Francesco Lavecchia: Welcome to Morningstar. I’m Francesco Lavecchia and today I’m in the company of Morningstar equity analyst and software industry expert Dan Romanoff.
Dan, reading the latest quarterly reports from many software companies, I’ve identified a few commonalities that I’d like to discuss with you to get a big picture of what’s happening in this industry. The first thing I’ve highlighted in your comments is the bad macro environment that’s affecting quarterly results. Can you explain the reasons why it’s having such a strong impact on the sector and which, in your opinion, are the most exposed companies?
Dan Romanoff: Thanks for the invite. With regard to macro factors, the strengthening of the dollar weighed on the sector’s growth rate by approximately 500-600 basis points. A considerable impact, the strongest in the last 20-25 years. In this case, it is an artificial obstacle to the growth of the sector which should, however, normalize in the short term.
In fact, already in the last few months we have started to see improvements in this sense. There are also other macro factors at work such as inflation, which reduces the purchasing power of customers, making it more difficult to finalize commercial deals and slowing down purchases. There are also problems of a geo-political nature, such as the war in Ukraine, which in some ways has helped to slow down demand in Europe. Add to this the fact that energy costs have risen dramatically, which has hit Microsoft and Amazon in particular.
What has happened is that the industry has experienced an artificial increase in demand during the first phase of Covid-19 and a subsequent attenuation of the same following the normalization of the pandemic. This has made the industry’s latest results look worse than they actually are. At the same time, the shares of these companies have performed strongly in 2020 and 2021. So, the fact that 2022 saw a slowdown in growth in the sector makes the overall picture look more negative than it is.
FL: Another common element is the high number of playoffs. Many companies are cutting their workforces, but in your latest report you argue that the sector will be supported by positive factors that will drive growth in the long term. Can you explain to us why we are seeing all these playoffs and what are these positive factors you speak of?
DR: In the last six months, more than half of the companies I cover have decided to implement a reduction of staff and a rationalization of their operating structures in order to achieve better cost management. Some companies like Salesforce, Shopify, RingCentral and Twilio, to name a few, have cut staff by 10%. Other major companies like Microsoft and Amazon have reduced their workforces by almost 5%.
What has happened is that during the acute phase of Covid we have seen a surge in demand. Companies have assumed strong growth in the sector and therefore have started to hire personnel, for example in customer service and sales. In the post-Covid period, however, we are seeing a slowdown in demand and many companies have discovered that growth in recent years was artificially high and is now normalizing. So those companies that had been hiring so aggressively are now downsizing. This is a short-term issue, but in the long-term I think the software industry is very attractive.
I believe the difficulties of this period are not dictated by a deterioration in demand, but rather by short-term macro factors, even if they could persist throughout 2023. There are actually many elements that make us positive about the software industry. From a Moat point of view, these companies are able to build a position of competitive advantage. No business could function without software. Furthermore, in a phase in which rationalizing costs is very important, software allows companies to increase employee productivity. From a fundamental standpoint, software companies tend to have strong balance sheets, low leverage, good liquidity, and generate high cash flows. This allows them to operate normally even in a recessionary context. For these reasons I am optimistic about the software industry in the long term.
FL: The last question concerns artificial intelligence. Given Microsoft recently announced a 10 billion dollar investment in OpenAI, can you explain what plan Microsoft has for this market and what other companies are investing the most in AI?
DR: Many companies in the software industry have been investing in artificial intelligence for years. Even among those analyzed by me there are several companies that have introduced this technology to help users with routine tasks and have made it a brand, as in the case of Salesforce with Einstein, for example. But Microsoft, Amazon and Apple have also adopted artificial intelligence to help users in some operations, but as this technology becomes more powerful, its applications will also increase.
With regard to Microsoft, the company has invested ten billion dollars in OpenAI, although management did not specify the sum but spoke of a multi-billion dollar investment. This deal makes Microsoft one of the leading candidates for industry leadership, alongside Amazon and Google, and I believe that as customers become more comfortable with this technology, its use will increase and this will drive Microsoft’s revenue growth not only for effect of the increase in the number of users and software licenses, but also thanks to the launch of new products and the increase in the price of existing ones that will incorporate the new technology in the future. I also think that there could be even greater developments for artificial intelligence, although it will depend on how its adoption evolves.
FL: Very good Dan, thank you very much for your time. For Morningstar, I’m Francesco Lavecchia. Thanks for watching.