Software Stocks Are Surging. Why the Gains Should Keep Coming. -- Barrons.com

Dow Jones
08 Feb

By Jacob Sonenshine

You can't keep software stocks down for long. The shares are surging after reaching a low last month, and they're likely to break new records soon.

The iShares Expanded Tech-Software Sector ETF -- which includes Salesforce, Microsoft, Oracle, Adobe, Palo Alto Networks, and Palantir Technologies -- has gained 9% to $105 from a multi-month low in mid-January.

The rally has cut through both macroeconomic and industry concerns.

On the macro front, President Donald Trump's tariffs on China put upward pressure on the price of imported goods, which could hurt U.S. consumer demand. China's retaliation also could hurt Chinese demand for American goods -- but none of this directly hurts enterprise demand for software.

For that to happen, any broader economic damage from the trade war would have to be particularly drawn-out and painful to cause companies around the globe to cut their technology budgets.

"Software is also more immune from potential tariffs than hardware [like chip makers] peers," writes Evercore strategist Julian Emanuel.

For the software business, the main concern is more about DeepSeek, the Chinese start-up that has said it is producing artificial intelligence software at a fraction of the cost for large U.S. software companies.

In theory, DeepSeek can sell its AI offering at a significantly lower price point, which could force U.S. companies to reduce their subscription prices and reduce the amount they invest. In reality, this hasn't dented the market's sentiment on these stocks.

First off, AI revenue still represents a small portion of total revenue for the large American software vendors. But DeepSeek's threat isn't even so dire right now. DeepSeek's AI is available on the Apple app store for consumers, while American software giants have spent years building up their enterprise offerings.

Fourth-quarter earnings reports across the board showed continued double-digit percentage sales growth year over year, while companies are still expected to invest gobs of money.

Amazon.com's earnings call, out Thursday evening, revealed the company's capital investments have been running at just over $100 billion annually, versus $83 billion for 2024, with management saying the investments are primarily geared toward improving the Amazon Web Services cloud segment. While Amazon isn't in the software fund because it is technically a consumer company, its AWS segment is relevant for investors to assess the state of U.S. software providers.

The result of all of these factors is the software fund is inching closer to its record close of $110, touched in December, as buyers keep coming in to support the price after brief declines. Expect the ETF to break out to new highs soon. That would come on the back of earnings growth, starting with growing demand.

Analysts covering companies in the software fund expect aggregate sales to grow 10% annually through 2027, according to FactSet. While that is a deceleration from 2024, it is still strong and should continue.

Some companies -- though not all -- are improving their AI offerings by moving them from "co-pilots" to "agents," the latter of which do tasks independently rather than just assist. Customers would pay higher prices for software subscriptions, supporting vendors' revenue growth.

That growth, should it meet or even exceed expectations, will power profit margins higher, pumping up earnings. On top of that, many U.S. software companies are large enough to buy back their shares, further pushing earnings per share higher. Analysts expect 17% annual EPS growth through 2027 to $3.80.

That means, by the end of 2026, the fund could trade at $141, for a just over 15% annualized gain. That price assumes the fund maintains its current 37 times multiple of earnings for the coming 12 months.

Even if the multiple drops, higher earnings would still push the fund higher. The software fund trades at just over 37 times expected earnings for this year versus the S&P 500's roughly 22 times, a slightly greater premium than the average for the past two years, which encapsulates much of the early AI boom.

As software growth inevitably slows, the multiple may slip, but even at the average 32.5 times multiple over the past two years, the fund would hit $123 by the end of 2026, for an almost 10% annualized gain.

Through all of the noise, stick with software stocks.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

 

(END) Dow Jones Newswires

February 07, 2025 15:55 ET (20:55 GMT)

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