Earlier this year we looked at how software valuations, having surged during the pandemic to a sector-wide peak of nearly 10x forward revenues in 2021, had been reined back in to pre-pandemic levels, even before Russia’s invasion of Ukraine. In the six months since, many of the macro headwinds apparent at the start of the year have intensified: interest rates continue to rise at an unprecedented pace and inflation in both the US and Europe is hovering at close to 10%, a 40-year high.
Investors’ changing priorities
Firstly, and perhaps surprisingly, there has been a convergence between the pricing of software companies in North America and those in the rest of the world. Secondly, we have seen a continued shift away from the ‘growth at all costs’ mentality and a ‘flight to quality’ towards higher-margin stocks. Finally, we can trace marked discrepancies in the performance of different sub-sectors within software. Sub-sectors combining mission-criticality with high margins and inflation-busting (i.e. double-digit) growth, such as Payroll software, Industrial tech and Supply Chain Management software, have performed relatively better than others when comparing current valuations to pre-Covid levels.
Drawing historical comparisons
While it is impossible to predict what the future holds, looking at historical market behaviour provides some interesting insights. If we look at the last five ‘corrections’ in software valuations (i.e. periods when the forward revenue multiple declined by 15% or more within six months), it took, on average, just over three quarters for the market to recover to its previous peak from the bottom.
What this means for software investors in the short-term
With these considerations in mind, we believe the current market conditions will temper the mid-term enterprise software growth cycle slightly, but the long-term structural tailwinds will persist for decades. Companies with a combination of robust profit margins, stable growth, mission-critical technology and subscription-based recurring revenue models will be best positioned to weather the storm.
This article was first published by Arma Partners
About Arma Partners
Arma Partners provides independent corporate finance advice to companies and investors active in the global Digital Economy. We act as trusted advisors to Digital Economy leaders throughout their entire corporate lifecycle, from raising private capital for fast-growing disrupters and founder-led businesses to orchestrating complex cross-border M&A deals for private equity investors and global large-cap public companies. Founded in 2003, Arma today employs a large dedicated advisory team with unparalleled domain expertise and an enviable track record in each of the diverse sub-segments that together comprise the ever-expanding global Digital Economy.
Arma Partners LLP is authorised and regulated by the Financial Conduct Authority. US Arma Partners LP is regulated by the Financial Industry Regulatory Authority (FINRA) and is a member of the Securities Investor Protection Corporation (SIPC). Further information at www.armapartners.com.