Valuations of Cloud Software Stocks Are Still Elevated

Cloud-software stocks have seen some of the steepest losses in the technology sector this year. Salesforce Inc (CRM) has lost -40% this year, and Snowflake (SNOW) has dropped -60%, steeper than the -30% decline for the Nasdaq 100 Index.  Cloud software stocks are underperforming the Nasdaq 100 Stock Index($IUXX) (QQQ), and as the global economy slows, confidence for a rebound in the sector is limited. 

The First Trust Cloud Computing ETF (SKYY), an ETF of cloud software stocks, has slumped -42% this year, a bigger decline than the -30% fall in the Nasdaq 100.  However, according to Penn Mutual Asset Management, valuations in the sector have not come down enough to make the stocks attractive yet.  Instead, Penn Mutual sees prices for cloud software stocks coming down more, saying, “multiples are well off their top, but if growth is slowing, the fact that they’re cheaper doesn’t mean they’re cheap.”

Despite the -42% fall in the SKYY ETF this year, valuations of cloud software stocks are still elevated, with the ETF priced at 29 times estimated earnings, above its long-term average of 25.  High-growth software stocks saw massive rallies during the pandemic.  However, soaring inflation has pushed the Federal Reserve to raise interest rates dramatically, a major bearish factor for high-valuation and unprofitable companies, whose shares are priced on their prospects far out in the future.

Earnings results for key companies in the cloud software sector have been mixed this season, even as they continue to show positive growth rates.  Amazon.com’s (AMZN) cloud business came in below expectations, and Microsoft (MSFT) gave a lackluster forecast for its Azure cloud product.  On the positive side, Alphabet (GOOGL) reported losing less money than expected in its cloud business. 

Analysts are hoping that the recent slump in cloud software stocks will cushion any further downside if the economy slows further.  ClearBridge Investments said, “earnings estimates look pretty close to reasonable, but even if there is some downside to the consensus, the cloud sector is a steadier ship overall.  Also, valuations have gotten creamed, but fundamentals are holding up better than other parts of tech, and unlike in prior downturns, the world runs on these services.  That will support them even in the event of a recession.”

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