The Computer Software industry is benefiting from continued strong digital transformation demand environment.
Software has become the focal point of technological innovation. The last few years have witnessed a series of breakthroughs in cloud computing, predictive analysis, artificial intelligence (AI), self-driving vehicles, digital personal assistants and Internet of Things (IoT), consequently setting the stage for strong growth in the software industry.
Moreover, continued enterprise investment in big data and analytics along with the ongoing adoption of Software-as-a-Service (SaaS) presents significant growth opportunity for industry players.
Notably, the cloud offers a flexible and cost-effective platform to develop and test new applications and the deployment time is also much shorter as compared with legacy systems.
Additionally, the increasing need to secure cloud platforms, amid growing incidences of cyber attacks and hacking, continues to drive demand for cyber security software.
Further, as enterprises continue to move their on-premise workload to cloud environments (emergence of hybrid cloud), application and infrastructure monitoring have gained utmost importance. This is creating more demand for performance management monitoring tools that are not only scalable but also suitable for cloud-based environments.
Industry Returns Positive
Robust demand for software and continuing innovations have been the key catalysts to consistent earnings and impressive sales growth. These are mainly behind investor confidence instilled in the Computer Software industry’s growth prospects.
The Zacks Computer Software Industry, within the broader Zacks Computer And Technology Sector, has outperformed both the S&P 500 and its own sector over the past year.
One-Year Price Performance
While the stocks in this industry have collectively gained 34.1%, the Zacks S&P 500 Composite and Zacks Computer And Technology Sector have rallied 13.7% and 19.2%, respectively.
We believe the near-term growth prospects are bright given increased spending by enterprises on software procurement.
Stretched Valuation a Concern
However, the Computer Software industry’s valuation looks stretched at the moment. One might get a good sense of the industry’s relative valuation by looking at its price-to-earnings ratio (P/E), which essentially shows how much an investor is willing to pay for each unit of earnings.
Notably, a lower P/E ratio is always better.
The industry currently has a forward 12-month P/E ratio of 26.65, which is close to the highest level over the past year.
The space also looks expensive when compared with the market at large, as the forward 12-month P/E ratio for the S&P 500 is 17.14 and the median level is 18.28.
Price-to-Earnings Ratio (F12M)
Moreover, a comparison of the group’s P/E ratio with that of its border sector ensures that the group is trading at a huge premium. The Zacks Computer And Technology Sector’s forward 12-month P/E ratio of 19.71 and the median level of 20.50 for the same period are way below the Zacks Computer Software Industry’s respective ratios.
Price-to-Earnings Ratio (F12M)
Improving Earnings Outlook to Drive Outperformance
Nevertheless, strong industry fundamentals and expectations of solid top-line growth should help Computer Software stocks continue generating positive shareholder returns in the near future.
Investors would also be eager to watch whether this group has the potential to perform better than the broader market in the quarters ahead. One reliable measure that can help investors understand the industry’s prospects is the earnings outlook for its member companies. Empirical research shows that a company’s earnings outlook significantly influences the performance of its stock.
One could get a good sense of a company’s earnings outlook by comparing the consensus earnings expectation for the current financial year with the last year’s reported number, but an effective measure could be the magnitude and direction of the recent change in earnings estimates.
The consensus earnings estimate for the Zacks Computer Software industry of $3.13 per share reflects solid year-over-year improvement. Moreover, the trend in earnings estimates revisions have been favorable of late.
Price and Consensus: Zacks Computer Software Industry
Looking at the aggregate earnings estimate revisions, it appears that analysts are gaining confidence in this group’s earnings potential.
The consensus EPS estimate for the current fiscal year has been revised 2.6% upward since Mar 31, 2018.
Current Fiscal Year EPS Estimate Revisions
Zacks Industry Rank Indicates Solid Prospects
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued outperformance in the near term.
The Zacks Computer Software industry currently carries a Zacks Industry Rank #63, which places it at the top 25% of more than 256 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.
Our proprietary Heat Map shows that the industry’s rank has continuously improved over the past five weeks.
Long-Term Growth Prospects Strong
The long-term (3-5 years) EPS growth estimate for the Zacks Computer Software industry appears promising. The group’s mean estimate of long-term EPS growth rate has remained steady since March 2018 to reach the current level of 11.89%. This compares to 9.8% for the Zacks S&P 500 composite.
Mean Estimate of Long-Term EPS Growth Rate
Computer Software’s long-term growth prospects are alluring. Growing adoption of hybrid cloud computing models, rapid usage of AI and machine learning tools, the proliferation of wearables & self-driving vehicles and increasing automation of the application development process bode well for the industry.
Moreover, the growing usage of Internet of Things (IoT) at home, in office, for cars and every other conceivable place is also an incredible business driver. These factors are expected to drive top-line growth that has gained significant momentum since the end of 2016.
Moreover, another indication of solid long-term prospects is the improvement in the group’s gross margin.
The role of software is evolving. Apart from running devices and applications, its usage is expanding in managing infrastructure. Moreover, the industry is significantly benefiting from the ongoing cloud transition.
SaaS companies are expected to register strong top-line growth due to a higher percentage of recurring revenues, subscription gross margin and a lower churn rate. Moreover, strong spending by enterprises is a positive.
Moreover, software companies are poised to benefit the most from Trump's repatriation policy. This enhanced liquidity is expected to boost their appetite for strategic acquisitions.
Despite stretched valuations, investors can build positions in the Computer Software industry based on the above-mentioned factors as well as strong earnings outlook.
Here, we list four stocks that have been witnessing positive earnings estimate revisions and carry a Zacks Rank #1 (Strong Buy) or 2 (Buy).
(You can see the complete list of today’s Zacks #1 Rank stocks here.)
ANSYS, Inc. (ANSS - Free Report) : The stock of this Pittsburgh, PA-based engineering simulation software and services provider has jumped 45.1% over the past year. The Zacks Consensus Estimate for the current-year EPS has increased 1.9% over the last 60 days.
Price and Consensus: ANSS
Citrix Systems, Inc. (CTXS - Free Report) : The consensus EPS estimate for this Fort Lauderdale-based virtualization, networking and cloud computing solutions provider has moved 8.2% higher for the current year, over the last 60 days. The stock has rallied 32.4% over the past year.
Price and Consensus: CTXS
Cadence Design Systems, Inc. (CDNS - Free Report) : The stock of this San Jose-based electronic product designing solutions provider has jumped 31.8% over the past year. The consensus EPS estimate for the current year has been revised 3.8% upward over the last 60 days.
Price and Consensus: CDNS
Adobe Systems, Inc. (ADBE - Free Report) : The stock of this San Jose, CA-based software solutions provider has gained 77.9% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 3.6% upward over the last 60 days.
Price and Consensus: ADBE
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