Navigating the Software Transition

• Despite near-term macro, IT budget and contract renewal challenges faced by many software vendors, the secular outlook for the industry remains positive as companies continue to invest in digital transformation.
• While the emergence of generative AI has sparked debate and uncertainty, we believe long-term investors should focus on the fundamental value proposition of software in driving business efficiency and innovation.
• Recent insights from leading SaaS and cloud-based software companies underscore the resilience of the industry and the potential for ongoing growth and value creation.

The software industry is currently experiencing a period of transition, with many vendors facing near-term challenges related to macroeconomic headwinds, evolving customer demands and the rapid emergence of new technologies like generative AI. While these factors have contributed to volatility in the market, we believe it is important for long-term investors to maintain perspective and focus on the fundamental value proposition of software in driving business transformation.

A weakening economy, whether it turns out to be a slow-growth soft landing or worsens into a recession, has led to cautious spending by enterprise customers (large companies) and even more so among small and medium-size businesses (SMB). This has weighed on software valuations compared to the S&P 500 Index (Exhibit 1). Software vendors serving the SMB market, who had seen relative weakness in 2023, continue to see a deceleration in net expansion rates of customer contracts. Visibility into the trough of business demand remains low and in many cases is being pushed out into the second half of this year and beyond.

Exhibit 1: Relative Software Valuations Near Recent Lows

SMB is a more cyclical industry than enterprise, with software often more of a discretionary purchase. Tighter credit conditions due to higher for longer interest rates especially impact smaller businesses. Customers have also pulled back following overconsumption during the COVID-19 work-from-home period, while slower payroll growth broadly has hurt cloud software vendors. For this cohort, we expect challenging macro conditions will likely push a bounce back to the fourth quarter or into 2025. Moving up market to larger customers requires product focus, sales hiring and the right leadership. We view the SMB segment as very idiosyncratic and would focus on companies delivering the best execution.

On the enterprise software level, AI has distracted key decision makers and led to a diversion of attention and IT budget allocations. These trends have diverged based on the business model of each software provider, whether they be seat-based software-as-a-service (SaaS) or consumption-based cloud software vendors. SaaS contracts are based on individual users tied to a license with revenue recognized pro rata over the terms of the contract. Enterprise SaaS contracts often run for three years with vendors having experienced a stepdown in revenues upon contract renewal based on lower seat counts versus a few years ago. This is a bigger factor in stock price performance than we believe the market is currently appreciating. While SaaS vendors are cross-selling more services to their customers, those have not fully offset meaningful seat reductions.

A number of deals slipped at the end of this year’s first quarter, including several large deals for the larger SaaS vendors. This followed a stronger fourth quarter of 2023 that had caused some industry watchers to extrapolate that trend into 2024. Enthusiasm over the benefits of generative AI and pressure to keep up with competitors has led enterprises to reprioritize IT budgets, leading to a pause in software spending that has shown up in performance dispersion within the IT sector (Exhibit 2).

Exhibit 2: Software Trailing Semiconductors in AI Spending Binge

Consumption-based businesses include cloud vendors (Microsoft’s Azure, Amazon Web Services and Google Cloud Platform) as well as names like DataDog, Snowflake and MongoDB . Consumption models recognize revenue based on the amount of cloud resources consumed, typically in arrears. During the downdraft in demand after COVID, cloud vendors allowed customers to adjust contracts down accordingly and, therefore, have already endured much of the pain tied to slowing macro and optimization efforts.

We view cloud-based consumption as a better barometer of the health of the software industry as it provides real-time indicators of activity. Strong recent results from cloud vendors, then, lead us to believe that underlying fundamentals across the industry have been better than recent SaaS results suggest. AI offerings are just being rolled out for this cohort, which is leading to an acceleration in new bookings, a positive trend ultimately for forward consumption. At the same time, complicating matters, most cloud vendors have provided conservative forward guidance after being hurt over the prior 18 months by contract markdowns.

For both SaaS and cloud software vendors, the growing prominence of AI comes at a time when software contract expansions are slowing to reflect more gradual, normalizing usage growth following a COVID-induced spending binge. We believe these are transitory factors unlikely to disintermediate SaaS vendors such as Salesforce and Workday. In fact, many recent earnings disappointments have been driven by timing or push outs of deals as opposed to lost business. That said, most SaaS vendors remain uncertain on the timing of a rebound and could see further guidance cuts before stabilizing.

For SaaS vendors, following the pandemic era spending acceleration, we see seat reductions on three-year contract renewals as another headwind to enterprise vendors that has been underappreciated by investors. Customer headcounts have not grown at the anticipated low to mid-teens rate modeled by software makers. The first big contracts of the digitization wave were signed following the onset of COVID and when financial conditions were significantly more accommodative than today.

