Software shares are taking it on the chin, with the S&P Software & Services Select Industry Index, dropping 24% so far this year. So what’s going on?
“Following a year of underperformance in 2021, the software sector has gotten off to a rocky start in 2022, as questions around rising rates and valuation levels have morphed into concerns around impacts of a potential recession,” Wells Fargo analysts wrote in a commentary.
“We remain selective with our ratings and recommendations—favoring those companies with more tangible valuation backstops and identifiable catalysts ahead, alongside vendors best able to lean into return-on-investment-based selling.”
The analysts cite three expected themes for this year:
1) “Incumbent platforms reinforcing their moats—presenting an advantage for larger-cap, more established software platforms;
2) “Labor shortages creating a critical need for automation—suggesting prioritization for those vendors able to present … efficiency/productivity gains in an increasingly tight labor market;
3) “A new data paradigm coming into focus—opening up new budget [space] for data-related infrastructure, ingestion tools, and sales/marketing-focused software applications.”
The analysts also point to an unexpected theme. “The drag on performance from a series of macro-related headwinds has presented [something] beyond what we were expecting,” they said.
“We expect software performance will remain choppy through end of summer, with second-half results where the rubber meets the road in terms of helping quantify any macro drag on fundamentals.”
The analysts suggest “a barbell approach to the space—core positions in large cap, defensive platforms, with selective shots on goal aimed at high-quality growth names with greater rebound potential.”
For the rest of the year, they offer three picks each for defense and offense.
Defense
· Microsoft (MSFT). “It’s still the best way to play the broad secular trend toward software,” the analysts said The company’s platform positioning is “especially advantageous in the current environment,” they said.
· ServiceNow (NOW). “It’s among the most well-positioned platforms and well-balanced financial profiles in software,” the analysts said.
· Workday (WDAY). “It has a series of meaningful growth drivers in motion and what we see as a favorable setup into fiscal year 2023, given the improving financial profile and defensive positioning of this platform.”
Offense
· Atlassian (TEAM). “Cloud transition represents a significant value-creating event for this well-positioned long-term focused company,” the analysts said.
· HubSpot (HUBS). “It has plenty of continued runway given still elevated new customer activity, record retention rates, an expanding set of products, and a steady move up-market,” the analysts said.
· Samsara (IOT) . “It has a significant market opportunity, differentiated technology, and a favorable demand backdrop, given its safety/efficiency focus,” they said. They expect that will “help bring investor attention back to this high-quality recent IPO.”
