FTEC: Software-Related Risks Emerge As Gen AI Disrupts (NYSEARCA:FTEC)

Trading at around $163 at the time of writing, the shares of the Fidelity MSCI Information Technology Index ETF (NYSEARCA:FTEC) have appreciated by 32.73% over the last year as charted below. This has been largely possible because its top holdings have benefited from the AI enthusiasm, but, after such a performance, it becomes important to assess whether the momentum can continue.

Also, things have changed recently after Salesforce (CRM) which had invested in artificial intelligence reported dismal earnings and was punished hard by the market, with volatility also engulfing other software stocks at that time. In consequence, this thesis aims to show that it is now time to exercise caution based on emerging risks as Gen AI starts to disrupt the enterprise software industry with related stocks constituting a substantial part of FTEC’s overall weight.

First, I show that despite valuations having become expensive for AI stocks, there are still opportunities.

AI has become Expensive

Nvidia (NVDA) has delivered a spectacular one-year performance of 222% after emerging as the dominant manufacturer of parallel computing chips for key players in the artificial intelligence space like OpenAI. In its wake, other stocks like Advanced Micro Devices (AMD) and Broadcom (AVGO) have also profited with gains of 42% and 77% respectively. The first has positioned itself as an alternative player in the accelerator GPU space trying to win market share from Nvidia and the second is a provider of customized chips for cloud service providers, whether it is for computing or networking.

Now, the cheapest among these three stocks, Broadcom comes with trailing price-to-earnings multiples of above 50x, which exceed the IT sector median by over 75%. While such a sky-high valuation may seem incomprehensible to the average value investor, it can still be justified with the growth and productivity prospects that artificial intelligence engenders.

There are Still Opportunities in AI

In this respect, according to Bloomberg Intelligence, AI spending is expected to reach $1.3 trillion by 2032, an average growth rate of 42% over the next ten years. Equally important, research by McKinsey shows that labor productivity could increase by 0.1% to 0.6% annually from 2024 to 2040 depending on the pace of adoption of Gen AI.

Moreover, the companies likely to benefit are not only those that supply related technologies like the three chip plays mentioned above but others in fields as diverse as robotics, cybersecurity, education, finance, and even health. However, to be realistic, not all companies can invest hundreds of millions of dollars in chips and data center infrastructures. Thus, to make AI available to these companies without them having to invest large amounts of capital and in an As-a-Service fashion, hyperscalers (giant cloud providers) like Microsoft (MSFT) are key.

Looking further, the market has been upbeat about companies likely to integrate artificial intelligence into their development strategy, and among these, we can notably cite Apple (AAPL) with its elaborate device (iPhone, iMac) and iOS ecosystems.

Now, with about 50.93% of its assets dedicated to the five stocks I have been talking about, FTEC has delivered an upbeat performance.

Looking forward, the number of times the annual revenue and EPS consensus estimates for these five stocks have been revised upwards (“Up”) by analysts, mostly exceeds the number of downgrades (“Down”) as illustrated in the table below.

Thus, only AMD saw both its revenue and EPS being downgraded, but it makes up only 2.13% of FTEC’s overall weight. Therefore, with more greens than reds, analysts generally remain optimistic that their financial results will continue to improve, meaning the upside could continue.

The Risks associated with Application Software

However, coming back to Salesforce which makes up 2.18% of FTEC’s weight and forms part of the ten top holdings, it fell by over 19% on May 31 after reporting financial results and guidance that missed estimates. Earlier last month, EPAM Systems (EPAM), another of FTEC’s 305 holdings fell by even more or 27% as a reaction to earnings with analysts downgrading its revenue expectations for its second quarter.

Moreover, according to Seeking Alpha News, other software stocks that fell in the aftermath of the Salesforce plunge, include software giant Microsoft, database giant Oracle (ORCL), Adobe (ADBE), and Intuit (INTU). Noteworthily, FTEC lost around 4.5% of its value at that time before eventually recouping its losses showing that the performance of software stocks does impact its trajectory.

