Economic uncertainty and the rise of AI mean the software sector is no longer a one-way bet. Which companies stand out?

by Arthur Sants

Big tech may be riding high, but there is still a lot of uncertainty in the software market. Valuations are highly sensitive to interest rate changes, which no one is able to predict with any accuracy. And while artificial intelligence (AI) has the potential to boost productivity, for some companies it could mean the destruction of their business. All this combines to create volatility – but also opportunity – for investors.

It is now two years since a sell-off took hold across the software industry. For years, scale had been viewed as the essential attribute for a software company, meaning businesses spent heavily in order to quickly add recurring revenue streams. This led to operating losses and, when interest rates rose, these high-growth businesses saw their share prices collapse.

Now, in 2024, a handful of profitable companies have emerged from the wreckage and are proving the resilience of their recurring revenue models. “The sector has always been a broad church of business models and end markets and so this variance is no surprise to us. It just means that stock selection is more paramount than ever,” Investec analyst Julian Yates said at the start of the year.

The most bullish investors had backed enterprise software shares in the expectation that they would be recession-resistant. The theory was that once a company got used to a certain type of software, it would be difficult for them to change providers. If a company’s employees all use Microsoft 365, for example, it is tough to convince them to switch to a different product. In short, businesses build up years of institutional knowledge that they are reluctant to throw away.

But Microsoft 365 and its many constituent parts (MS Excel and beyond) is one of the most successful enterprise software products ever made. While Microsoft has seen little harm from a period of slower economic growth, the past two years have tested the durability of smaller businesses and served as an acid test of how essential their products really are.

The average enterprise value (EV)/Ebit multiple for the UK software sector dropped around 35 per cent in 2022, with only the most defensive stocks – including Sage (SGE), Computacenter (CCC) and tangential picks such as Autotrader (AUTO) and Moneysupermarket (MONY) – able to protect their valuations.

End markets matter

By contrast, more cyclical stocks have struggled, in particular marketing software businesses. As companies were squeezed by inflation, marketing budgets were often cut back first. FD Technologies (FDP) provides a clear example of this. The business is split between its MRP marketing platform and its database product, KX, which can analyse huge amounts of data rapidly.

The difference in performance has been stark. In the six months to August, KX’s revenue grew 12 year on year and its recurring revenue was up 23 per cent. Meanwhile, MRP’s revenue fell 33 per cent, which saw the company as a whole post a loss of £4.5mn, having been in the black the year before. Management said customers’ marketing budgets “remain under pressure” but insists the business has stabilised in recent quarters.

Digital marketing platforms are largely driven by the growth or otherwise of the ecommerce industry, which has now slowed from its pandemic-era highs.

Dotdigital (DOTD) is a marketing platform that automates email campaigns and then collects data on their effectiveness. It hasn’t suffered quite as much as MRP, but profit growth has stalled. In the year to June, revenue growth was 10 per cent while operating profit was flat. This was a big slowdown from the 22 per cent revenue and 11 per cent operating profit growth in 2021 at the height of the pandemic.

Tougher times have hurt other sub-sectors, too: Spirent Communications (SPT)‘s share price collapsed last year. Its software is used to test telecoms equipment. Historically, this made it a cyclical business, because its revenue was directly linked to the big telecom companies’ capex investment. During the good times. they invested more in infrastructure; when things were difficult, they cut back to preserve cash flow.

WORKING OUT WHICH SOFTWARE IS A MUST HAVE IS EASIER IN SOME CASES THAN IN OTHERS

Again, there were hopes this cycle would be different. Numis analyst John Karidis previously argued that the underinvestment in 5G meant telecoms couldn’t afford to cut back in this cycle: 5G technology is much more complex, requiring more towers and more cables to connect to data centres.

It didn’t play out like this. Spirent warned on profits twice last year, and FY2023 revenue ended up dropping 22 per cent, while its order intake was down 24 per cent.

But not everyone agreed with the market valuation. At the start of March, US competitor Viavi (US:VIAV) made a 175p-a share-offer, which has been accepted by Spirent’s board. Even this came in below what Numis considered acceptable; Karidis said the bid “materially undervalued” the company and that its true value is closer to 240p.

The transition of the telecoms industry towards 5G isn’t yet benefiting Spirent, but there is value to be unlocked in related industries. Gamma Communications (GAMA) is confident it can prosper from a shift in practice by BT.

