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Murky Outlook for Internet Services, But Here Are 3 Opportunities

Macro factors currently driving the economy, such as inflation, rate hikes, supply chain issues, the relative strength in labor and so forth have a varied impact on players in the extremely diverse Internet – Services industry.
 
However, since this is a capital-intensive industry with high fixed cost of operation and the fairly constant need to expand capacity, rate hikes just aren’t very positive for it. This along with rising inflation and ongoing concerns about a recession in the offing is weighing on stocks. Valuations are coming down across the industry. Therefore, this may be a good time to make some long-term bets.
 
Our picks are Shopify (SHOP), Zscaler (ZS) and Crexendo (CXDO).

About the Industry

Internet - Services companies are primarily those that rely on huge software and hardware infrastructure, referred to as their properties, to deliver various services to consumers. Therefore, people can avail the services by accessing these properties with their personal connected devices from almost anywhere in the world.

Companies in the sector generally operate two models: an ad-based model where the service is offered free and an ad-free model where they charge for the service. Alphabet, Baidu and Akamai are some of the larger players while Dropbox, Etsy, Shopify, Uber, Lyft and Trivago are some of the emerging players.

Because of the diversity of services offered, it is difficult to identify industrywide factors that could affect all players. macro factors such as inflation, rate hikes, supply chain issues and so forth affect different players differently.

Factors Shaping The Industry

  • Being a capital-intensive industry, there is the need to raise funds to build out costly infrastructure. Funds are also needed to maintain this infrastructure. Therefore, the rising interest rate environment, which increases operating cost is a net negative for the industry. This also hurts the outlook for the industry over the next few years. Moreover, in the event of a recession, which also looks likely as things stand now, revenue growth and therefore, cost absorption will be tougher for industry players.

  • It goes without saying that increased digitization of different aspects of daily life is a driver for the entire industry because digitization essentially transfers work online, which is where Internet service providers are required. To that extent, the pandemic has proved course-altering for the industry because of the huge volume of transactions that moved online. And people are not giving up all of these conveniences to go back to their old ways. This is reflected in the continued revenue growth since. The expansion of the installed base of connected devices beyond PCs and smartphones to IoT, automotive and more is creating additional opportunities for targeting. The ownership of multiple devices automatically drives people to use these services more as they increasingly automate routine chores.

  • Over the last few years, companies have been investing a lot of their cash into infrastructure that could support the surging demand they have been seeing. As a result, debt levels have increased across the industry and liquidity has plummeted.

  • Traffic acquisition is one of the most important drivers of revenue, so companies invest in advertising or building communities that can draw more users to their online properties and get them to spend more time there, much like a store owner would try to keep a prospective buyer within the store. Some large players, including those providing infrastructure services, grow by tying up with other such large players for access to their customers. Since the personal touch is absent in an online store, many rely on cookies and other technologies to track users, collect data on them and profile them in order to better understand their needs.

  • As these companies have grown over time, some of them have collected such a wealth of information on their users that the data itself is now helping them build artificial intelligence (AI) to lower cost and generate revenues from new technologies and services. As a result, ad-based services are no longer considered free in some parts of the world and the EU in particular has framed a complex law in GDPR that requires service providers to acquire explicit permission from users before collecting their data. While not all businesses are built on the same scale or have the same customer reach, the scope for growth is huge. For companies that are already pursuing research in AI, the prospects are even brighter.

Zacks Industry Rank Indicates Mixed Prospects

The Zacks Internet - Services industry is housed within the broader Zacks Computer and Technology sector. It carries a Zacks Industry Rank #96, which places it among the top 38% of more than 250 Zacks-classified industries.

The group’s Zacks Industry Rank, which is basically the average rank of all the member stocks, indicates that there may be opportunities in the space. But the diverse range of companies means that stock selection will be key.

Looking at the aggregate earnings estimate revisions over the past year, we see that estimates have deteriorated significantly since March, most likely because of the Fed’s hawkish stance and fears of an impending recession. Additionally, the inclusion of certain larger companies like Alphabet in the group can result in skewed averages. Overall, the industry’s earnings estimate for the current year is down 26.4% from November 2021. The average earnings estimate for 2023 is down 27.2%.

Historically, however, the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1. So the industry’s positioning in the top 50% of the Zacks-ranked industries should be considered a positive. Especially because a recession is not a done deal and there are several factors indicating that it may not be too deep.

Before we present a few stocks that you may want to consider for your portfolio, let’s take a look at the industry’s recent stock-market performance and valuation picture.

Industry Lags on Stock Market Performance

Over the past year, the industry has traded at a discount to the S&P 500 and more or less in line with the broader Zacks Computer and Technology Sector.

The industry has lost 36.1% of its value over this period compared to the S&P 500 index’s loss of 14.8% and broader sector’s loss of 33.0%.

