The recent sharp sell-off in tech stocks is not the backdrop for a takeover frenzy. But improving valuations could eventually tempt tech giants to pounce on weakened prey.

A correction in global tech stocks is long overdue. The Nasdaq Composite Index shed almost 3% this week as institutions reduced positions in tech stocks and as sentiment towards sector stars, such as Facebook, waned.

Electric-vehicle maker Tesla Inc, a target of short sellers, lost almost 8% at one stage. Amazon and Netflix were down almost 5% and Microsoft and Facebook lost almost 3%. These are significant falls for stocks that led the global equities rally.

The odds favour further short-term price falls given the Nasdaq had soared almost 50% since 2016. The index’s chart pattern is worrisome: it shows a double-top pattern (a price peak in the same area twice) that some technical analysts interpret as a precursor to a trend reversal.

Chart 1: Nasdaq Composite Index

Source: Yahoo Finance

Expect further tech-stocks weakness over the next few weeks, although not a rerun of the March 2000 dotcom bust, as some bears predicted this week. This tech rally has far more substance and sustainability than the last great tech boom, built on shaky foundations.

Still, just as tech stocks led global equities higher, so too will they lead markets lower before a new floor is found in the second or third quarter that sets equities up for a strong end of year and resumption of the bull market.

ASX-listed tech companies have also been sold off this month after stunning share-price gains. Electronic circuit board designer Altium, a standout from this year’s interim profit-reporting season, is down from a 52-week high of $22.49 to $19.72.

Language-technology provider Appen, another strong earnings performer, is down from a high of $10.94 to $9.00. Logistics software provider WiseTech Global, a disappointment in this year’s reporting season, has slumped from $16.27 to $9.45.

Altium and WiseTech are part of a new breed of ASX-listed technology companies that have quickly built multi-billion-dollar valuations. Another tech star, Aconex, a provider of construction-project software, was taken over by Oracle late last year for $1.6 billion.

The Oracle deal is a sign of things to come for a small group of ASX software-as-a-service (SaaS) companies that successfully target global markets and build lucrative niches. They look like neat bolt-on acquisitions for cashed-up offshore tech giants.

Tech takeover targets

It’s tempting to add WiseTech (WTC) to the Switzer Report takeover portfolio, given the extent of its sell-off this year. WiseTech looked expensive at its share-price peak. Some good judges I know consider it among the world’s most expensive SaaS stocks after soaring gains. Even after recent falls, WiseTech still trades at a significant valuation premium to comparable domestic and international software peers.

WiseTech is growing quickly, just not quickly enough to satisfy the market’s high expectations in the recent interim result. Underlying earnings leapt 31% in the half and it confirmed its FY18 guidance for revenue and earnings.

Longer term, WiseTech is well placed to benefit from growth in e-commerce and supply-chain complexity, and take market share by replacing legacy in-house software and that offered by competitors. It can grow organically and by acquisition in a fragmented market.

An average share-price target of $10.82, based on the consensus of seven broking firms, suggests WiseTech is undervalued at the current $9.39. The market might be right, but I need a bigger margin of safety to buy the stock given the short-term risks and loss of positive market sentiment.

Altium (ALU) stands out

Circuit-board software provider Altium needed a strong result to justify its soaring valuation and it did not disappoint. It delivered 30% growth in revenue and 51% in net profit – ahead of market expectation. Earnings-per-share growth of 50% trumped the consensus forecasts.

Altium is flying. The company develops electronic design automation software for printed circuit boards (PCBs), which are contained in virtually every electronic product. About 31,000 subscribers globally use Altium’s software to develop PCBs.

Short term, Altium will benefit from a new software release in January, not reflected in the strong half-year result, and from new premium products in the enterprise space.

Longer term, Altium is superbly leveraged to the boom in the Internet of Things, which is driving the proliferation of electronics. PCBs are fundamental to the design of electronics and Altium’s software is helping design these boards.

The company is eying a tiny slice of an estimated US$2 trillion market for on-demand electronic design and manufacturing. As 3D printing grows, novice developers could use Altium software to design products that are made overnight, giving Altium a small fee from the manufacturer.

It’s a powerful business model if it takes off – and a reason for a larger software player to acquire Altium and increase exposure to the expected 3D-printing boom.

Altium has big ambitions: it wants revenue of $200 million by 2020, from $144 million in FY17, and an earnings margin of 35% or better by then. It will need such growth to justify a $2.6 billion market capitalisation and forward Price Earnings (PE) multiple of about 50 times.

I am always wary of stocks on nose bleeding valuation multiples. Share prices tank when stocks that are priced for perfection even slightly disappoint.

Altium’s expected PE in FY19 falls to 40, based on consensus earnings-per-share growth of 29%. I believe it can grow earnings faster than the market expects as new products are released, subscriber numbers grow and as profit margins expand.

If all goes to plan, Altium will be a market leader in the global PCB software market and an emerging leader in electronic product design software, as 3D printing grows by 2020.

That would put Altium on the radar of global tech giants that are building their leverage to the Internet of Things and 3D-printing megatrends and will pay high valuation multiples for emerging leaders, to shore up their competitive position.

Altium is not for the risk-averse. Portfolio investors might wait for the global tech sell-off to play out and buy the stock at lower prices in the next few months.

With or without a takeover, Altium has long-term appeal and potential to be one of the next great Australian tech companies with global presence.

Takeover portfolio update

There was a mixed performance from stocks in the Switzer Report takeover portfolio in the first quarter of 2018. Santos was a highlight after receiving a takeover proposal from long-term suitor Harbour Energy at $6.50 a share.

The deal still needs approval from the Foreign Investment Review Board and there is always the possibility of a rival suitor emerging. But it looks like a knockout offer and was enough to drive the Santos share price up 17% on the day. After persevering with Santos for years in the takeover portfolio, during bouts of share-price weakness, the takeover bid is pleasing.

Flight Centre Travel Group and Treasury Wine Estates were other highlights in the portfolio. Both rallied after beating market expectations with their latest profit results. 3P Learning, another portfolio member (and a Professional’s Pick for today), had a good set of results that confirmed its recovery is on track.

Amaysim Australia, iSelect and the troubled Vocus Group were the main disappointments.

Altium is added to the takeover portfolio this month.

 

• Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor All prices and analysis at April 4, 2018.