The global software industry has become a mammoth force in the world economy. Industry revenues are estimated to be more than $500 billion in 2021 and the industry is forecast to grow +10% from 2021 to 2028. By any measure, software is one of the top secular growth industries and should be included in any growth stock investor’s portfolio.
The COVID-19 pandemic caused a surge in software spending in areas such as communications and ecommerce. The emergence of the “work from anywhere” phenomena has stressed corporate networks and increased the need for cybersecurity. Companies in these areas saw an associated spike in demand and sales last year. Global lockdowns resulting from the pandemic also stimulated demand for video games, many of which are played and delivered entirely online. In 2021, many back-office areas of business software, including ERP and CRM products, should see a pickup as economies re-open. The emergence of virtual implementations, particularly of cloud-based software-as-a-service (SaaS) offerings, should also help sales and deployment this year.
Despite this strong growth, the software sector as a whole is not overly expensive relative to its history. The IGV, the software ETF comprising 124 stocks that acts as a proxy for the overall industry, is forecast to grow revenues +16% and EPS +10% in FY22.
The industry is presently valued at 10.7x FY22 sales, in line with its long-term average. In addition, the software industry’s shift from perpetual or term license sales to a subscription model has meaningfully increased revenue stability. The percentage of software industry revenues from subscriptions rose from 36% in 2005 to 70% last year. I expect investors will reward this increased sales stability with a continued premium valuation for the industry.
Despite a tough upcoming comparison with June 2020 results, which could result in a slightly down Q2 2021 in terms of EPS for some software groups, full-year 2021 results are expected to be solid. Five sub-groups (Design, Desktop, Enterprise, Gaming, and Security) are expected to produce double-digit median revenue and EPS growth. Enterprise is expected to top the list with a median of 27% revenue and 18% EPS growth.
Investors are uncertain in the short run whether value stocks, driven by the economy’s recovery from COVID restrictions, or growth stocks, driven by low interest rates and a possible slowing of growth in 2022, will dominate the equity markets over the next three years. However, given its strong secular growth, the software industry should perform well. I believe investors should increase their exposure to software, and I’d like to highlight a few stocks with both strong fundamentals and positive technical setups.
DocuSign (DOCU; $58B market cap) provides cloud-based electronic signature solutions. Since its IPO three years ago, its TAM has doubled to $50B, mainly driven by expansion via acquisitions into eNotary, Contract Lifecycle Management (CLM), and Insight (Contract Analytics). As a rare software name to come to the market already profitable, DocuSign has since sustained excellent growth, with a five-year revenue CAGR of 40%, compared with 22% for its main competitor ADBE (Adobe Sign). The primary overall growth driver is a seven-year customer CAGR of 37%. As of Q1 2021, total customer count jumped 50% to 988K and in May surpassed 1M. Net dollar retention rate accelerated to 125% (+600bps y/y). The company sees 40% growth in revenues and double-digit operating margins for 2021, implying margin expansion of ~460bps. DOCU is expensive, at EV/S 26.7x and EV/EBITDA 119.4x, compared with EV/S 10.7x and EV/EBITDA 32x for the IGV (median). However, it is profitable and likely growing EPS at least 30% for the next two years. It is currently pulling back on light volume toward the pivot range ($290–306) from a 43-week consolidation, which it broke out of in June.
While leadership in the U.S. market has swung between Value and Growth this year, the trends propelling the software industry’s strong secular revenue and profit growth means that software stocks should be rewarding investments over the next several years. These names represent some of the leaders in this dynamic space and I encourage investors to consider them for their portfolio.
Kenley Scott, Director, Global Sector Strategist and Cornelio Ash, Director, Research Analyst at William O’Neil + Company, an affiliate of O’Neil Global Advisors, made significant contributions to the data compilation, analysis, and writing for this article.
No part of my compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed herein. O’Neil Global Advisors, its affiliates, and/or their respective officers, directors, or employees may have interests, or long or short positions, and may at any time make purchases or sales as a principal or agent of the securities referred to herein.