every single product company from elastic to get lab is built on some open source franchise and they have good businesses. But what dominates is the fact of open source and I think it’s inevitable that things are gonna go open source Nvidia is a backer of risk five. So it was Qualcomm, Western Digital. So there are parties that believe in this intel believes in risk five, it’s going to go away risk five and being a boutique, instruction set, vendor such as arm is going to have less appeal to it.
Simon Erickson 45:48
Well, we touched on quite a few topics here. And we talked about quantum computing, we talked about Silicon carbide talked about Cisco’s acquisition, we talked about Intel. Now we’ve talked about the arm IPO. Is there anything else that you’d like to add is there I know that you’ve got kind of a podcast and you’ve got kind of a portfolio of tech stocks that you’re very interested in anything else that individual investors should be keeping an eye on in the technology space right now?
Tiernan Ray 46:12
Yeah, I think some of these hydrogen energy companies, hydrogen cell companies, and I haven’t done enough work, Simon to look at them. But things such as alternative energy forms, right alongside silicon carbide and alternative materials aren’t going to be increasingly important. It’s a materials sort of century we’re in engineering of novel materials and the kinds of prospects for low energy computing that they can bring an energy efficient, everything that they can bring. So I’d say that whole constellation of things that go hand in hand with silicon carbide, new materials, new approaches, and renewable energy is going to be still be very, very interesting. And it may be that let’s say solar had its time in 2007, right with First Solar and sun power. But there are other forms out there, hydrogen energy, geothermal energy, and those are interesting areas. And I’m just starting to kind of figure it out what it means.
Simon Erickson 47:12
Well, turn on, this was a lot of fun. Thanks very much for being on the 7investing podcast this afternoon.
Tiernan Ray 47:17
My pleasure. Thank you for having me, Simon.
Simon Erickson 47:19
And once again, you know, if you’re not yet familiar with Tiernan Ray, I highly recommend that you subscribe to the technology letter. That’s the technology letter.com. He’s probably one of the most forefront thinkers when it comes to the technology world. I’ve signed up since the very first day he had offer it and I will fully endorse this. You will not regret signing up for his newsletter. It’s fantastic. And it’s really a pleasure to have you. Thanks very much for being on the show. I always enjoy these conversations. And thanks for listening to this edition of our 7investing podcast. We are here to empower you to invest in your future. We are 7investing. Have a great week.
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