Software stocks are on a tear, with the S&P Software & Services Select Industry Index up 25% since June 16. But don’t get too excited, Wells Fargo analysts say.
The first half of the earnings season in the second quarter “provided some preliminary signs of relief” for the sector, as the results beat negative expectations, they wrote in a commentary.
While the rise in software stocks is “encouraging, we view it as a function of valuation falling too far, too fast rather than the underlying improving business environment,” analysts said.
“In fact, the majority of software companies we cover still refer to some degree [negative] macro impact.” Stocks are likely to face uncertainty going forward, they said.
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As for the macro picture, “we are hearing a significant increase in the volume of … recession-related commentary throughout the early part of the current earnings cycle,” the analysts said.
This “suggests that the current climate is having at least a moderate impact on the underlying fundamentals for software vendors,” including slowdowns in hiring. The strength of the dollar also represents a
headwind, analysts say.
In addition, “most companies have noticed that end-markets are starting to see a shift in spending from where things stood six to 12 months ago,” they said.
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That resulted in “significantly more mentions of longer deal cycles, deal slippage, and other execution-related challenges,” the analysts said.
“Most companies noted that these effects are still ongoing …, which to us suggests that we are not out of the woods yet in terms of a rebound in reported results commensurate” with gains in stocks.
‘Not All Are Created Equal’
In terms of picking software stocks, “not all are created equal,” analysts say. After the stock’s recent rally, “we see selection as key,” they said.
“We remain focused on those companies that sell to more resilient end markets, with the ability to lean on favorable offsets [such as pricing power]and operating more balanced growth profiles.”
Companies with product-led growth that are earlier in technology adoption cycles should thrive, analysts said.
With that in mind, analysts mention two sets of stocks they like:
1. “Large-cap platforms with incumbency advantages and free cash-flow-based valuation support: Microsoft (MSFT) , Salesforce (CRM) and Service Today (NOW) .”
2. “Small and mid-cap growth names that benefit from leaner, product-led growth profiles or secular winners that are better insulated from macro-based headwinds: ZoomInfo Technologies (ZI) , HubSpot (HUBS) , Atlassian (TEAM) , Five9 (FIVN) .
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