The Recovering Software Sector Still Has A Long Road Ahead
Reviewed by Michael Paige, Bailey Pemberton
Quotes of the Week:
“In short, software is eating the world” - Marc Andreessen
“Software is eating the world, but AI is going to eat software” - Jensen Huang
After a brutal 2022 with large declines, software stocks had a big year in 2023 as they rode the wave of enthusiasm for AI. It’s a dynamic space that is constantly evolving at an ever-growing pace, ripe with opportunity.
With that being the case, we thought it would be a good time to check in on the sector, the outlook and current valuations.
🎧 Would you prefer to listen to these insights? You can find the audio version on our Spotify or Apple podcasts!
What Happened In Markets This Week?
Here’s a quick summary of what’s been going on:
- 💸 BlackRock warns of UK bond sell-off in election year ( Bloomberg )
- Our take: The impact of elections on markets is often greater before rather than after voters go to the polls. In the UK’s case, the last thing the country needs is more bond market volatility.
- 🏢 US Office vacancies rose to 19.6%, breaking the previous record set in 1986 and 1991 ( Moody’s )
- Our take: Companies are trying to get employees back to the office, but this suggests there’s a bigger secular trend in place. While large corporations want their staff in the office, a growing wave of smaller companies are happy to employ people who want to work from home.
- 💱 All 11 Bitcoin ETFs finally approved by the SEC ( Reuters )
- Our take: The news was largely already “priced in”, and the price seemed to move more on the fake announcement than it did on the real announcement. Now that institutional money has a way to hold the asset that can comply with their mandates (ETFs vs self-custody), these ETFs could see inflows in the tens of billions, which would support the price of the underlying asset.
- ✈️ Boeing’s reputation takes another knock ( FT )
A Quick Pulse Check On The Software Sector
For those who held onto software stocks during 2023 after a rough 2022, you’d be quite pleased with yourself. They have been amongst the top performers over the last 12 months after a tough year in 2022.
So, since their prices have risen so much, where does this leave them in terms of current valuation and the future outlook?
Well, the average P/E ratio for the US software sector is now 62x, compared to a 10-year average of 47.7x. Seems high, right? Especially when we compare that 62x multiple against the sector’s forecasted growth rate of 18%.
For context, the overall US market is trading at around a 29x P/E multiple, with an expected earnings growth rate of 14.6%. Comparatively speaking, it looks more appealing - better value for money.
This doesn’t necessarily mean the Software sector is too expensive - but at some point, growth expectations need to catch up with valuations (higher than 18% earnings growth), or performance is likely to be disappointing. Alternatively, valuations could reduce to match the current growth expectations.
Now, let’s have a look at how software companies are actually performing.
The Recovery In Software Revenue
In a recent edition of the Clouded Judgement newsletter , Jamin Ball had a look at the third quarter earnings from cloud software companies.
His overall takeaway was that financial performance is improving, but has some way to go.
Or as he put it: “Unfortunately, I don’t think those green shoots have really sprouted yet, but they have got a little stronger.”
The following chart summarizes the situation and shows the YoY change in net new ARR (annual recurring revenue) each quarter across the cloud software sector.
(Note: this universe excludes some of the largest software companies like Microsoft , Oracle and Adobe , but includes most of the cloud-based application software providers.)
The chart above reflects the fact that revenue additions have only just turned positive and are still a long way off the levels seen in 2021.
Some of the other observations worth noting included:
- Median revenue numbers only just beat consensus estimates (by 1.6%).
- This is low relative to historical averages, and the lowest it’s been since 2020.
- Guidance for the fourth quarter was also low relative to consensus estimates.
- Companies were being more conservative given the broader conditions.
- Net revenue retention (NRR) was at 112%, the lowest it's been since 2020.
- NRR represents the ability to retain and expand existing customers. This metric was steady at 120% from the start of 2021 to the end of 2022.
- Jamin considers anything >130% best in class, 115%-130% as good, and anything below 115% as subpar.
These numbers suggest the sector is still under pressure. However, ARR additions have turned positive again, so corporate spending on software services may be recovering.
It will be worth paying attention to these metrics over the next few quarters to see if the recovery is really gathering pace.
The full article is worth a read if you want to dive into the metrics for individual companies in the cloud software space.
What To Look For When Analyzing Software Companies
The trends mentioned above reflect the overall performance for the software industry. Obviously, some companies are in far better shape, and others are in worse shape.
When it comes to analyzing individual software companies, qualitative factors are often more important than quantitative factors.
In many cases, by the time the numbers start to look good, they are already reflected in the price. So, before you dive straight into the numbers, it's important to understand the business, its products and the environment it’s operating in.
