(Bloomberg) -- Cloud-software stocks have been among the most hard-hit areas of the technology sector this year, and some investors are skeptical that demand from business customers will hold up well enough to stem the declines any time soon.
Two closely watched companies in the industry will report after the market closes Wednesday: Salesforce Inc., which is expected to post its slowest revenue growth ever, and data-warehousing company Snowflake Inc., which had soared during the pandemic after its landmark initial public offering.
The $2.8 billion First Trust Cloud Computing exchange-traded fund has slumped 42% this year, steeper than the 29% decline for the Nasdaq 100 Index. Salesforce has lost 40% while Snowflake has dropped 61%. Valuations in the sector haven’t come down enough to make the stocks attractive yet, said Brendan Boken, an investment analyst at Penn Mutual Asset Management.
“Cloud software is a critical service for enterprises, but with so many headwinds and so much uncertainty heading into 2023, I think you can see prices coming down more,” he said. “Multiples are well off their top, but if growth is slowing, the fact that they’re cheaper doesn’t mean they’re cheap.”
Salesforce rose 0.9% on Wednesday while Snowflake fell 3.1%.
Even with the drop, the cloud index underlying the ETF is priced at 29 times estimated earnings, above its long-term average of 25.
While high-growth software stocks saw massive rallies during the pandemic, that trade has dramatically reversed this year. Inflation has pushed the Federal Reserve to raise interest rates, a particular headwind to high-valuation and unprofitable companies, where shares are priced on their prospects far out in the future. In addition, the prospect of a recession could mean that the sector’s growth comes under pressure if businesses cut back on spending.
Results for key companies in the sector have been mixed this season, even as they continue to show positive growth rates. Growth for Amazon.com Inc.’s cloud business came in below expectations, while Microsoft Corp. gave a lackluster forecast for its Azure product. Alphabet Inc.’s cloud offering was a relative bright spot, losing less money than expected.
While Cloudflare Inc. beat expectations and raised its outlook, the report wasn’t seen as strong enough to justify the stock’s high valuation. NetApp Inc. slumped as much as 10% Wednesday data-management company cut its guidance for earnings and revenue growth.
Still, software and services remains the only sub-sector of tech for which analysts expect earnings growth in 2023. They predict a 6.3% increase in earnings, according to data compiled by Bloomberg Intelligence. While that is down from the 10.9% pace expected three months ago, the hardware and equipment segment is expected to see earnings fall 1.5% next year and semiconductor companies are seen posting a 15% drop in profits.
“Estimates look pretty close to reasonable, but even if there is some downside to the consensus, cloud is a steadier ship overall,” said Hilary Frisch, senior research analyst at ClearBridge Investments. “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.”
Tech Chart of the Day
The tech sector has been underperforming this year, and technical analysis suggests it could continue trailing the broader market, according to Bloomberg Intelligence, which looked at a tech-sector exchange-trade fund as a ratio of an S&P 500 ETF.
“Failing to close above resistance (the April low) suggests the XLK/SPY ratio could drop 3% to its November trough,” wrote Anthony Feld, a senior technical strategist at Bloomberg Intelligence. “The April floor -- which was support -- becomes resistance when pierced.”
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--With assistance from Subrat Patnaik.
(Updates to market open.)
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