Another Bad Sign for Tech Stocks—Cloud Spending Is Fading
The move to cloud-native software was supposed to be unstoppable. But this past week, we learned even the best secular trends have their limits and aren’t completely immune to a slowing global economy.
For much of this year, enterprise spending for cloud projects held up better than consumer-oriented end markets. Many analysts expected demand to remain robust because the shift to the cloud from legacy on-premise technology offered real cost savings, better reliability, and flexibility.
But corporate demand seems to be faltering. On Wednesday, Salesforce CRM –1.66% (ticker: CRM)—the market leader in sales and marketing cloud software—disappointed investors by forecasting less revenue than expected for the current quarter. Fiscal third-quarter billings, a metric viewed as a leading indicator for future revenue, also fell short of Wall Street consensus by nearly 10%, coming in at $6.21 billion, representing year-over-year growth of just 5%.
Beyond the softening financial numbers, Salesforce’s commentary about business trends and the economy were worrisome. On the earnings call with analysts and investors, Salesforce executives said that as the third quarter progressed they began to see a “more challenging buying environment,” with customers increasingly scrutinizing every dollar spent for its return on investment.
While not as bad yet, co-CEO Marc Benioff compared the current buying behavior and uncertainty among clients to what he saw in prior financial crises in 2001 and in 2008-09. Another executive said the company would take a “hard look” at its cost structure, which could mean further expense cuts and staff reductions in the future. Either action would mean the company isn’t expecting a return to higher growth soon.
Salesforce wasn’t alone. Earlier in the week, cloud cybersecurity firm CrowdStrike Holdings CRWD –0.06% (CRWD) provided revenue guidance below the consensus for the January quarter. The company’s net new annual recurring revenue for the fiscal third quarter also missed estimates by about 8%.
CrowdStrike CEO George Kurtz was downbeat in a call with investors, saying smaller companies were taking longer to pull the trigger on purchases as recession fears grew during the quarter. CrowdStrike now expects corporate customers to be more hesitant to spend in the coming months, even if they have budget left over for the year.
In assessing the latest software earnings, J.P. Morgan analyst Mark Murphy noted the stark change in tone from the industry. “The macro appears to be worsening and most of the cautiously optimistic language that was present...in the July time frame, also appears to have evaporated,” he wrote in a note to clients. “We don’t think any vendor will be immune.”
CrowdStrike and Salesforce investors reacted accordingly to the disappointing numbers. CrowdStrike shares tumbled 15% the day after it reported earnings, and Salesforce stock fell 8% following its results.
The reports added to a difficult year for the cloud sector. The WisdomTree Cloud ComputingWCLD –0.95% exchange-traded fund (WCLD), which tracks the performance of an index of cloud-computing software and services companies, has declined 50% this year, compared with the 15% drop for the S&P 500SPX –0.12% .
Shares of CrowdStrike and Salesforce are both down roughly 40% year to date.
Given the big drops, investors may be tempted to go bargain hunting. That may not be a good idea. First, while valuations may be lower than they were in the past, they are still high on an absolute basis given the anemic growth outlooks. Salesforce now trades at 27 times next year’s earnings estimates, but Wall Street expects revenue growth to slow to under 10% over the next two quarters. Not an attractive combination.
Second, cloud-software names face the prospect of downward earnings revisions that could make the stocks more expensive on a price/earnings basis. CrowdStrike trades at more than 60 times next year’s analyst earnings estimates. If the profit outlook deteriorates, the valuation would surge higher.
The high valuations and the latest round of weak data points around corporate spending aren’t the only negative factors. There was another signal this past week that a quick upturn isn’t imminent: Alongside its earnings, Salesforce announced that co-CEO Bret Taylor is stepping down at the end of January to return to his “entrepreneurial roots.” One way to read that message is Taylor sees greener pastures elsewhere versus leading Salesforce for the intermediate future.
Cloud-software investors should brace for more turmoil. It pays to be patient until valuations get much cheaper or there is visibility around a real bottom.
Like Benioff, I’ve seen a number of these downturns before. The cycles tend to last several quarters after they begin—and this one is just getting started.