Navigating the Software Sector: What Opportunities Are There in 2020?

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As we enter 2020 with continued momentum in the equity markets, we wanted to take a step back and evaluate a few interesting stocks and opportunities within the software sector. For many value investors, the recent rally in the markets can be daunting as it may be difficult to find “value”. While this is true for certain stocks and in certain areas of the market, we wanted to provide some insight into some of the names that we do like, as we believe select software will outperform the broader market this year.

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Q4 2019 hedge fund letters, conferences and more

We do caution that a better entry point will likely present itself throughout the year, so please proceed with caution as volatility will be your friend for this sector. At Logos LP, we have been overweight software sticks since the early Q4 selloff as we valuations scale back from their August highs and there was a lot of fear and pessimism within the sector.

China trade deal, instability within the Trump administration, fear of what the Fed might do next and even some profit taking from within the sector depressed valuations late last year. As a result, we increased our portfolio weighting in software and technology related services and our focus has been on companies in the sector in the small to mid-cap arena with strong secular growth stories and operating cash flows. As such, we initiated positions in companies like the following, and believe they are still buyable even at today’s levels:

A look at three software stocks

  1. New Relic Inc (NYSE:NEWR): Company provides analytic and data monitoring software for DevOps teams. Company is trading a little over 7.52x sales with ~80% gross margin. Stock was down 47% from 2018 and FCF has nearly quintupled since then. New Relic has more FCF than companies like Zscaler with a similar growth profile is trading at nearly half the market cap.
  2. Zuora Inc (NYSE:ZUO):Company provides software to utilities, industrials and other technology firms that are developing subscription services. Trading under 6.25x sales with growth in enterprise accounts over 100k at 20% and overall growth at over 40% since 2018, the company blew past quarterly earnings and raised guidance last quarter. Stock was down 61% since 2018. Gross margins are in the 50% range (which is low for SaaS based business) but we expect these to meaningfully expand over the next few years.
  3.  Upland Software Inc (NASDAQ:UPLD): Marked as the U.S. version of Constellation Software, the company trades at 4.48x sales and a little over 15x next year’s earnings, yet FCF has quintupled since 2016. Company has been on an acquisition spree and has raised full year guidance. We expect to see continued rapid growth in FCF as cuts in valuation of private cloud companies will continue to drive the acquisition pipeline. We believe operating income (which grew over 4x from 2017-2018) will continue to accelerate at a rapid clip and we forecast further acquisitions in 2020, at the right price.

Other software stocks to check out

Although there are other companies we like in this space, we are most focused on companies that have the relatively low price-to-sales ratios and are avoiding the outlandish valuations of many of the more recent IPOs.

Further, we like companies who have set their eyes on the sticky enterprise software market, as these are the kinds of businesses that can experience “toll road”-like qualities after growth starts to slow down and IT departments are used to their service.  Companies that solve real problems for the enterprise, saving time, money and making departments more efficient and productive are the kinds of lightweight software businesses we love the most. A few other companies that are worth taking a look at on a prolonged drawdown include the following:

  1. Solarwinds: IT performance management software; very strong operating cash flow/sales.
  2. AppFolio: Niche software for vertical markets (think real estate management software and legal software). Strong OCF/sales, high gross margins.
  3. Anaplan: Sophisticated software that automates planning within an organization (think planning to launch a new product, major IT implementation). High gross margins (north of 70%) and strong revenue growth. Large segment of revenue derived from CIO and IT departments.
  4. Bill.com: Interesting company and we think could be ripe for acquisition at the right price (even though it just went public). They provide software that completely automates AR/AP for small-to-medium businesses. Uses machine learning and AI for the software to manage small business processing. Additionally, We think it could be the perfect candidate for Intuit, albeit at a much lower valuation.

Conclusion

We would like to remind that not all technology or software stocks are created equal. We believe the market has unfairly treated many SaaS providers with strong growth and cash flows by lumping in real software companies at reasonable valuations with companies that are either tremendously overvalued or that are not even technology focused to begin with. Uber, Lyft, Beyond Meat etc. cannot reasonably be compared to the solutions of the next ServiceNow or Workday.

Although the recent run up in SaaS providers to start the new year has provided many investors with FOMO, markets never go up in a straight line and we believe there will be a chance in 2020 to enter into some of these names at somewhat attractive valuations.

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About the Author

Peter Mantas
Peter has an assortment of business and financial experience at global institutions. Peter's prior experience includes senior managerial roles at large information service and enterprise technology companies in addition to legal experience within the capital markets, alternative investments and tax groups at McCarthy Tetrault LLP. Peter has also been involved in a variety of private equity transactions, ranging from retail to renewable energy, in addition to leading a proprietary trading team for a boutique desk. Prior to this, he held various economic research positions at the Export Development Bank of Canada, Statistics Canada and other various federal government departments.

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