Some software stocks may be even less desirable in a rebounding market

Some recent developments suggest the beleaguered software group of stocks may be coming back into favor, as I noted a couple weeks ago following positive responses to both Snowflake and Elastic. The interest in software is showing up again this week, with initiations and upgrades and downgrades on a raft of names. NOT EVERYONE’S A WINNER First, the bad news: Some software stocks may be even less desirable in a rebounding software market. Wednesday, J.P. Morgan’s Pinjalim Bora rejiggered ratings on three software stocks: C3.ai, which just reported positively on Monday; PagerDuty, which sold off last month on its rather mixed earnings report; and Sprinklr, which also had a downbeat report last week. In contrast to the exuberance around C3 at most shops, Bora is not impressed. He cut his rating to Underweight from Neutral, as the company’s “uneven and subpar growth-plus-margin performance leaves a lot to be desired, and it remains a big outlier compared to a broader base of peers trading at over 10 times FTM revenue.” I think Bora pretty much summed up what I said on Monday in being underwhelmed: tepid growth, rich stock price. PagerDuty is a little more surprising. Bora cuts his rating to Underweight as well because of rising competition. In case you don’t remember, PagerDuty makes software that allows a company’s IT team to know when computer systems are having issues, such as a system failure, and the software helps them take steps to remediate it. Lots of companies are coming into the market, threatening PagerDuty’s customer acquisition and potentially putting pressure on its pricing control, writes Bora. “We are observing a commoditization of the core on-call scheduling capabilities in the market,” he writes. “We are seeing large established vendors come into this space recently, in addition to the emergence of a large swath of startups in the space, most of which are entering the market as cheaper alternatives to PagerDuty.” Many of these new entrants are banking on the idea that “AIOps,” a focus on artificial intelligence and automation, is taking over PagerDuty’s market, Bora notes. For example, Bora says Datadog rolled out something competitive this summer called “On-Call,” and in the most recent earnings call the company said it was getting a “very strong reception . . . as customers are requesting On-Call as part of their deal.” Likewise, software maker Atlassian is directing customers to use its JIRA software for IT. There’s also progress being made in the open-source world, including something called Grafana. Bora notes an “explosion” of startups, as “the number of Incident Response vendors has gone from ~70 in the beginning of 2022 to ~100 as of now, with the number of vendors serving the enterprise doubling in that time period from 15 to 30.” For Sprinklr, Bora cuts his rating to Neutral from Overweight. The stock’s valuation is “undemanding at current levels,” he writes, namely, two times next year’s likely revenue. Still, he’s “moving to the sidelines” because the growth just isn’t there at the moment. “We await the emergence of a sustainable growth plus margin glide path over the next 12 to 18 months,” he says. SOME LONG-AWAITED AI PAYOFF Thursday, Macquarie Research’s Steve Koenig started coverage of six companies, including Datadog and Atlassian, but also Salesforce, Autodesk, GitLab, and MongoDB. Koenig’s overall theme is that these vendors are poised to finally get some of the artificial intelligence payoff investors have been waiting for. He sees the “accelerating cloud revenue trends at major hyperscalers” as something that “bodes well for software, as customers have largely worked their way through cloud spending optimization efforts and are investing in digital transformation, cloud migration, and AI.” AI is no longer just about Nvidia’s chips: “AI investments are flowing upwards in the stack, from GPUs to infrastructure-as-a-service (IaaS) to platform-as-a-service (PaaS) and applications,” writes Koenig, referring to two cloud-based software categories. Koenig likes Autodesk, Datadog, and GitLab, rating them each Outperform, and slaps a Neutral rating on the other three. GitLab is Koenig’s “top pick” based on “our perception of a significant valuation discount and catalysts that could include FY26 revenue outperformance, margin expansion, improving Rule of 40 scores, and strong FCF generation.” The company is past the worst of the macroeconomic headwinds in its market for developer tools, he writes. And the valuation, at 10.8 times the next 12 months’ projected revenue, is a 28% discount to what he thinks it should be,  which is 13.8 times. That is “the seventh-largest discount in our 40-company growth software index,” he notes. Datadog has “near-term catalysts that could include significant FY25E revenue outperformance as the year progresses,” Koenig says. For instance, the company’s “moves to embrace AI provide exposure