Equity research: In the wake of COVID-19, the strong get stronger
“Bad companies are destroyed by crisis, good companies survive them, great companies are improved by them.”
—Andrew Grove, former Intel Corp. chairman and CEO
As we consider the potential long-term economic effects of COVID-19, it seems increasingly clear that the crisis will accelerate structural changes that were underway before the first outbreak. We also believe the crisis will spotlight the need for business resilience as companies across sectors and economies look to grow stronger through—not merely survive—the crisis.
In this article, we look at several trends that are likely to pick up steam as the focus on resiliency increases: digital transformation and the move to the public cloud, more diversified supply chains and an accelerating shift to factory automation. We also consider the subject of business risk appetite in a post-COVID-19 context.
Digital transformation and the shift to the public cloud
Well before COVID-19, our analysts were focusing on the trends of digital transformation (in both business and society at large) and the migration to the public cloud; these were also investment themes across many of our portfolios. The coronavirus crisis has only underscored the power of those forces. Managing on-premise equipment becomes less desirable during a pandemic, thus speeding up the move from a desktop-centric world (e.g., from applications that exist only in a Windows environment) to a more distributed information technology (IT) architecture (apps at home on mobile devices and in the cloud).
Our research team has looked to understand the scale of the public cloud migration and its potential for further growth. We developed a proprietary tracker to monitor enterprise information technology, public cloud spending and cloud penetration over the past eight years (EXHIBIT 1). As of 4Q 2019, we estimate, the public cloud had a 20% penetration of what we believe is a roughly USD 1 trillion market (our estimate of the enterprise IT market that is addressable by the public cloud). We forecast penetration of approximately 40% in 2026 as the use of the public cloud grows at a significantly higher rate than the use of legacy IT systems.
These are early days for the public cloud, whose use is growing much faster than legacy it systems
EXHIBIT 1: PUBLIC CLOUD PENETRATION AND REVENUE TRENDS
($1T total Addressable market)
Who will be the likely winners in the transition to the public cloud? Some names are unsurprising (the Amazons and Microsofts of the world), but the trend permeates the investment universe. In the semiconductor sector, Taiwan Semiconductor is taking market share in providing the chips that drive the computer intelligence for this infrastructure. ASML, a leading manufacturer of equipment used by semiconductor companies, is another beneficiary of the migration to the cloud.
The digital transformation has the potential to impact many businesses over time. It may accelerate the move to virtual banking, benefiting the companies born as digital-only enterprises and now acting as industry disrupters, as well as the incumbents that made prescient early investments in the trend. There are also many companies that are embracing the cloud to differentiate themselves to their customers in terms of cost and service; we expect to see more of this in the future.
Diversified supply chains and a renewed push for factory automation
As U.S.-China trade tensions intensified in recent years, companies began to reevaluate their supply chains with an eye toward making them more localized and less globalized. Those discussions have become more animated during the pandemic, with some companies considering diversifying their suppliers and others bringing production closer to the end consumer (a trend known as on-shoring).
Rebalancing supply chains away from China will likely come with new risks and uncertainties. China’s infrastructure (access to electricity, transport, labor supply) is in generally good condition, and Beijing has been essentially supportive of foreign direct investment. Manufacturing profits have been expanding for nearly 20 years, largely because of the savings associated with globalization. That profit support could reverse quickly and materially, especially if many companies rush to relocate supply chains at the same time.
Factory automation and robotics is a structural trend that will likely accelerate if companies do look to on-shore/diversify supply chains in their efforts to increase productivity to offset higher costs. Additionally, a corporate focus on pandemic resilience will likely spur further moves toward automation—the coronavirus crisis has highlighted the additional utility of mechanical solutions to replace human labor. Among the beneficiaries of this trend: Keyence Corp., a Japanese maker of machine vision systems and sensors for factories, and industrial giant Schneider Electric, a leader in the digital transformation of factory automation and energy management systems.
The appetite for business risk
Like all crises, the COVID-19 crisis has highlighted the importance to businesses of liquidity and solvency. Many company balance sheets, it turned out, were in no position to withstand a sustained period of minimal revenue. As businesses now look to become more resilient, they may aim for more conservative balance sheets, with a larger cash component. At the same time, an extended period of low interest rates could make it easier for companies to take on more debt. And to the extent that large-scale government stimulus (in the global financial crisis and, more recently, in the COVID-19 crisis) spurred a corporate expectation of future government bailouts, it could encourage businesses to become less risk averse.
The strong get stronger
In the aftermath of most crises, higher quality companies tend to take market share from their competitors. Simply put, the strong get stronger and the weak get weaker. As companies continue to navigate the effects of the pandemic, they will look to build their resilience, grow their revenues and protect their profits. As Andrew Grove reminded us, the best companies will not just survive but thrive.