What happened
Shares of enterprise software companies Datadog (DDOG 1.12%), Okta (OKTA -0.06%), and DocuSign (DOCU -1.74%) were plunging today, down 5.3%, 6%, and 7.2%, respectively, as of 2 p.m. EDT.
It was a bad day for tech in general, and especially for higher-priced growth stocks such as these three. Interest rates continued to rise this week after the fallout from Tuesday's inflation report. In addition, there have been several preannouncements from major companies that are hinting at a global recession. Finally, today was an expiration day for options, which can cause high volatility.
So what
High-growth stocks with little or no profits, such as these three enterprise software names, have been crushed this year, as the multiple tailwinds seen during the pandemic are all reversing into headwinds.
Enterprises accelerated digital transformation initiatives during the pandemic lockdowns, which may have pulled forward some demand for these companies' offerings. So there is concern over a slowdown this year. Of these three, DocuSign has seen the worst growth deceleration, with operational issues and now major uncertainty with the company now looking for a new CEO. Billings decelerated to just 9% growth last quarter.
Okta has also seen its long-term growth projections come into question, following the messy acquisition of Auth0 and the announcement that its chief operating officer would take a one-year sabbatical.
Therefore, when a large company like FedEx (FDX 0.10%) preannounces a major shortfall on this quarter's earnings per share, as it did last night, and with FedEx CEO Raj Subramaniam hinting that we may be in the midst of a global recession, it doesn't exactly spark hope growth will reaccelerate for these companies anytime soon. So if a company is in transition or going through a difficult operational period, this risk-off mentality will cause a big sell-off.
On the other hand, Datadog's recent financial results have been nothing short of spectacular, with revenue growing 74% last quarter and solid forward guidance. Moreover, Datadog is actually operating close to breakeven in terms of profitability, whereas most software-as-a-service companies may have positive "adjusted" numbers but are actually losing lots of money on a GAAP basis when factoring in stock-based compensation.
So why is Datadog falling in sympathy? Well, not only are recession fears in the air, but inflation and the expectation for higher interest rates are taking down high-priced stocks. While Datadog has been outperforming, it also trades at a whopping 23 times sales, which is now much higher than Okta's 6.3 price-to-sales ratio and DocuSign's 5.8 mark.
After the hotter-than-expected inflation report on Tuesday, the two-year Treasury bond yield jumped and has continued to rise through the end of this week to 3.87% as of this writing. The 10-year bond yield is also much higher on the week and is now at 3.45%, near the June high.
However, note that it is lower than the two-year, making for an inverted yield curve. That's usually a prelude to a recession or slowdown.
All things being equal, higher interest rates make bonds more competitive with stocks and lower the value investors put on future earnings. That is a killer for growth stocks, since the bulk of their earnings power is years away. Thus, Datadog is unable to escape this, despite its operational success.
Now what
Unfortunately, high-growth stocks appear to be at the mercy of inflation data and the movements of the Federal Reserve, regardless of how well a company is performing.
Still, the Federal Reserve is intent on bringing inflation down. It may cause a recession of some kind to do so, but eventually, inflation should come down. That could mark a turning point for these long-suffering growth stocks.
With discounted prices across the software sector, investors may want to begin looking at the sector ahead of a potential recovery. However, tough times ahead may separate the strong from the weak companies in a difficult macroeconomic environment. So it may be different from 2020-2021, when virtually all digital transformation stocks soared amid strong demand and low interest rates. The trick is identifying the eventual winners that are also trading at a reasonable price.
