COVID-19 Fear Creates Rare Opportunity for Software Investors
Sharp sell-off leaves valuations attractive.
|Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.|
Concerns about the developing global COVID-19 pandemic have sent the equity market, and software along with it, into a tailspin. Before the sell-off, we viewed software in general as a compelling secular growth story but with limited opportunities for upside based solely on valuation. The situation is rapidly evolving, with the worsening crisis in the United States offset somewhat by the advancing of the giant $2 trillion financial rescue package. Uncertainty remains high, but we think fear remains higher.
Our view on software hasn’t changed: We still consider it an attractive secular growth industry. We see increasing complexity arising from the mix of on-premises, hosted, multitenant software as a service, public cloud, hybrid cloud, open source, and new programming languages. This complexity suggests to us that software will consume a higher portion of enterprise IT spending in five years than it does today.
Our crystal ball is no better than that of any other investor. However, we think it is constructive to look at prior recessions to explore how software companies fared in challenging conditions. If the current situation in the U.S. persists through April, we are likely to see pressure building on our models. That said, the nature of subscription and SaaS models, with high visibility arising from deferred revenue balances and unbilled contractual off-balance-sheet amounts, is such that it takes longer for decaying macro conditions to show up in financials.
Our preferred names are Microsoft (MSFT), ServiceNow (NOW), Salesforce.com (CRM), and Tyler Technologies (TYL). We like these companies specifically for their wide moats, the defensive nature of software revenue models, and the increasingly attractive valuations.
Software Stocks Are Down but Not Out
From its peak on Feb. 19, the S&P 500 is down 27% as of the April 2 close, which is still better than the March 23 comparison. During the 2008 recession, the S&P 500 sold off 56% from peak to trough, while in the Internet bubble recession in 2000, the market was down 47%, and in the 1990 recession, it was down 18%.
Our software coverage is down 28% on average from the recent peak, while a broader measure of approximately 40 software stocks we track has declined 27%. Some days have been better than others, and the pandemic situation has been fluid, to say the least.
We think the market sell-off has provided long-term investors with buying opportunities in wide-moat, high-quality software companies. Looking at the near term, it is logical to us that software should hold up relatively well based on the underlying business model and big-picture fundamentals. Software companies are moatworthy businesses in general, as they have high customer switching costs. Once installed, most software systems, platforms, and applications are not often replaced and will generally remain in operation, with regular updates, for 10 or more years. This is especially true with larger enterprise customers, in our view. Further, we think the more critical the software is, the stronger the moat will be. Of the 17 software companies we cover, eight have wide moats, seven have narrow moats, and two have no moats.
Software companies also have highly recurring revenue. Modern software companies deliver solutions via a SaaS model, which has monthly, quarterly, or annually recurring revenue. Customer retention is typically better than 90% annually, with most good software companies at 92% and the truly elite at 98%. Dollar retention is better still, usually 105% or better.
Even if a software company does not sign another new customer during the year, there is still a strong likelihood that revenue will actually grow from a combination of price escalators, additional seats, or cross-selling of additional modules. Software dramatically increases productivity and lowers costs, and it is virtually impossible to perform certain operational tasks without it.
Finally, while past performance is not an indicator of future results, software stocks traded rather well in the aftermath of the 2008-09 credit crisis as the resiliency of the business models played out. We are optimistic that shares could follow a similar pattern during this COVID-19-related sell-off, where high-quality software names have sold off despite solid fundamentals. From the March 9, 2009, bottom to the end of 2009, the S&P 500 was up more than 60%. While this is an imperfect measure, a group of 26 software companies (including a variety currently under Morningstar coverage) from the 2009 period shows a much sharper snapback for the software group, which was up more than 85%.
Long-Term Software Story Remains Intact
From an investment perspective, the exact path the COVID-19 pandemic takes is somewhat irrelevant, in our view. Not only do we take a longer-term view that macroeconomic conditions will recover from the pandemic, but more important for our coverage, software businesses have been resilient in prior recessions, and we think they will hold up well again for a variety of reasons.
