By Hagen Ernst, Deputy Head of Research & Portfolio Management at DJE Kapital AG
Trust no one - and other software success models
Although technology stocks are not as much focused at the moment as they were in 2020, the digital transformation continues and with it the demand for software solutions. The call for security is particularly strong because the shift of sensitive data to cloud systems, like the omnipresent collection of customer data, also triggers unauthorized desires. An investment theme for the DJE - Alpha Global.
Technology stocks have experienced a stunning 2020. But with interest rates rising and the prospect of an economic recovery, they have been taken out of focus a bit. The market has become broader. Software stocks in particular have been in stagnation for six months now. Within the technology sector, cyclical semiconductor stocks are in demand, if at all, or more recently classic stocks that benefit from easing and - as vaccinations progress - a return to a more normal life. These include mobility platforms such as Uber and Lyft or online travel agencies such as Booking and Expedia.
„Zero Trust“ – the model for success
However, the software sector is by no means out: Here, too, opportunities are likely to present themselves again, initially selectively because companies will have to continue to invest heavily for years to advance digitalization. The focus is on the development of e-commerce presences, the use of intelligent software in marketing and customer relationship management (CRM), but also security and soon more back-office software such as enterprise planning software (ERP).
The security aspect has particular growth potential as the threat of cyber-attacks is becoming increasingly dangerous and costly. Therefore investments in improving security have top priority. According to research by the US IT market researcher Gartner the security software segment increased 10% and is expected to continue to grow at this rate in the future. There are many smaller and larger software providers in this segment. The fastest growth is currently in security solutions for the cloud (leased software on third-party data centers, secure data access must be ensured here) and the "zero trust" model.
This model aims to minimize the risk for company networks and applications and to exclude not only external threats but also internal potential dangers. With Zero Trust nobody who wants access to resources or services in the network is trusted from the start. Each access is individually authenticated and data traffic is always encrypted. Leading providers of "Zero Trust" security architecture for cloud applications are Cloudflare and Palo Alto. Cloudflare grew by 50% p.a. on average between 2016 and 2020. However given the high revenue multiple the potential is more or less already priced in. Palo Alto, on the other hand, still generates a large part of its revenue in the "classic" firewall business, which is no longer growing as much. The share of security software for cloud computing is expected to double this year according to the company's forecast, but it will only account for 15% of sales.
Classic network suppliers such as Cisco are also pushing more strongly into the lucrative security software business, thanks to numerous acquisitions, among other things. However the security segment accounts for less than 10% of sales and is growing only slightly below the market average. A possibly somewhat better share price development should primarily depend on whether the corporate customer segment recovers, should employees increasingly work in offices again after Corona.
Data and CRM software solutions are in demand
At the top of the agenda are software solutions around big data and artificial intelligence. Thanks to the Internet of Things (IOT), data collection is becoming more and more complex and can be processed better and better through artificial intelligence and new methods and more powerful computers in the field of machine learning. Classic enterprise software providers such as SAP or Oracle should be mentioned here. We should also mention Twilio as a provider of a cloud communication platform for virtually all messaging channels (WhatsApp, email, chat, FB, Instagram, etc.) and also increasingly cloud providers such as Microsoft Azure, Amazon AWS or Google GCP.
Besides data customer relationships are a key success factor. Therefore growth in software solutions around customer relationships (CRM) also continues to be high. The market is very fragmented, but Salesforce has been able to steadily increase its market share in recent years to now 18%, followed by SAP and Oracle with 5% market share each (with a downward trend). However Salesforce has fallen out of favor with investors after the recent, rather expensive takeover of Slack and a somewhat slowing growth dynamic. The CRM software solution Microsoft Dynamics (market share currently at 4%), which is in high demand especially among small and medium-sized enterprises (SMEs), is developing well. Dynamics, however, is only of minor importance within the Microsoft group, but is well positioned. This also applies to Hubspot, a provider of CRM solutions for SMEs. Margins and turnover are still expandable here, however.
