What happened
Shares of cloud-based software companies Datadog (DDOG 1.19%), MongoDB (MDB -2.10%), and CrowdStrike (CRWD 0.14%) were sinking this morning, down 7.3%, 4.1%, and 5.6%, respectively, as of 11:20 a.m. ET.
There wasn't much company-specific news out of these three today, but it appears all are falling hard based on commentary from Microsoft (MSFT -1.84%), after the cloud giant released its earnings results last night for the second quarter of its fiscal 2023, ended Dec. 31, 2022.
Microsoft stock actually rose initially after the report, as its quarterly cloud numbers came in better than feared; however, when giving guidance on the post-release conference call, management pointed to a sharper slowdown in the current quarter. And if a defensive, competitively advantaged juggernaut like Microsoft is slowing down that much, it makes these more expensive and profitless software-as-a-service (SaaS) companies more vulnerable.
So what
Datadog is a purely cloud-based software suite in the field of observability, which helps enterprises monitor and protect the health of their important applications. MongoDB started as an on-premises software database company, but its cloud-based MongoDB Atlas database-as-a-service product is its fastest-growing. And CrowdStrike also takes a cloud-first approach to cybersecurity, with its endpoint security agent consistently feeding data back into its cloud-based Threat Graph to improve its algorithms.
So, overall health of cloud spending is central to each of these companies' growth. Yet on last night's conference call with analysts, Microsoft CEO Satya Nadella said:
[W]e are seeing customers exercise caution in this environment, and we saw results weaken through December. We saw moderated consumption growth in Azure and lower-than-expected growth in new business across the stand-alone Office 365, EMS, and Windows commercial products that are sold outside the Microsoft 365 suite. From a geographic perspective, we saw strong execution in many regions around the world. However, performance in the U.S. was weaker than expected.
CFO Amy Hood added that Microsoft saw its 38% Azure cloud growth (in constant currency) decelerate to the mid-30% range in December, and now expects that growth to decelerate another 4 to 5 percentage points in the current quarter.
That's a pretty big drop-off, as management noted customers have gone from accelerating their cloud spend during the pandemic to optimizing their cloud workloads and wringing out cost savings, while also pulling back on adding new software seats.
So why are Datadog, MongoDB, and CrowdStrike reacting even more harshly than Microsoft, which is only down about 3% as of this writing? This is likely because all of these companies are not profitable under generally accepted accounting principles (GAAP) yet, and are somewhat expensive based on a multiple of their sales. With interest rates increasing and the economy looking highly uncertain, investors are setting a much higher bar for no-profit growth stocks.
That means if a company is in its pre-profit growth and scaling phase, revenue growth needs to be really good to please investors today. And if a company as strong as Microsoft is seeing a growth slowdown, investors now fear a big deceleration in these three companies this year as well.
One other note of caution on CrowdStrike. One positive Nadella did note was the strength of Microsoft's cybersecurity products. Over the past year, Microsoft's integrated security stack surpassed $20 billion in revenue, with Microsoft noting customers were looking to consolidate cyber vendors across the space to save costs. While it's possible CrowdStrike could be one of those remaining winners, it appears the hypergrowth of cybersecurity software could become more challenged and competitive this year.
Now what
The technology sector is feeling the heat not only from the Federal Reserve's interest rate increases and a slowdown in the economy, but also coming off the accelerated cloud spending brought on by the pandemic.
The environment is a really tough one for unprofitable tech growth stocks, as they get hit in two ways; higher interest rates disproportionately penalize profits that are farther out into the future, and the hyper-growth of the past two years reverts to the mean. Until these companies start showing better profitability on a GAAP basis, and not "adjusted" for stock-based compensation, their stocks could remain challenged.
One positive to keep in mind; Nadella also reemphasized his view that technology, especially companies involved in digital transformation, should continue to grow at a higher pace than gross domestic product over the long term. That still means the tech sector is attractive from a long-term standpoint.
However, the sector appears to have run too far ahead of itself during the pandemic from a valuation standpoint. That makes profit-less software stocks a difficult trade right now. Still, these category leaders should be on investors' watch lists if they decline to lower valuations, or if interest rates fall in a meaningful way later this year.
