2 ASX tech shares to boom when inflation rises: analyst

According to one analyst, a 40% boost in profits awaits these high-tech companies when the Reserve Bank raises interest rates. This is how.

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Technology shares have been pummelled over the last 4 months.

Dominated by growth stocks that rely on low-interest rates for future earnings, inflation fears have seen investors abandon the darling sector of last year.

The S&P ASX All Technology Index (ASX: XTX), in fact, has lost about 15% since February. Yikes.

But ECP Asset Management analyst Damon Callaghan argued this week there are ASX tech shares that will actually benefit from higher inflation.

"We believe concerns of rising discount rates impacting present day valuations need to be weighed in conjunction with potential changes to business profitability," he said on the company blog.

"It's important to appreciate how changing macroeconomic environments can affect the profitability of individual businesses."

Two examples Callaghan cited of tech companies that will benefit from rising inflation are Hub24 Ltd (ASX: HUB) and Netwealth Group Ltd (ASX: NWL).

How Hub24 and Netwealth make money

Both companies provide wealth management software platforms.

Callaghan said Hub24 and Netwealth are clear leaders in their field, holding 2% and 4% of the market respectively.

"Each business is increasingly taking market share, aided by a structural adviser shift to independence and general incumbent platform dissatisfaction across the industry."

But unlike many other technology companies, the near-zero interest rates in the past couple of years have depressed their business.

This is because a core source of profitability for both is the 'cash spread' generated from the money they hold from investors.

"The platforms pay clients interest on uninvested cash, typically with reference to the RBA cash rate (i.e. RBA less 0.50%)," said Callaghan.

"Platforms then utilise their scale, pooling tens of thousands of client accounts, and provide this cash at a wholesale rate to tier-1 banks. For example, Netwealth recently disclosed its standing contract with Australia and New Zealand Banking Group Ltd (ASX: ANZ) pays it RBA plus 0.95%."

The difference between the interest received from the banks and the interest it pays investors is all sweet profit for Hub24 and Netwealth.

How Hub24 and Netwealth benefit from higher inflation

But since the arrival of COVID-19, the Reserve Bank slashed its cash rate to below 0.5%. This means the margin for Hub24 and Netwealth has disappeared.

"Every basis point below 0.50% ate into the spread earned by both Hub24 and Netwealth," said Callaghan.

"In the Netwealth example, the running cash spread was cut from 1.45% down to 1.05%."

This is why if the RBA rate spikes up, both these platform providers will be cheering.

"With economic normalisation, extreme liquidity support and record low rates will no longer be a necessary monetary policy setting — and potentially sooner than expected," Callaghan said.

"When this period of heightened stimulus passes, we see scope for Hub24 and Netwealth cash spreads to normalise back to pre-COVID levels."

Using forecasts for the 2023 financial year, ECP Asset Management estimates both software providers will see a 40% boost in profit expectations if "historic" cash spreads returned. 

"The consensus earnings headwinds caused by excess liquidity are now behind the wealth platforms, and are set to accelerate profit growth when this economic recovery matures."

Hub24 shares were down 1.61% at Friday's close to trade at $27.58. They started the year at $21.73.

Netwealth stocks were up 1.76% on Friday to change hands at $15.05. They began 2021 at $16.35.

The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of and has recommended Hub24 Ltd and Netwealth. The Motley Fool Australia owns shares of and has recommended Netwealth. The Motley Fool Australia has recommended Hub24 Ltd. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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