Morgan Stanley Sifts Through Software Sector, Flags 'Picks,' 'Holds'

Software stocks have seen an average pullback of 20% from their 52-week highs, as rich valuations and high ownership interest made them susceptible to macro volatility, according to Morgan Stanley.

Notwithstanding the pullback, Morgan Stanley does not see these software stocks as bargains, especially those with high multiples, but highlighted opportunities in growth-at-reasonable-price, or GARP, names.

The Analyst

Analyst Keith Weiss downgraded ServiceNow Inc NOW from Overweight to Equal-weight with a $267 price target.

The Thesis

Software spending growth is expected to decelerate into 2020, with a number of companies experiencing difficult comps into the back half of the year, Weiss said, citing the third-quarter CIO survey.

The analyst sees unfavorable risk/reward for a lot of high fliers in software. He said he sees continued opportunity in several areas of the software group,particularly in names with solid support from P/E, or EV/FCF multiples.

Morgan Stanley said it is buying into:

• GARP software names with durable earnings growth, thanks to largely ratable revenue base, such as Adobe Inc ADBE and Microsoft Corporation MSFT.
• Beaten-up software names such as New Relic Inc NEWR, Smartsheet Inc SMAR, Zendesk Inc ZEN and Twilio Inc TWLO
• FCF growth stories that are looking attractive at current levels, such as Twilio Inc TWLO and Palo Alto Networks Inc PANW. 

The firm remains sidelined on: 

• Companies with high multiples that are operating in a highly competitive environment, such as Zscaler Inc ZS, Slack Technologies Inc WORK and Zoom Video Communications Inc ZM
• Segments lower on the CIO priority list such as VMware, Inc. VMW and Citrix Systems, Inc. CTXS

Service Now, Atlassian, Citrix Trending

Service Now, Citrix Systems and Atlassian Corporation PLC TEAM are among stocks that are actively sought out.

ServiceNow is a best-in-class SaaS asset growing at 30%-plus, propped up by its $3-billion=plus subscription base, with superior unit economics and FCF margins, according to Morgan Stanley.

That said, the firm sees increasing near-term risks such as a CFO transition, tough comps and high expectations.

Atlassian — a  provider of products for improving software development, project management and collaboration — is scheduled to report its first-quarter earnings Thursday after the market close.

Analysts, on average, expect the company to report earnings per share of 24 cents for the quarter, up from 20 cents a year ago. Revenues are estimated to have risen 31.6% to $351.8 million.

The Price Action

At last check, the SPDR S TR/S&P COMPUTER SOFTWA XSW was edging up 0.1% to $95.03.

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