Cabot Early Opportunities Issue: February 15, 2023

Stocks in This Issue

An Opportunity Hiding in Plain Sight

In November 2014 I was running a growth newsletter covering companies across the full market cap spectrum.

While my preference was (and still is) to focus on small and mid-cap companies I saw an opportunity in a very large company that seemed so obvious many investors didn’t see it.

I would talk about this company with relatives, friends and co-workers. The response was almost always the same. Something along the lines of, “Yeah, it’s good. Reliable. But have you looked at XYZ company? I feel like they’re going to be big.”

Grrrr. Despite the lack of interest, I jumped in with both feet.

That company was Microsoft (MSFT).

Microsoft released Azure, its cloud computing platform, in 2008. Over the following years, the company laid the groundwork for a cloud-centric business.

In 2014 it was gaining momentum with Office 365, the cloud-based subscription version of the company’s popular application suite.

Office 365 was clearly a better product than the perpetual license version that users download about every six years. More important to investors, my math showed the company would make 2.8 times more money per subscriber over the six-year time span that a typical Office license lasted.

Office 365 also had the potential to help pull back a massive user base that had drifted away from Microsoft over the years.

It seemed like a no-brainer investment.

This is an excerpt of what I wrote to subscribers in a report titled, A Window Into The Future.

“Sometimes you don’t have to look all that hard for a great investment. That’s especially true when a dominant company is doing something better than it has in recent history. This is exactly the scenario I see playing out with Microsoft (Nasdaq:MSFT) today … The release of Office 365 is likely to be the biggest strategic move by the company in years … I see Microsoft as a company that has finally gotten back in the game. It’s a stock that you can buy and hold, and not worry about.”

At the time Microsoft stock was trading for 43. Yesterday it closed at 272.

That works out to a total return of about 532%, or 26% on an annual basis. Not too bad.

The big buzz today is around Microsoft’s investment in artificial intelligence (AI), specifically ChatGPT.

ChatGPT is a natural language processing tool developed by OpenAI. The language model can answer questions and help people complete tasks such as writing a letter, crafting a poem, writing an essay and writing code.

It is not perfect. But it is quite good. Better than anything the general public has seen so far. And the implications for efficiency gains for coders, content creators, etc. are massive.

That’s why ChatGPT is the fastest-growing app in history. Reports suggest it gained over 100 million active users in just two months.

It took TikTok nine months to cross that threshold.

Microsoft is currently integrating the tech into many of its cloud-based tools, including its Bing search engine.

I’m not an AI revolutionary that thinks the technology will turn the world upside down. But it’s pretty easy to see how Microsoft’s already sizeable user base will embrace the technology across multiple products AND be willing to pay more for it.

Then there are the products we haven’t even thought of yet that could be released with this tech in them.

In other words, this feels like another “Office 365 moment.”

That’s why, despite its size and too-obvious-to-bother-with profile, I’m adding Microsoft to our portfolio today.

In my view, the downside is that the stock does modestly better than the broad market and its AI investments don’t move the needle.

The upside is that it crushes the broad market and cements itself (again) as a must-own stock that a lot of investors kick themselves for not buying.

Doesn’t seem like a tough choice to me.

What to Do Now

Same as last month, continue to add exposure to a diversity of emerging opportunities, but don’t overdo it.

The market continues to digest variable economic data way better than it did in 2022, largely because the end of rate hikes is (we think) just over the horizon. While that can change, the current evidence is leaning toward a soft landing. That is setting up a “bad to better” scenario for stocks.

Microsoft (MSFT) ★ Top Pick ★

Microsoft (MSFT) is a massive company providing software, cloud computing infrastructure, consumer electronics and personal computers to consumers and businesses around the world.

The company’s mission is to empower every person and every organization on the planet to achieve more.

Microsoft is organized into three segments, Productivity and Businesses Processes (Office 365, Teams, LinkedIn, Dynamics, etc.), Intelligent Cloud (Azure and other cloud services, consulting, Nuance, etc.), and More Personal Computing (Windows operating systems, devices, gaming, search and news advertising, etc.).

In 2022 total revenue grew by 18% to $198.3 billion while EPS grew by 16% to $9.21. In 2023 analysts see revenue up 5%, then up 11% in 2024.