Gamma Communications’ software allows companies to make calls over the internet. In 2025, BT is switching off its public switched telephone network (PSTN), meaning analogue landlines will no longer work. Gamma is hoping to turn the some 3mn small businesses that still use PTSN into its customers. A forward price/earnings ratio of just 16, combined with this growth story and its strong free cash flow, makes it one of the most attractively valued software companies in the UK.

Sage leads the way

Working out which software is a must-have is easier in some cases than in others. Accounting software company Sage is a good example. The finance function is essential for any business and a change of suppliers carries more risks than it would in most other departments. But that alone is not enough: growth rates are also important, as are ensuring services keep pace with the modern world.

As the largest, and one of the older, software companies in the UK, there was a concern the business wouldn’t be able to successfully transition its legacy software, as well as thousands of small and medium sized customers, to the cloud.

However, Sage is now reaping the benefits. In the three months to December, its revenue grew 10 per cent year on year to £573mn, with its cloud business growing 18 per cent. Cloud sales now make up 79 per cent of the total. In the past year, its share price has risen 66 per cent, with its market cap rising to £12.5bn as a result.

The cloud business has been driven by the acquisition of US company Intacct. This took time – the acquisition was completed at the end of 2017 – but now North America is Sage’s largest and fastest-growing region. In the three months to December 2023, North American revenue rose 13 per cent year on year, and it now makes up 45 per cent of the total revenue, with 28 per cent coming from the UK and 27 per cent from Europe.

The only concern with Sage is that its share price growth has been outpacing earnings forecasts. This means that, in the past year, its valuation has expanded from 23 times consensus forward earnings to 33 times, which looks a little stretched for some. Broker Peel Hunt has downgraded the company from buy to hold, citing the fact that it was trading on the same forward earnings multiple as Microsoft.

US exposure helps

A US presence isn’t necessary for success, but it definitely helps, and not just because its economy is still growing faster than other developed countries’. In the past year, US healthcare software company Craneware (CRW) has benefited from the end of the pandemic as its hospital customers have been able to focus on investment again. Its software allows hospitals and pharmacies to analyse operational, financial and clinical data. In the US, where there are multiple payers for every treatment, being able to easily track this information is essential.

The pandemic slowed growth as hospitals focused on survival rather than productivity enhancements. But in the six months to December, Craneware’s revenue and adjusted Ebitda each rose 8 per cent, and its new cloud platform, Trisus, saw revenue increase from $1mn to $6mn. Promisingly, its customer retention remained above 90 per cent, which shows the sticky nature of the product.

Kooth (KOO) is another UK-based healthcare software company that is hoping to profit from the massive US market. Last summer, the mental health application won a $188mn contract with the state of California. The deal will run until 2027 and makes Kooth the primary vendor partner for digital mental health services to the golden state’s 6mn 13-to 25-year-olds.  As you can imagine with a contract this size – California’s gross domestic product (GDP) is larger than that of the UK – competition was fierce. Kooth was selected from more than 450 competing providers.

Meanwhile, the company is in the final stages of negotiating a contract with Pennsylvania, where it has been running a pilot programme since 2022. The consensus forecast among analysts is for revenue to rise to £69mn in 2024, more than three times the £20mn it made in 2022. Correspondingly, Kooth is expected to swing from a loss to earnings per share of 10.5p, giving a 2024 price/earnings ratio of 27.

IT services are the safest bet

Not all companies are dependent on specific end markets: some sell software indiscriminately. IT services businesses Softcat (SCT) and Bytes Technology (BYIT) don’t have their own product, but they do sell everyone else’s. If a company is looking to upgrade their digital capabilities, they will ask one of these IT services businesses to recommend and install products for them.

Margins are low but business is booming. While companies are

cutting back on products deemed less essential, companies are still spending on IT services. According to the Harvey Nash spending survey, 45 per cent of chief information officers are expecting a technology budget increase next year. “As a result, tightening economic conditions are not going to affect stocks in the sector equally, and there are going to be pockets of strong performance,” notes Investec’s Yates.

In the year to July 2023, Softcat’s gross invoiced income rose 2.2 per cent to £2.5bn, while its gross profit was up 14 per cent to £374mn. This growth might not seem like much, but these numbers were against strong comparators. In fact, since 2020, gross profit is up 58 per cent and management expects double-digit gross profit growth again next year.

