Even though many software stocks are still well below their 2021 highs, the software sector is an attractive one -- assuming you pick the right stocks.
Software companies generally have recurring-revenue subscription models, low capital requirements, and high gross margins, making their results somewhat predictable and their stocks attractive.
However, many software-as-a-service companies overspent during the pandemic, while overpaying their employees via stock-based competition, putting their ultimate ability to generate profits in question.
But the following three software stocks have both solid growth prospects and yes, actually make real profits. Investors should use the recent tech sector pullback to enter these stocks for the long haul.
Microsoft
In an uncertain world Microsoft (MSFT 1.82%) offers a bulwark in your portfolio. In fact, Microsoft now even has a higher credit rating than the U.S. government!
Microsoft owes its sterling credit rating to not one, but multiple highly profitable software franchises. These include the widely used Office suite, Windows PC operating system, Dynamics enterprise resource planning suite, and job social media network LinkedIn. Then there's also the up-and-coming growth star of the Azure cloud infrastructure-as-a-service platform, which has a strong second place position in the cloud IaaS industry, and may very well be number one in the future.
But Microsoft is never one to rest on its laurels. The company has made two major growth investments in the past year or so. One is a $13 billion investment in AI start-up OpenAI, the parent company behind ChatGPT. And a second is the acquisition of video game studio Activision-Blizzard, which just closed last week.
The close partnership with OpenAI puts Microsoft at the forefront of the artificial intelligence revolution, and the company recently showed how that partnership will turn into real revenue and profit growth. Microsoft recently announced Microsoft 365 Copilot, an AI-infused version of Office, for an extra $30 per user per month. That's a pretty big increase in the price of Office 365, and shows how the new AI-enhanced offerings can boost Microsoft's pricing power across a host of its products.
While Microsoft doesn't look "cheap" at 34 times earnings, investors can also count on robust cloud growth and AI-infused pricing power for years to come. Along with low risks, investors can still buy shares at these levels for the long-term.
Image source: Getty Images.
The Trade Desk
The Trade Desk (TTD 1.67%) is a leader and innovator in programmatic digital advertising, which is the use of data to tailor advertising with more specificity and automation than traditional advertising. Over the years, The Trade Desk has been a leader and first-mover with a software platform that automates ad campaigns across all sorts of media, especially in the ascendant streaming television and retail advertising verticals.
The Trade Desk even pioneered a new ad targeting standard called Universal ID 2.0, or UID2. UID2 correlates phone numbers and emails into hashed identifiers that protect privacy while also providing targeting capabilities, in an age when cookies are being phased out and iOS IDFA privacy rules make older forms of digital ad targeting antiquated.
With a leading position in the buy-side digital ad buying and getting a critical mass of publishers to buy in to UID2.0, The Trade Desk is now leveraging its data advantage and using the power of artificial intelligence to cement its lead. This past June, The Trade Desk introduced Kokai, its next-generation AI-powered buying platform with a host of new features that allow advertisers to buy ads with even greater specificity and returns on investment.
More precise and efficient advertising for customers is also good for The Trade Desk, and that's showing up in its numbers. The Trade Desk's customer retention is over 95%, and revenue grew 23% last quarter, or 24.5% when adjusting for the political ad spend last year -- and that is in an otherwise soft advertising environment.
And the Trade Desk is also profitable, with both GAAP and non-GAAP profitability in its recent quarter, while producing lots of free cash flow. In fact, The Trade Desk is even repurchasing lots of stock as well, offsetting the dilution from stock-based compensation.
While its stock doesn't seem cheap at the moment, The Trade Desk's stock hasn't yet recovered its 2021 all-time highs. But with the switch to programmatic advertising in its early innings and The Trade Desk in a strong leadership position, it should compound earnings for many years to come.
Synopsis
The complexity of semiconductor production has benefited software firm Synopsis (SNPS 2.56%), which is one of the two major software design automation software companies. In fact, despite being the leader in its field, Synopsis has been able to not only maintain but actually accelerate its growth rate over the past decade.
SNPS Revenue (Quarterly YoY Growth) data by YCharts
Synopsis generates revenue from both its EDA software software, as well as IP products, which is the licensing of optimized Synopsis designs that are incorporated by designers as building blocks for more complex chipsets. The combination of subscriptions and licensing revenue is a very capital-light business, leading to solid operating margins over 20%.
Of course, chip complexity isn't slowing down but rather accelerating, with new innovations such as "chiplets," gate-all-around transistors, and other new novel design features for artificial intelligence and other new applications. That should be a boon for both Synopsis' EDA software and licensing revenue for years to come. And given that Synopsis is one of only two major EDA software players, it should also be able to maintain solid profitability along with strong long-term growth.
