The cloud software maker
has a market capitalization of nearly $50 billion but doesn’t make any money.
and others in the sector also are unprofitable.
It may be an overstatement that software is eating the world—as internet pioneer and venture capitalist Marc Andreessen proclaimed in 2011—but no industry is more popular on Wall Street.
For those companies, investors are willing to overlook a lack of earnings based on standard accounting. What is attractive instead is the sector’s high revenue growth and large market opportunity, as corporations and smaller businesses increasingly move toward cloud-based subscription software for many uses like human resources.
Annual revenue growth of 25% or more is a rarity among large U.S. companies—software is about the only place where it exists. But now, even some fans are wondering if valuations are too frothy, as the stocks continue to climb. “Software valuations are at all-time highs,” Sarah Hindlian, a Macquarie Research software analyst, wrote earlier this month. “Bubble risk rises.”
The exchange-traded fund (ticker: IGV) is up 32% this year and 100% over the past three years. Some of the hottest companies in the sector, including Okta (OKTA) and
(ZS), have climbed more than 100% in 2019. And the iShares ETF understates the performance of the sector’s high fliers because it’s dominated by larger, more mature companies, such as
Many software companies are now valued at more than 20 times projected 2019 sales—and without any earnings. No major industry has a higher valuation. The S&P 500 index is valued at about two times sales. Leading technology companies, including
(FB), Microsoft, and
(AMZN) are valued at four to eight times sales.
While Microsoft and Abode are less expensive than their highflying peers, they are also no bargains. Adobe trades for more than 50 times earnings, and Microsoft, 25 times. Microsoft became the most highly valued company in the world this year, at almost $1.1 trillion, after a 39% stock-price gain.
“It’s a bubble, just like 2000,” says Fred Hickey, editor of the High-Tech Strategist newsletter. “These price/sales ratios are normally what you would see as price/earnings ratios.”
Many of the stocks appear to be priced for perfection—or near perfection—and that makes them vulnerable to small disappointments. ServiceNow (NOW) fell 4% on Thursday after reporting that its second-quarter subscription revenue rose 33%, but came in just below the consensus estimate for the first time in two years. The shares finished on Friday at $289, unchanged on the week.
With Wall Street expecting annual revenue gains of 30%-plus, more disappointments could be coming. Software spending isn’t immune to economic cycles; if there is a slowdown or a recession, the stocks could take a major hit.
And growth stocks have been in vogue for a decade now. If investors ever shift back to value, the software sector would probably reset to a lower valuation.
Another risk is accounting. If investors begin to focus on earnings based on Generally Accepted Accounting Principles, which properly reflect stock compensation as an expense, valuations could fall. Software is one of the few remaining industries in which companies pretend that isn’t the case.
Most software companies emphasize earnings that don’t conform to GAAP and exclude heavy stock compensation, thus overstating profitability. Reported free cash flow—another favorite financial metric among software makers—also excludes stock compensation and is inflated.
Software investors and many analysts seem happy to indulge management in this fantasy because doing so justifies higher share and acquisition prices. The rationale is that stock compensation isn’t a cash expense and thus doesn’t matter. But nearly all such compensation now consists of cash-like restricted stock, as opposed to hard-to-value stock options.
argues in its financial statements that “it is useful to exclude share-based compensation expense to better understand the long-term performance of our core business and to facilitate comparison of our results to those of peer companies.”
The company says that stock-based compensation takes into account factors “that are beyond our control and generally unrelated to operational decisions and performance in any particular period.”
Outside the software industry, few businesses play the non-GAAP game involving stock compensation. Facebook and Alphabet used to report non-GAAP earnings, but now emphasize GAAP financials, joining longtime GAAP proponents Apple and Microsoft.
1 Fiscal year ends Jan. 2020; 2 Fiscal year ends July 2020; 3 Fiscal year ends June 2020; 4 Fiscal year ends Nov. 2019; E=Estimate; Slack YTD change from 6/19/19; Zoom Video YTD chnage from 4/17/19
The treatment of stock compensation is a pet peeve of Berkshire Hathaway CEO Warren Buffett. In his 2015 shareholder letter, Buffett wrote that excluding it from earnings is “egregious.”
“The very name says it all: ‘compensation,’ ” Buffett wrote. “If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong? Wall Street analysts often play their part in this charade, too, parroting the phony, compensation-ignoring ‘earnings’ figures fed them by managements.”
With Wall Street willing to ignore stock compensation, it’s no surprise that software producers issue a lot of it. At ServiceNow and Workday, stock compensation is about 20% of sales, compared with 6% to 7% at Alphabet and Facebook.
Workday’s non-GAAP earnings last year of $1.36 a share turned into a loss of $1.93 based on GAAP numbers, largely because of stock compensation. The company is expected to remain unprofitable on a GAAP basis again this year. Its shares trade at $214.
ServiceNow had 71 cents of non-GAAP earnings in the second quarter, but a loss of six cents a share, based on GAAP. And it had just $22 million of free cash flow in the period after stock compensation. This is for a company with a stock market value of $53 billion. ServiceNow is valued at 90 times its projected 2019 non-GAAP earnings of $3.22 a share and more than 5,000 times its estimated GAAP profits of a nickel a share.
Cloud industry leader
(CRM) trades around $159, or 200 times its projected GAAP profits of 79 cents a share in its current fiscal year, ending in January 2020. The stock is more reasonable, but is still expensive at 57 times its projected non-GAAP earnings of $2.80 a share.
“This is what happens in bubbles—you have to find ways to rationalize valuations,” the High-Tech Strategist’s Hickey says.
Software bulls argue that the industry has attractive core margins, sticky relationships with business customers, and a large market opportunity. Renewal rates regularly run above 90%. The stocks have rarely been cheap, and investors who balked at high valuations have missed out on enormous gains. Okta, a maker of security software, went public at $17 two years ago and today trades around $136.
Cloud-based software has many advantages. It’s cheaper than the old packaged products that required complex installation and maintenance, allowing smaller businesses to benefit from services once affordable only for corporations.
John DiFucci, a software analyst at Jefferies, says the industry is attractive, thanks to strong recurring revenue. Investors, he says, tend to view sales and marketing expenses as investments to generate profitable new business. “We are as positive as ever on the business of software,” he says. “However, valuation does give us pause in some instances.”
Acquisition activity has been strong, as buyers see it as a quick way to expand their product portfolios. The acquirer often believes that it can use its own sales force to reduce the target operation’s sales and marketing costs.
German software giant
(SAP) bought privately owned Qualtrics for $8 billion, or 21.5 times trailing sales, earlier this year. The rally in software stocks, however, has left many software issues trading above such takeout multiples, prompting Morgan Stanley analyst Keith Weiss to write recently that “the potential for M&A to act as a broader software catalyst may be somewhat muted.”
The sector has a bright future, but the stocks have little margin for error. Warns Hickey: “Software is really risky for investors. The risks are not reflected in the stocks.”
Write to Andrew Bary at email@example.com