There is nothing like an economic crisis to bring highly valued technology stocks back to earth. The flight to quality that follows usually hurts companies with stretched valuations the most, as investors worry about a collapse in the growth rates that have supported their high prices. But for software companies at least, the coronavirus shutdown is not turning out to be one of those crises.
Already at sky-high levels, software shares have proved more resilient than the overall stock market — and in some cases are rising to new records. Investors accustomed to looking to history as a guide have had to think again. In the meltdown that followed the 2008 financial crisis, the revenue multiples on software stocks contracted by 75 per cent. This time, according to Goldman Sachs, they had fallen back only about 30 per cent by the time the market bottomed in the middle of March — before a rebound over the next three weeks that saw them expand again by 18 per cent. Software executives such as Bill McDermott, former chief executive of SAP and now head of ServiceNow, claim the remarkable resilience reflects a fundamental change in the importance of software, making it more central to how businesses are run and the way workers do their jobs. “This is not that,” he said, comparing the shutdown to the 2008/9 crisis. “This is now a different way of working, a more virtual way of working.” Even after a 20 per cent correction, ServiceNow’s shares are still trading at 12 times analysts’ most recent estimates of 2020 revenues, valuing it at about $54bn.To Wall Street sceptics, however, investors have failed to grasp how hard the downturn will hit a group of companies that have not faced a sharp contraction before. “I think we’re absolutely in the denial phase,” said Alex Zukin, an analyst at RBC Capital Markets. “We haven’t had a crisis for a long time — and these [cloud companies] weren’t around for the last one.” The resilience of the cloud software stocks owes much to Wall Street’s faith in a fundamental change in the industry’s business model.
Instead of selling one-off licences — a form of revenue that can quickly dry up in a downturn — many software companies now rely on regular subscriptions, which customers have to keep paying to maintain access to the technology. Other cloud businesses charge customers based on the amount of computing power or storage capacity they consume. “There’s no denying that some industries are in absolute survival mode — there’s going to be a knock-on effect for everybody when the tide is running out,” said Frank Slootman, a longtime software executive and head of private cloud database company Snowflake. But he added that, even if some customers are suffering, consumption of his company’s services is running ahead of expectations as businesses prioritise IT spending on new technologies that help them reap value from their data. A second factor behind the strength of software stocks has been a surge in demand for the technologies needed to support working from home.
That has reached beyond companies such as videoconferencing concern Zoom, whose shares are up 30 per cent since the crisis struck, to others whose technologies support remote work, like Citrix (up 15 per cent) and Equinix (25 per cent). Shares have also rebounded strongly in a wide range of software companies whose services are geared towards helping businesses operate virtually, reflecting a belief that the pandemic will accelerate a shift that was already under way in the way business is done. They include remote electronic agreement company DocuSign, identity management concern Okta and cyber security company Fortinet. To sceptics, though, such confidence ignores the inevitable damage that will come from an economy in sharp contraction. “Just because they have a subscription model doesn’t mean they’re going to be able to close deals,” said Walter Price, a portfolio manager at Allianz Global Investors. New sales tied to “digital transformation” — one of the hottest buzzwords in business — will inevitably suffer, he said: “Near-term, it’s hard to get meetings, and it’s hard to get consultants to work on transformation. I see a lot of these projects getting postponed.”
Most investors appear to be counting on any fall-off in new contracts like this being shortlived, said RBC’s Mr Zukin. German software maker SAP last week said new software licence revenue had fallen off 31 per cent in the first quarter, but predicted a recovery later in the year. The optimistic prediction extended a rebound in which its shares have risen 30 per cent since mid-March. Asked whether new contract signings were likely to dry up, Mr McDermott predicted customers were likely to maintain their spending in the current crisis to try to protect their revenues and ensure business continuity. Critics counter, however, that predictions like these are made without the experience of previous downturns.
“I think they have rose-coloured glasses on,” said Mr Zukin.
“You can’t believe what the companies tell you, because they don’t know, and they don’t want to see their multiples impacted.” Even optimists such as Snowflake’s Mr Slootman admit it is impossible to predict how well sales will hold up because most software companies are heavily dependent on signing new business in the final days of their fiscal quarters. Another risk is that seemingly dependable subscription income will evaporate as some cash-strapped customers seek to renegotiate payment terms. “If you sell to an airline, or to a hotel, they’re going to ask you for help,” said Allianz’s Mr Price.
Any temporary dent to revenue, however, might not be significant as long as the coronavirus collapse does not lead to widespread customer bankruptcies. Cloud software companies manage their businesses to maximise the lifetime value of their customers, said Tien Tzuo, chief executive of Zuora, whose technology is used by other companies to support subscription operations. As a result, he added, helping a financially strapped customer through a difficult period might not end up having much impact on the longer-term value of that customer. Even many of those wary about the sector’s stock prices, meanwhile, agree that the upheaval to business from the pandemic is likely to accelerate the longer-term shift to cloud software, as companies look for more flexible ways of working. “There’s no doubt in our minds that the cloud will become even more important” as a result of the crisis, said Brad Zelnick, an analyst at Credit Suisse. The only question is how much pain the coronavirus shutdown will inflict in the meantime.