Fresh from a powerful three-year surge, the software industry is entering a new period of uncertainty. But for companies that look as if they can stay the course, Wall Street’s enthusiasm is undimmed.
Shares in Salesforce, the leading software-as-a-service player, surged more than 6 per cent on Thursday after a quarterly earnings report that dispelled recent worries about flagging growth. Meanwhile, tax and small business software company Intuit, which has seen it’s stock market value jump nearly threefold over the past four years, to $71bn, forecast another solid year of growth, sending its shares up 5 per cent.
On the same day, however, shares in data centre software company Vmware fell more than 5 per cent, as it reduced its key licence revenue forecast for the rest of this year and unveiled the two largest acquisitions in its history, for a combined $4.8bn. Meanwhile, data analytics company Splunk, which reported earnings the day before, dropped 8 per cent on a disappointing cash flow forecast.
The divergence points to a growing separation in the expected fortunes of leading software companies, as Wall Street searches for those best placed to ride out what many fear will be a broader downturn in IT as big customers pull in their spending.
With valuations in the sector looking highly stretched after the long rally, recent slips have been punished severely. Shares in Zoom — the video conferencing company that debuted on Wall Street earlier this year — currently change hands for nearly 50 times this year’s expected revenue, a symptom of sky-high expectations for many of the new cloud-based players.
The software industry has just been through “a once-in-20-years infrastructure cycle”, said Brad Zelnick, software analyst at Credit Suisse in New York. That has been capped by a surge in sales over the past 12 months, he added, driven by a number of factors, including a US tax cut, a shift to “hybrid cloud” platforms that has seen many companies overhaul their basic IT infrastructure to combine their existing facilities with new cloud services, and a new urgency to accelerate their “digital transformation” to make their businesses more agile.
After that burst of growth, year on-year comparisons are starting to look challenging. According to Mr Zelnick, infrastructure software companies like Vmware are losing momentum compared to cloud services that are seen as critical to how businesses are repositioning themselves in the digital age. Along with Adobe, Salesforce is “one of the first two cars on the digital transformation freight train,” he said.
Uncertainty ahead
Two things are complicating the picture as the software industry faces more uncertain times. One involves the business model changes the sector has been going through as it adjusts to a new reality in which cloud-based subscription services come to represent a bigger share of sales.
Splunk, for instance, said that its disappointing cash flow forecast reflected a move to a new way of charging which will see more payments delayed into future periods. Vmware, meanwhile, blamed a disappointing licence revenue forecast for the rest of this year on an accelerating shift to subscriptions in part of its business, which also results in more revenue being deferred until later periods.
Perhaps inevitably, however, Wall Street chose to see the disappointing forecasts as partly a sign of the dark economic clouds that are starting to gather. Pointing to the economic uncertainty, Pat Gelsinger, Vmware’s chief executive officer, conceded: “There is uncertainty, and nobody is immune from that.”
The second factor complicating the picture has been a rise in mergers and acquisitions, as software companies look for new avenues of growth. This week, VMware — which is majority owned by Dell — announced two purchases for a total of $4.8bn — security company Carbon Black, for $2.1bn, and cloud tools developer Pivotal, which had been majority owned by Dell, for $2.7bn.
According to Mr Gelsinger, the deals reflect a shift to “hybrid cloud”. But Vmware’s purchases received a mixed reception from Wall Street analysts, who questioned why it was acquiring the minority in Pivotal when Dell already controlled the company, and whether Carbon Black was too small a company to make Vmware a real player in the security market.
“The organic growth is starting to slow down, so they’re starting to turn to acquisitions,” said Daniel Elman, an analyst at IT research firm Nucleus Research. Growth in Salesforce’s original sales software fell to 13 per cent this quarter, compared to the 22 per cent growth in its newer customer service business. “They’ve dominated the market for quite a while and it’s starting to get tapped out,” Mr Elman added.
‘ We see a buying environment’
The acquisitions have also weighed on Salesforce’s profit margins — contributing to longrun unease on Wall Street about the company’s failure to boost margins more as its business has grown. Announcing its latest quarterly figures this week, however, Salesforce predicted a further boost to the profit margins on its “organic”, or existing, businesses in the coming months, even as it steps up the acquisitions.
“We do make trade-offs between our organic growth and margin,” said Mark Hawkins, the company’s chief financial officer. “We’ve made considerable progress over the years, but we know there’s more to be done.”