In addition to consistent growth, most software names we cover offer relatively high growth. The average revenue growth of the S&P 500 was approximately 5% in 2019 compared with north of 20% for our software coverage and for the approximately 40 software companies we track.
Even with COVID-19 concerns in 2020, we don’t particularly believe that software’s growth will evaporate. We can look back at the credit crisis in 2008-09 to see a time where software names still rose despite a severe economic recession.
In the 2009 recovery, the U.S. lost approximately 10,000 lives to the H1N1 (swine flu) pandemic, while the S&P 500 powered its way to a return of about 23% for the year. We are not economists, but the single macro opinion we will offer here is that we do not think the next evolution from here is worse than 2008.
When we look at calendarized revenue growth for the companies we cover that existed during the 2008 recession, broadly speaking, revenue growth was surprisingly resilient overall. Salesforce was a stellar performer despite the credit crisis, due to an inflection in enterprise acceptance of the SaaS model. Tyler Technologies delivered solid revenue growth because of the steadier nature of government-related sales. Microsoft also held up relatively well, due to the relative importance of its solutions to the PC and server end markets. ServiceNow was not yet publicly traded during the financial crisis.
Among other wide-moat companies, we attribute the dramatic depressing effect on revenue growth at Aspen Technology (AZPN) to its transition from a perpetual license model to a SaaS model in 2009. Additionally, during this period, Adobe (ADBE) was still selling shrink-wrap software and did not have what is now called the Marketing Experience segment to provide some degree of buoyancy to revenue. In recessions, advertising budgets are quick to get cut, so the creative freelance market was hit, as was the creative segment more broadly.
Software companies also offer a better margin profile on average than most other industry groups. Compared with the S&P 500 free cash flow margin in the midteens in 2019, the software companies we track generated free cash flow margins upward of 20%. Operating margins generally follow a similar pattern. As with revenue, we think software margins during the Great Recession were stressed but still held up pretty well overall.
Lastly, software companies typically have strong balance sheets. On average, our software coverage has a debt/total capital ratio of just 7%. Excluding Microsoft, our coverage carries approximately $24 billion in cash, with less than $17 billion in debt. On a gross basis, our companies are leveraged at 0.5 times trailing EBITDA on average (excluding cases of negative EBITDA). Further, a number of our companies are carrying only convertible debt, which is better viewed as equity and need not be refinanced. With their attractive free cash flow margins, software companies should be able to manage modest debt levels.
Software Picture Seemed Fine, Even as COVID-19 Was Spreading
Recent earnings reports are perhaps outdated, given the rapidly evolving nature of the pandemic. However, we think they offer at least some insight into the ability of various software vendors to close business. Generally speaking, quarterly results so far in calendar 2020 have been strong. More important, guidance has been only modestly affected. That said, even for earnings reported March 12, U.S. cities had still not adopted social distancing or strict shelter-in-place measures. Companies acknowledged the situation and were generally saying they continued to close business via phone, email, and other means. Even Adobe said that some deals that slipped at the end of February had closed by the time of the earnings call. Guidewire (GWRE) has been struggling with its model transition from perpetual license to SaaS, which continued in the most recent quarter and led to lower-than-expected guidance, but this was not related to COVID-19.
We think this is important for context, as the market seems to be mostly pricing in a recession, which does not seem unreasonable. Despite the data we present, we think a recession would surely bring some downward pressure on our estimates for this year and next. We think our coverage would hold up well fundamentally, however.
But what happens if the U.S. does not slip into a recession? It seems plausible that growth could slow to near zero for several quarters as a result of this pandemic. It also seems at least possible that GDP could contract (perhaps sharply) for one quarter and then grow again, which by definition is not a recession. We think the impact would be minute on our coverage in these circumstances. There are reports from China, for example, that factories are back on line and life is returning to normal. We will begin getting first-quarter updates in mid-April and have better clarity at that time. In the meantime, we direct investors toward the wide-moat, high-quality software companies we cover.
