Microsoft (MSFT) is now up just fractionally after delivering a very strong earnings report and issuing solid guidance on Thursday afternoon.
German enterprise software giant SAP (SAP) , meanwhile, has dropped about 7% since it slightly missed Q2 estimates and reiterated its full-year and long-term guidance on Thursday morning.
The market's reactions to Microsoft and SAP's reports arguably say something about how high expectations have gotten for many software stocks following many quarters of multiple expansion.
Heading into earnings, Microsoft's shares were up 35% in 2019, and had doubled since the spring of 2017. That had left the software giant sporting an enterprise value (EV-market cap minus net cash) equal to about 25 times its expected fiscal 2020 (ends in June 2020) free cash flow (FCF).
Though it's entirely possible that analyst FCF estimates prove conservative, Microsoft's recent multiple expansion goes a long way towards explaining why its stock is seeing only modest gains after the company comfortably beat revenue and EPS estimates, exceeded sales expectations for all three of its reporting segments, reported 22% commercial bookings growth and reiterated that it expects double-digit revenue and operating income growth in fiscal 2020. If Microsoft was trading where it was in, say, March, its stock would undoubtedly be up more strongly on Friday.
SAP was also up 35% on the year heading into its earnings -- news that activist Elliott Management had bought a stake provided a lift in April -- and had risen about 80% since the spring of 2016. This run-up had left SAP sporting an EV equal to 30 times its expected 2020 FCF.
That, in turn, helps explain why SAP has sold off so much in response to a Q2 report that was mildly disappointing, rather than truly awful. The company did slightly miss revenue and EPS estimates, while noting "trade-related uncertainty" was weighing on its Asian software sales. But it also maintained full-year guidance for cloud and software revenue -- boosted by both organic growth and the $8 billion Qualtrics acquisition -- to grow by 8.5% to 10.5% in constant currencies (CC), and for its operating profit to grow by 9.5% to 12.5% in CC.
SAP also maintained its 2020 and 2023 guidance. This includes a forecast that cloud revenue will more than triple from 2018 to 2023, and that SAP's operating margin will grow an average of one percentage point through 2023.
Looking more broadly at the enterprise software landscape, there's no shortage of growing, well-executing companies whose recent multiple expansion gives them very little margin of error. With the qualifier that analyst estimates for such companies have been frequently hiked in response to good earnings reports, here's a look at the forward EV/FCF multiples that some high-flying enterprise software firms now trade at, based on fiscal years that end between the end of 2020 and mid-2021. Forward EPS multiples, it should be noted, are generally even higher.
- ServiceNow (NOW) : 43x
- Workday (WDAY) : 73x
- Atlassian (TEAM) : 49x
- Splunk (SPLK) : 49x
- Veeva Systems (VEEV) : 54x
- CyberArk (CYBR) : 33x
There are also a number of growth-stage software firms that for now are producing little or no earnings and FCF, and which trade at steep forward billings multiples following big run-ups. MongoDB (MDB) , for example, now sports an EV equal to 16 times its expected fiscal 2021 (ends in Jan. 2021) billings.
In such a valuation environment, software high-flyers need to deliver earnings reports of a similar quality to the one that Microsoft just posted in order to keep their momentum going. And f, instead, they deliver a report similar to the one that SAP just posted, markets aren't likely to be forgiving.
