After a tough 2016, three key factors have shifted in favor of the software sector, which could set the stage for better stock performance this year.
Strong demand, positive margin trends and reasonable valuations could set the stage for a recovery in the software sector, particularly for companies with strong secular growth stories, says Keith Weiss, Morgan Stanley’s lead analyst for the software sector.
Most enterprise software applications today focus on automating, or analyzing the data from transactions.
Investors should keep their eyes on three key positive factors for the software group.
No. 1 on the list: “Software is eating the world,” says Weiss. What does he mean by that? Try to imagine any part of work or personal life that isn’t somehow tied to an app of some sort. “Software functionality is driving deeper into every aspect of commercial and consumer life, which sustains strong demand trends across the group,” he says.
Indeed, Morgan Stanley’s recent AlphaWise survey of Chief Information Officers found that as a group, these executives, who are responsible for IT budgets at major corporations across a broad swath of industries, are expecting spending for external software to grow by more than 4.2% in 2017, which would outpace expectations of broader IT budget growth of 3.5%.
Some of the key drivers for 2017 include:
- Deeper workflow automation: Most enterprise software applications today focus on automating, or analyzing the data from transactions. In order to drive deeper organizational adoption of digitalization and the resulting improved efficiency, many CIOs plan to shift new investment to building apps that automate workflows and coordinate resources around them. Investors should look to companies that plug into those goals.
- Gauging secular vs. cyclical security challenges: Top line growth slowed across the cybersecurity group in 2016, sparking concern on the secular positioning of security in the face of rising public cloud adoption. “In our view, a massively expanding surface area of digitized assets in both commercial and consumer realms sustains strong demand for security,” Weiss says. He expects software companies that are positioned to consolidate various functions into broader security platforms to drive more effective and efficient spending on cybersecurity, as well as vendors who can secure new threat vectors, such as cloud and mobile, to perform better than the overall group.
- Refocus on small and midsized businesses, which are still a well under-penetrated market opportunity for software, according to Weiss. Software providers that can help customers in this niche market solve their business challenges with easy-to-use, but effective solutions—and efficient distribution models—could sustain outsized growth in the software sector.
- What about artificial intelligence? AI development is unlocking new capabilities for software-based solutions that previously existed only in the realm of human labor. “The emerging ability to effectively automate image recognition, natural language processing, speech recognition, and even decision making represents a foundational technology capable of sustaining massive new market opportunities,” Weiss says. While still early days, cloud-platform vendors are building out AI tool sets, and the software companies that are most aggressively incorporating these emergent capabilities could represent the best software plays on this theme, he says.
The second positive factor for the software sector: attractive market valuations. “Investors continue to underestimate both the strong unit economics of the recurring revenue bases building in most software companies and the durability of the resulting cash flow streams,” says Weiss. On a broad basis, at 20 times earnings per share over the next 12 months, the overall group is trading at the lowest premium to the S&P 500 since 2008, he notes.
Finally, the software sector as a whole is sitting on underutilized balance sheets. The consolidated ratio of net debt to earnings before interest, taxes, depreciation and amortization, is -1.0 across the large-capitalization software companies, while the broader market average is 1.8 times, Weiss calculates. If the large-cap software names were to push their leverage ratios in-line with the market average, “we estimate over $200 billion in debt capacity,” Weiss says.
The group is also flushed with cash. Across the entire group, net cash represents almost 7% of their market capitalization. “Freeing up this latent capacity gives massive potential for stock repurchase, higher dividends, and a continued upward trend in accretive mergers and acquisitions,” Weiss says, adding: “We see this potential coming unstuck through two main mechanisms: legislation lowering the tax burden of repatriating offshore cash and increasing investor activism in software. On the flip side of the equation, around 70% of our small- and mid-cap group currently trade below the five-year average M&A takeout multiple of 4.5 times forward revenues.”
Go ahead, do the math.