Microsoft Has Most Near-Term Exposure to China, but Long-Term Drivers Intact
In our coverage, Microsoft has the most direct exposure to COVID-19 in that it has several pieces of hardware that are made in China, and its Windows OEM operating system software is installed at factories where PCs are manufactured. On Feb. 26, the company announced it would not meet its revenue guidance for the More Personal Computing segment. Parts of China were severely affected by COVID-19, which drove delays in reramping factories after the Lunar New Year. Some facilities, in fact, were closed during the month of February. We expect manufacturing capacity to be somewhere near normally utilized at the end of March. Management noted that demand remained strong for software products.
Nonetheless, we think hybrid cloud environments will persist over the next decade and Azure powers growth in the medium term. Microsoft continues to use its dominant position of on-premises architecture to allow customers to move to the cloud easily and at their own pace, which we believe will continue over the next five years. We think Microsoft’s enterprise salesforce is an asset that makes a move toward cloud adoption via hybrid cloud environments as painless as possible for customers. Adoption of infrastructure-as-a-service, platform-as-a-service, and SaaS cloud services remains robust and continues to outperform our expectations from both a revenue and margin perspective. The company has made tremendous progress toward remaking nearly its entire business a recurring revenue model. Office is a crown jewel that has a near monopoly in productivity software and still has some runway left in terms of transitioning to a recurring revenue model. We are encouraged by the innovative solutions the company is introducing within gaming. We also view LinkedIn as a nice growth element that is often overlooked within the bigger story. There is a lot to like here.
We have assessed our model and see trivial changes arising from the company’s late February announcement that ultimately have no meaningful impact on valuation. That said, if the COVID-19 pandemic and local lockdowns persist beyond early April, we think there could be modest downward pressure on revenue growth. Microsoft did deliver strong revenue growth throughout the tech bubble, although revenue slowed in 2008 and declined in 2009. We think the history matters, but we also think a strict historical comparison does a disservice to both investors and Microsoft, as it is a different company now. We think the two key differences are that the model has shifted to a recurring revenue model and the rise of Azure. The SaaS and subscription model by definition makes today’s revenue highly visible, and Azure provides a secular growth pillar that did not exist during the 2008 financial crisis.
While Microsoft generates exceptional growth for a company its size, the largest software company in the world also generates strong margins. Regardless of the margin measure you might prefer, Microsoft is near the top of the software universe--GAAP operating, non-GAAP operating, and free cash. In fiscal 2019, the company delivered a GAAP operating margin of 34% and a free cash flow margin of 30%. Microsoft delivered excellent margins throughout the last recession, and we think it ability to navigate a potential COVID-19-related recession will produce relatively high margins as well.
As is the case for most software companies, Microsoft’s balance sheet provides an excellent cushion should the pandemic take a turn for the worse. The company has $134.3 billion in cash, offset by $69.6 billion in debt. Its fat margins combined with a net cash position of nearly $65 billion mean that it would have no problem accessing the credit market in any reasonable recession scenario.
We view Microsoft as a wide-moat company with high customer switching costs, network effects, and cost advantages. We see a variety of core products like Windows, Server, Office, and Azure as wide-moat solutions, with some at a narrow moat (LinkedIn, Dynamics) and still others at none (Surface, Xbox). Because its key solutions serve as the backbone of infrastructure and the primary productivity solutions of enterprises around the world, we view Microsoft as possessing one of the strongest wide moats in the broader software group.
Salesforce.com Has Proved It Can Deliver in a Challenging Environment
Salesforce.com is a particularly relevant case study for the current market turmoil and potential recession, as not only was it around during the 2008 financial crisis, but in the midst of the economic shock, it hit $1 billion in annual revenue for the fiscal year ended January 2009. About half of our coverage is similarly sized and growing somewhere at least in the ballpark of Salesforce’s spectacular 44% top-line growth achieved in fiscal 2009 (approximately calendar 2008).
