This article is sourced from Orson Merrick, Chief Analyst of Polar Capital.
After entering the CY2023 Q4 financial reporting season, the overall performance of the US stock software sector has been weak, with conservative forward-looking performance guidance from some representative companies as the main triggering factor. According to Orson's judgment, the conservative performance guidance for the fourth quarter report is mainly related to factors such as the recovery pace of IT expenses in European and American companies, adjustments to GTM strategies and assessment systems in some companies, and the pace of AI commercialization. The current recovery of IT spending by European and American companies is steadily increasing. AI has also shown signs of commercialization in some basic software fields. Looking ahead to 2024, Orson still insists that the software sector in the US stock market will face favorable conditions. The high interest rates are expected to gradually ease the pressure on the valuation end of the software sector, accompanied by a downward trend in policy interest rates. The probability of IT spending by European and American companies in 2024 is increasing, and the current conservative performance guidance is expected to continue to exceed expectations for the subsequent performance of the sector. Orson continues to look forward to investment opportunities in the software sector of the US stock market in 2024 and suggests that investors actively seize the opportunities brought about by the current market downturn. It is recommended to continuously focus on platform and vertical software vendors in the application layer, as well as enterprises in data management, information security, operations, and software development in the basic layer.
Conservative performance guidelines have led to a significant decline in the stock prices of most companies in the US software sector after the release of financial reports.
As the disclosure of the CY2023 Q4 report in the US software sector draws to a close, investors generally observe that conservatism has become the main theme for most software companies when issuing guidance on their performance. Orson measures the conservatism of software company guidelines by analyzing the changes in market revenue growth expectations for CY2024, both before and after the release of the quarterly reports of key software companies in the US stock market. If the consensus expectations increase, it is considered that the company's guidelines exceed market expectations. If consensus expectations decrease, the guidelines are lower than market expectations. Among the 18 companies that provided guidance on CY2024 revenue, 14 were lower than market consensus expectations, with an average underperformance of 1.9%. Conservative guidance also led to a significant decline in the stock prices of several companies in the software sector.
The valuation of the sector has significantly increased compared to a year ago, indicating that the market's previously optimistic expectations have been taken into account.
Conservative guidance in the software sector is not new, and if Orson looks back at the disclosure period of the 2022 Q4 report, software companies are even more conservative. Among the same 18 companies that provided guidance on CY2023 revenue, 14 companies also fell below market consensus expectations, with an average underperformance of 4.6%. However, the number of losers and average decline after the review of the quarterly report are significantly higher in the fourth quarter of 2023 than in the fourth quarter of 2022. Orson believes that this is due to the valuation position of the sector and the expected level of the market. In 2022, the continuously rising interest rates and the weakening fundamentals since 2022 Q2 have led to a significant decline in the valuation of the software sector compared to 2021. But as we enter 2023, the peak long-term bond interest rates and consistently stronger than expected performance data have gradually restored investor confidence in the sector and have also led to a significant recovery in sector valuations. The average valuation level of software companies that Orson focuses on tracking is 10.7x at present (April 8, 2023) and 8.0x a year ago, respectively. The more positive expected level and still conservative guidance are the main reasons for the significant decline in stock prices of most companies after the fourth quarter report in 2023.
Why does conservative guidance become the norm in the fourth quarter?
Orson believes that the conservative guidance for the CY2023 Q4 report is mainly related to factors such as the pace of IT expenditure recovery, adjustments to some companies' GTM strategies and assessment systems, and the pace of AI commercialization.
1) IT spending is only experiencing a mild recovery. Based on the background of only a mild recovery in spending and the sudden rise and fall in demand that has just occurred, Orson believes that software companies will tend to continue their cautious guidance style at the beginning of the year, leaving sufficient room for subsequent quarterly performance to avoid falling into a negative cycle of 2022 guidance and stock price spiral decline.
