Why Snowflake, Datadog, and HubSpot Plunged Today

What happened

Shares of enterprise software-as-as-service (SaaS) companies Snowflake (SNOW 1.83%), Datadog (DDOG 1.11%), and HubSpot (HUBS 0.54%) are falling hard on Thursday, down 5.5%, 5.2%, and 4.5%, respectively, as of 11:21 AM EDT.

In the SaaS world, these three stocks have displayed some of the strongest and most resilient growth over the past year. On the other hand, that means the market has awarded these companies with high valuations.

Ironically, this can mean that when jobs and employment data surprise to the upside, it may actually be a bad thing for these growth stocks, since better jobs data could point to higher interest rates for longer. That's what happened today, as the ADP National Employment report showed December jobs data that surprised again to the upside, and government figures for last week's unemployment claims also dropped.

So what

This morning, the monthly ADP report, conducted by Automatic Data Processing (ADP -0.34%) in conjunction with Stanford Digital Economy Lab, estimated that December saw 235,000 job gains, nearly doubling over the 127,000 job gains in November and well above the Reuters poll of economists that projected 150,000.

In addition, the Bureau of Labor Statistics also released data showing last week's claims for unemployment fell to 204,000, down from 223,000 in the week prior, and the lowest since September. The BLS will come out with its own jobs data for December tomorrow.

It may be confusing for some who read almost daily accounts of big technology companies laying off workers and hear the constant drumbeat of economists forecasting a recession that these numbers were so strong.

And yet the numbers are what they are; likely, the shoring up of U.S. manufacturing, strong demand for services outside of technology, and early retirements and reduced immigration from the pandemic are what's keeping the job market incredibly strong.

Unfortunately for these three tech companies, that also likely means the Federal Reserve will feel compelled to keep raising interest rates to keep inflation at bay. The minutes of the Federal Reserve's December meeting, released yesterday, showed almost no letup in the Fed's determination to make sure inflation comes down, as no Fed governors forecast any interest rate cuts for all of 2023.

For unprofitable companies with the majority of earnings far out in the future, such as these three, the valuation difference between a world of 0% interest rates and one of 5% interest rates is very big. That's why these stocks have continued to fall even as their businesses have performed well.

Since these stocks are likely to grow even if there is an economic downturn, a shallow recession in which interest rates come down would almost be preferable to a stronger economy with much higher ongoing interest rates.

Yet if we are in fact in a new regime of a strong economy with higher interest rates, the very technology stocks that have thrived the most since the Great Financial Crisis of 2008 -- namely those sporting very high revenue growth but little profitability -- could continue to struggle if they don't generate profits in the here and now.

That means real profits, not those "adjusted" for excessive stock-based compensation. Unfortunately, these types of high-growth tech companies have been rewarded for investing aggressively in top-line growth, with many highlighting adjusted numbers to give the sense of profitability. However, stock compensation is a real dilutive cost to shareholders, and if interest rates stay high, investors will lose their patience with companies garnering big losses according to generally accepted accounting principles (GAAP).

Now what

Here's how each of these three stocks looks right now on growth, profitability, and price-to-sales ratio.

Data source: Yahoo! Finance. TTM = trailing 12 months.

Of the three, Datadog may look like the most solid choice, as it appears to be on the cusp of profitability while also sporting impressive growth rates. Meanwhile, its valuation is well below that of Snowflake, despite just slightly lower growth.

Still, today it appears that investors are eschewing basically all expensive unprofitable tech stocks in favor of other sectors or more profitable subsectors in technology. If the economy remains strong and rates stay high, that trend should continue.

It is possible that these stocks may be close to bottoming -- after all, Snowflake is nearly back to its IPO price, at which Warren Buffett's Berkshire Hathaway (BRK.A -0.82%) (BRK.B -0.86%) bought shares. However, even if these stocks are close to bottoming -- a big if -- I wouldn't expect them to run back to their 2021 highs anytime soon.