Software: Still Eating the World Just Taking a Pause to Digest

In 2011, venture capitalist Marc Andreessen famously said that “software is eating the world” referring to software’s role in digitizing industries and transforming the way businesses operate and interact with their customers. Since then, software companies have been among the stronger stock market performers, consistently innovating and rolling out new solutions that have found favor across all corners of the business universe.

However, they have not been immune to the disruptive effects of technology advances such as Generative AI and the impact it is having on how enterprises allocate their IT spending. As we discuss in this article, we believe this to be a temporary effect, especially as key software vendors are folding AI features into their own offerings.

As earnings season for the opening quarter of 2024 unfolded, a number of disappointing results from software stalwarts such as Salesforce, Workday, and Adobe prompted some concern that a focus by enterprises on Generative AI could be having a disruptive effect on the sector’s fortunes. Based on our conversations with customers and companies (and subsequent Q2 results reported in the July/August timeframe), we believe software vendors are simply experiencing a pause in spending as enterprises digest the large deployments made during the pandemic era and as they plan the significant investments they will be making in newer, Generative AI-enabled solutions. It is our expectation that as vendors such as Microsoft, Salesforce, Workday, and Adobe fold new AI features into their solutions (and as these solutions are adopted by customers), we will see a reacceleration in growth from those disappointing reported outcomes, which should benefit software stock performance.

Software Earnings Left Investors with Questions

Software stocks delivered a strong performance in 2023. The IGV software index, which tracks US software and select interactive media companies rose 59%, considerably outpacing the S&P500 (up 26%). The return also topped that achieved by the tech heavy NASDAQ, although the gap was significantly smaller as the latter generated a return of 54% (Figure 1). Software stock performance in 2023 was lifted by a number of factors including (i) entering the year at depressed valuations, (ii) stabilizing interest rates after a period of rapid increases and (iii) strong end-of-year budget spend. Given the demand seen in Q4 2023, many software vendors were likely overly optimistic around pipeline conversion prospects in the first half of 2024, which set up a mismatch between expectations and results on earnings.

With expectations elevated into earnings, results in Q1 2024 for several software vendors missed forecasts as deals were delayed due to greater buyer scrutiny – with a consequent dampening on share price performance (Figure 2). Quarters that occur early in the year for software companies typically generate relatively lower total sales, to the extent that a few large slipped deals can meaningfully impact performance in a quarter. Commentary on companies’ earnings calls pointed to large deals slipping out of early quarters as well as some deals proving not to be as big as initially anticipated. While this commentary was consistent across vendors such as Salesforce and Workday, these vendors also specifically stated that they were not seeing an increase in competitive losses.

What Caused Large Deals to be Delayed?

Based on our research and conversations with companies and industry sources, we believe that enterprises are focused on formulating their Generative AI strategies – determining exactly what new Generative AI solutions are available, what they are capable of, and how they need to update their IT environment to take full advantage of this new functionality. In some cases, Generative AI solutions will be additive to IT budgets and in other cases budget will be simply reallocated from other IT spending priorities. While enterprises are clear that they don’t want to be left behind in the AI revolution, these are large budgetary decisions that need to be well vetted before buyers proceed. Companies are thus hesitant to make other large IT purchases before they have plotted out their AI strategy and understand where the budget for these projects is coming from.

We believe most companies are looking to have made some decisions regarding their path forward before the end of 2024. Even those that have not finalized their plans by year-end will have a stronger idea of how they expect to spend their budget in Q4 – this will likely result in full utilization of their budget in the second half the year, as stalled deals make their way through the pipeline.

Is Generative AI a Threat or Opportunity for Software Vendors?

While a focus on Generative AI has created a near-term pause in spending, we believe software companies should be able to benefit from the theme in the medium-to-long term. Software vendors will embed Generative AI functionality into their existing offerings, improving usability and functionality. Along with these enhanced features, we expect to see vendors raise prices and potentially update their go to market models. These new features will be adopted at different rates, as some will provide much quicker and more obvious return on investment.

Given that vendors such as Microsoft, Salesforce, ServiceNow, and others have large and sticky installed client bases, they will have an advantage in selling additional Generative AI features to these customers. Today, buyers are looking to reduce the number of vendors they work with and are often hesitant to rely on untested providers. We believe that incumbent software vendors will benefit from these trends as customers choose which companies to work with for their Generative AI deployments.

While we expect incumbent software vendors to see a tailwind to growth from newer AI solutions, some analysts have argued that with productivity improvements due to AI adoption, customers will need fewer employees and this could negatively impact seat growth (the growth in the number of instances of applications sold) for software vendors. Mitigating this risk, some software vendors are currently experimenting with consumption based pricing. Our belief is that software vendors will be able to price for the value that they deliver and if productivity improvements are large enough to allow customers to reduce headcount, these vendors will still be able to grow their businesses through price increases, enterprise-wide agreements, value based pricing or other models.

