AI lands a blow on some Aussie stocks – yet stands to benefit others
AI is reshaping ASX tech moats - but some are more insulated than others.
Mentioned: WiseTech Global Ltd (WTC), PEXA Group Ltd (PXA), REA Group Ltd (REA), FINEOS Corp Holdings PLC Chess Depository Interest (FCL), Technology One Ltd (TNE), Hansen Technologies Ltd (HSN)
You’d be hard pressed not to come across AI doomsday pieces in the media recently. From dystopian forecasts on AI’s economic impacts to AI leaders announcing the end to white collar jobs.
This article will cut through all the superficial noise to answer two questions. Which ASX tech companies are exposed to AI and which ones will benefit over the long run? Our tech analyst Roy Van Keulen recently downgraded the moats of four major ASX tech shares on the back of AI disruption. Let’s take a deep dive into our research and extrapolate everything investors need to know.
Where AI has already deteriorated moats
Over the past year, the ASX200 Tech index is down 28%. The fall in this benchmark suggests investors are anticipating a slowdown in profitability in the tech sector. Much of this concern is closely linked to AI disruption. The term ‘AI disruption’ is thrown around a lot but it doesn’t explain the mechanisms at play. A simple way to put it is AI reduces switching costs for software customers. Switching costs are one of five core pillars that Morningstar use to validate our moat ratings.
Switching costs are simply the inconveniences or expenses associated with a customer switching to another competitor. The big four banks are a prime example of this. Switching between banks is a lengthy process involving updating recurring payments, salary deposit details and covering fees on existing accounts. Unless there is a pronounced perceived economic benefit, customers are more likely to just stick with their current bank.
Now in software terms, large customers (think corporations) that use mission critical software will avoid switching software unless absolutely necessary. This is due to the costs associated with switching such as retraining staff, migrating data and teething issues. AI collapses switching costs by acting as the middleman bearing the load of these issues. AI also reduces the development costs to replicate existing software systems. This increases the likelihood of more competitive pricing. Lastly, AI also makes it far more viable for customers to build their own systems instead of outsourcing.
Downgrades sweep across ASX tech sector
Roy downgraded four moats across our Aussie tech sector. TechOne (ASX:TNE), REA Group (ASX:REA) and Fineos (ASX:FCL) saw their moat cut from wide to narrow. Hansen (ASX:HSN) saw its moat reduce from narrow to none. As a reminder a wide moat implies confidence in a sustainable competitive advantage over 20 years while a narrow moat is closer to 10 years. The moat rating can be used for some context as to the extent and timing of AI disruption. The common theme across all four moat downgrades is collapsing switching costs. Historically, these companies have benefited from carving out a niche where customers find switching providers costly.
For example, Hansen develops billing software for companies in the energy, utilities and communication service sectors. They have enjoyed high switching costs for decades given switching poses short term risks to cash collection and customer satisfaction. This was a core pillar of Hansen’s narrow moat rating. Roy believes this moat no longer exists given Hansen’s pricing power diminishes when switching costs fall.
There is one caveat among the four downgrades that warrants further discussion. REA could face additional challenges on top of switching costs. If AI interface’s become the primary source for home buyers, REA’s pricing power will erode. The long term threat is that AI curated lists could diminish value from real estate agents paying for tiered visibility on realestate.com. For this to occur, AI would need to collapse the network effects that agents and buyers have built (no easy task). AI still relies on listings, verified data and agent relationships which provides insulation against disruption for now. It is this network effect that is the pillar holding REA’s narrow moat together.
Can AI benefit ASX tech shares?
The amount of wide moat ASX tech companies in our coverage has fallen to just two. Although this will continue to fluctuate, it is worth highlighting the characteristics that these two companies share. WiseTech (ASX.WTC) and Pexa (ASX.PXA) both demonstrate uniquely high switching costs and network effects.
In a recent report from Eric Compton and Mark Giarelli’s Moat Ratings Guidebook Amid AI Disruption, it was shown network effects were the most AI resistant moat source. Furthermore, companies built around infrastructure, proprietary data, network effects or specialised domain workflows could see AI strengthen their moat over time.
The kingmaker
WiseTech’s moat stems primarily from switching costs. In my previous article on “3 ASX opportunities after earnings season” I explained why WiseTech stands to benefit from AI development. A good question to ask is why isn’t WiseTech’s moat effected if AI collapses switching costs? The short answer: AI does not reduce switching costs evenly across industries. Freight forwarding is notoriously sticky with WiseTech boasting the industry’s best gross retention rate at 99% since 2013.
CargoWise, its flagship software, is deeply embedded in the daily operations of freight forwarders. It essentially acts as the primary operating system instead of a supporting software. Roy calls WiseTech a “kingmaker” as the software drives significant cost reductions and increased market share for its customers. The real cost of switching away from CargoWise is the loss of competitiveness in the industry. Given its “kingmaker” status, Roy believes AI acts more as a tailwind for further efficiencies instead of a threat. AI implementation in CargoWise drives cost reduction and further dominance over competitors.
The Aussie monopoly
Pexa is a digital property settlement exchange that dominates a monopoly in Australia. The electronic platform allows lawyers, conveyancers and financial institutions to streamline the process of buying, selling or refinancing a property. Adoption of Pexa’s platform was led primarily through the co-ownership by the big four banks and state governments. The network effects are its primary source of its moat. Network effects just mean the more users it has, the more valuable it is. Think of social media as an example, the more users Instagram has – the more valuable the platform is.
The network effects in Australia have created substantial benefits for Pexa. Think of the network experiencing a gravity pull effect as its popularity drives more adoption. Pexa has 90% market share of total transactions in the Australian property market while Pexa’s main digital competitor, Sympli, has less than 1% of total transactions. It also benefits from high switching costs given the lack of scalable competitors in Australia.
Don’t buy into “Everything non-AI is dead”
I have highlighted both weakening and sustained moats in the ASX tech sector. The core lesson from this article is that AI does not impact tech shares evenly. The AI disruption narrative is far more complex than just “everything non-AI is dead”. Importantly, falling switching costs from AI developments does not completely make or break an investment thesis. WiseTech is a prime example of this. Being aware of the real mechanisms impacting tech shares is important for investors as we move into the new age of AI developments.
