The software sector was enjoying impressive market performance last year – until the end, that is. A fourth quarter slump erased most of its 2018 gains and called into question the sector’s ability to weather a more volatile macro environment. We spoke with Gregg Moskowitz, Mizuho’s new software research analyst, to understand the fundamentals driving performance in 2019 and what he means when he says it’s a “new age” of software.
You launched coverage of the software sector this year under the macro-theme “The New Age of Software.” Can you briefly describe what that means?
Our “new age of software” expression is reflective of a few things. The first is that organizations are much more pervasively utilizing software to improve their businesses. In addition, we have seen the emergence of several very important technology trends that directly impact the software sector. And third, there has been a rapid evolution over the past few years with respect to the majority of software vendors’ business models.
What are the macroeconomic trends most heavily impacting the sector right now?
There’s a fair degree of macro concern to consider more broadly, primarily revolving around the impact of tariffs and whether there will be a hangover effect from last year’s tax cuts and deregulation that will create a tougher year over year comparison in 2019. Some investors also worry about an overall slowdown in global demand and spending.
Having said that, while we are focused on any potential changes in the macro environment, we’re confident that tariffs and tax cuts will not have any meaningful impact on software spending in 2019. And more importantly, there are a host of software companies that we define as secular winners, and for these companies we would generally expect continued strong growth and execution.
What is meant by “digital transformation” and how does it affect the software sector overall?
Digital transformation is the process of utilizing technology to change the way businesses work, both in terms of operations and culture. This includes helping organizations deliver an improved and personalized customer experience, which people increasingly demand in a cloud-first, mobile-first world.
Digital transformation has taken hold rapidly: three years ago it was a phrase that was rarely heard, but now the International Data Corporation (IDC) estimates that 60 percent of enterprises will have articulated an organization-wide digital-transformation strategy by 2020. Our checks indicate that the percentage is even higher among large enterprises.
What we’ve found from our research is that digital transformation is pushing companies across all industry verticals to spend more on software to drive incremental revenue, operate more efficiently, and ensure they are not falling behind the competition. We believe it is also the primary catalyst for the widening divergence between software spending growth and real GDP growth, and we expect that gap to continue to widen somewhat over time.
Where are we on the path to 5G? Why is 5G so important?
5G will deliver massive increases in bandwidth along with lower latency. Companies will also be able to prioritize traffic associated with key offerings, and that should drive additional revenue opportunities. Having said that, it's important to note this is a multi-year process and that we are in the very early innings, and as such we currently don’t expect to see significant 5G buildouts before next year.
Where do current valuations stand compared with historical averages?
Current valuations are roughly 25-30 percent higher than the historical 10-year average. It’s worth noting, however, that current valuations are roughly 10 percent off peak levels and, more importantly, we firmly believe this new age of software should translate to higher valuations than in prior years, all else being equal. We say that because digital transformation and the confluence of megatrends are driving meaningful incremental growth. In addition, a very significant transition across the software sector to subscription models yields greater recurring revenue and higher lifetime value per customer.
What are some of the key themes and trends to watch this year?
The six technology themes or “megatrends” to keep an eye on this year and beyond are public/hybrid cloud, artificial intelligence (AI), DevOps, mobility and the Internet of Things (IoT), containers – which is changing the way in which developers work - and 5G. We believe these themes are highly relevant to software and will help drive healthy growth in the sector for years to come.