Software stocks are on a tear, with the S&P Software & Services Select Industry Index soaring 25% since June 16. But don’t get too excited, say Wells Fargo analysts.
The first half of the second-quarter earnings season “provided some initial signs of relief” for the sector, as results beat negative expectations, they wrote in a commentary.
While the rise of software stocks is “encouraging, we view this as more a function of valuation having fallen too far, too fast than of the underlying business environment improving,” the analysts said.
“In fact, the majority of software companies we cover still referenced some degree of [negative] macro impact.” The stocks likely face uncertainty ahead, they said.
Macro Picture
As for the macro picture, “we're hearing a significant uptick in the amount of … recession-related commentary throughout the first portion of the current earnings cycle,” the analysts said.
This “suggests the current climate is having at least modest impact on underlying fundamentals for software vendors,” including hiring slowdowns. The dollar’s strength also has represented a
headwind, the analysts said.
In addition, “most companies have noted that end-markets are beginning to see a shift in spending from where things stood six to 12 months ago,” they said.
That has resulted in “significantly more mentions of longer deal cycles, deal slippage, and other execution-related challenges,” the analysts said.
“Most companies noted these impacts are still unfolding …,which to us suggests we're not out of the woods just yet in terms of a rebound in reported results commensurate” with stock gains.
‘Not All Created Equal’
In terms of choosing software stocks, “not all are created equal,” the analysts said. After the recent stock surge, “we see selectivity as key,” they said.
“We remain focused on those companies selling into more resilient end markets, capable of leaning into 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, the analysts said.
With that in mind, the analysts cited two sets of stocks they like:
1. “Large-cap platforms with advantages of incumbency and free-cash-flow-based valuation support: Microsoft (MSFT), Salesforce (CRM), and ServiceNow (NOW).”
2. “Small- and mid-cap growth names benefiting from leaner, product-led growth profiles or secular winners better insulated from macro-based headwinds: ZoomInfo Technologies (ZI), HubSpot (HUBS), Atlassian (TEAM), Five9 (FIVN).
