Software Stocks Are Under Pressure, so Wall Street Is Hunting for Bargains

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With software stocks under intense selling pressure, Wall Street is engaged in a debate on how to approach the sector given that fundamentals remain strong, while valuations have come down dramatically, but remain elevated relative to historical levels. The questions is when—and whether—to go bargain hunting.

Valuations for the fastest growers in particular have been hurt by rising interest rates , and on that score, the Federal Reserve hasn’t even begun the process. Fundamentals remain strong; enterprise spending has been accelerating. The issue is what the market is willing to pay for growth as rates creep higher.

Jefferies analyst Brent Thill, for one, points out in a note Tuesday that valuations in software stocks are down 23% this year after a 10% decline in 2021, and 80% expansion in 2020. He cautions that valuations at an average 10.7 times forward sales are still above historical levels, and advises staying selective in the group.

Thill contends that the highest multiple stocks are still at risk. In that category, he includes companies like

Snowflake (ticker: SNOW),

Cloudflare (NET),

Datadog (DDOG),

Atlassian (TEAM), and

SentinelOne (S). 

But the Jefferies analyst also provides a lengthy list for intrepid investors looking for stocks to buy. Thill’s favorite large-cap picks include

Microsoft (MSFT), which reports earnings Tuesday after the close of trading,

Adobe (ADBE),

Salesforce.com (CRM), and

Intuit (INTU). Other Jefferies picks include Workday (WDAY);

Datadog, despite the aforementioned high valuation;

Smartsheet (SMAR); PowerSchool (PWSC);

Chegg (CHGG); Vimeo (VMEO); SimilarWeb (SMWB); and Wix (WIX), among others.

Meanwhile, KeyBanc analyst Josh Beck writes in a comprehensive look at the group on Tuesday that “a confluence of factors related to rapidly changing rate and labor conditions, unusual Covid comparisons, and a meaningful expansion of the tech universe”—with more than 50 tech initial public offerings over the past year—“have collectively raised the bar to be viewed as a premier tech company.“

But Beck adds that fundamentals remain strong, with a recent survey of chief information officers showing expected 7% growth in IT budgets this year. He recommends investors focus on “disruptive platforms with a multitude of untapped growth vectors,” specifically calling out

Shopify (SHOP), Global-e Online (GLBE),

Bill.com (BILL), and

Coupa Software (COUP), as well as stocks where he thinks the market has grown too conservative on valuations, citing

AvidXchange Holdings (AVDX) and

Alkami Technology (ALKI).

To better reflect the market’s more conservative stance on software stock valuations. Beck chopped target prices for 19 stocks, including some he is still recommending, like Shopify and Intuit. Beck cut ratings on three stocks, lowering Blackline (BL),

Anaplan (PALN) and

Q2 Holdings (QTWO) to Sector Weight from Overweight. In all three cases, he writes that he wants to see “improved visibility into prospects for sustainable growth acceleration and elevated strategic positioning.”

At Citi, software analyst Fatima Boolani late Monday launched coverage of 21 companies, 13 new to Citi, and eight assumed from another analyst. Boolani joined Citi as co-head of software equity research in August, after eight years covering software at

UBS.

Boolani sees a “Cambrian explosion of infrastructure software,” a reference to a period 541 million years ago when there was an explosion of life on Earth. A “convergence for the ages” is under way in the group, she says, with cybersecurity, IT development tools, and networking companies colliding, creating both challenges for incumbents and opportunities for insurgents.

“The onslaught of remote work, ongoing democratization [and] dispersion of the corporate network, and voluminous nature of cyberattack activity is revolutionizing the enterprise IT footprint, and accelerating the unification of previously siloed buying centers,” she writes.

Boolani set Buy ratings on 10 infrastructure stocks. Her top pick is

Atlassian, a provider of collaboration software tools, where she sees outsize growth and margins. She is also bullish on Dynatrace (DT), Datadog,

Fortinet (FTNT), CrowdStrike (CRWD), CyberArk (CYBR),

Varonis Systems (VRNS),

Zscaler (ZS),

Palo Alto Networks (PANW), and

Akamai Technologies (AKAM). 

She downgrades VMware (VMW) to Neutral from Buy, and has concerns about the company’s shift to a cloud-based revenue model. Other Neutral rated stocks include

Hashicorp (

HCP), KnowBe4 (KNBE), Okta (OKTA),

Rapid7 (RPD),

Cloudflare,

SentinelOne and Splunk (SPLK).

Boolani cut Citi’s rating on Citrix (CTXS) to Sell from Neutral, saying that the stock has already priced in a potential sale. Other Sells include SailPoint (SAIL), Fastly (FSLY), and

Check Point Software (CHKP).

Write to Eric J. Savitz at eric.savitz@barrons.com