How software investors should view the AI 'tsunami' as chip stocks outperform

By Emily Bary

Jefferies thinks software investors should stay choosy as they wait for the sector's AI windfall to take shape

Chip stocks have been crushing software stocks so far this year, and a Jefferies analyst thinks it will take more time for investors in the latter to see the financial benefits of artificial intelligence.

About half of software companies so far this earnings season have issued outlooks below consensus expectations, noted Jefferies analyst Brent Thill. And while the 5% year-to-date rally for the iShares Expanded-Tech Software ETF IGV is "a decent start," the VanEck Semiconductor ETF SMH is up 29% - a gap in performance that he attributes to "overzealous AI expectations, which seem to be coming back to reality" in software.

See also: AMD's AI story is 'unfolding fast.' This bull sees a 25%-plus stock gain ahead.

Chip companies are having their moment right now as AI starts translating into meaningful revenue contributions. Software players could see a similar dynamic eventually, but Thill said over the weekend that it will take some time for that story to manifest: "We believe the AI [revenue] wave hits in [the second half of 2024] and into '25, and investors want to be selectively long AI beneficiaries ahead of this incoming tsunami."

His top picks among large-cap software stocks are Microsoft Corp. (MSFT), Intuit Inc. (INTU), Adobe Inc. (ADBE) and Salesforce Inc. (CRM).

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AI isn't the only thing that can drive software stocks higher. Thill notes that the "next leg up" for software would require that valuations stay reasonable, as right now software stocks are trading at an average valuation a bit below their eight-year average, though above that average when factoring out the COVID-19 period.

Additionally, Thill will be watching for a more dramatic pickup in the macroeconomic environment and an increase in merger activity.

Evercore ISI analyst Kirk Materne took a similar view in a weekend video sent out to clients. Software stocks "probably got a little ahead of themselves," and he agreed that the generative-AI growth benefits weren't likely to start hitting until the second quarter.

"Enterprise spending is stabilizing, but going from first gear to fifth gear in enterprise takes some time," he wrote in an accompanying report.

Materne continues to like shares of Microsoft, outlining in a note last week that the company could reap more than $82 billion in incremental revenue from generative AI, come calendar 2028.

"To be certain, there are still a lot of unknowns as to the extent of gen-AI monetization across Microsoft's business over the long term, but we continue to believe that the impact of AI will ultimately cut across every industry in every geography, and Microsoft is uniquely positioned to significantly benefit from this generational shift in computing, especially in the commercial market," Materne wrote at the time.

-Emily Bary

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03-11-24 1653ET

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