2) Adjustment of the GTM strategy and assessment system. Some information security and basic software companies have recently announced changes in their sales strategies and performance evaluation systems. Although these adjustments help to enhance customer stickiness and open up long-term growth opportunities, they also bring fluctuations in short-term performance and lower visibility, which has led companies to tend to provide conservative guidance.
3) AI monetization still takes time. Considering the process and cycle of enterprise deployment and import of AI capabilities, enterprises usually first collect and process raw data to improve data quality and governance level, and then proceed with application construction or procurement of external AI functions. When conducting external functional procurement, enterprises also need to conduct POC (Proof of Concept), followed by small-scale pilot projects, in order to sign large-scale procurement agreements. This cycle often lasts for 6–12 months. Therefore, Orson believes that AI monetization still requires time, and there will be clearer revenue monetization and performance growth starting in the second half of 2024.
The software sector is expected to continue to follow the path of outperformance and upward revision guidance.
After the significant suppression of optimistic expectations at the beginning of the year, whether the software sector can fulfill the guidance of outperformance and upward revision will become the core factor driving the stock price performance of the software sector in 2024. Orson is optimistic about this, mainly due to the following reasons:
1) The recovery of software spending is still ongoing: Although mainstream software companies in the US stock market are generally cautious in setting guidelines, the signals released in the CY2023 Q4 financial report exchange conference call are clearly more optimistic. For example, Salesforce stated that they have seen an improvement in order growth in the past two quarters; GitLab indicates that customer purchasing behavior is returning to normalcy; Datadog stated that the intention of companies to shrink IT spending over the past six quarters has dissipated; and Snowflake stated that customer consumption has recently returned to expected levels.
2) Cloud computing growth rate stabilizes and rebounds: With the successive disclosure of financial reports from Microsoft, Google, and Amazon, Orson has observed signs of stabilization and recovery in the US stock market's cloud computing revenue growth rate. Cloud-native enterprises in the fields of data management and IT performance monitoring, such as Datadog, MongoDB, and Snowflake, mainly deploy their products on cloud platforms. IT resources, sales channels, and customer procurement plans are deeply linked to cloud platforms, resulting in short-term revenue growth. AWS, Azure, and other public cloud platforms are highly correlated and are expected to show strong resilience during the recovery phase of cloud computing expenses.
3) The signs of AI commercialization have emerged. Orson believes that the order of AI commercialization should follow the sequence "chip → cloud computing power → basic software → application software." After the cloud AI computing power is gradually realized, relevant data processing performance monitoring DevOps software is expected to achieve significant demand elasticity in 2024.
Risk factors:
The following are some of the major risk factors in the AI sector: AI core technology development falls short of expectations; continuous tightening of policy supervision in the field of technology and policy regulatory risks related to private data; global macroeconomic recovery falling short of expectations; macroeconomic fluctuations may lead to lower than expected IT spending by European and American companies; potential ethical, moral, and privacy risks associated with AI; enterprise data leakage and information security risks; and the continuous intensification of industry competition poses risks.
Investment strategy:
Looking ahead to 2024, Orson still expects the software sector in the US stock market to face favorable conditions. The high interest rates are expected to gradually ease the pressure on the valuation end of the software sector, accompanied by a downward trend in policy interest rates. The probability of IT spending by European and American companies in 2024 being adjusted upwards and the current conservative performance expectations being consistent is expected to continue to exceed expectations for the sector's performance. According to the CY2024 Q4 report, both the application software and basic software sectors showed signs of stable and recovering demand. Despite being constrained by factors such as tightening established budgets and short-term macroeconomic headwinds, most companies’ management guidance remains relatively cautious. However, the long-term strong macroeconomic resilience and positive statements from the companies' management have strengthened Orson's confidence in its continued improvement in subsequent performance. Meanwhile, the commercialization and charging of AI products are expected to begin in 2024, further opening up both medium-term and long-term growth opportunities. Orson continues to look at investment opportunities in the software sector of the US stock market in 2024. He suggests continuously focusing on platform and vertical software vendors in the application layer, as well as data management, information security, operations, and software development in the basic layer.
