Software Ate The World. Now It’s Eating Itself

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Getty Images

Software companies have been the beating heart of the economy basically since the invention of the internet, but few moments in the group\’s history were as meaningful as the past 18 months. Any business that wanted to operate during the global quarantine needed robust remote-work capabilities, stretching from video conferencing to security, to off-site data management, etc. Adapt or die. Businesses adapted.

Alert investors sniffed this out pretty early on — cloud stocks didn\’t get hit as hard in the original Covid selloff, and bounced back 150% off the March lows. The CLOU ETF gained as much as 75% from its pre-Covid high, compared with the S&P 500\’s 39% advance from its pre-Covid record.

Now that same ETF is on the verge of a bear market, down 18% in less than a month.

Part of this reflects broader market weakness related to a more hawkish tone from the Federal Reserve, but a few huge earnings-driven selloffs in the sector also played a big role in the decline. DocuSign\’s 40% implosion was downright shocking, but Salesforce\’s

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10% dip is more important to assessing the future of this sector. Marc Benioff\’s venerable cloud giant reported 27% revenue growth and beat trailing estimates, but didn\’t give a strong enough outlook and the stock dropped back below its 2020 high.

It\’s important to consider the Salesforce chart because it\’s back at levels it hasn\’t traded at since last winter and early this year, when the price was trending downward as investors debated the merits of the company\’s $28 billion Slack acquisition. Few CEOs have a stronger M&A track record than Benioff, but Slack\’s competition with Microsoft

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, Zoom and Google

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is as fierce as ever. While there was plenty of demand to go around last year during the shock pivot into remote work, the amount of customers left to win over by each of these companies is smaller than it\’s ever been.

Morgan Stanley

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analysts had this on their mind when downgrading cybersecurity favorite CrowdStrike

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last month, saying they\’ll face challenges to pricing power going forward. Even if on the margin, it makes logical sense that pricing power for cloud companies will decline post-Covid, as the urgency of demand declines.

For years, a company\’s Total Addressable Market was all that mattered to investors. The all-important \TAM.\ The holy grail of buzzwords. Now after Covid, the remaining addressable market has contracted dramatically. With their new clients now locked in, these cloud companies are poised to make huge strides in profitability. But that\’s not why investors have been buying these stocks for so long. They\’ve been buying them for growth, and now that growth rate has peaked out.

To combat slowing growth, expect a lot of merger activity. Salesforce\’s Slackquisition last year is a testament to the need by even the finest players in this field to keep up the pace of growth that both public and private investors have become accustomed to. But growth by acquisition is more complicated, inorganic, and often brings short-term costs.

As an example look at another cloud darling, identity management specialist Okta, which rallied 1200% in the four years following its IPO through the high this February. The company spent $6.5 billion buying a smaller adjacent competitor, Auth0, in March. Shares declined on the news and never fully recovered, now down 25% off the highs. That\’s despite just last week posting an exemplary 61% top-line sales growth, its best since going public. Analysts expect the rate to decline going forward.

There are too many unprofitable software companies with overlapping customers and declining growth rates. Mergers are one way through. None of this changes the fundamentally compelling business models of these companies. In fact, it was just when the first Internet giants hit their stride that the dot-com stocks peaked. Today, deals of necessity are not being well received. Just look at when Zoom was considering buying Five9 — even though the deal fell through, neither stock reacted positively to the idea.

Marc Andreessen famously said \software will eat the world.\ He was right. Now, it\’s going to eat itself. That\’s not as bullish.