What happened
Shares of enterprise software stocks Snowflake (SNOW -1.61%), Twilio (TWLO -1.59%), and HubSpot (HUBS -2.40%) fell more than the market Tuesday, down 3.3%, 4.1%, and 2.8%, respectively, as of 1:39 p.m. ET.
Software stocks are struggling broadly, as long-term bond yields remained high, while today the International Monetary Fund (IMF) downgraded the global economy. Furthermore, Snowflake and Twilio saw lukewarm analyst notes today and lower price targets, hurting these former growth darlings even further.
So what
Long-term Treasury bond yields rose early this morning, with the 10-year Treasury yield nearly touching 4% before retreating to about 3.89%, where it started the day. The 10-year yield has more than doubled this year, hurting valuations across a host of asset classes. High long-term bond yields tend to especially hurt growth stocks, with the bulk of their earnings far out in the future. That remains the case for these three stocks, as each currently garners hefty net losses.
In addition, the International Monetary Fund lowered its outlook for U.S. growth in 2022 and global growth in 2023 today, casting further doubt on whether even high-growth cloud software stocks can live up to lofty expectations.
Analysts who were formerly bullish on these stocks in a lower-rate environment are now growing skeptical. On Tuesday, Bernstein software analyst Mark Moerdler started coverage on Snowflake, giving the former darling a mere neutral rating and a $166 price target, which is not that far above where the stock trades now.
Moerdler is more skeptical than others that Snowflake can grow into a high valuation, given that it still trades for a whopping 30 times sales. According to Moerdler, that would require the company to continue growing at 30% all the way into 2029, which would require new products and markets. "To meaningfully beat those numbers will require gaining significant revenue and share in new markets competing against strong often entrenched Cloud competitors which we believe is going to be difficult," he wrote.
Meanwhile, software analysts at Morgan Stanley maintained their overweight rating on Twilio, but dropped their price target by 60 points, from $160 to $100. While maintaining the overweight rating is still nice, it's clear this analyst got things wrong over the past year given Twilio's massive year-to-date decline, so investors seem to be skeptical that rating means much next to the giant price target cut.
HubSpot didn't receive any downgrades today, but it is still a high-growth, money-losing stock that has a price-to-sales ratio around 9. HubSpot has been a stellar outperformer in the space, routinely beating revenue and earnings estimates. However, some may be worried over how HubSpot's small and medium-sized business customers would fare in a recession, and if they would be inclined to spend more on the customer relationship management suite that HubSpot sells.
Now what
It is very hard to know where these stocks will bottom, despite their having sold off so much already in 2022. Unfortunately for high-growth software stocks, they came into the year priced at a significant premium, so the abrupt rise in inflation and interest rates can upend their stocks, even if the businesses underneath perform well.
A turnaround in the sector will likely require the evasion of a recession, or getting through one, along with a decline of inflation back down to 2%. While investors will get a glimpse of how these businesses are faring in the upcoming earnings season, it may be harder for the stocks to move higher unless broader economic conditions reverse.
Software investors should have a solid understanding of the total market potential and potential future profit margins for any unprofitable software stock they own, and not just price things off current revenue and revenue growth. The market could be entering a new paradigm, where valuations matter more than they did in the pandemic and pre-pandemic eras.
