Software growth stocks continue to flounder. The outlook for software stocks is largely tied to 2023 guidance.
XInvestors should be cautious of any buys amid the bear market and Fed rate hikes. "Software stocks remain besieged by high inflation, rising yields, supply chain constraints, currency headwinds, and the ongoing Russia-Ukraine war," said Mizuho Securities analyst Gregg Moskowitz in a report.
The next round of earnings reports starts in late October. ServiceNow (NOW) reports third-quarter earnings on Oct. 26.
"The debate is really about 2023 estimates at this point," said EvercoreISI analyst Kirk Materne in a recent report. "Valuations are largely washed out around current levels. For those taking a longer-term view, software remains a sector that is going to benefit from healthy secular trends."
Research firm Gartner projects that worldwide enterprise spending on software will grow 11.3% to $879.6 billion versus 8% growth in 2022 and 14.8% growth in 2021.
Software Growth Stocks Retreat
Meanwhile, the iShares Expanded Tech-Software ETF (IGV) has plunged 36% in 2022. The software index has tumbled 44% from its Nov. 9, 2021 all-time high. The index fell over 11% in September.
And IBD's enterprise software group ranks only No. 69 out of 197 industry groups tracked.
The 2022 pullback in software stocks followed stellar gains in previous years. In 2020, the software index soared nearly 52% vs. the S&P 500's gain of 16.3%. Software stocks also outperformed in 2019 and 2018.
At MoffettNathanson, a division of SVB Securities, analyst Sterling Auty in a report noted what's behind the software sell-off.
"As we have moved through 2022 there are four overwhelming factors that led to the third biggest bear market in software over the last 22 years: rising interest rates, the war in Ukraine, recession fears and downward estimate revisions," he said. "Interestingly, the average software bear market lasts just over three months, and we are currently 10 months into the pullback making it the longest software bear market on record."
Software growth stocks that traded at the highest multiples of forward-looking revenue have been the hardest hit. Amid worries that the U.S. economy will fall into a recession, management guidance will be key, said Goldman Sachs analyst Gabriela Borges.
De-risking 2023 Guidance For Software Stocks
"We believe that in order for the sector to move higher we need to see guidance for 2023 being derisked (due to a stabilization in demand, easier year-over-year comparisons and/or management teams taking a more conservative approach to guidance," she said. Borges added that "clarity on the broader trajectory of interest rates/inflation" would also be helpful.
During the July-August earnings reporting season, some companies lowered 2023 earnings estimates.
"Companies are taking the right steps to lower expectations and acknowledge the uncertainty in the current environment," Jefferies analyst Brent Thill said in a note to clients.
At MoffettNathanson, Auty said the software sector should stabilize.
"On the bull side, demand for software is likely to remain robust driven by companies continuing digital transformations to improve productivity as labor remains tight or there comes a need to save costs due to macro headwinds," he said. "Companies are also re-architecting networks as a greater percentage of workloads move to the cloud and companies need to support hybrid workforces in the post-pandemic world. These drivers should help software industry growth remain near the top in the economy."
He added: "Bears have one big argument going for them: estimates and guidance are coming down for a growing portion of the industry and that may continue for another quarter or two."
On the plus side, Microsoft (MSFT) increased its quarterly dividend by 9.7% from 62 cents per share to 68 cents. Salesforce (CRM) said its board of directors has approved a $10 billion buyback for CRM stock.
As it stands, software companies with improved technical ratings include DoubleVerify (DV), Paylocity Holding (PCTY) and Paycom Software (PAYC).
Adobe Makes Big Acquisition
Amid falling valuations of public software companies, Adobe (ADBE) on Sept. 15 acquired Figma for $20 billion. The deal is expected to close in 2023 and represents a multiple of 50 times Figma's expected annual recurring revenue, or ARR, for calendar 2022 of $400 million.
A Morgan Stanley report said: "According to Qatalyst, the deal represents the highest revenue multiple ever paid for a scaled SaaS company; the largest sale of a private technology company in history; and the second largest sale of a SaaS company in history."
Figma sells a collaborative Web-based interface design platform. Adobe expects the deal to be accretive to earnings by the end of the third year following the close. Also, approximately 6 million additional restricted stock units will be granted to Figma's chief executive and employees that will vest over four years.
Meanwhile, more cost-cutting looms.
On Sept. 12, Twilio (TWLO) announced a restructuring plan that will reduce headcount by about 11%, or 930 employees. The company had 8,510 as of June 30. In a letter to staff, Chief Executive Jeff Lawson said that the layoffs are due in part to the company having grown too fast (including acquisitions) without enough focus on top priorities.
Software Growth Stocks Pull Back
Salesforce hosted an investor day on Sept. 21. Salesforce as expected gave no preliminary guidance for fiscal 2024 (calendar year 2023). But management for the first time provided a long-term non-GAAP operating margin outlook.
Workday (WDAY) hosted an investor day Sept. 13. Management reiterated organic 20-plus% subscription growth for WDAY stock and implied mid-20% cash flow growth over the next few years, according to Wolfe Research.
Amid the shake-out in software growth stocks, some analysts have steered away from companies with higher exposure to stock-based compensation. According to a Baird report, software companies with "more options underwater" amid falling stock prices have a higher risk of employee turnover.
In addition, stock-based compensation issues could eventually affect earnings.
On the plus side, private equity firms have been active in buying public software companies in 2022. Companies purchased this year include Citrix, Anaplan, CDK and SailPoint.
Meanwhile, worries over rising interest rates have pressured software and other tech stocks.
In addition, software makers involved in e-commerce were pressured by concern over supply chain constraints. Further, companies that benefited from work-at-home trends during the Covid pandemic are experiencing slower growth as the economy normalizes.
Free Cash Flow Growth A Plus?
Some analysts favor software stocks that generate more free cash flow.
Software companies remain one of the sectors that offers the best revenue growth in technology. Increased corporate spending on cloud computing, digital transformation, big data analytics and artificial intelligence all drive revenue growth for software stocks.
In the long run, low code programming tools could boost use of artificial intelligence and cloud native applications.
Software container technology also is making it easier to develop cloud applications.
Further, software stocks with the highest percentage of subscription-based, recurring revenue stand out. They're known as software-as-a-service, or SaaS stocks.
Salesforce has been a leader in subscription-as-a-service.
The customers of SaaS companies purchase renewable subscriptions, rather than one-time software licenses. Further, customers receive automatic software updates via the web.
Software Growth Stocks Soared In 2020
Also, investors should monitor the IBD Stock of the Day, which gives readers a close look at a company's technical and fundamental performance.
As it stands, however, Microsoft dropped off the IBD Leaderboard. The Leaderboard is IBD's curated list of leading stocks that stand out on technical and fundamental metrics.
When deciding whether the time is right to buy software stocks, Relative Strength Ratings are important. They're available at IBD Stock Check-up.
Also, investors should look for software stocks with Composite Ratings above 90. IBD's Composite Rating looks at technical and fundamental factors. Those factors include relative price performance, earnings growth and return on equity.
Software Stocks: Spending On Digital Transformation
Amid Covid-19, demand for next-generation collaboration and productivity tools increased as companies shifted to work-from-home arrangements. Also, the pandemic forced some companies to digitize customer-facing functions for the first time.
Further, cloud computing, digital transformation and artificial intelligence projects should remain corporate priorities, analysts say.
IBD groups software companies as enterprise stocks as well as in vertical markets such as financial and medical. Also, some companies belong to product groups, such as database software and computer security.
Follow Reinhardt Krause on Twitter @reinhardtk_tech for updates on 5G wireless, artificial intelligence, cybersecurity and cloud computing.
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