So where does Microsoft’s investment in OpenAI and ChatGPT fit into the picture?

Microsoft has been laying the groundwork in AI for years. It invested in OpenAI in July 2019 and has been investing in AI within Azure, GitHub Co-pilot and Microsoft Designer, among other solutions, since.

The primary focus on AI right now is in Search, namely the Bing search engine and Edge browser.

Management says Search is the largest software category in the world and that the digital ad market is worth roughly $500 billion and growing at about 18% a year.

It only holds about 3% market share. That translated into just $18 billion in 2022 ad revenue (9% of total revenue).

The number is so small because the big tree in this market is Google (GOOG), which holds roughly 85% market share.

That said, Microsoft has been gaining share for seven consecutive quarters. And each percentage point of share gain equates to about $2 billion of Bing revenue.

If the company captured an additional 10% market share that’s $20 billion in revenue, enough to add roughly 10% to 2022 revenue.

I’m not saying that will happen overnight, but it frames the opportunity here.

Beyond Bing, Microsoft is also bringing ChatGPT/AI technology to other solutions. It recently announced premium editions of its Teams solution for $10 per user per month. The new technology will help with note taking and meeting scheduling.

There is a cost to the new AI-powered Bing and Edge solutions. Rough math suggests the cost to run all Bing search queries through ChatGPT technology will cost about $600 million to $1 billion per year, assuming no major changes to market share.

That works out to about 0.4% of estimated 2023 revenue. Which seems reasonable given the monetization opportunities of better-targeted ads and new subscription tiers across other products.

This is all new enough that there’s a good deal of uncertainty regarding how it all works out. But one thing is crystal clear – Microsoft has prepared for a big fight in Search and AI and is coming out swinging.

The Stock

MSFT has done very well since Satya Nadella became CEO in early 2014. At that time, it was a 38 stock. Shares peaked at 349 in November 2021. In 2022 the stock did poorly. Despite a few multi-week rallies shares ended the year near 240, down 28% from where they started. Over the first six weeks of 2023, MSFT has begun to shape up and the stock is now back above its 200-day line for the first time since last April. Trading at 273 now the next zone of resistance is 294, which is where MSFT was last August. BUY

PowerSchool (PWSC)

PowerSchool (PWSC) is a leading provider of cloud-based educational software for K-12 schools in North America and 90 other countries. The company’s software connects students, teachers, administrators and parents with tools that ease administrative burdens and help improve student outcomes.

The software helps schools and districts manage state reporting, compliance, special ed, finance, HR, talent, enrollment, attendance, funding, learning, instruction, grading, assessments and analytics.

More than 15,000 customers, including over 90 of the top 100 U.S. school districts by student enrollment, use the platform. That works out to over 45 million students and implies around 70% of schools in the U.S. and Canada are on the platform.

International exposure is limited now but growing very strong in select areas, such as the Middle East.

The company enjoys a resilient education market. While many software companies are reporting slowing growth PowerSchool’s management is talking about strong demand and improving sales cycles. Recent results show the company continues to be successful in landing new deals and cross-selling solutions to current customers.

In the most recent quarter (Q3 2022) revenue grew by 14% to $470 million. Annualized recurring revenue (ARR) grew 11% to $585 million while net revenue retention (NRR) was up 1.4% to 109%. PowerSchool is profitable, and adjusted EPS jumped 40% to $0.21.

Given the trends, revenue should be up around 13% to $632 million this year while EPS should be up about 20% to $0.78. In fiscal 2024 analysts see revenue growing 11% to $700 million and EPS growing 12% to $0.87.

Earnings are due out next Wednesday.

The Stock

PWSC came public at 18 in July 2021 and the stock had a great start, doubling by September of that year. The bear market pulled PWSC down in 2022, however, and by July 2022 the stock was trading at 12. That appears to be the bottom as shares gained steadily in the second half of the year and entered 2023 trading near 23. There was a little rally to 26 a couple of weeks ago then PWSC pulled back to its 50-day line, near 22.6. It found support there and has been looking like it wants to go higher over the last week. BUY HALF

Samsara (IOT)

Samsara (IOT) was founded in 2015 and is a software company with a cloud-based platform for tracking vehicle fleets and other physical assets.