These are some of the qualitative factors that apply to most businesses, but are particularly important for software companies
- 🥇 Product leadership
- Does the company have a meaningful advantage over competitors? How easily and cheaply can its products be copied?
- 🌍 Total Addressable Market (TAM)
- How big is the market, and is it growing or shrinking?
- 🔀 Switching costs
- If the cost to switch vendors is high, a company will be less likely to lose customers. Conversely, It’ll also be harder for them to poach customers from competitors.
- 🔍 Customer Concentration
- When a company has a few very large customers, those customers may have a lot of leverage, and be able to demand lower prices.
- 💳 Cross-selling opportunities
- Are there opportunities to sell new products to existing customers? This has been a huge opportunity for companies like Microsoft, Salesforce and CrowdStrike .
- 🤝 Partnerships
- Partnerships can be great, but they can also be a risk if partners have too much power.
- 🕺 Talent retention
- Employees are amongst the most important assets for a software company, so being able to attract and retain talent is crucial.
- High salaries and rising stock prices help - but some smaller companies are able to attract talent because of their culture or the products they are building.
- ↔️ Breadth
- Over the last decade, we have seen how much companies like Microsoft and Alphabet that span multiple markets and technologies have benefited from that breadth.
- Not only does this sort of breadth create opportunities, but it gives a company multiple sources of revenue.
Getting Exposure to A.I. Through Software Stocks
Since almost every software company is involved in or exposed to artificial intelligence, this is a major driver of valuations.
BUT there’s no guarantee that any single company will succeed with its AI investments. In fact, AI could be a threat if it gives competitors an edge, or gives a company’s customers other options. Investors need to walk a careful line between simply having exposure to key trends, and making informed investment decisions.
The Insight: Your Narratives Will Evolve Over Time
With the accelerating investment in artificial intelligence, the software industry is evolving at an even faster pace.
Software companies don’t need to build factories or production lines, so new products can be rolled out quickly (though there are some current limitations on computing power. This means the competitive landscape can change in a matter of months.
If you look at the Simply Wall St stock report for Adobe you’ll see two narratives with very different fair value estimates.
The catalysts within these narratives highlight the fact that AI is both an opportunity and a risk for Adobe.
On the one hand, AI could increase the addressable market size by making it easier for more people to use Adobe products. On the other hand, Adobe needs to catch up with competitors within the generative AI space, which will require more R&D spending.
Adobe’s failed attempt to acquire Figma has been another development that has changed its competitive position. Not only did it not acquire a competitor, but it had to pay Figma a ‘breakup fee’ of $1 billion , meaning Figma is now better capitalized to compete.
Adobe also has a tremendous opportunity with augmented and virtual reality - but this opportunity is difficult to quantify precisely right now.
The point is that an investment narrative is not static - it’s dynamic. You may build out a narrative and realize you don’t have enough information to make a high-convictio n call. And that’s okay - you can fill in the blanks when more information becomes available.
Alternatively, you might see a scenario that could create an opportunity later. Investment cycles often result in margin compression and lower stock s prices, which ultimately creates an opportunity before those investments start to pay off.
This is particularly valuable for companies benefitting from secular trends that could last for decades. The opportunity might only arise in 5 years time, but if you’re anticipating it now and the market isn’t accounting for it, you’ll be able to position yourself accordingly now to benefit when it does.
One last thing!
We covered some of the key software stocks in our big trends series. If you missed them, check out Part 1: Healthcare Technology , Part 4: AI and Data Management and Part 5: Cybersecurity .
Key Events During The Next Week
The week gets off to a slow start with US markets closed for Martin Luther King Jr Day. Also on Monday, Germany’s full-year GDP growth rate will be released. It’s expected to be in negative territory at -0.3%, down from 1.9% in 2022.
On Tuesday, the UK unemployment rate for November will be published. It’s been tracking at 4.2% for the last six months. Canada’s inflation rate (previously 3.1%) is also due on Tuesday.
On Wednesday there's quite a lot of data due in China, including 4th quarter GDP growth which is expected to be 5.3% compared to 4.9% in the third quarter.
Also on Wednesday, we will see how UK inflation is tracking when CPI is released. Economists are expecting the annual inflation rate to have stabilized at 3.9% rate, which would be the same as November's print.
On Friday Japan’s inflation rate is expected to come in at 2.6%, down from 2.8% in November.
Earnings season continues with financials and the first of the large industrials:
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com
Simply Wall St analyst Richard Bowman and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
Richard Bowman
Richard is an analyst, writer and investor based in Cape Town, South Africa. He has written for several online investment publications and continues to do so. Richard is fascinated by economics, financial markets and behavioral finance. He is also passionate about tools and content that make investing accessible to everyone.
