2 Stocks of distressed and overvalued Internet software and services industry

The outlook for the software and online services industry looks negative according to the discretionary review trend over the past year, driven largely by the pandemic. However, some companies have been positively affected by the pandemic and the rush to digitization that has given rise to it. The diversity of players in this group is the reason for this dissonance.

As it is the backbone of the digital economy, it’s hard to see this industry doing poorly in the long run. However, the near-term outlook has deteriorated amid negative economic indicators, rising inflation and geopolitical tensions. To make matters worse, the rating is still high. Under the circumstances, none of the players look exciting, but we picked Squarespace SQSP and Verisign VRSN to take a closer look.

about the industry

The Internet software and services industry is a relatively small industry primarily involved in enabling platforms, networks, solutions and services for online businesses and facilitating customer interaction and use of Internet-based services.

The most important topics driving the industry

  • The overall impact of COVID has been mixed on the industry. Although it entailed working from home for employees, the industry, which is technology-centric in nature, has had relatively fewer problems with this. On the other hand, business continuity concerns have accelerated the shift to cloud-based work for many companies, while service providers, whether business-related or otherwise, have moved to internet-based channels. Another retail sector that has generated huge amounts of online business is retail. All of these moves were positive for the industry (in terms of revenue) and partly offset the negative impact of declining business in traditional players. At least some of the positives will persist after the pandemic. In others, a return to physical processes is still ongoing, hampered by new strains of virus, hypertrophy, and other concerns.
  • Geopolitical tensions in Europe affect oil prices and some supply chains, and thus also affect large sectors of the economy. Most experts fear that the Fed’s actions to contain inflation are pushing us into a recession. Since any improvement in the general level of economic growth improves the outlook for the industry, the current environment contributes to negative expectations.
  • The sheer scale of businesses that are powered by the cloud and the growing demand for enabling software and services involves building infrastructure, which increases costs for players. This leads to large swings in profitability as new infrastructure is amortized and new debt is serviced. So, even for players who have seen revenue growth accelerate as a result of the pandemic, profitability has remained a challenge. The current inflationary conditions are also a concern.
  • The level of companies’ adoption of technology and the proliferation of connected consumer devices that can help people connect and do business online is also affecting growth. The high prevalence of mobile devices among users and the necessity driven by the pandemic are prompting more companies to adopt the technology they turned away from earlier due to the cost involved. This is a positive for the industry.

Zacks Industry Ranking Indicates Challenges Continue

Zacks Internet – Software and Services Industry falls within the broader Zacks Computer and Technology sector. It holds a Zacks Industry Rating of #152, placing it in the bottom 40% of the over 250 Zacks industry rated. Our research shows that the top 50% of industries ranked by Zacks outperform the bottom 50% by a factor of more than 2 to 1.

The group’s Zacks Industry Rating, which is essentially the average Zacks rating of all member stocks, indicates that while the industry is recovering from the problems created by the pandemic, some problems remain.

The industry’s position in the bottom 50% of industries ranked on Zacks is because the earnings outlook for component companies in aggregate continues to deteriorate. Looking at the revisions to the aggregate estimates, it appears that analysts’ confidence in the group’s earnings growth potential for 2022 has been somewhat steadily declining since last July although flat in the past two months. Over the past year, average earnings estimates for 2022 are down 42.2%. Estimate for 2023 decreased by 39%.

Before we introduce a few stocks you might want to consider for your portfolio, let’s take a look at stock market performance and a recent valuation picture for the industry.

Industry stock market performance suffers

The performance of Zacks Internet – the software and services industry in the past year, shows that it has lagged behind the broader Zacks computer and technology segment, as well as the S&P 500 for most of the year. But while the discount on the S&P 500 is significant, especially in the past few months, it has been trading near the sector, which has not done well in the face of current macro concerns.

The industry’s overall share price is down 29.2% over the past year compared to the broader sector’s 21.0% decline and the S&P 500 down 6.9%.

Price performance for a year

Image source: Zacks Investment Research

The current valuation of the industry is rich

While many players are still making losses, the industry as a whole continues to profit. On a 12-month P/E basis, we see that the industry is currently trading at 44.7X, well below the 61.8X average over the past year. However, the P/E of the S&P 500 is only 18.0X (the median value over the past year is 20.2X). The industry has also been overestimated compared to the 12-month sector P/E multiple of 22.4 times (lower than its average over the past year).

The industry traded in the annual range of 78.0X to 41.7X, as the chart below shows.

12-month forward price-to-earnings ratio (P/E)

Zacks Investment Research
Image source: Zacks Investment Research

2 stocks worth a closer look

Squarespace, Inc. SQSPSquarespace operates a platform that allows businesses and creators to open an online storefront where they can manage their online presence and branding including across websites, domains, e-commerce operations, marketing, and scheduling. It also provides tools to manage your social media presence.

While the current environment is not ideal for stocks facilitating online commerce and digitization, this is certainly where the world is headed and where consumers and businesses (especially small and medium-sized enterprises likely to require their services) will wind up over the next few years. There is also a growing number who need to seamlessly coordinate their online and offline operations. Therefore, the long-term growth prospects for Squarespace are bright. However, near-term challenges remain which are likely to continue to pressure the stock.

Shares of No. 3 (Hold) Zacks have fallen 55.1% over the past year. The Zacks consensus estimate of a 2022 loss per share is down 16 cents (64.0%) in the last 60 days. The 2023 earnings estimate is also down 16 cents (66.7%).

Price and consensus: SQSP

Zacks Investment Research
Image source: Zacks Investment Research

VeriSign, Inc. VRSNVeriSign provides Internet infrastructure services, primarily including domain name registration services as well as infrastructure assurance services.

Verisign is benefiting from a growing trend in new domain name registrations as well as price increases of up to 7% pursuant to the Third Amendment to the .com registry agreement with ICANN and up to 10% in .net registrations. The static nature of businesses associated with digital transformation leads to relatively stable cash flows. However, like any other company, rising costs and the broader economic slowdown are affecting it as well. The competition from Google’s free public domain name service is also a concern.

Shares of Zacks No. 3 are down 8.3% over the past year. The Zacks consensus estimate for 2022 and 2023 EPS has not changed in the last 60 days.

Price and consensus: VRSN

Zacks Investment Research
Image source: Zacks Investment Research

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The opinions and opinions expressed here are those of the author and do not necessarily reflect the views and opinions of Nasdaq, Inc.

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