In fact, Salesforce.com’s revenue decelerated as the company grew. It appears that revenue in 2009 (which is effectively fiscal 2010 for Salesforce) was damped by macro conditions. All else equal, we might have expected higher revenue growth that year. That said, 21% growth in a recession is no small feat. Similarly, margins were increasing throughout most of the financial crisis, with the dip in fiscal 2010 and a sharp snapback in fiscal 2011. The balance sheet is in great shape, with $7.9 billion in cash, equivalents, and short-term investments, offset by $2.7 billion in debt, with $995 million due in April 2023. Given the company’s demonstrated ability to navigate a recession, we have some confidence that CEO Marc Benioff will be able to manage through the current pandemic, which may ultimately include a recession.
Salesforce’s portfolio is more robust now. Circa 2009, it consisted predominantly of the core salesforce automation solution and the newer and therefore smaller Service Cloud and Force.com offerings. Today, Sales Cloud, Service Cloud, and Platform and other are each 28%-29% of revenue, with Marketing Cloud accounting for the remaining 16%. Salesforce led the move to SaaS, and we think it is still a clear leader, not just in its key applications, but also in software modernization more broadly through the popularity of its development platform as well as the recent acquisitions of portfolio broadening MuleSoft and Tableau. We think the company has become a strategic partner for enterprise customers in their digital transformation as well, with its portfolio of revenue-enabling and customer-retaining software solutions, in addition to its integration and analytical tools.
On an organic basis, we think Salesforce can deliver high teens revenue growth for the next several years. Indeed, we are near the low end in our discounted cash flow model against management’s $34 billion-$35 billion organic revenue target in fiscal 2024. Once the dust settles from the Tableau acquisition, we think Marketing Cloud will be the fastest-growing segment, followed closely by Platform and other and Service Cloud, with Sales Cloud bringing up the rear somewhere around 10% growth annually over the next several years.
On Feb. 25, Salesforce reported material upside compared with its outlook and offered guidance that was at least in line with, if not better than, CapIQ consensus. While the situation is evolving rapidly and the pandemic looks different in the month since, China, Italy, Iran, and South Korea were known problem areas when Salesforce reported. We think there is little risk to revenue over the next couple of quarters given the SaaS model. Where we might see some revenue pressure is during the main thrust of renewals in the fourth quarter, which could have some modest pressure on revenue next year. Based on management comments from the earnings call, we think it is too early to change our forecast. If the U.S. is moving back to work in early April, then we think the revenue impact to Salesforce will be negligible.
We think Salesforce.com has a wide moat arising primarily from switching costs, with support from a network effect as well, and its acquisitions that push the portfolio into other related areas drive a positive moat trend.
Salesforce.com revolutionized the software industry in 2000 with the release of its salesforce automation application. The feature set was generally similar to those offered by peers--streamlined process management for sales leads and opportunities, contact and account data, process tracking, approvals, and territory tracking. Salesforce.com’s critical differentiator was that the software was accessed through a web browser and delivered over the Internet. This was a novel concept during the Internet bubble. The company paved the way for the software industry as it exists now by first selling the concept of software as a service to prospective customers, and then selling the actual salesforce automation product.
Over the years, Salesforce has gobbled up market share and ventured into related areas, moving from salesforce automation to service to marketing. Management has also layered in broad tools to help customers link old systems to new systems, unlock data, and bring powerful artificial intelligence and analytics to bear. The broad portfolio along with its intelligence tools allows users to obtain a 360-degree view of customers. A customer that originates as a Sales Cloud customer can be sold on Service Cloud, or any other solution for that matter--and customers have clearly embraced the platform.
This Is ServiceNow’s Time to Prove Its Mettle and Join the Elite
ServiceNow is one of our top software stocks, as we think it really excels at executing the land-and-expand strategy. ServiceNow continues to leverage its strength in workflow automation to penetrate existing customers more deeply in IT and more broadly with human resources and customer-service-specific products. It has become a key partner in digital transformation, as shown in retention statistics that remain at the elite level. We are impressed by ServiceNow’s excellent balance between strong revenue growth and margins. We also favor the fully organic growth displayed by the company, versus other models that are more acquisitive.
