Trade wars. Federal Reserve monetary policy. Slowing growth in China and Europe. Chaos in Washington, D.C. There is a long list of potential bugaboos for investors this year.
But one secular investment story looks so powerful that it could still work in a weakened global economy: enterprise software disruption.
In 2011, Marc Andreessen, venture capitalist and co-founder of Netscape, penned an essay titled, “Why Software Is Eating the World.” He predicted that software would disrupt large portions of the economy and nearly every industry, due to the internet’s increasing ubiquity and the transformative effects of the cloud’s cheaper computing power.
Andreessen was right. His bets on native-cloud software companies were remarkably prescient. Amazingly, the trend shows no signs of letting up. Andreessen’s venture capital firm, Andreessen Horowitz, still uses the slogan atop its corporate website.
Over the past few weeks, five major banks have flooded my inbox with comprehensive industry reports, all proclaiming the resilience and defensive nature of the sector. “Companies are going to invest in software even in a weaker economic environment,” Morgan Stanley analyst Keith Weiss told Barron’s in a phone interview on Thursday. “It is no longer a choice. It’s a must-have. Software has very durable demand trends.”
Companies now rely on software to improve customer experience and increase efficiencies in their back offices.
Once upon a time, software-driven services helped companies cut costs by dropping unnecessary hardware. Take Google’s G Suite, which corporations began choosing instead of pricier servers running Exchange from Microsoft (MSFT).
Fast-forward a few years, though, and G Suite is now as much about an improved experience as it is about lower cost. Barron’s uses G Suite for corporate email, essentially an enterprise version of Gmail and related services. Its features and functionality are much improved, compared with my previous experiences with legacy on-premise email products. G Suite’s search function works dramatically better; there are no storage limitations, and the calendar collaboration is seamless.
This month, Google announced that it’s increasing the per user price of its G Suite productivity offering by 20%, the first price hike in 10 years. Google, a unit of Alphabet (GOOGL), knows it’s operating from a position of strength. It claims that more than four million organizations now use G Suite.
The cloud has become a key component of the software revolution. Software built on the cloud offers better reliability, easier scalability, and greater cost savings than traditional software running on-premise computing equipment.
Meanwhile, companies that make physical products such as hardware devices are already feeling the impact of a trade-war escalation, tariffs, and rising commodity costs due to their complex global supply chains. Software has none of those issues. Once a program is written, it can be resold an unlimited number of times and has nearly no incremental costs.
The business model for software has also dramatically improved over the past decade. Weiss noted that nearly 80% of software sales on average are now recurring, with more than 90% renewal rates, compared with just 50% recurring in 2008. Investors love recurring revenue due to its consistency and sustainability, versus chunky front-end-loaded one-time license sales.
Jefferies analyst John DiFucci told Barron’s that he is more excited about the software business than at any point in the two decades he has covered the sector. Similar to Andreessen’s thesis, he said that the combination of faster and cheaper computing power, memory, and storage with pervasive internet bandwidth has enabled companies to truly “extract value” and business insights from customer data.
The transformation from legacy applications to cloud-native software may still be early in its growth curve. Wedbush Securities has said that about 30% of technology workloads are currently on the cloud, a share that will rise to 55% by 2022, according to the firm.
To be sure, if the world enters a deep recession, cloud-based software companies will be hurt as major layoffs eat into their per user subscription-based sales. But in a milder scenario, corporations may actually be incentivized to purge servers from their basements, turning to the cloud and to software for cost savings.
Investors have been benefiting from software stock gains for some time. Wells Fargo points out that the software sector has beaten the S&P 500 index (.SPX) by 14 percentage points per year on average since 2009.
So how should investors ride the trend from here?
Both Morgan Stanley and Jefferies software analysts named Salesforce.com (CRM) among their top ideas for 2019. “Salesforce.com has become a trusted partner to enterprises. Companies will buy more from them beyond its sales-force automation offering,” DiFucci says, referring to its widening array of marketing and analytics services. “There is so much they can sell into its customer base.”
Jefferies has a $189 price forecast for Salesforce shares, while Morgan Stanley has a $178 price target. That’s 26% and 19%, respectively, above the stock’s close on Friday.
Weiss named Microsoft as another top software pick. He says the company benefits on three fronts: as a vendor of cloud computing, business analytics, and productivity subscription software. Weiss forecasts that Microsoft can increase profits 16% to 17% annually for the next three years and is reasonably priced. He has a $140 price target for Microsoft stock, 31% above its current price.
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