Software companies were amongst the biggest drivers and beneficiaries of buoyant early-pandemic equity markets. This reflected their resilient business models, a durable software spending environment in the face of uncertainty and an acceleration in several secular growth trends aided by historically low cost of capital.
Russia’s invasion of Ukraine late last month has shifted the attention of governments, companies and investors away from the pandemic and towards this regional conflict with far-reaching implications for geopolitics and the global economy. Some of the consequences of the war may echo those of Covid-19, such as the threat to life for millions, significant supply chain disruption, back-pedalling globalisation and a potential economic recession. Other effects, such as mass migrations, accelerating inflation and interest rate rises, will present a very different macro environment to that navigated by software companies over the past two years.
The software ecosystem was extremely resilient through the pandemic, a characteristic that will be tested again.
The long-term impact of the war in Ukraine cannot be foretold. However, the software ecosystem was extremely resilient through the pandemic, a characteristic that will be tested again. Our detailed analysis of the last three years uncovers some interesting trends and traits that hint at why and how software businesses are best placed to weather this latest wave of uncertainty.
Arma Partners’ latest analysis of the three-year trading performance of 241 listed software companies (191 of which traded publicly pre-pandemic), from March 2019 to March 2022 inclusive, sheds some light on how to frame recent valuation volatility and anticipate its future trajectory.
A key headline is that broader software sector trading valuations remain at healthy levels, but the exuberance of the last two years had already largely been reined in even before the Ukraine invasion added further volatility. At 6x forward revenues, last month’s sector-wide valuation multiple was essentially flat on the early 2019 level, having fallen by a little under a third from its pandemic-era peak of almost 9x in February 2021, before contracting by another 15% in March. A more granular analysis of the data reveals highly varied performances during the bull run, subsequent sell-off and recent geopolitical instability.
Broader software sector trading valuations remain at healthy levels, but the exuberance of the last two years had already largely been reined in even before the Ukraine invasion added further volatility.
Perhaps the most obvious takeaway and a second headline is that the “growth at all costs” valuation theme, having been the driving characteristic of the rally in software stocks in 2020, has abated over the last 12 months, with investors now seeking a more balanced approach to growth and profitability.
We divided our 191 sample public software companies into ‘high-growth’ and ‘low-growth’ buckets – the former with annual revenue growth rates in the mid to high 20s, over twice that of the latter, which were growing at double-digit to low-teen rates. The ‘high-growth’ stocks exhibited significant volatility in valuation multiple, jumping from c.10x forward revenue pre-pandemic to a peak of almost 20x in early 2021, before contracting back to 10x in February 2022.
The “growth at all costs” valuation theme, having been the driving characteristic of the rally in software stocks in 2020, has abated over the last 12 months, with investors now seeking a more balanced approach to growth and profitability.
The market response to the Russia-Ukraine crisis appears to have continued the shift in investor sentiment away from “growth at all costs”.
By contrast, the ‘low-growth’ stocks stayed consistently flat at around 5x forward revenues throughout the past three years, peaking at just under 6x. The market response to the Russia-Ukraine crisis appears to have continued this shift in investor sentiment away from “growth at all costs”. The ‘low-growth’ stocks have suffered only a 6% fall in valuation multiple from February to March, compared to the 12% multiple contraction seen in ‘high-growth’ stocks.
A ‘Rule of’ analysis corroborates the narrative of the market moving to a more balanced assessment of companies’ value, as the gap between the top-performing Rule of 50% or greater companies and those performing below Rule of 30% has steadily widened over the past two years. Rule of >50% companies have enjoyed moderate multiple expansion compared to pre-pandemic levels, while Rule of <30% companies experienced 16% multiple contraction. We have seen a clear “rush to quality”, with insatiable investor demand for the limited supply of top-decile companies driving valuations even higher for those most coveted businesses.
We have seen a clear “rush to quality”, with insatiable investor demand for the limited supply of top-decile companies driving valuations even higher for those most coveted businesses.
A third headline from the analysis is the clear divergence in performance across different sub-sectors of software. Up until February, the winners, most notably, were those segments with strong long-term fundamentals for whom the transformative impact of the pandemic provided additional tailwinds.
In particular, digitisation of supply chains and various industrial verticals pushed up software valuation multiples in SCM and industrial tech by 65% and 40% respectively versus pre-pandemic. The rise of remote working fuelled a 36% multiple expansion in the valuation of software companies focused on collaboration and productivity. In a tight labour market, human capital management software providers saw their multiples expand by 27%. The necessary transition to telehealth and the security implications of increased digital activity also drove up valuation multiples of software providers in the healthcare and cybersecurity spaces by 18% each. ERP software, one of the highest valued sub-sectors pre-pandemic, essentially held its value, with marketing technology and customer experience software seeing modest contractions.
Companies in the collaboration and productivity segment have almost entirely erased the gains of the pandemic.
The Ukraine crisis is likely to reverse some of these trends and shift the focus to downside protection. Over the past month of trading, Security and ERP have been the standout sectors in resisting the industry-wide drop in valuations. The former has, unsurprisingly, gained from governments and companies’ focus on cybersecurity threats, with the latter benefiting from investors’ preference for mature market segments and scaled players. By contrast, companies in the collaboration and productivity segment have almost entirely erased the gains of the pandemic.
It is noteworthy also that a geographic breakdown, comparing North America with the rest of the world, did not indicate a pronounced shift towards either market during the pandemic or since. North American companies have consistently traded at a premium over their international peers, yet the gap between North America and the rest of the world, particularly Europe, has not significantly contracted or expanded post-pandemic or post-invasion, highlighting the truly global nature of these crises.
North American companies have consistently traded at a premium over their international peers, yet the gap between North America and the rest of the world, particularly Europe, has not significantly contracted or expanded post-pandemic or post-invasion, highlighting the truly global nature of these crises.
However, there was a clear delineation between mostly North America-listed mega-cap (>$100bn market cap) software companies and smaller listed peers. Whilst smaller software company valuations have declined in line with the broader market in the last 12 months, mega-cap company valuations have been significantly less impacted and remain 31% higher today than pre-pandemic average valuation multiples, indicating a premium for scale and stability.
The recent downturn in public markets has obscured several positive and enduring trends evidenced in this analysis. A closer look at three-year historical data would suggest that longer-term themes such as secular growth, digital transformation and strong business fundamentals, historically prominent features of software valuations, remain largely intact. If anything, Covid-19 shined a light on software businesses’ ability to thrive in uncertain times. Investors will continue to rely on this vital characteristic in the months ahead as the world navigates geopolitical instability, acute volatility, inflationary pressures and the humanitarian cost of the ongoing crisis in Ukraine.