One-Year Price Performance

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Zacks Investment Research


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Industry's Current Valuation

On the basis of forward 12-month price-to-earnings (P/E) ratio, which is a commonly used multiple for valuing technology companies, we see that the industry is currently trading at a 20.74X multiple, which is below its median value of 21.51X over the past year. However, the multiple is above the S&P 500’s 17.61X and about in line with the sector’s 20.84X, suggesting a reasonable valuation.

Forward 12 Month Price-to-Earnings (P/E) Ratio

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Zacks Investment Research


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3 Stocks With Promise

Shopify Inc. SHOP: Ottawa, Canada-based Shopify offers commerce solutions including inventory management, order and payments processing, customer relationship management, back-office operations, and analytics. It sells subscriptions to merchants operating on various web-based (store fronts and marketplaces), mobile and physical retail locations but generates the bulk of revenue from what it charges them for Shopify Payments, Shopify Shipping, Shopify Capital, other transaction services and referral fees, as well as Point-of-Sale (POS) hardware.

Strong growth in the merchant base coupled with solid adoption of various new applications and products, and partnerships with YouTube, Twitter, Facebook, Instagram and Google are expected to drive results although high inflation and the impending recession will be dampeners. The pandemic in 2020 clearly prompted Shopify to add debt, although its debt levels are low by any standards. The company has also made several acquisitions this year (particularly Deliverr for $2.1 billion), which has led to a jump in its intangibles to about 20% of total assets. Such investments are necessary for growth but they are also worth keeping an eye on because they take resources in a market that many people think is headed down.

Shopify’s losses in the last quarter came in 41.7% lighter than analysts were expecting on revenue that beat by 2.5%. In the last 30 days, the loss per share estimate for 2022 has come down by another penny while the EPS estimate for 2023 has increased by a penny. Analysts currently expect revenue growth of 19.3% in 2022 and 20.5% in 2023. While 2022 has been a bad year, with difficult comps pulling down performance, 2023 is expected to look up with the 4 cent loss this year expected to grow to a 5 cent profit.

The shares of this Zacks Rank #2 (Buy) stock are down 75.6% over the past year.

Price and Consensus: SHOP

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Zacks Investment Research


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Zscaler, Inc. ZS: Zscaler is a provider of cloud-based security solutions to more than 150 data centers across five continents and 185 countries. It offers a full range of enterprise network security services including web security, internet security, antivirus, vulnerability management, firewalls, as well as control over user activity in mobile, cloud computing and IoT environments.

The company has steadily grown its revenues since inception but the pandemic has served to accelerate this growth trend. Zscaler was able to make the most of the at-home economy since this increased demand for security solutions to a distributed workforce. There is no visible slowdown in its revenues now that the economy is opening up. However, it has taken on substantial debt financing to support this growth, which along with constantly rising operating costs have weighed on profitability. However, building all that leverage appears to be paying off now, as there was notable reduction in the per share loss in the July quarter (October quarter results will be reported on Dec 1).

Zscaler thrashed analyst estimates by 36.5% on the bottom line with the top line also coming in 4.1% ahead. Although estimates have been shaved off slightly in the last 30 days, they still represent 37.4% revenue growth and 69.6% earnings growth in 2022 followed by 30.8% revenue growth and 40.9% earnings growth next year.

The shares of this #2-ranked company are down 61.1% over the past year.

Price and Consensus: ZS

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Crexendo, Inc. CXDO: The company provides Unified Communications as a Service (UCaaS), Call Center as a Service (CCaaS), communication platform software solutions and collaboration services with video designed to provide enterprise-class cloud communication solutions to businesses of all sizes through its business partners, software licensees, agents and direct channels. Its solutions currently support over 2.5 million end users globally.

Crexendo is recognized as an important player in the cloud communications segment, which is a nascent market with tremendous growth opportunities. According to a Frost & Sullivan report which management has quoted, the UCaaS market is expected to grow at the rate of 9.5% from $15.8 billion to $24.8 billion between 2019 and 2024. The firm’s survey showed that 29% of respondents intended to move their videoconferencing to the cloud over the next two years, 35% intended to move their instant messaging, 38% their customer experience management and 38% their enterprise IP telephony. Therefore, this represents huge growth opportunity. Frost & Sullivan also recognizes Crexendo as the fastest-growing UCaaS platform in the US.

Crexendo beat the Zacks Consensus Estimate by a cent on revenue that was more or less in line. Analysts currently expect revenue and earnings to grow double-digits both in 2022 and 2023. In the last 30 days, the 2022 estimate increased by a penny while the 2023 estimate increased by 6 cents, representing 12.5% and 60.0% growth, respectively.

The shares of this Zacks Rank #2 company are down 56.5% over the past year.

Price and Consensus: CXDO

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