The company’s fleet management solutions (Connected Fleets) help customers monitor and manage their fleets for compliance, safety, fuel, navigation and more. Equipment (Connected Equipment) and site management (Connected Site) solutions help customers keep an eye on non-mobile assets.

These investments often pay for themselves through lower accident expenses, less waste and lower fuel and insurance costs.

The company competes in a large (roughly $23 billion) market in the U.S. that is still fragmented. Analysts estimate Samsara holds about 2% market share. Competition is ramping up with Verizon (V), Amazon (AMZN), Microsoft (MSFT) and several privately held players all seeing opportunity.

Competition is a risk, but also an opportunity as Samsara’s platform makes it a potential acquisition target.

Samsara wins business because it has an easy-to-use cloud-based platform that was purpose-built to serve a wide market. This has helped the company land bigger clients and expand sales with them over time.

The company has around 30,000 customers. About half spend north of $5,000 per year. Roughly 1,100 customers spend $100,000 per year and at least 40 spend over $1 million.

Management has said sales cycles are getting a little longer. But also that they feel comfortable guiding for high 20% revenue growth in fiscal 2024. Given management’s conservative track record that seems very achievable.

In the most recent quarter (Q3 fiscal 2023) revenue grew by 49% to $170 million while EPS came in at -$0.02. Full-year revenue growth should be about 49% ($640 million) and EPS should be about -$0.16.

Analysts are currently projecting 28% revenue growth in fiscal 2024 and EPS of -$0.15.

Stepping back, the business isn’t recession-proof, but it is proving to be resilient. And there is a lot of room to cross-sell non-fleet management solutions (just 14% of revenue) to current customers. A stronger economy presents upside potential, while M&A could help Samsara grow faster or present an opportunity for the company to sell itself.

The Stock

IOT came public at 23 on December 15 and rose 7% the first day. Shares traded up to an intra-day high of 31.4 within a few weeks then the trend turned south. IOT looked to have bottomed at 8.7 on May 12, rallied into the summer, then fell back to 8.42 in November. Momentum picked up after the December 1 earnings report. Shares ended 2022 trading near 12.4 and a six-week rally has carried IOT well above both its 50 and 200-day moving average lines. WATCH

SiTime Corporation (SITM)

SiTime Corporation (SITM) is a fabless semiconductor company that provides MEMS (micro-electro-mechanical systems) and silicon-based timing systems. Silicon MEMS is a superior technology as compared to quartz crystal because it offers higher performance and programmability and lower power consumption.

The product portfolio encompasses oscillators, clock ICs and resonators.

Historically, most revenue came from sales of oscillator products. In 2020 the company made a big leap forward with its first MEMS clock system-on-chip (SoC).

These advanced systems – which feature an integrated MEMS resonator, oscillator and clock integrated circuit (IC) in a single package – further differentiated SiTime’s solutions from legacy quartz systems.

Big picture, SiTime serves a market where electronics are moving beyond controlled environments and into the great outdoors, where temperatures, interference, shocks, vibration and more are thrown at electronic systems.

The company serves a broad array of end markets, including datacenter, automotive, aerospace, industrial and mobile/consumer electronics. Apple (AAPL) is one of SiTime’s biggest customers and drives over 20% of revenue.

Like other semiconductor companies, SiTime had supply issues during the pandemic. Once supplies became available manufacturers ordered everything they could. They are currently working through this excess inventory, which has limited revenues to SiTime.

These supply-demand imbalances led revenue to contract in Q4 2022, and we’ll likely see lower revenue in 2023 than we saw in 2022.

However, management says excess inventory should be drawn down in the first half of the year and Q1 2023 will be the low point. In other words, things should get better soon, and investors should look toward the future.

In Q4 2022 (reported February 1) revenue fell by 20% to $60.8 million. That capped off a year in which sales rose by 30% to $284 million.

Analysts see full-year 2023 revenue of about $210 million, down 26% from 2022. EPS should be down about 65%, to -$1.32.

Then in 2024 growth should return. Analysts see revenue up 30% and EPS doubling. Granted, that’s a little way off. But this “bad to better” setup is why analysts from Barclays, Needham, Raymond James and more have been raising their price targets and maintaining buy ratings on SITM following the Q4 earnings report.