Now, for the sake of clarity, it is important to distinguish between the Systems Software and Application Software industries which both belong to the IT sector as shown in the comparison table below. These two groups when combined are referred to as Enterprise software. Here, investors will note that Microsoft and Oracle are classified in the System Software industry because, in addition to software, they are also providers of operating systems and databases respectively. As such, their one-month price performance shows they have suffered less than Application Software players like Salesforce and peers.

One reason for the underperformance of Application software companies (relative to System Software) is they are already facing the disruptive power of Gen AI.

One example is chat-based tools like ChatGPT developed by OpenAI which significantly enhances the customer experience through features like interactivity, personalized interactions, and improved response times while improving accuracy. This is causing CEOs to rethink the way they interact with and even procure software. Another example is Microsoft’s Copilot which is a Gen AI chatbot developed on the heels of ChatGPT that helps software developers write codes faster and helps them with several office productivity tasks.

Hence, we are in the age of super-smart AI personal assistants which are reshaping customer engagement models to deliver more productivity according to IDC. The consequences are changing organizational structures, re-platforming of different industries, and other changes. Along the same lines, a new study by McKinsey highlights that while Gen AI could accelerate growth in the enterprise software industry, it also introduces new challenges that could instill a realignment of product categories and competitive dynamics.

Translating this to FTEC’s holdings, customers may put on hold subscription renewals as they obtain more clarity, in turn impacting their revenues. In this case, it is not only about promptly investing in Gen AI-based applications as Salesforce has done with Einstein GPT for CRM or EPAM with Vivien digital assistant but also being able to rapidly realign priorities and generate returns, especially when investors’ expectations are running so high.

Not the time to Invest as there are also Rate-related Risks

This is the reason it is not the appropriate time to invest in the ETF at this moment in time because of its 14.66% exposure to Application Software as encircled below in red. I believe that up to now, the volatility has been largely confined due to the strength of the AI hype, but things could change during the next wave of financial results reporting.

To further justify my cautious position, the ETF trades at a P/E of 28.61x which exceeds the category average, and the SPDR S&P 500 ETF Trust (SPY) by 6.7% and 31.5% respectively.

Now, with their relatively high valuations, tech is particularly sensitive to interest rate risks and can be volatile in case there are fewer chances of the U.S. Central Bank reducing rates. Such was the case on Friday, June 7 when non-farm payrolls numbers showed the job market had added more jobs than expected thereby demonstrating economic resiliency, in turn reducing the need to cut rates.

In this case, investors expect tech to grow faster, which requires relatively more capital and higher borrowing costs as interest rates remain above 5%. This is especially so for FTEC’s hundreds of smaller IT plays that may not benefit from the same level of cash inflows as big tech like Apple or Microsoft. At the same time, inflation remains above 3% which increases operating expenses since IT experts specializing in artificial intelligence are not only scarce but charge more than the average worker, in turn pressurizing profitability.

Looking across the ETF space for those looking for an alternative fund, there is the Vanguard Information Technology Index Fund ETF (VGT) which charges only slightly more as shown below. However, the problem is that in the same way as FTEC, it also passively tracks the MSCI USA IMI Information Technology 25/50 index. Thus, for those who want to invest in the AI story without being exposed to Application Software, an alternative is the VanEck Semiconductor ETF which is devoted to chip plays. Noteworthily, it shares some common names operating in the software industry as the Fidelity ETF like Synopsys (SNPS) and Cadence Design Systems (CDNS) but these are specialized for the chip industry.

In conclusion, this thesis has shown that while Gen AI opportunities remain intact for some of FTEC’s main holdings, new risks have emerged for those belonging to the Application Software industry. This is shown in the way their share prices have been impacted in the last month and the pains could continue when next quarter’s results are announced as investors run out of patience. In addition to risks posed by the disruptive nature of innovative technology, the market also has to contend with the possibility of rates remaining higher for longer. In these circumstances, I have a Hold position.