Additionally, analysts who are more bearish on the Generative AI theme have claimed it has been over-hyped, as no new “Killer Application” or application that is so transformative that it must be adopted, has emerged. While some applications that have been brought to market have received mixed reviews, we would note that it is early days in the AI technology cycle. Past cycles have begun with infrastructure build-out (just as this one) and eventually progressed to the application layer. Additionally, there are some compelling AI solutions already in the market that we expect to be widely adopted in the next few years.

Microsoft GitHub Copilot: Microsoft is having early success with one of its Generative AI solutions, GitHub Copilot. This is used by software developers and can turn natural language prompts into software code. Some customers have seen 10% -50% productivity improvements in their software developers from this solution.¹ This means that developers are saving significant amounts of time writing and debugging code as GitHub Copilot is able to write lengthy pieces of code with simple prompts and makes suggestions for additional code. This is a clear example of a strong use case for Generative AI as developers are less concerned with exactly how the code is written, as long as it is efficient and serves the use case. Given this significant productivity increase, it is no surprise that total GitHub Copilot customers grew 180% year-over-year in Microsoft’s June quarter.

Adobe Firefly: Adobe is in the early stages of rolling out its Firefly Generative AI offering and is also seeing some success. Firefly is Adobe’s suite of Generative AI creative tools which allow users to create images from text prompts. Firefly helps companies lower costs while decreasing product time to market. For example, toy maker Mattel saves time when creating initial concepts for background art on toys like Barbie. Historically, artists initially created rough sketches of packaging concepts and would create multiple versions as concepts went through internal review cycles. Firefly’s text-to-image offering allows designers to create and change designs more quickly, reducing the time and employee effort on this portion of the product development. Over time, Adobe will monetize Firefly, thus adding a growth tailwind to its dominant creative franchise as customers better understand the benefit and return on investment from this product.

In 2025, Generative AI solutions such as GitHub Copilot and Firefly, should make their way into more software offerings, improving the functionality and bolstering vendor growth.

Software is a Fertile Hunting Ground for Investors

We continue to view the software sector as one of the best hunting grounds for high quality companies. Our investment philosophy is to look for quality companies with repeatable growth at reasonable valuations. The structure of the Enterprise Software space results in many investments that fit these criteria. The Active Fundamental Equity team’s proprietary Confidence Quotient research process is used to assess the competitive strength of software companies.

Successful software companies tend to have high profit margins as the incremental cost of delivering software to an additional customer is low. These high profits and returns are protected by high substitution costs where customers are unwilling switch from a solution that is working and risk damaging or losing the data they have stored in these applications. Finally, software vendors often have large barriers to entry as the significant R&D expense that is spent to maintain functional superiority, is spread over a large customer base, making it expensive for newer upstarts to compete.

Enterprise software’s long-term profitability, recurring revenue, and high renewal rates make for attractive compounding growth stories. As a counterbalance, valuations are higher than average market multiples, although investors understand the value of these quality, high growth companies and are willing to pay a premium for them.

What Makes for an Attractive Software Investment?

Adobe and ServiceNow are two companies in the software space that score well on our CQ framework and, in our view, warrant closer attention.

Adobe: While we expect Adobe to benefit from the deployment of Generative AI solutions, such as Firefly, over the medium term, there is more to the company than AI. The stock has a greater-than-70% market share in the content creation market, a sticky installed base of users, and it is growing its top line by double digits annually. Furthermore, it has a pro forma operating margin that is greater than 45%. We believe concerns regarding competition from graphic design platform Canva are overdone and at a price-to-earnings (PE) multiple of 25x (next 12 months (NTM)), which is a 24% discount to its five-year average, the current valuation is relatively attractive for this market leader.

ServiceNow: ServiceNow is a leader in IT Service Management and has expanded its platform to help companies manage a plethora of additional digital workflows. The company is in the early stages of bringing to market Generative AI solutions, such as its ITSM Pro Plus offering, and has been able to effectively execute during this tumultuous time for software. ServiceNow trades at a higher multiple (14x NTM Revenue) than its peers, but we believe this is warranted given the company’s strong top-line growth (22% year-over-year in the most recent quarter) and attractive margin profile (27% pro forma operating margin).

While the software space has been more challenged in the year to date, we believe Adobe and ServiceNow make attractive, medium-term investments, underpinned by the likely benefits derived from increasing Generative AI adoption.

The Bottom Line: A Return to Form for Software in 2025

As we work through the remainder of 2024 and enterprise purse strings begin to loosen, we would expect software results to show some improvement. Given that we won’t see Q4 results until early 2025, we believe this may translate to stronger stock performance from software next year, as software vendors convert deals in their pipelines and 2025 sees easier comparisons relative to the first half of 2024. For investors who are able to be patient, we believe the software space remains an attractive and high-quality area for investment that can benefit from AI tailwinds over the medium term.