3 'Resilient' Software Stocks for a Slowing Economy: Morgan Stanley

Three software industry leaders have the potential to keep boosting their revenues and stock prices, even as the economy slows. Tech companies including Palo Alto Networks Inc. (PANW), Salesforce.com Inc. (CRM) and Microsoft Corp. (MSFT) have a built-in stabilizer – nearly 80% of software sales on average are now recurring, and boast renewal rates over 90%. This should enable these tech players to rise at least 20% during a time of heightened market volatility, in which a larger number of investors are turning away from the once high-flying tech space to more defensive names. 

“Demand behind strategic digitalization efforts should prove durable even in a slowing macro environment, supporting growth for well positioned software vendors,” wrote Morgan Stanley in a recent report, per Barron’s.

3 Tech Stocks as the Economy Slows

• Palo Alto Networks; Stock Performance YTD: 6.9%
• Microsoft Corp.; 3.8%
• Salesforce.com Inc.; 8.5%

Sector With Earnings Resilience

At a time when the market is concerned over slowing earnings and sales growth, Morgan Stanley analysts argue that software earnings tend to be more resilient versus other industries. As for top line growth, analysts at forecasting these three companies to post double digit increases, thanks to the “relatively durable” nature of software revenue streams throughout economic cycles. Meanwhile, the average S&P 500 company is forecasted to see sales increase 5.3% in 2019 and 2020, a deceleration from 9.3% growth in 2018. Meanwhile, earnings are expected at 21.8% in 2018, followed by 6.5% in 2019 and 11.1% in 2020, per MarketWatch.

While earnings and growth prospects look strong for software companies, their valuations have also been beaten down significantly after a series of downdrafts starting last year.

More Attractive Valuations

“With the recent pullback, we see attractively priced opportunities in strong secular growers,” wrote Morgan Stanley’s Keith Weiss, noting that the sector’s valuation is near its historical averages. 

The iShares Expanded Tech-Software Sector ETF (IGV) has fallen 9.8% since the end of September through Wednesday close. The industry has been making a comeback in the recent period however, with the XSW S&P software and services ETF up 8.8% in two weeks, compared to the S&P 500’s 6.9% rally. 

Oppenheimer’s head of technical analysis Ari Wald is another software industry bull, noting in an interview with CNBC’s “Trading Nation” that “our overall macro view [is] that a premium is going to continue to get placed on these high-growth companies in a low-growth world." He recommends grabbing shares of Salesforce, Microsoft, PayPal Holdings (PYPL) and Adobe (ADBE).

Cloud Security Bet

Morgan Stanley highlights cloud cybersecurity company Palo Alto as a top pick, rating the stock at outperform. His $266 price target implies a 32% upside from current levels.

“With a solution portfolio expanding from the network to endpoints and into the Public Cloud—Palo Alto Networks leads in the race towards a comprehensive Intelligent Security Platform,” wrote Weiss. The analyst expects Palo Alto to grow its revenue by more than 20% per year.

Cloud Industry Leader

Cloud marketing pioneer Salesforce should see its shares grow 19.5% over 12 months to reach $178 as the firm continues to expand into its $200 billion end-market opportunity, according to Morgan Stanley.

“With a cloud-based platform automating and optimizing all stages of the customer life cycle, Salesforce.com looks best positioned to benefit from these initiatives,” wrote Weiss.

Wald echoed the upbeat sentiment on Salesforce, pointing to the the stock’s chart. 

Salesforce “made a higher low in December, while the rest of the market was selling off and fell to that extreme bottom," said Wald. "Now, as the market turns higher, you're starting to see Salesforce come out of the consolidation pattern it's been in,” said Wald.

Looking Ahead 

It’s important to note that a steep economic downturn might force customers to cut their demand for these software companies' products before other staples. Further, as is the nature of the tech space, even the most powerful and dominant companies are always vulnerable to sweeping changes in technology that threaten to upend them. That being said, legacy IT giant Microsoft may be the best long-term play, as they have shown that they know how to adapt in the face of disruption.