Hard times for the software sector

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Wall Street’s powerful 2023 tech rebound has left a world of haves and have-nots: big tech companies that have recovered most or all of their steep losses from the year before, and a much larger group of smaller, once-hot stocks that have seen growth fizzle and are trading far below their peaks. Nowhere has that been more pronounced than in the cloud software industry.

The combined market value of the 70 companies in the Bessemer emerging cloud index — which includes names like Adobe, Salesforce and Zoom — soared from $1tr just before the pandemic to $2.7tr in November 2021. A combination of rock-bottom interest rates and strong digital demand, as customers were forced to buy online software and services to keep operating during the pandemic, sent so-called software as a service (or SaaS) companies into the stratosphere. 

For some, the post-pandemic hangover has been brutal. The index shed nearly two-thirds of its value by the end of 2022, before a near-40 per cent bounce last year as some of the biggest names rebounded. But the sector’s combined market cap is still $1.1tr down from the peak, with the losses heavily concentrated among smaller companies.

Two events this week have underlined the struggles of these once-hot companies, as they scramble to cut costs and find new sources of revenue in the aftermath of the pandemic boom.

Jeff Lawson, co-founder and chief executive of Twilio, a communications service that other developers “plug in” to their own apps, stepped down after months of pressure from activist investors.

Meanwhile, Carta, a private company that provides software to private tech companies to track their shareholder lists, shut down part of its business after it emerged some of its customer data was being used improperly. Shareholder data had been used to generate sales leads for the company’s high-margin broking operation — a business that has now been shuttered to avoid even the appearance of a conflict of interest.

These very different cases have at least one thing in common: the pressure to find new sources of growth has been intense as core businesses mature. Companies that stumble can expect a harsh reaction from investors.

During the pandemic, it was easy to believe that the markets for many cloud software products would be much bigger than previously thought. Companies with highly targeted services, such as DocuSign for remotely signing contracts, or identity management company Okta, thrived. But the boom turned out to be partly founded on digital purchases that had been brought forward from future periods, and a weaker economy has added to the sales slump.

At Twilio, growth has collapsed from more than 60 per cent in 2021 to an estimated 7 per cent last year. The pressure to diversify has been intense. But Twilio’s attempt to take on more powerful companies like Salesforce and Adobe has foundered, leading to calls for it to shed its new data and applications business. Meanwhile, Carta moved into a business that, its own CEO now admits, raised the perception of conflicts with its own customers’ interests.

It has also taken time to move past the “growth at all costs” mindset that set in when Wall Street was solely focused on revenue expansion. Both Twilio and Carta have been through three rounds of job cuts in the past year or so.

Tech buying trends have also been moving against them. Many customers these days are less interested in specialist, or “best in breed”, products and looking instead for suites of software from larger vendors, says Tomasz Tunguz, an investor in private software companies at Theory Ventures. That reflects a familiar pendulum-swing in the software industry as periods of rapid innovation give way to periods of consolidation. 

All of this has been taking place against the background of a turn in the interest rate cycle that has severely compressed the revenue and earnings multiples on high-growth stocks. The result has been a double whammy. Zoom, whose revenue jumped fourfold in the first year of the pandemic, is estimated to have grown only 3 per cent over the past year. Vanishing growth and higher rates have left its enterprise value at only around three times forward revenue, down from more than 40 at the peak.

No wonder this has been a feeding ground for bargain hunters. According to Tunguz, eight out of a selection of 70 of the most prominent software companies were taken private last year, including expense management concern Coupa and web tracking company New Relic. A stabilising economy and the prospect of lower US interest rates this year may relieve some of the pressure, but there is surely much more to come.

richard.waters@ft.com