What happened
Shares of cloud software companies Datadog (DDOG 0.55%), Zscaler (ZS -0.05%), and Cloudflare (NET -0.95%) were falling on Tuesday in another rough day for tech stocks. As of 2 p.m. ET, these three were down 10.2%, 11.5%, and 12%, respectively.
Tuesday was a bad day for high-multiple software-as-a-service stocks more broadly, as investors feared rising interest rates. Yet it was especially bad for these three, as they were unfortunately part of a sector-wide analyst downgrade at J.P. Morgan.
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So what
In a wide-ranging note at the bank, J.P. Morgan software analyst Sterling Auty made new calls across the sector. Based on concerns over high valuations and the prospect for slowing growth as these companies lap the pandemic-year boom, Auty cut ratings and lowered price targets across the space. A deluge of new software IPOs over the past year has also increased the supply of investor options, he noted, which could lead to fewer investor dollars chasing each individual name.
While he maintained some stocks at buy, others he downgraded to neutral, such as large-cap favorite Adobe, which is also having a rough day.
Unfortunately for Datadog, Zscaler, and Cloudflare, they were demoted to the dreaded underweight rating. Likely, valuation plays a big part; Datadog trades at 61 times sales, Zscaler trades at 55 times sales, and Cloudflare trades at a whopping 73 times sales. These are enormously high valuations, and we seem to be entering an environment in which investors are starting to focus on intrinsic value as rising inflation and interest rates eat into perceived value of future profits, hurting profitless growth stocks.
These stocks also saw tremendous revenue growth during the pandemic that may be hard to match going forward. The deadly combination of slowing growth and higher discounting of future cash flows is leading to a big de-rating, even though each company's business fundamentals look quite strong today. Auty noted he is cautious on these types of stocks following the tremendous 40% plunge in pandemic-era darling DocuSign (DOCU 0.97%) following its recent earnings report that disclosed slowing billings growth and underwhelming guidance.
Now what
All hope may not be lost. Even though each stock received an underweight rating today, all three of Auty's new price targets are still above where these stocks trade after their rough day. He lowered his Datadog price target to $195 versus a price of $155 today, lowered his target on Zscaler to $320 versus a price of $273, and lowered his target on Cloudflare to $144 versus a current price of $127.50.
Analysts usually give price targets for a year out, but these buoyant targets suggest Auty still likes all three companies' business fundamentals. However, it's normally the tone and direction of analyst notes that capture investor attention, especially in a downbeat environment like the one we're in today. Hence, all are trading lower.
Given the big slide all three stocks have had, long-term holders and believers should probably continue to hold through this difficult period; after all, Auty's price targets do offer some hope. However, it's a trickier proposition for those who are looking to enter these types of stocks. All three are still expensive, and it's unclear how quickly interest rates will rise in the next year. I'm not sure what will change sentiment in the weeks ahead, so this malaise in high-growth stocks could last for some time.