For enterprise vendors, additional crowding out and pausing of spending has occurred due to the actions of two large software vendors in particular. Germany’s SAP is gradually “end of lifing” prior versions of its software, leading to required upgrades to the latest versions of its software that shift from a perpetual license and maintenance model to a meaningfully higher recurring subscription fee (often 2x-3x the maintenance model). Broadcom, meanwhile, is doing something similar, and on fairly short notice, for the installed base of its recently acquired VMware cloud and data center management software business, inducing a shift from perpetual to SaaS subscription contracts, which also entail a meaningful uplift. VMware software dominates its market, leaving customers little choice but to upgrade. Both represent large ticket items and, we believe are likely having some interim “crowding out” effect in the marketplace.

Recent discussions with executives from leading software companies provide valuable insights into the current state of the industry and the long-term opportunities for growth and value creation.

Intuit, a leader in financial management and tax preparation software, recently announced significant price increases for its QuickBooks Online (QBO) offerings, particularly in the Pro and Advanced segments. While this move may impact near-term growth modestly, it also reflects the company’s confidence in the value of its products and its ability to drive long-term growth through a combination of pricing power and innovation. As Intuit continues to invest in new offerings like TurboTax Live, the company is well-positioned to capitalize on the ongoing digitization of financial services and the increasing demand for automated tax and accounting solutions.

Workday, a leading provider of cloud-based human capital management and financial management software, has recently acknowledged the impact of macroeconomic headwinds on its business, particularly in terms of longer sales cycles and increased scrutiny of deals. However, the company remains confident in its ability to execute on its long-term growth strategy, driven by its differentiated product offerings, strong customer relationships and ongoing investments in innovation. As more companies look to modernize their HR and finance functions in the cloud, Workday is well-positioned to capture a share of this market opportunity.

SAP offers modern enterprise resource planning and AI to unlock the power of huge troves of customer data housed within its systems, as well as a technology infrastructure layer to access and integrate that data with other digital systems. As a trusted enterprise vendor, customers are likely to leverage SAP data to improve their internal processes (such as financial closing, or settling accounts, at the end of accounting cycles, supply chain management and employee HR self-service, among a variety of potential use cases). SAP is on track to deliver over 100 AI use case templates that customers can more easily leverage on SAP’s next-generation platform by years end, helping to drive upgrade activity.

Mongo DB is a cloud-based database, offering customers the flexibility of modern data architectures as well as a one-stop shop for many forms of data management across unstructured and, increasingly, structured data. Moreover, MDB is slowly becoming a default play on GenAI, with the company’s new vector database likely to see strong future adoption by customers seeking to leverage GenAI across their existing applications and unstructured data assets. The company’s recently introduced relational migrator and new solutions, such as stream processing, should drive cloud consumption and compute levels higher, which in turn should drive revenues.

DataDog is a compelling platform for cloud enablement, offering a variety of tools and telemetry for better understanding and managing the performance of cloud deployments. A highly innovative company, DataDog enjoys strong viral adoption and is successfully expanding its product portfolio into security and other areas of cloud application and infrastructure management to solve key problems on behalf of their customers. The company should enjoy the growth tailwinds of rising penetration of its traditional cloud observability solutions, ongoing share gains, and expanding uptake of its growing portfolio of solutions, as well as growth in its customers’ underlying workloads.

Snowflake is a key player in data analytics and data management, offering data warehousing and advanced analytical solutions to its broad base of customers. As a destination for data in the cloud offering the easiest to use solution, the benefits of cloud portability and a logical place for integrating and sharing data within and across organizations, Snowflake should benefit from growing data volumes generally and from customers leveraging GenAI within its platform via new solutions just coming to market. A faster pace of new product introductions than we’ve seen from Snowflake since becoming a public company should drive consumption volumes and revenues in future periods.

At its core, the software industry is built on the premise of using technology to solve complex business problems, automate processes and drive innovation. Despite the current challenges, this fundamental value proposition remains intact, and companies across industries continue to invest in digital transformation initiatives to remain competitive in an increasingly data-driven and automated world.

GenAI, while still in the early innings of use case testing and deployment, is at the forefront of business transformation. Software-based AI adoption itself is facing some interesting headwinds but is poised to see continued adoption, albeit at a slower initial pace than originally expected. With the first half of the year behind us, we expect typical seasonality in software results to ensue following the latest round of larger than expected estimate cuts, bringing software to a two decade low versus semiconductors. The current situation is highly reminiscent of the early 2016 software selloff, which was followed by strong gains thereafter. It may take some time, but history suggests that the greatest AI value will be created at the software layer.

While the current software transition may be painful for some vendors in the near term, it is important for long-term investors to keep the faith in the transformative power of software and the ongoing opportunities for growth and value creation in the industry. By focusing on companies with strong product offerings, differentiated market positions and a proven ability to execute on their growth strategies, investors can position themselves to benefit from the long-term trends driving the industry forward. Ultimately, the software industry remains a critical enabler of business transformation and innovation, and companies that can navigate the current challenges and emerge stronger on the other side will be well-positioned to create significant value for their shareholders in the years ahead.