Software stocks will rebound from AI scare, says D.A. Davidson's Gil Luria

Key Concepts

• Software Valuations: Assessing the financial worth of software companies, shifting from revenue multiples to cash flow multiples.
• Recurring Revenue: A business model where revenue is consistently generated from ongoing subscriptions or contracts.
• Incremental Margins: The profit gained from each additional unit of sales, particularly high in software.
• AI Disruption Narrative: The market perception that Artificial Intelligence poses a significant threat to existing software companies.
• Investment Grade Debt: Bonds considered relatively safe with a lower risk of default.
• Debt Ratio: A financial ratio indicating the proportion of debt and equity a company uses to finance its assets.

Software Sector: Opportunities Amidst AI Fears & Oracle’s Debt Concerns

The discussion centers on the current state of the software sector, specifically addressing undervaluation despite strong fundamentals and concerns surrounding the impact of Artificial Intelligence (AI), as well as Oracle’s financial situation. The core argument presented is that the market’s negative sentiment towards software companies is largely unwarranted, creating buying opportunities for selective investors.

Software Fundamentals & Valuation Shift

Gloria, Head of Technology Research at Davidson, argues that software businesses remain fundamentally strong, characterized by recurring revenue and high incremental margins. She highlights a shift in valuation metrics, moving away from relying solely on revenue multiples (like 6x or 8x revenue) to focusing on cash flow multiples. Specifically, she notes that many well-performing software companies, growing at 20% or higher, are now trading at attractive price points – in the teens on cash flow, or the 20s on earnings. This represents a significant opportunity, as these companies are being penalized despite continued strong performance. The speaker emphasizes a selective approach, focusing on “the good ones” whose stock prices continue to decline despite positive business performance, anticipating a “rerating” once the current negativity subsides. A key point is the assertion that AI has not demonstrably disrupted any software company to date. The speaker questions whether AI will ultimately prove to be a disruptive force that differentiates between well-managed and poorly-managed companies, suggesting that investing in the former is a sound strategy.

Adobe: A Case Study in Undervaluation

Adobe is presented as a specific example of a company trading below its intrinsic value. Despite reaching an all-time high in the fall of 2021, the stock is now trading at levels seen in the fall of 2022. The bull case for Adobe rests on its resilience; its growth has only decelerated modestly (from 12% to 10-11%) despite the broader market concerns. This demonstrates the strength of its recurring revenue model, deeply embedded within marketing organizations and agencies. The stock currently trades at low teens multiples on earnings and cash flow, suggesting it is unsustainable for the price to remain depressed if Adobe maintains its 10% growth rate. The speaker attributes the negative sentiment to a narrative unsupported by evidence, noting that Adobe has not lost business to AI and doesn’t appear likely to do so in the near future. The argument isn’t predicated on a specific catalyst, but rather on the expectation that continued solid performance will eventually drive a re-evaluation of the stock.

Oracle: Debt Concerns & OpenAI Exposure

The discussion then shifts to Oracle, focusing on a bondholder lawsuit alleging malfeasance related to a $38 billion debt raise. The core issue is Oracle’s overextension in its partnership with OpenAI. OpenAI, according to the speaker, overpromised to multiple parties, and Oracle subsequently overborrowed to build infrastructure based on those promises. This has placed Oracle in a precarious financial position, approaching the bottom rungs of investment grade and nearing its debt ratio ceiling, while still needing to borrow more to fulfill its commitments. The consequence is a declining stock price and a discount on its debt. This situation highlights a broader concern: the potential for increased risk as companies repeatedly access the debt market to finance ventures, particularly those tied to speculative technologies like AI.

Logical Connections & Synthesis

The conversation flows logically from a broad overview of the software sector’s undervaluation to specific examples (Adobe) and cautionary tales (Oracle). The common thread is the disconnect between market perception and underlying fundamentals. The AI narrative is presented as a key driver of the negative sentiment, but the speaker consistently argues that this fear is overblown, particularly for well-managed companies. Oracle’s situation serves as a warning about the risks of overextending financially based on potentially unrealistic expectations.

The main takeaway is that the current market environment presents opportunities to invest in fundamentally strong software companies at attractive valuations. A selective approach, focusing on companies with robust recurring revenue and strong execution, is crucial. While acknowledging the risks associated with debt-fueled ventures, the speaker maintains a positive outlook on the long-term prospects of the software sector.