Bytes Technology is benefiting from the same tailwinds as Softcat. Like Softcat, Bytes has Microsoft Azure expert status, which means it is one of its primary vendors in the UK. In 2021 and 2022, Bytes was named Microsoft partner of the year. Given Microsoft’s huge investment in AI through deals with OpenAI and Mistral, Bytes is in a strong position to help customers that want to integrate AI into their business by shifting to Azure, Microsoft’s cloud service.

THERE ARE STILL PLENTY OF GOOD TECHNOLOGY BUSINESSES LISTED IN THE UK MARKET

This has helped Bytes’ growth accelerate ahead of Softcat in the past year. In the six months to July, gross invoiced income rose 38 per cent to £1.1bn while gross profits rose 15 per cent to £75mn. A lot of this growth came from a couple of large “strategically important” contract wins from the public sector, with both the NHS and HMRC signing up to large Microsoft contracts. By contrast, Softcat had difficult comparators due to a large cloud computing contract that didn’t repeat in 2023.

Former chief executive Neil Murphy has claimed that Bytes’ prospects can be estimated just by looking at the growth rate of Microsoft Azure. If this is the case, then things look encouraging given Azure is returning to an annual growth rate of around 30 per cent. The rollout of Copilot 365, Microsoft’s new AI-enabled enterprise software product, should accelerate this growth, and Bytes said it is expecting strong demand in the coming year.

That said, last month Murphy had to step down because he “made a number of trades in the company’s shares that had not been disclosed to the company or the market in compliance with disclosure requirements”. Bytes’ share price dropped 15 per cent on the date of the announcement, and fell again this week as it announced an internal investigation into the matter.

The AI effect

Both Softcat and Bytes see AI as a tailwind for their businesses. If the technology proves as revolutionary as many expect, companies will be hurrying to update their IT systems and transferring their operations to the cloud where they can utilise their data. All of this will require advice.

But the impact AI will have on software companies on a case-by-case basis is less obvious. There is one argument that they, too, will benefit from lower costs. Microsoft AI coding program Github Copilot is already thought to improve coding efficiency by up to 20 per cent. “There are a lot of companies that could strip out costs and accelerate their product road maps,” Panmure Gordon analyst Alasdair Young told the IC.

The flipside of this is that IT advances like these will lower barriers to entry into the market, especially given software can now be built in the cloud, which already means there are minimal capital costs to starting a new business. “The small guys could build a platform because it costs them nothing, creating a lot more competition and eating into margins,” says Young.

One company some see as being in the crosshairs is Keywords Studios (KWS), which provides an outsourcing service for games developers and film studios. It helps companies with translation services, marketing and graphics. Last year, Goldman Sachs included Keywords in its AI ‘risk list’, and since then its share price has halved.

However, Young doesn’t agree that the company is necessarily in danger. Keywords’ strength is its relationship with all leading games developers and its geographic scale, with offices across the world. If it can leverage AI it could use it as a tool to boost profitability. “Keywords is a lot cheaper than it has been for a while and now it can use AI to train its tools more effectively,” Young says.

 Meanwhile, Investec has identified FD Technologies as a company that could integrate AI successfully into its business via its KX platform, which is effectively just a database that could be used to train an AI model. “One basic point of generative AI is its ability to make unstructured data useful,” Investec says. “We see GenAI as the ‘killer app’, at the top of all CIO priority lists, driving demand for data platforms.”

After years of share prices moving upwards across the board, the software market has become a more discerning place. The world will keep digitising, to the benefit of the IT services companies, but an uncertain macroeconomic outlook, coupled with the rise of AI, does mean investors are now aware that many of these companies will fail to ever scale effectively.

At the same time, the weakened market offers buying opportunities for shares of fundamentally good businesses such as Keywords Studios and Gamma Communications.

UK software companies are as cheap as they have been for years, and outsiders scent the opportunities. Viavi’s deal for Spirent is not an isolated case, even in the past six months. Blancco Technology, which sells software to wipe smartphones and servers so they can be recycled, was acquired by US private equity group Francisco Partners for a 25 per cent premium in December.

There are still plenty of good technology businesses listed in the UK market. If investors don’t recognise their value, there are a lot of US investors that are willing and able to look past the headwinds and do so themselves.

Lee R.J. Green   Cert.PFS