Macquarie's 2022 in Software: Re-rating lower but still bullish on growth
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Macquarie's look-ahead to 2022 in U.S. Software stocks isn't departing too far from conventional wisdom: The names are ripe for re-rating in the rising interest rate/falling stimulus environment, but the firm is staying constructive while "broadly" reducing valuations.
"We are no strangers to volatility in software, and we firmly believe our sector offers high quality, compounding growth opportunities," analyst Frederick Havemeyer says. "However, we recognize that the financial backdrop has shifted."
That means a few different approaches to the sector, the firm notes. It's introduced a "Growth-Valuation Curve" to see what the growth appetite is - and finds the curve flattened year-to-date (in other words, smaller premiums for hypergrowth), though it's still above 2019.
Volatility also means shifting its valuation approach to discounted cash flow, a more "rigorous and conservative" stance rather than the relative valuation it used in key cases.
Interest rates are just one of seven trends it thinks are driving U.S. Software stocks. Another: "We believe automation software is an arms race with the disintermediation of users at stake." Software-as-a-Service names will largely defend their walled gardens, the firm says, and consolidation made simple automations "table stakes."
The best-positioned SaaS stock for that battlefield is ServiceNow (NYSE:NOW), it says. But it's also upgrading UiPath (NYSE:PATH) - a "best-of-breed automation pure play" - to Outperform.
Talent shortages combined with the digital transformation means developers have more power than before, and companies will benefit from addressing those demographics, it says; best positioned: Atlassian (NASDAQ:TEAM), MongoDB (NASDAQ:MDB) and Twilio (NYSE:TWLO).
The future-of-work debate has been largely settled in favor of a hybrid/remote work environment, the firm says, which should support demand for collaboration/connectivity software.
This year should also bring a multi-year re-acceleration in IT spend as small businesses undertake a "digital renaissance." There, it believes that Datto (NYSE:MSP) is in the best position.
Rounding out the key trends it's following, "Digital-first customer engagement was normalized in the West due to the pandemic. We now expect AI to ubiquitously augment human communications, and we look to Asia for the future of B2C engagement." And it says ESG will shape software as the companies get into position to attract the funds and compete for younger, ESG-conscious talent.
The firm acknowledges its bullish stance may raise questions (with the upgrade to UiPath, it has no Underperform ratings and only one Neutral, on Appian (NASDAQ:APPN)). But it says it's been "selective," choosing only the best-of-breed representatives, and it's confident in the new valuation research.
Highlighted stocks to watch in the sector are ServiceNow (NOW), Atlassian (TEAM) and Datto (MSP). As mentioned, it's upgraded UiPath (PATH) to join almost every other stock in the sector at Outperform, and it's shifting its valuation approach to DCF from relative valuation on MongoDB (MDB), nCino (NASDAQ:NCNO) and Atlassian (TEAM).
And its broadly cut price targets, though considering the sector's performance, that still leaves room for healthy upside in particular cases. Notably, a target cut on 2U (NASDAQ:TWOU) to $33 from $55 still implies 124% upside from Tuesday's close. A new target for PowerSchool (NYSE:PWSC) trimmed to $24 from $37 implies 72% upside. And a target for Pegasystems (NASDAQ:PEGA) cut to $150 from $172 still implies 54% upside.

ServiceNow is expected to report earnings Wednesday after the closing bell; consensus expectations are for EPS of $1.43 on revenues of $1.6 billion.