What happened
Shares of Palantir (PLTR 0.56%), Twilio (TWLO -1.59%), and HubSpot (HUBS -2.40%) each had a great month of January, rising 21.2%, 22.2%, and 20%, respectively, according to data from S&P Global Market Intelligence.
These enterprise software stocks share some common attributes. First, each represents a high-growth yet unprofitable company, and that type of security generally saw a large decline in value in 2022. That primed growth stocks for a rebound in 2023, as short-sellers booked profits and inflation seemed to moderate at the end of the year.
Second, each is part of a new cohort of software businesses that enable companies to do more with data and automate either operations or customer communications. So while growth could very well decelerate in a slowing economy, these three companies should continue to grow somewhat through a downturn because they help other businesses become more efficient.
So what
During the month of January, many beaten-down growth stocks saw a big bounce from their lows. But is this really the beginning of a rebound or just a dead-cat bounce?
These stocks might have been due for some relief. Each was pummeled in 2022, as you can see, down between 56% and 82%:
PLTR 1 Year Total Returns (Daily) data by YCharts.
In the first part of 2023, the inflation that had sparked such a big sell-off in 2022 showed continued signs of moderation, which, in turn, spurred optimism that the Federal Reserve might soon stop its interest rate hikes. In December, the Fed downshifted to a 50-basis-point federal funds interest rate hike, and it just implemented a 25-bps hike on February 1.
Inflation and interest rates are very important to valuations for unprofitable growth companies, whose earnings and cash flows are far in the future. The higher interest rates are, the less those future earnings are worth in today's dollars. So seeing inflation and interest rate trends moderate was a positive sign.
The change in inflation and interest rate expectations was likely the main catalyst for these three names, as Wall Street analysts had more mixed takes on each stock during the month based on slowing fundamentals.
Palantir actually received a slew of price-target downgrades during the quarter, as both Jefferies and Deutsche Bank lowered their targets due to Palantir's slowing growth and the "lumpy" or uncertain cadence of government contracts. And Mizuho initiated coverage of Palantir at neutral during the month, with a $7 price target.
Despite analyst doubts, Palantir managed to rise on hopes for a moderation in interest rates as well as a slew of announced partnerships, including with cybersecurity firm Cloudflare, drug wholesaler Cardinal Health, and data science start-up Posit. Because the growth of Palantir's government business remains somewhat uncertain, it is encouraging that more and more private enterprises seem to be seeing benefits from implementing Palantir's software.
Twilio also saw analysts at Oppenheimer and Piper Sandler lower their price targets during the month, although each maintained an outperform rating, since their targets were still above Twilio's beaten-down share price. Twilio has forecast a deceleration in growth for the fourth quarter, but it also has a lot of cash on its books, and the unified communications-as-a-service company was down the most of these three in 2022.
Meanwhile, HubSpot actually had opposite price-target movements from two different analysts during the month. While Piper Sandler lowered its target on shares from $400 to $350 based on a sectorwide slowdown, Stifel analyst J. Parker Lane raised his price target on HubSpot from $325 to $390. Lane's channel checks with agency partners suggest no dramatic drop-off in demand, and retention appears to be relatively solid for this provider of small-business digital marketing and customer relationship management software.
Image source: Getty Images.
Now what
While the tone has turned more optimistic for these software companies, I am more in the camp that thinks January's surge might just be a dead cat bounce. That's because while rate hikes may be decelerating, it doesn't seem as if we are going back to the pandemic era of extremely low interest rates.
In fact, just last week, the January jobs report saw many more jobs created than forecast, which seems to imply the Fed could need to continue raising rates, albeit in smaller increments, or keep them higher for longer. Long-term interest rates also rose last week, and it's possible we'll be in a higher-growth, higher-rate environment, relative to the last decade, for some time.
Unfortunately, even if the overall economy grows at a solid pace, these three software names are unlikely to see their growth rates accelerate meaningfully to the figures we have seen over the past few years. This is for two reasons. First, it's more difficult for a company to grow at high rates as it gets bigger, and second, it's unlikely the tech world will see a reacceleration of digitization investment similar to what occurred during the pandemic.
With growth likely to remain slower for these stocks, what about profitability? The 2022 interest-rate shock has made investors more focused on company profitability rather than just top-line revenue growth, so if these companies can show some real profits, even when factoring in stock-based compensation, they could succeed.
On that note, Twilio implemented layoffs back in September that would shed 11% of its workforce, and HubSpot announced layoffs for 7% of its workforce just last week. While it's encouraging that both companies are looking to achieve profitability in the near term, it's also possible that once they become profitable, their profit figures could underwhelm.
Therefore, it's just as easy to imagine these stocks giving up their January gains as it is to envision a recovery to higher levels. With January's rise likely due to short covering and the perception that the Fed might lower interest rates at some point, those factors are unlikely to repeat in February.
Loss-making growth stocks still remain a risky play in 2023.
