Datadog reported solid earnings yesterday morning, but despite that, it wasn't enough to offset broader concerns over the killer combination of higher interest rates and slower growth on the software sector. Last night, a slew of other SaaS stocks reported slowing growth outlooks, and therefore the entire sector sold off hard today.
The losses in these companies weren't so much the result of company-specific factors today, but rather their relationship to other peers who reported last night. On the enterprise software front, both Twilio (TWLO 3.58%) and Atlassian (TEAM 4.49%) had disappointing reports, as Twilio lowered its long-term growth forecast from 30% to 15%-25%, and Atlassian cut its fiscal 2023 guidance. Meanwhile, even though cybersecurity software company Cloudflare (NET 0.80%) beat on revenue and losses per share and raised its guidance, it wasn't enough to offset Wall Street's dour mood on unprofitable software stocks with high valuations, and the stock plunged nearly 20% today.
So, Snowflake and Datadog are likely falling in sympathy with Twilio and Atlassian, despite Datadog reporting a good quarter and raising guidance yesterday, while CrowdStrike is likely falling in sympathy with Cloudflare.
On Wednesday, Fed Chairman Jay Powell expressed concern that inflation was still running too hot, and that he believed the Fed's prior forecast for the path of the Federal Funds rate would have to go higher than previously thought.
Higher rates are a killer for growth stocks with little or no profits, since higher interest rates make cash flows further out into the future worth less. Technology growth stocks are "long-duration assets," and any type of long-duration asset, even long-term government bonds, will sell off on the prospect of higher rates.
Of course, if a company can increase revenue and profits along with higher rates -- in other words, pricing power -- it could be enough to offset the effect of higher rates and inflation. Yet with the economy pulling back on spending and Twilio and Atlassian lowering their growth outlooks, investors are seeing a double whammy of slowing growth along with higher rates. Hence, the violent sell-offs we are seeing today and throughout 2022.
Make no mistake, Snowflake, Datadog, and CrowdStrike may be the very best three stocks in the entire enterprise software sector. Snowflake is the go-to platform for cloud-based data insights, Datadog is outpacing its peers in cloud observability, which helps enterprises keep their IT infrastructure up and running, and CrowdStrike has a powerful model for best-in-class cybersecurity with a modern cloud architecture and strong network effects.
Still, these stocks are not cheap on conventional financial metrics, with Snowflake trading at 25 times sales, Datadog at 16 times sales, and CrowdStrike at 16 times sales.
It has been a brutal year for these types of enterprise software stocks, and the picture probably won't change until inflation comes down so that the Federal Reserve can lower interest rates again. However, investors really don't know how high rates will have to go, and how long they will have to stay there, before inflation cooperates. It could be soon, or it could be a year from now. Until that happens, it's going to be difficult for these types of growth stocks to recover.
If an investor's portfolio is too overweight in no-profit growth stocks, they should perhaps look to diversify their holdings to other sectors with lower valuations, which also make profits and pay shareholders dividends and repurchases today.