Being the backbone of the digital economy, it’s hard to see this industry doing badly over the long term. Some of these long-term trends are playing out this year even as concerns of a slowing economy looms large. The negative economic indicators, inflation and geopolitical tensions affect most players but some are better equipped than others to deal with the situation.
The industry usually trades at a premium to the S&P 500 because of its innovation-driven growth, but the past year has been something of an anomaly. With prices picking up gradually since January, there’s still time to find beaten-down stocks with better staying power or strong long-term potential. Our picks are Donnelley Financial Solutions (DFIN), Okta (OKTA) and Squarespace (SQSP).
About the Industry
The Internet Software & Services industry is a relatively small industry, primarily involved in enabling platforms, networks, solutions and services for online businesses and facilitating customer interaction and use of Internet based services.
Top Themes Driving the Industry
- The level of technology adoption by businesses also impacts growth. With some companies already reaping the benefits of artificial intelligence, others are scrambling to catch up in order to stay competitive. This is further accelerating the adoption of technology that can help collect and analyze data, whether on premise or in the cloud. Additionally, today we have many more cloud-first companies than ever before. Therefore, there is steadily increasing demand for software and services delivered through the Internet.
- The last few years have been tumultuous for the industry and the situation is likely to continue for another year at least. As the pandemic receded into the background, we were faced with record levels of inflation. And the Fed’s actions to control that is pushing us towards a recession. Additionally, the geopolitical tensions in Europe have a bearing on oil prices and supply chains, and therefore, also on large segments of the economy. Since the industry thrives on a strong economy that continues to do increasing levels of business, the outlook for 2023 is cloudy at best.
- The current instability in demand is increasing uncertainties for players. Since software and services are of varying kinds, some players did well during the pandemic while others did well during the reopening. Some offer a subscription-based model, which has led to relative stability, especially when the companies have critical offerings. The ability to retain subscribers and raise prices as necessary is proving to be the key to success in the current environment.
- The higher volume of business being operated through the cloud and the increasing demand for enabling software and services involves infrastructure buildout, which increases costs for players. This causes great fluctuations in profitability as new infrastructure is depreciated and fresh debt is serviced. So even for those players that have seen revenue growth accelerate as a result of the pandemic, profitability has remained a challenge.
Zacks Industry Rank Indicates Improving Prospects
The Zacks Internet – Software & Services industry is housed within the broader Zacks Computer and Technology sector. It carries a Zacks Industry Rank #98, which places it in the top 39% of more than 250 Zacks classified industries.
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates that the industry is coping better than many others. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.
The industry’s positioning in the top 50% of Zacks-ranked industries is because the earnings outlook for the constituent companies in aggregate is improving. The aggregate estimate revisions indicate that analyst opinion likely bottomed in January, with estimates for both 2023 and 2024 trending up since then. The group’s aggregate earnings are now down 3.2% over the past year while the 2024 estimate is up 11.4%.
Before we present a few stocks that you may want to consider for your portfolio, let’s take a look at the industry’s recent stock-market performance and valuation picture.
Industry's Stock Market Performance Remains Poor
The past year’s performance of the Zacks Internet – Software & Services Industry shows that it has lagged the broader Zacks Computer and Technology Sector, as well as the S&P 500 during this period. But while the discount to the S&P 500 is substantial, it has traded closer to the sector on occasion, which hasn’t had a great run in the face of current macro concerns.
The aggregate share price of the industry dropped 12.8% over the past year compared to the broader sector’s decline of 0.5% and the S&P 500’s decline of 0.2%.
One-Year Price Performance
Image Source: Zacks Investment Research
Industry's Current Valuation
While many of the individual players are still making losses, the industry as a whole continues to generate profits. Therefore, on the basis of forward 12-month price-to-earnings (P/E) ratio, we see that the industry is currently trading at a 33.44X multiple, which is an 8.38% discount to its median level of 36.5X over the past year. The S&P 500’s P/E is however just 18.15X (median value over the past year is 17.86X). The industry is also overvalued compared to the sector’s forward-12-month P/E of 22.37X. The premium to the industry at the median level is 71.7%.
The industry has traded in the annual range of 59.75X to 29.38X, as the chart below shows.
Forward 12 Month Price-to-Earnings (P/E) Ratio
Zacks Names "Single Best Pick to Double"
From thousands of stocks, 5 Zacks experts each have chosen their favorite to skyrocket +100% or more in months to come. From those 5, Director of Research Sheraz Mian hand-picks one to have the most explosive upside of all.
It’s a little-known chemical company that’s up 65% over last year, yet still dirt cheap. With unrelenting demand, soaring 2022 earnings estimates, and $1.5 billion for repurchasing shares, retail investors could jump in at any time.
This company could rival or surpass other recent Zacks’ Stocks Set to Double like Boston Beer Company which shot up +143.0% in little more than 9 months and NVIDIA which boomed +175.9% in one year.
Free: See Our Top Stock and 4 Runners Up >>Okta, Inc. (OKTA) : Free Stock Analysis Report
Donnelley Financial Solutions (DFIN) : Free Stock Analysis Report
Squarespace, Inc. (SQSP) : Free Stock Analysis Report
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