The Stock

SITM came public at 13 in November 2019 and had a heck of a time during the pandemic. In November 2021 the stock peaked at 342. Tall trees fall hard and SITM was no exception. Last October this was a 73 stock. But a recovery seems to have taken hold and SITM has traded in a tight range while inching consistently higher since crossing back above its 50-day line in November. The stock is currently challenging its 200-day line right at 128. WATCH

Timkin Company (TKR)

Timkin is an industrial manufacturing company specializing in high-end engineered bearings and industrial motion products. The stock has both growth and value characteristics and yields 1.5%.

Its ball bearings, hubs, drives, belts, couplings, clutches, etc. help clients design and build the next generation of machinery and equipment while also keeping current equipment up and running.

The company serves industries ranging from food production and transportation to automation and renewable energy. It’s been around for a long time, since 1898 in fact. But it’s not a stodgy old company.

Timkin’s highly engineered products and pricing power have earned it a leadership position in this specialized market. While M&A and expansion into new markets, like renewables and automation, are helping to diversify the company from the typical industrial production cycle.

Roughly half of Timkin’s revenue comes from its Mobile Products division, which is mainly bearings for new heavy equipment. The remaining half comes from Process Industries, which includes a lot of aftermarket parts. Just over half of revenue comes from the U.S.

China, which drives 15% of sales and was a headwind during COVID lockdowns, is turning into a tailwind due to re-opening and renewables exposure.

Like other industrial players, Timken had a rough time during the pandemic due to supply chain constraints, then prices surged. It is in a period of potential normalization now as the pace of price increases slows and, hopefully, revenue and profit growth become more predictable.

Fourth-quarter results came out a few weeks ago. Revenue was up 7% to $1.08 billion while EPS jumped 56% to $1.22. That quarter capped off a year in which revenue rose 9% to $4.5 billion and EPS rose 28% to $6.02.

Looking ahead, management set cautious guidance for 2023, likely setting up a beat-and-raise cadence for the year, barring a rough recession scenario and a lot of inventory destocking. Investors should look for revenue to grow by around 7% to $4.8 billion and EPS to grow by 14% to $4.88.

I think Timken will do better than expected as strength in renewables, aerospace, heavy industries and marine, combined with M&A (recent Nadella and acquisitions add roughly $135 million) and some self-help projects can drive top and bottom-line outperformance.

Following the Q4 report analysts have boosted price targets. Goldman has gone from 70 to 79, Citigroup from 78 to 98, Stifel Nicolaus from 85 to 100, Morgan Stanley from 83 to 88 and KeyBanc from 88 to 102.

The Stock

TKR peaked near 92 in May 2021 then a choppy downtrend took over that pulled shares down to 51 by last June. That looks like the recent bottom. The stock popped back up and spent much of last summer in the 60 to 70 range, then rallied into the fall and traded up to 76 before pulling back to the 50-day line near 68 in December. After consolidating for a few weeks, TKR took off again in January and has moved up into the mid-80s where it continues to act strong. BUY

Previously Recommended Stocks

We have done very little since the January issue. Our lone sale has been to exit our remaining quarter position in Axonics (AXNX) for a gain of 25%.

An updated table of all stocks rated BUY, HOLD and WATCH as well as recent stocks SOLD, is included below.

Please note that stocks rated BUY are suitable for purchasing now. In all cases, and especially recent IPOs, I suggest averaging into every stock to spread out your cost basis.

For stocks rated BUY A HALF, you should average into a position size that’s roughly half the dollar value of your typical position. We may do this when stocks have little trading history (for instance, IPOs), when there is more uncertainty in the market or with a stock than normal, or if a stock has recently jumped higher.

Those rated HOLD are stocks that still look good and are recommended to be kept in a long-term-oriented portfolio. Or they’ve pulled back a little and are under consideration for being dropped.

Stocks rated SOLD didn’t pan out, or the uptrend has run its course for the time being. They should be sold if you own them. SOLD stocks are listed in one monthly Issue, then they fall off the SOLD list.

Please use this list to keep up with my latest thinking, and don’t hesitate to email with any questions.

Recently Sold Positions

The next issue of Cabot Early Opportunities will be published on March 15, 2023.