3 software stocks to watch in a booming industry

The Zacks Computer Software industry is benefiting from accelerating digital transformation around the world. Software is ubiquitous and has become the center of technological innovation. In addition to running devices and applications, its use has expanded to manage infrastructure. The sector mainly benefits from the ongoing cloud transition. The role of software is constantly evolving. With the continuation of remote working and the mainstream adoption of the hybrid/flexible work model, the demand for voice and video communications and productivity software is expected to increase exponentially. These trends bode well for industry participants Adobe ADBE, Sales team CRMs Cadence Design Systems CDNS. However, inflationary pressures and uncertainty about global macroeconomic conditions are worrying.

Industry description

The Zacks Computer Software industry includes companies that provide software applications related to cloud computing, electronic design automation (primarily for the semiconductor and electronics industries), digital media and marketing, customer relationship management, on-premises and cloud-based database management, accounting and tax purposes, management of human capital, cybersecurity and application performance monitoring and a cloud-based business communications platform. Some companies develop and sell simulation software (such as computer-aided design or CAD, 3D modeling, product lifecycle management or PLM, data orchestration, and experience creation), which engineers, designers, and researchers use in various industries, such as architecture, engineering and construction, product development, design , production and digital media.

3 trends shaping the future of the software industry

Higher software spending will help the outlook: The outlook for the sector is bright, given higher spending by companies on software purchases. Continued investments in big data and analytics and the continued adoption of software as a service or SaaS provide opportunities for industry players. Cloud provides a flexible and cost-effective platform for developing and testing applications. Implementation time is also shorter compared to older systems. SaaS companies are expected to achieve strong revenue growth thanks to a higher percentage of recurring revenue, subscription gross margin, and lower customer churn.

Adoption of cloud computing is gaining ground: The increasing need to secure cloud platforms amid increasing cyber attacks and hacking incidents is driving the demand for cybersecurity software. Apart from this, the rapid development of advanced technologies such as artificial intelligence, machine learning and the Internet of Things is leading to increasing use of advanced software applications. Enterprises are focused on rapidly migrating to the cloud and DevOps technologies to achieve scalability and flexibility for software development and IT operations. This helps provide customers with a flawless digital experience. This trend has provided tremendous value for monitoring application and infrastructure performance. It drives demand for performance management monitoring tools that are scalable and suitable for cloud-based environments.

Macroeconomic headwinds are a concern: Mainstream adoption of the distributed workforce model is driving demand for software solutions for business communications, workspace management, and human capital management. However, global macroeconomic weakness and volatile supply chain dynamics remain concerns. Rising inflation could impact the spending of small and medium-sized businesses worldwide. The uncertainty about business visibility could affect the sector’s performance in the short term.

Zacks Industry Rank indicates good prospects

The Zacks Computer Software industry is included within the broader Zacks Computer And Technology sector. It has a Zacks Industry Rank #46, putting it in the top 18% of over 251 Zacks industries.

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The group’s Zacks Industry Rank, which is the average of the Zacks Rank of all member stocks, indicates strong near-term prospects. Our research shows that the top 50% of Zacks-ranked industries outperform the bottom 50% by a more than 2-to-1 margin.

Looking at headline earnings estimate revisions, it appears that analysts are becoming increasingly confident in this group’s earnings growth potential. Since April 30, 2023, the industry’s 2023 earnings estimate has improved by 2.5%.

Before we present a few stocks you may want to consider for your portfolio given their strong prospects, let’s take a look at the sector’s recent stock market performance and valuations.

Industry outperforms sector and S&P 500

The Zacks Computer Software industry outperformed the broader Zacks Computer and Technology sector and the S&P 500 Index over the past year.

The sector gained 48% during the period, compared with gains of 13.3% and 35.2% for the S&P 500 and the broader sector, respectively.

One year price performance

Current valuation of the sector

Based on the trailing twelve month price-to-earnings ratio, a commonly used multiple for valuing software companies, we see that the sector is currently trading at 31.84x, compared to the S&P 500’s 19.09x. It is also above price-to-earnings ratio of 24.45x for the sector over the next twelve months.

Over the past five years, the sector has traded as high as 37.37x, as low as 22.63x, and at the median of 28.83x, as the chart below shows.

Future price-earnings ratio (P/E) over 12 months

Forward 12-month price-earnings ratio

Three software stocks to strengthen the portfolio

Adobe: Based in San Jose, CA, Adobe is one of the largest software companies in the world. The company receives licensing fees from customers, which make up the majority of its revenue.

Adobe is benefiting from strong demand for its creative products. The company’s Creative Cloud, Document Cloud and Adobe Experience Cloud products drive revenue. Rising subscription revenues and solid momentum within mobile apps are big positives. Growth in emerging markets and robust demand for online video creation remain the tailwind. Solid demand for Adobe’s commercial offerings and increasing adoption of Acrobat also bode well.

Adobe has a Zacks Rank #2 (Buy). You can see You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

The Zacks Consensus Estimate for Adobe’s fiscal 2023 earnings per share increased 0.1% over the past 60 days to $15.93. ADBE’s long-term earnings growth is 13.5%.

Adobe’s revenues surpassed the Zacks Consensus Estimate in each of the last four quarters, with an average surprise of 3.3%. Shares of ADBE are up 85.2% in the past year.

Price and consensus: ADBE

Sales team: Salesforce, headquartered in San Francisco, is the leading provider of on-demand Customer Relationship Management (CRM) software, helping organizations better manage critical operations such as sales force automation, customer service and support, marketing automation, document management and analytics, and development of custom applications.

Salesforce is benefiting from a robust demand environment as customers undergo major digital transformations. The continued focus on tailoring products to customer needs determines sales. Continued deals in the international market are another growth driver. The acquisition of Slack positioned the company as a leader in enterprise team collaboration and improved its competitive position against Microsoft Teams. Salesforce’s strategy to continuously expand its generative AI offerings will help the company tap into the growing opportunities in the space.

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Salesforce has a Zacks Rank #2. The company’s earnings for fiscal 2024 are pegged at $8.06 per share, indicating year-over-year growth of 53.8%. The long-term growth rate is set at 22.5%. The stock is up 50.8% in the past year.

Price and consensus: CRM

Cadence Design Systems: Cadence, based in San Jose, CA, offers products and tools that help customers design electronic products. The major electronic design automation software and services enable engineers to develop various types of ICs.

Cadence’s stock price is driven by healthy demand for its diversified product portfolio across all segments. Riding strong momentum, CDNS reported robust third-quarter 2023 results, delivering non-GAAP earnings of $1.26 per share, which surpassed the Zacks Consensus Estimate by 4.1% and by 18.9% year over year rose. Revenues of $1.023 billion surpassed the Zacks Consensus Estimate by 1.7% and rose 13.3% year over year.

Management has raised full-year expectations based on strong quarterly results. It highlighted that design activity remained solid due to transformative generation trends such as AI, hyperscale computing, 5G and autonomous driving. Management noted that there has been an increase in production of 3D IC and chiplet designs, and more systems companies are now building custom silicon, which bodes well. Cadence stated that its comprehensive JedAI GenAI platform witnessed continued growth, with sales of its GenAI solutions nearly tripling over the past year.

The stock has a Zacks Rank #2. The company’s consensus earnings estimate for 2023 is set at $5.11 per share, up 19.7% year over year. The long-term growth rate is set at 19.5%. Shares are up 63.6% in the past year.

Price and consensus: CDNS

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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.

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