We do not have comparisons to draw from a prior recession, as the company was founded in 2003 and completed its initial public offering in 2012. However, we think it is likely to benefit from some of the same things that Salesforce did in the financial crisis. ServiceNow primarily serves the the biggest 2,000 companies in the world and thus has no exposure to small and midsize businesses, which we think are more at risk in a recessionary environment. Further, we point to $2.2 billion of deferred revenue on the balance sheet, which represents approximately half of our full-year revenue estimate and will be converted into revenue throughout the year. We further note $3.3 billion in current remaining performance obligation and $6.6 billion in total remaining performance obligation. Renewal rates have remained in a tight 97%-99% range since 2011. Together, these data points underscore our broader point that in general, software companies’ revenue is highly recurring. In fact, ServiceNow’s metrics compare quite favorably with peers.
In 2019, ServiceNow delivered $3.4 billion in total revenue, representing 33% growth over 2018. By way of comparison, when Salesforce hit similar revenue levels, it was growing in the 33%-35% range. We stress that ServiceNow’s revenue growth has been entirely organic, as it has ported its workflow logic from the IT service desk to a variety of other areas, notably HR and compliance. Additionally, the company recently introduced its financial close management solution, which helps automate the periodic closing of financial records for companies. This represents ServiceNow’s first foray into the office of the CFO, and we think will contribute meaningfully to revenue over the next five years.
Finally, ServiceNow offers among the very best balances of growth and profitability in all of software--certainly within our coverage. Few companies can match the 35% free cash margin ServiceNow produced in 2019. Again, relative to Salesforce, ServiceNow is already producing slightly higher free cash flow and non-GAAP operating margins. The company has consistently delivered margin expansion beyond expectations, which we think will continue over the next several years.
ServiceNow enjoys a clean balance sheet, with $1.7 billion in cash and $783 million in convertible bonds. The convertible bonds pay a 0% coupon and are due in June 2022, with a convertible date of Feb. 1, 2022, at $134.75. Like the company’s last convertible issue, we believe these bonds will also be converted into common shares. Even if they are not converted, the balance sheet is strong.
We view ServiceNow as a wide-moat company, driven by high customer switching costs. In our opinion, ServiceNow’s moat is strengthening based on increasing switching costs, as the company has significantly ramped its revenue within existing clients while going deeper into the IT function and then broadening to more functions across its enterprise customers.
While ServiceNow positions itself as a workflow solution, it is more easily understood as a provider of software for information technology service management and IT operations management. That said, the workflow element of ITSM has been critical in driving adoption for use cases outside of the IT function. The broad appeal of automating processes across the enterprise has opened up a larger array of use cases for the company’s solutions. These factors have allowed ServiceNow to initially bore deeply into the IT function and then to expand to other non-IT functions. Both of these sales dynamics have allowed ServiceNow to become deeply entrenched in an organization across a variety of critical functions. Since the software sales process across the enterprise will regularly touch the IT department, ServiceNow adopted a stance early on that it would let the internal IT function sell the platform to other areas of the customer. This process has been successful.
We posit that the company has established itself as a key strategic partner for digital transformation in the IT function much in the same way Salesforce has done in the sales function. The market already considers ServiceNow the clear leader in ITSM based on product strength alone, as evidenced by its rapid ascension to approximately 40% market share. We see the adoption by nearly half of the largest 2,000 enterprises in the world as further support that it has built a disruptive and best-of-breed solution. Exceptionally high customer retention rates further demonstrate the strategic importance of ServiceNow’s offerings.
Tyler Technologies Should Be a Safe Harbor in Stormy Seas
We think Tyler Technologies is interesting during the current market volatility because it is an attractive mid-cap software stock we would focus on. We think an exploration of Tyler’s performance during the 2008 financial crisis is instructive, although the company has evolved since then. It is bigger now and has a much broader portfolio. One thing that has not changed much is the company’s target market for municipal governments, although its expanding portfolio allows it to target bigger cities and counties. In fact, since the crisis, Tyler is capable of serving and has landed deals involving states and even the federal government. As customer size has increased, so has deal size, and larger deals increasingly involve multiple solutions--both of which we think will continue for years to come. Overall, we continue to believe there is a decadelong runway for 10%-plus revenue growth at Tyler because of local governments’ need to modernize legacy enterprise resource planning systems, coupled with the firm’s strong position in this niche.
