Did SaaS lost too much? Morgan Stanley says yes.

A basket of Software stocks, understood mainly as SaaS, has been lagging the main US stock indexes by more than 40% for some time now. Many sector leaders have fallen more than 60% from their peaks. This would not be so puzzling if most of these companies were showing clear signs of weakness in their results, but they are not.

• A market that buys stocks, often with questionable health and prospects, hoping for growth far greater than what the market environment and or the company’s business model might superficially suggest, is a fairly common phenomenon.
• Investors who dump a single company’s shares en masse based on poorly understood market mechanisms, or who price in catastrophic scenarios with a negligible chance of occurring, are much rarer, but still happen with some regularity.
• But extrapolating that second process to an entire industry, despite good results, and keeping valuations below levels implied even by the most pessimistic valuation models, is almost unprecedented. The unprecedented phenomenon I mean is the “SaaS-o-calypse”, a trend of persistent and deep selloffs in the software sector (the name refers to the dominant “Software as a Service” model in the sector).

Morgan Stanley has already highlighted this phenomenon, publishing an extensive set of reports and recommendations for SaaS companies and the industry as such.

“The moat and the journey”

The scale of the selloff in SaaS companies is now so deep and so disconnected from fundamentals that it can no longer be explained by any speculation (the term “hypothesis” should not be used for solutions that often do not even exist yet) about further AI development. The investment bank commented on the state of this market segment in a measured but specific way.

The bank’s analysts pointed to a number of issues that are pushing the market to mark down SaaS companies. One is the degree of potential threat to the business model from AI and “agentic intelligence”.
In the publication, the analyst refers to the “Moat & Journey” framework, which in a fairly simple way measures and explains how difficult a company’s business model is to replicate or marginalize. As leaders in “resilience”, the bank points mainly to cybersecurity (Palo Alto, Cloudflare), Microsoft, selected cloud companies (Datadog, Snowflake), Shopify, and ServiceNow.

The last one is particularly interesting because even though the company is a leader in designing and deploying AI solutions in businesses, with double digit year over year profit growth, the mere classification as “SaaS” was enough for the stock to lose more than 60% of its valuation in 1.5 years.

ServiceNow price (D1)

Despite significant changes in the business model and steady improvement in results, the stock remains in a steep downtrend, currently fighting to preserve its long term uptrend. Source: xStation5

Another very interesting and important issue raised in the report is the cyclical nature of the market, with the current cycle showing extreme values in every respect. The key point of the cycle argument, however, is that value and benefits move through successive sectors, industries, and companies depending on the stage of the investment cycle. Software and SaaS companies are usually at the end of it, and this time is expected to be the same.

This suggests that current results at SaaS companies are a byproduct of the market environment, and that real profit growth still lies ahead for these companies in later stages of the “AI boom”. Given very low valuations on a multiples basis, the likely normalization of valuations in this sector over the next 2 to 6 quarters could be very sharp.

Valuations say more than words

The market’s reaction to the report is quite telling. Almost all the companies mentioned in the report posted noticeable losses in today’s session, despite gains in the broader market and generally positive sentiment in Tuesday’s US session. This may clearly show the scale and persistence, the depth, but also the currently irrational selectivity in how information is being priced in that is affecting the SaaS sector.

Kamil Szczepański

Financial Market Analyst at XTB