Though most software stocks now trade well below their 2021 highs, I think many of them could still be hurt by rotational action in the near-term, given the current macro and interest-rate environment.
Here are a few reasons why tech investors might want to tread carefully when it comes to many popular software firms, particularly unprofitable companies and those trading at high sales and billings multiples.
1. Higher Treasury Yields Are a Valuation Headwind...And Long Yields Might Not Be Done Rising
Since they mean investors can get greater returns on bonds at little or no risk, higher Treasury yields (a byproduct of higher inflation and a tightening Fed) spell a higher rate at which a firm's expected future cash flows have to be discounted back to the present. And due to how the discount rate compounds with each passing year, this is a bigger issue for companies that (like many cloud software firms) aren't expected to produce significant cash flows for at least a few years than it is for, say, a company trading for just 10 times its trailing earnings and free cash flow.
What's more, unless we get a major deflationary recession featuring plunging consumer demand and a big spike in unemployment, it's not hard to see yields for long-dated Treasuries rising from current levels, given that the yield curve is already pricing in a substantial recession.
Time will tell, but (though the economy is likely to soften some more in 2023) I'm still not sold on seeing the kind of downturn/deflation/Fed pivot that the yield curve is pricing in, given how the labor market now appears structurally tighter than it was in the past, how healthy consumer and corporate balance sheets still are overall, and how the Fed will need to take its dual mandate (price stability and maximum sustainable employment) into account once job losses pick up.
2. Huge Stock Comp Is a Bigger Problem When Stock Prices Are Lower and Yields Are Higher
It's no secret that software firms often give out massive stock compensation packages to executives, developers and salespeople. But it's perhaps not fully appreciated just how dilutive they are to earnings and free cash flow (FCF) per share over time, and why it's now a bigger problem than it was 12 or 18 months ago.
Even among the minority of software firms that can be valued using a non-GAAP P/E, GAAP earnings are often elusive due to heavy stock comp. For example, DocuSign (DOCU) trades for 30 times a fiscal 2023 (ends in Jan. '23) non-GAAP FactSet EPS consensus estimate of $1.65, but (thanks in large part to stock comp) it has a fiscal 2023 GAAP EPS consensus estimate of negative $0.78.
Of course, one could argue that since stock comp is a non-cash corporate expense, the proper way to account for it isn't to expense it out of earnings, but to calculate how much it will dilute the cash earnings and FCF per share that investors can expect over time. In which case, it's worth noting that with many software firms diluting shareholders by 4% to 6% annually via stock comp, dilution becomes enormous within a few years. For example, if a firm gave out stock grants equal to 5% of its outstanding shares each year, this would increase its share count by 27.6% within five years, assuming none of its cash was used on buybacks.
And if (as is often the case) a software firm's valuation depends heavily on the earnings and FCF it's expected to produce several years from now and later, such dilution is especially harmful to a firm's valuation during a time of higher Treasury yields, since these expected earnings and cash flows are now being discounted at a higher rate.
Meanwhile, the fact that the shares of so many software firms have nosedived over the last 12 months means that companies now often have to significantly increase the number of shares given out via stock grants to keep employee compensation steady. While this problem should be partly offset by (amid growing tech-sector layoffs and hiring freezes) a more favorable hiring/compensation environment for tech employers, it will still likely lead to an uptick in dilution for many companies.
3. Many Software Firms Are Now Seeing Growth Cool Off
The last few weeks have seen quite a few well-known software firms issue disappointing guidance and/or signal that deal activity is slowing, particularly among larger enterprises. And among firms that bill customers based on their consumption levels rather than via per-user subscriptions, commentary about lower consumption levels (especially within pressured verticals, such as retail and financial services) hasn't been hard to find.
Cloudflare (NET) , Atlassian (TEAM) , Twilio (TWLO) and Varonis Systems (VRNS) are among the software companies to have recently plunged post-earnings in recent weeks thanks to their guidance and commentary. And on Wednesday, ZoomInfo (ZI) nosedived after CFO Cameron Hyzer suggested at an RBC conference that (after having guided for 4% sequential Q4 sales growth two weeks ago) his company is modeling 4% to 5% sequential growth for each quarter in 2023, a growth rate that implies high-teens full-year growth.
For comparison, the FactSet consensus prior to the RBC conference had been for ZoomInfo to grow revenue 27% in 2023, following 47% growth in 2022. With many other cloud software firms having thus far only guided as far as December or January, ZoomInfo's outlook (while potentially conservative due an uncertain backdrop) might be a sign of things to come.
Software is still taking IT spending share with each passing year. And the recurring nature of SaaS/cloud software revenue streams allow them to hold up better overall during a downturn than some other types of IT spending. But valuations for many popular names in the sector have been pricing in a lot of growth (particularly in the current rate/yield environment), which makes any sharp deceleration in growth a major problem.
4. Institutional Investors Who Have Been Aggressive Buyers Might Turn Into Sellers (If They Haven't Already)
A lot of the hedge funds and other institutional growth investors that crowded into high-multiple software stocks in 2020 and 2021 now have big year-to-date losses. What's more, some of these investors have a lot of money tied up in illiquid venture-capital investments that have been or will be significantly marked down.
All of this has apparently made many of these investors eager since June to chase 2020/2021 software favorites higher on any sign of strength, as they desperately try to erase some of their 2022 losses. One could see such desperation in July and August, as high-multiple names such as Cloudflare, Snowflake (SNOW) and Zscaler (ZS) were chased higher following good-but-not-amazing earnings reports (they'd later more than give their gains back). And one could see it more recently in how such stocks briefly took off after the October CPI report arrived (they've generally been coming back to Earth over the last two days).
As we get closer to year's end (and the aforementioned investors run out of time to make their 2022 numbers look better), I think such chasing action is likely to diminish. On the other hand, we could see a pickup in forced selling by institutional growth investors due to fund redemptions, as well as more tax-loss selling by both institutional and retail investors.
Amid this challenging backdrop for software stocks, I think there are still a few places where investors can find companies with intriguing risk/rewards, at least on pullbacks. Specifically:
- Large, established, software firms that have big competitive moats, generate a lot of FCF and sport moderate valuations even after accounting for the impact of stock-comp dilution. Think firms such as Microsoft (MSFT) and Adobe (ADBE) .
- Software firms that have low multiples and -- due to high gross margins and sales and marketing spend making up a relatively small percentage of revenue -- are solidly profitable. Companies such as Dropbox (DBX) , forensics software firm Cellebrite (CLBT) and ID-verification and mobile check-deposit software firm Mitek Systems (MITK) come to mind. Though more expensive, Atlassian might also fit the bill if its stock keeps falling, given that it has much better sales efficiency than some of the high-growth software names it's often grouped with.
- (More of a "maybe" idea) Established, growing, security hardware and software firms that -- while having substantial sales/marketing spend and stock comp -- produce a lot of FCF and don't look especially expensive, given how strong security spend remains. Names such as Palo Alto Networks (PANW) (reporting on Thursday afternoon) and Fortinet (FTNT) (recently tumbled post-earnings) come to mind.
Overall, however, I think this is a good time to remain pretty selective about which software companies one invests in, and not to rush to buy the dip in popular names just because they're well off their highs.