Software shares have stumbled this year, in line with other technology stocks. The S&P Software & Services Select Industry Index has slid 31% so far in 2022.
But hope isn’t lost, says Wells Fargo analyst Michael Turrin.
“Rising rates, inflation, [the war in Ukraine], and tightening labor markets have contributed to increasing concerns around a tougher spending environment and potential recession in late 2022/2023,” he wrote in a commentary.
And that’s putting the kibosh on software stocks.
Nonetheless, “fundamentals have remained remarkably resilient thus far,” Turrin said.
“Outside of foreign-exchange impacts, most companies in our coverage actually continued to perform quite well through first-quarter earnings, with minimal impacts from geopolitical conflict and the tougher hiring environment.”
Standoff
There’s a “standoff between investor sentiment/valuation levels and management commentary/reported results [that’s] likely to extend further into 2022, as macro concerns have shown minimal signs of easing,” Turrin said.
Also, software stocks often react to those concerns later than other sectors, he said.
“Valuation levels are now back to decade-long averages, versus 18 months ago, when they seemingly required a decade's worth of forward [earnings] assumptions,” Turrin said.
“We expect the macro will dictate near-term performance trends, presenting some admitted challenges with our fundamental-focused sector view.”
But, “ultimately, we expect software to again prove deserving of a market premium, driving an eventual rebound in performance,” Turrin said.
His best guess is that will happen with earnings reports in the second half of the year. It will be “shorter if macro concerns subside, longer if the recession scenario gains steam,” Turrin said.
He recommends that investors consider “businesses with strong platform positioning, balanced growth profiles, and management teams with proven track records,” preferably led by founders.
Turrin put three stocks in the basket of “large-cap platforms likely to prove more resilient”:
1. Microsoft (MSFT). It’s “the best way to play the broad secular trend toward software,” Turrin said. Microsoft’s “platform positioning is especially advantageous in the current environment,” he said. “And management has proven adept at making the right strategic moves in a fast-changing backdrop.” Turrin rates the stock overweight.
2. ServiceNow (NOW). It’s “among the most well-positioned platforms and well-balanced financial profiles in software, delivering a balance of high-growth and free cash flow,” Turrin said. He rates the stock overweight.
3. Workday (WDAY). It has a “series of meaningful growth drivers in motion and … a favorable setup into fiscal 2023 given the improving financial profile and defensive … positioning of this platform,” Turrin said. He rates the stock overweight.
Turrin put three stocks in the basket of “balanced growth companies poised to rebound”:
1. HubSpot (HUBS). “We see plenty of continued runway for HubSpot, given still-elevated new customer activity, record retention rates, an expanding set of products and a steady move up-market,” Turrin said. He rates the stock overweight
2. Australia-based Atlassian (TEAM). “The cloud transition represents a significant value-creating event for this well-positioned, long-term profitable company,” Turrin said. It has potential for annual 30%-plus growth and 30%-plus free-cash-flow margins, he said. He rates the stock overweight.
3. ZoomInfo Technologies (ZI). “It’s achieving a rare balance of nearly 50% organic revenue growth and 35%-plus free-cash-flow margin,” Turrin said. “We see a long, well-balanced runway still ahead.”
The author of this story owns shares of Microsoft.
