Software Stocks Hit Record Valuations Just in Time for Earnings Season :-

Credits : Barrons

As we head into the second-quarter earnings season, it’s worth taking a moment to recognize the remarkable performance of software stocks in 2019. The SPDR S&P Software & Services ETF (ticker: XSW) is up 36% year to date.

Microsoft (MSFT), the world’s most valuable public company, has rallied 36% this year, sports a market cap of $1.05 trillion, and trades near an all-time high. If the market likes the company’s June quarter and fiscal year-end financial results on Wednesday afternoon, the stock could very well go higher still.

Microsoft is no anomaly. Oracle (ORCL), Workday (WDAY) , SAP (SAP) and VMware (VMW) are all up more than 25% in 2019; ServiceNow (NOW) is up 65%. And it isn’t just the large cap names either. Shopify (SHOP), Coupa Software (COUP), Anaplan (PLAN), Okta (OKTA), and Zscaler (ZS) have all more than doubled year to date; MongoDB (MDB), CyberArk (CYBR), Veeva (VEEV), and Paycom (PAYC) all sport gains for the year of at least 70%.

And of course, there have been strong public market debuts in 2019 by software firms like CrowdStrike (CRWD), Pager Duty (PD), Zoom Video (ZM), and Slack (WORK).

The investor Marc Andreessen once famously declared that software will eat the world; now software seems to be absorbing vast swaths of investor portfolios.

As a group, software companies enter the second-quarter earnings period trading at record valuations. Macquarie Capital analyst Sarah Hindlian finds that the average software stock is trading for a record 7.1 times next fiscal year’s projected revenues. The one-year average valuation on that basis is 5.6 times, she reports. The five-year average is 4.4 times and the 10-year average is 3.9.

In a research note Tuesday, Hindlian wrote that average multiples are elevated by a combination of persistently low interest rates and highly valued new issues.

But there are other issues at play, as well. The widespread adoption of cloud-based software is shifting the dynamics of the software industry, spreading the reach of enterprise-class applications to smaller businesse and reducing the costs involved in creating, selling, and supporting applications.

The prevalent old model involved selling packaged software through quota-carrying armies of swaggering, Armani-clad salespeople to the white-coated rulers of corporate-hosted data centers, which came with complex installation and maintenance issues. The new model is increasingly self-service and flexible, hosted by Amazon Web Services , Google Cloud or Microsoft Azure, with the ability to cast a wide net both geographically and down market. The companies are reaching wider markets, and generating better gross margins—even while many of the younger players forego profitability to focus on growth.

The obvious result of that can be found in newly public software stocks trading at 15 times to 25 times projected revenue, and sometimes higher, defying historical conventions about what enterprise technology companies are worth. But valuations are also growing for more established companies. Microsoft is trading at 7.5 times fiscal 2020 projected revenue—that’s a premium to the broader software group, with consensus forecasts expecting continued double-digit sales growth—all for a stock that has already more than tripled in five years.

But the rules are changing for software stocks—the market may simply be “re-rating” them to reflect the industry’s shifting business model. We’ll know more in the coming weeks.

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