While the Morgan Stanley software research team is generally bullish on the outlook on software-as-service plays, they have turned cautious on Salesforce.com, the industry’s biggest player and pioneer.
The research firm issued several related research notes on the sector on Thursday.
Analyst Keith Weiss cut his rating on Salesforce shares (ticker: CRM) to Equal Weight from Overweight, while keeping his $275 price target.
Weiss asserts that at the company’s current growth rate, scale, and market cap, “an increasing focus on free cash flow and earnings is likely necessary for further price appreciation.” But he says that “subscription model dynamics and management’s growth philosophy may make that difficult near term.”
With a market cap of about $230 billion, Salesforce joins a software peer group that includes Adobe (ADBE), Intuit (INTU), and Microsoft (MSFT), “all stalwarts of the software industry, dominant franchises and leaders in their respective domains sustaining above market growth at scale,” Weiss writes.
But he notes those companies are valued primarily on a price/earnings basis by investors. “Given the current scale of Salesforce and a growth strategy heavily incorporating M&A, we believe a sharper focus on EPS growth will likely be needed to drive shares materially higher from here,” Weiss writes.
The analyst writes that he thinks the market opportunity supports a path for Salesforce to nearly $40 billion in revenue—about twice the current level—but that a “lack of confidence in significant margin expansion leaves us unable to push our current price target of $275 higher, balancing the risk/reward at current levels and pushing us to an Equal Weight rating on the stock.”
Meanwhile, Weiss’ colleague Stan Zlotsky issued a broad report on the software-as-a-service sector and finds a lot to like, despite elevated stock valuations. “We once again weigh the strong unit economics in software against multiples at all time highs, despite macro uncertainty,” he writes. “As efficient business models meet the improving demand into 2021, there is still plenty to like in SaaS.”
He writes that across the SaaS universe, “enterprise value appreciation this year has outpaced that of subscription bases, as potential unit economics improvements were hampered by the pandemic.” That’s a messy way of saying that the stocks have become more expensive.
That said, he sees “opportunities in a select group of names that reflect above average unit economics, as well as defensible valuations.” His picks include Box (BOX), DocuSign (DOCU), ServiceNow (NOW), Proofpoint (PFPT), Palantir Technologies (PLTR), TeamViewer (TMVWY), Veeva Systems (VEEV), and ZoomInfo Technologies (ZI).
Zlotsky argues that there are four reasons investors have been flocking to SaaS stocks in the current environment: The search for growth and strong secular positioning; improving unit economics and profitability; the defensive nature of sticky recurring revenue; and low exposure to both U.S. politics and geopolitical tensions.
“Ultimately, some of the best secular growth stories are in SaaS, and the pandemic has accelerated the pace of transition to the cloud and adoption of many different types of software to help companies work better in a distributed/virtual world,” he writes. “As the pandemic recovery unfolds, we believe the SaaS names we are highlighting are best positioned to capitalize on improving demand trends, with spring-loaded unit economics, to generate strong [free cash flows], with supportive valuations.”
Here are brief comments on all of the stocks Zlotsky is recommending:
- Box: “We see an opportunity for shares to move higher, especially considering improving unit economics and low expectations for future growth.”
- DocuSign: “We continue to see the company’s durable growth and strong unit economics as under-appreciated.”
- ServiceNow: Upgraded on Thursday to Overweight from Equal Weight. “A growing priority of workflow automation into 2021 combined with sustained investment in 2020 ahead of an expanding market opportunity that now spans across IT, customer service and HR delivery workflows well positions ServiceNow for durable 25%-plus revenue growth in the year ahead.”
- Proofpoint: “We continue to forecast ~30% free cash flow growth over the next 5 years…an under-appreciated asset.”
- Palantir: “Attractive risk/reward given the prospect of rapid margin expansion and accelerating growth ahead.”
- TeamViewer: “A leading player in the remote access, support and control markets.”
- Veeva: “A unique asset in software, given its combination of best-in-class unit economics and durable topline growth.”
- ZoomInfo: “Some of the most efficient unit economics across the SaaS group.”
In Thursday morning trading, Salesforce is down fractionally. ServiceNow is up 3%. Palantir, which has had a huge run since election day and which will report earnings Thursday afternoon, is down 5%, and most of the other stocks cited by Morgan Stanley have posted gains in the 1% to 2% range.
Write to Eric J. Savitz at firstname.lastname@example.org