What happened
Shares of popular enterprise software stocks Datadog (DDOG -1.43%), Snowflake (SNOW -1.61%), and DocuSign (DOCU 0.10%) surged today, up 5.4%, 4.4%, and 6.9%, respectively, as of 2:13 p.m. ET.
There wasn't much in the way of news out of these three companies today, although Datadog did announce a product update to its Observability suite.
More likely, this move had to do with investors actually pricing in an economic downturn. A downturn, you say? Here's why that may actually benefit these high-growth software names.
So what
On Friday, long-term interest rates declined off their highs, and the price of oil plunged as traders began to price in slowing growth and a higher probability of a recession.
Why might this lead to a bounce for software and other growth tech stocks? Well, an economic slowing or downturn would cause long-term rates to fall, meaning inflation may top out and begin going the other way. All three of these companies are growth stocks losing money on a generally accepted accounting principles (GAAP) basis, with the entirety of their profits well out into the future. Thus, the lower long-term rates are, the more valuable those far-off profits become.
But won't these companies suffer in an economic downturn? Perhaps a bit, as no company is immune to a recession. However, software tends to be mission-critical for enterprises, and it's a pain to switch one's employees off their current tools and have them learn a different set. Thus, enterprise software tends to be much stickier than other discretionary products. So these companies should still grow, though perhaps not as fast, even if there is a recession. In lean times, investors would pay up for that kind of business stability.
Among the fastest-growers in the space is Datadog, which also introduced a great-sounding feature to its Observability software suite. Observability software allows companies to peer into their tech infrastructure to make sure everything is running smoothly and optimized for cost and security. Today, Datadog introduced its Datadog Observability Pipelines, an open-source feature that enables IT organizations to see a unified view of all their observability data and route that data seamlessly anywhere in their organizations.
Datadog has been especially impressive as of late on the operating level, with revenue surging 83% last quarter.
DOCU Year to Date Price Returns (Daily) data by YCharts.
Now what
Is this finally the bottom for these software stocks? Certainly, these stocks have seen quite a sell-off, with each down between 54% and 66% on the year. Today's market action could signal a change in market sentiment if traders begin to anticipate slower growth and lower inflation beyond this year.
On the other hand, these stocks are still by no means "cheap." Snowflake and Datadog still trade at over 20 times sales. While DocuSign trades at just 5.4 times sales, its operating performance has also lagged well behind the other two. A darling of the pandemic as all sorts of businesses rapidly adopted digital signatures, DocuSign's billings outlook has rapidly deteriorated amid reopening.
So I don't think there is an "all-clear" yet for these software stocks. Valuations are still high, and much will depend on inflation. If inflation continues to be persistent despite rate hikes, it's possible the Federal Reserve may allow some higher-than-normal inflation for the foreseeable future. That would reverse today's trend. However, if the economy decelerates or goes into a downturn, and rates keep falling, we may be getting closer to a bottom.
Despite today's action, investors should have a clear view of these companies' future profit potential over the next decade, not just the next quarter. One suggestion would be to make a discounted cash flow model that incorporates investors' view about future growth, profits, and interest rates. While it's impossible to predict these numbers exactly, it's a much better guide than guessing these companies' values based on price movements or quarter-to-quarter revenue beats or misses.
