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Internet - Software Stock Outlook: Growth Prospects Abound

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The Zacks Internet software industry primarily comprises software infrastructure and application providers. The industry is benefiting from continued strong digital transformation demand.

The strong adoption of Software-as-a-Service (SaaS) cloud computing model presents significant growth opportunity for industry players. SaaS offers a flexible and cost-effective delivery method of applications and the deployment time is also much shorter than legacy systems.

SaaS attempts to deliver applications to any user, anywhere, anytime, on any device. It has been effective in addressing customer expectation of seamless communications across multiple channels, including voice, chat, email, web, social media and mobile. This is driving customer satisfaction that eventually increases retention rate.

Additionally, the increasing need to secure cloud platforms, amid growing incidences of cyber attacks and hacking, continues to drive demand for web-based 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 web-based performance management monitoring tools that are not only scalable, but also suitable for cloud-based environments.

However, increasing worldwide regulations related to data privacy, and data protection and accessibility do not bode well for the industry participants.

Industry Returns Positive

Robust demand for Internet software and continuing innovations have been the key catalysts to consistent earnings and impressive sales growth. These are mainly behind the investor confidence instilled in the Internet Software industry’s growth prospects.

The Zacks Internet 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.

While the stocks in this industry have collectively gained 33%, the Zacks S&P 500 Composite and Zacks Computer And Technology Sector have rallied 16.7% and 17.5%, respectively.

One-Year Price Performance


 

Stretched Valuation a Concern

However, valuation of the Zacks Internet - Software industry looks stretched at the moment. The industry primarily comprises growth companies that are investing heavily in research & development (R&D) to boost top line.

So, one might get a good sense of the industry’s relative valuation by looking at its price-to-sales ratio (P/S), which reflects how much investors are paying for each dollar of revenues generated by the company.

The Internet - Software industry currently has a trailing 12-month P/S ratio of 7.39, which is close to the highest level in the past year.

The space also looks expensive when compared with the market at large as the trailing 12-month P/S ratio for the S&P 500 is 3.49 and the median level is 3.37.

Price-To-Sales Ratio (TTM)


 

Moreover, a comparison of the group’s P/S ratio with that of its broader sector ensures that the Zacks Internet - Software industry is trading at a significant premium. The Zacks Computer and Technology Sector’s trailing 12-month P/S ratio of 3.72 and the median level of 3.67 for the same period are way below the Zacks Internet Software Industry’s respective ratios.

Price-To-Sales Ratio (TTM)


 

Steady Earnings Outlook to Drive Outperformance

Growing demand for cloud-based and software-only application services that can be deployed in any kind of environment (including virtual) is a major growth driver. The subscription-based business model ensures recurring revenues for industry participants.

However, what really matters to investors is 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 - Software Industry’s prospects for a solid price performance going forward is its earnings outlook. Empirical research shows that earnings outlook for the industry, a reflection of the earnings revisions trend for the constituent companies, has a direct bearing on its stock market performance.

The Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for it and the industry's aggregate stock market performance.

Price and Consensus: Zacks Internet Software industry


 

This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.

Please note that the $0.06 EPS estimate for the Zacks Internet - Software Industry for 2018 is not the actual bottom-up EPS estimate for every company in it, but rather an illustrative aggregate created by our proprietary analytics model. The key factor to keep in mind is not the EPS of the industry for 2018, but how this projection has evolved recently.

As you can see here, the $0.06 EPS estimate for 2018 has remained steady from the end of August.

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 Internet Software industry currently carries a Zacks Industry Rank #94, which places it at the top 37% 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.

Long-Term Growth Prospects Strong

The long-term EPS growth estimate for the Zacks Internet Software Industry appears promising. The group’s current level of 19.40% is much better than 9.83% for the Zacks S&P 500 composite.

Mean Estimate of Long-Term EPS Growth Rate


 

Internet software’s long-term growth prospects are alluring primarily due to the growing adoption of the SaaS-based cloud computing model. The increasing customer-centric approach is allowing end-users to perform all the required actions, while minimal intervention is needed from the software provider’s side.

Moreover, the pay-as-you-go model helps Internet Software providers to scale their offerings according to the needs of different users.

These factors are expected to drive top-line growth that has gained significant momentum since the end of 2013.




 

The affordability of the SaaS delivery model particularly for small and medium business is a major driver. Notably, the SaaS applications are easy to use. Hence, the need for specialized training reduces significantly, which significantly lowering expenses, thereby driving profits.

The improvement in the group’s gross margin is another indication of solid long-term prospects.




 

Bottom Line

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.

Despite stretched valuations, investors can build positions in the Internet 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.

Five9, Inc. (FIVN - Free Report) : This San Ramon, CA-based cloud software for contact center provider has returned 98.7% over the past year. The Zacks Consensus Estimate for the current-year EPS has increased 48.1% over the last 60 days. The stock sports a Zacks Rank #1.

Price and Consensus: FIVN


 

Paycom Software, Inc. (PAYC - Free Report) : The consensus EPS estimate for this Oklahoma City-based     Human Capital Management (HCM) solutions provider has moved 5.2% higher for the current year, over the last 60 days. The stock has rallied 101.7% over the past year and flaunts a Zacks Rank #1.

Price and Consensus: PAYC


 

F5 Networks, Inc. (FFIV - Free Report) : The stock of this Seattle-based Internet traffic management solution provider has jumped 62.7% over the past year. The consensus EPS estimate for the current year has been revised 1% upward over the last 60 days. The company has a Zacks Rank #2.

Price and Consensus: FFIV


 

Paylocity Holding Corp. (PCTY - Free Report) : The stock of this Illinois-based payroll and HCM software solution provider has jumped 72.5% over the past year. The consensus EPS estimate for the current year has been revised 35.6% upward over the last 60 days. The company has a Zacks Rank #2.

Price and Consensus: PCTY

 

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