Tyler’s revenue performance remained robust throughout the 2008 financial crisis but eventually flatlined. Ultimately, the source of Tyler’s revenue is largely property tax receipts, which seem to move in only one direction: up. Further, Tyler has increasingly drifted toward a subscription and SaaS model since then, so we think there is some additional revenue insulation. Lastly, the company has introduced new recurring revenue streams that are transactionally recurring--e-filing of court documents (typically a few dollars to Tyler per document) and municipal website transactions (paying a water bill or buying a vehicle sticker, for example), which yield a percentage of the transaction price to Tyler as a fee. We generally view Tyler as a 10%-12% revenue grower, which includes a modest boost from acquisitions.
Revenue is also highly visible, with customer retention for core solutions in excess of 98% for more than a decade. Current deferred revenue is $412 million compared with our revenue estimate of more than $1.2 billion for 2020. Fourth-quarter software-only backlog was in excess of $1.4 billion. Taken together, we think this means that revenue for 2020 is largely known.
Adjusted operating margins increased throughout the crisis but finally succumbed to prolonged pressure and declined slightly in 2010. Adjusted operating margins grew as high as 30% in 2017, which briefly had management discussing a 40% margin target. However, a series of acquisitions as well as increasing SaaS adoptions pressured non-GAAP operating margins in both 2018 and 2019, which ultimately drove more than 100 basis points of contraction each year to about 25% in 2019. Management has let the transition to the cloud happen organically and still intends to do so. In the December quarter, 54% of new annual contract value came from SaaS. Our model shows margins approximately flat in each of the next two years, but we think margins will return to a historical cadence of 100 basis points of expansion annually once the model is normalized.
Tyler’s balance sheet is strong, with $272 million in cash and no debt. In the past, the company has used debt to finance acquisitions and tends to clean up its balance sheet pretty quickly. Free cash flow margin has averaged 21% over the last three years. We think these factors would allow Tyler to easily access the credit market in a disaster-case scenario, but we also do not believe it will come to that.
We view Tyler as having a wide moat arising from high customer switching costs and, to a lesser extent, intangible assets. We think the sleepy nature of local governments and Tyler’s clear leadership make its moat stable. Given that Tyler provides the core systems that enable normal operations of governmental units, including financial management, human resources, revenue management, tax billing, and asset management, coupled with an extremely slow-moving customer base and the typical long-tailed investment in such core software systems, we believe customer retention will be extremely high and that excess returns will more likely than not remain for at least 20 years. Critically, software companies tend to have low capital intensity and generate high free cash flow margins, which supports our contention for excess returns over a prolonged period. Further, high perceived friction from changing core systems is not theoretical, as Tyler enjoys among the highest retention in the entire software industry. This last point is important in that Tyler does not risk losing customers to mergers or acquisitions.
According to management, existing core systems at customer sites are at least 20 years old. Further, many customers are still operating on green screens with 50-year-old Fortran and Cobol-derived custom solutions. In these instances, the employees who have maintained these aging systems are retiring and there is no next wave of programmers who are fluent in computer languages that are no longer used. Even what might have been a smaller glitch could develop into a catastrophic system failure without proper maintenance and support. We believe that as many as half of the company’s wins are replacing such systems. Given that a vertical enterprise resource planning solution is mission-critical, we believe extending the life of legacy systems is no longer tenable. Tyler’s solutions, by contrast, are developed on Microsoft’s .NET platform using modern techniques, the interface is clean and simple, much of the functionality is available through mobile devices, residents can access local websites and complete certain transactions, and they are easier and cheaper to maintain than the legacy systems they replace.
Dan Romanoff does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.