High growth potential in computer-assisted customer communication
Besides the big topics like IT security, CRM or ERP, there are a number of promising niches. Thanks to ever higher computer performance, there has been a breakthrough in the field of "Conversational AI". Today more and more computer-assisted programs are taking over communication with customers. Humans in call centers will soon be a thing of the past. Conversational AI is currently one of the most promising and fastest growing segments within the software sector. Market research institutes estimate the market potential at about at least USD 60 billion. Twilio is well positioned here.
Also on the rise are so-called " ChatBots", which can take over a large part of customer communication by means of artificial intelligence. There are niche players here such as Five or Liveperson. Projects by these providers show an average of 20% better customer satisfaction and save a quarter of the costs. ChatBots are increasingly used by airlines, hotels or telecom providers. However, they are also finding their way into healthcare and public administration. Currently a lot of "manual training" is still required, often between two and three years, before they can be used. However the algorithms are getting better and better. According to Liveperson 50% of ChatBots are already autonomous, i.e. they can learn about issues without manual training. Given the enormous growth potential, sales for conversational AI are particularly high. Accordingly the price correction in the recent sell-off of technology stocks was strong.
Corona crisis: remote control solutions in demand
There was also strong Corona-driven demand for remote control and maintenance software. The travel restrictions in the lockdown accelerated the development of software solutions that enable technicians to connect to machines and perform maintenance remotely. Rigid maintenance intervals, which are still common in cars today, have long been a thing of the past in some areas. Thanks to more and more sensors in the course of the advent of the Internet of Things (IoT), most maintenance is carried out on a needs-based and predictive basis (predictive maintenance). Virtual reality can also be used to support more complex machines such as semiconductor production equipment. One niche provider of remote control solutions is Teamviewer. Their customers are still mainly private users, but the company is increasingly addressing corporate customers, which promises more lucrative margins. However, the share price has come under greater pressure following the announcement of expensive advertising contracts with Manchester United and Mercedes from Formula 1. A leading provider of IT remote control is ServiceNow. The company is one of the fastest-growing larger software vendors, but the revenue multiple is still quite high despite the recent correction.
Software solutions with the topic health also have a high market potential. Thanks to sensors, IoT and artificial intelligence, it is now possible to monitor the most important vital functions. Subfields such as health informatics or remote healthcare are developing rapidly. Apple in particular with its IOS operating system and tracking, i.e. the tracking of medical data via the smartphone or smart watch is leading the way here.
Software is also increasingly entering other sectors, for example construction. Large projects in particular are becoming increasingly complex - the start of operations at Berlin Airport, which was delayed by years, showed what can go wrong. In order to minimize such risks, "Building Information Modelling" - the modelling of building data - has become indispensable. Such networked planning, execution and management of buildings and other structures with the help of software can help to identify planning errors at an early stage. Autodesk or the German company Nemetschek are well positioned here.
Traditional software companies remain a lucrative investment
The key figures or turnover multiples of the fast-growing software companies are very high. It is therefore worth considering whether it might make sense to invest in established but rather lower-growth software companies. In contrast to US software providers, their European counterparts have risen much less. Companies like SAP are only growing at high single-digit rates, but well-functioning enterprise software from SAP or even Oracle is the basis of digital transformation. The new CEO Klein wants to push the migration to the cloud even more. In the short term this will lead to almost zero growth in the next two years but it should pay off in the long term.
Note: All information published is for your information only and does not constitute investment advice or other recommendation. Long-term experience and awards do not guarantee investment success. Securities are subject to market-related price fluctuations which may not be compensated for by the active management of the asset manager or investment advisor. This information cannot replace a consultation. All information has been provided with care and to the best of our knowledge at the time of preparation. Despite all due care, the data may have changed in the meantime. Further information on opportunities and risks can be found on the website www.dje.de. The sales prospectus and further information are available free of charge in German from DJE Investment S.A. or at www.dje.de The fund management company is DJE Investment S.A. DJE Kapital AG is the distribution agent.