With the close of 2024 approaching fast, artificial intelligence continues to set the narrative on Wall Street. The tail end of October marks the start of another highly anticipated earnings season, which for the most part, will continue to be dominated by AI. On the hardware front, investors will be on the lookout for whether the demand for AI GPUs is sustaining and if the firm that is the market leader is also improving its margins and profitability. For software stocks, investors will pour over profitability data to determine whether the billions of dollars invested in training and testing AI as well as in business partnerships are yielding results.
For software stocks, their exposure to AI is so strong that it has divided the 2024 stock performance of some firms into neat halves determined by investor sentiment about their AI products. One such AI software stock ranked 5th on our recent list of AI stocks that insiders are selling. Looking at its year-to-date share price performance, it’s rather neatly divided into two halves that converge on June 13th. Year to date on June 13th, the shares were down 19.8% even though the firm’s fiscal 2023 revenue was a cool $19.4 billion and had grown by 10% annually. Before that eventful day, the firm’s first quarter had seen it grow revenue by 11% annually but struggle to keep costs low and profit margins high.
Yet, the investor bearishness surrounding this well-known provider of productivity software tools such as Photoshop and Reader, would change in the blink of an eye. From June 13th to the third week of October, the shares have reversed course and gained 8.5%. In fact, between the 13th and September 12th, the stock had gained 27.9%. June 13th was the day that this firm reported its second-quarter earnings. The results led to its shares jumping by 13% in aftermarket trading, with investors impressed by the fact that the firm increased full-year guidance to range between $21.40 billion and $21.50 billion from an earlier $21.30 billion $21.50 billion.
The optimism was driven in part by the firm’s Creative Cloud business which includes products such as Acrobat Pro, Photoshop, and Express. The AI addition to Creative Cloud was the firm’s set of generative AI models dubbed Firefly. Management shared that Firefly was at the heart of the ARR guidance bump to $1.95 billion as they shared:
“We’re excited about the accelerating pace of innovation across the Digital Media business and pleased with the adoption of AI functionality as well as its early monetization across Document Cloud and Creative Cloud, including our flagship applications, Firefly Services and Express. We’re pleased to raise our annual net new ARR target to $1.95 billion and excited to deliver on our rich product roadmap in the second half.”
With AI profitability driving the second-quarter earnings season, investors were naturally ecstatic and sent the stock higher.
However, the June respite would be short-lived as the shares tanked by 13.4% in September. As usual, AI was the culprit. The downward trend started in the form of a 9.2% drop in after-market following the firm’s third-quarter report. It saw the company guide Q4 revenue at a midpoint of $5.525 billion which fell below the $5.61 billion analyst consensus.
While this firm is a consumer and professional software stock, the broader software as a service (SaaS) industry hasn’t been spared by the AI-driven Wall Street trends either. SaaS and software stocks are predominantly valued through two metrics: the Rule of 40 and EV/Sales (or variants such as EV/EBITDA or Price to Sales). These multiples are somewhat unique to the software and SaaS stock narrative as they evaluate the firms based on their ability to grow. This is key since one of the main reasons behind SaaS stock popularity is that they do not have to deal with inventory, logistics, or supply chain issues like other businesses.
In the AI era, SaaS valuation multiples and revenue growth estimates have been severely compressed. Data shows that the median price to forward sales SaaS multiple is 5.5x right now. The valuations are driven by lower growth expectations. After AI and the decimation ushered in by high interest rates, just 1% of SaaS and software companies have a 12-month future revenue growth rate higher than 30% as of June 2024. Digging deeper, investors have also placed a higher premium on growth as while firms with a Rule of 40 score greater than 40 have a median EV/Sales multiple of 8.9x, those with a growth rate greater than 30% but a Rule of 40 score lesser than 40 have a median multiple of 11.6x.
These AI-driven software shifts, precipitated by worries of a reduction in SaaS demand due to businesses self-developing software using AI have also affected investor sentiment. According to Jefferies’ latest Trading Positioning Survey, 19% of institutional investors were overweight on software stocks as of October 2024, a sharp drop over July’s reading of 28% and January’s 51%. Yet, investors have also tempered their short positions as Jefferies shows that 54 software stocks were shorted as of October compared to 73 in July.
Our Methodology
To make our list of Jefferies’ top overcrowded software short positions, we ranked the top nine crowded short positions from the latest Trading Positioning Survey by their shares short as a percentage of outstanding shares.
For these stocks, we also mentioned the number of hedge fund investors. Why are we interested in the stocks that hedge funds pile into? The reason is simple: our research has shown that we can outperform the market by imitating the top stock picks of the best hedge funds. Our quarterly newsletter’s strategy selects 14 small-cap and large-cap stocks every quarter and has returned 275% since May 2014, beating its benchmark by 150 percentage points. (see more details here).
An international stock trader intently watching the markets on a floor of monitors.
Palantir Technologies Inc. (NYSE:PLTR) is a data analytics software provider that caters to the needs of the public and private sectors. It is one of the best-known players in the national security software market, and the firm has also been growing its presence in the US commercial market. On the commercial front–and particularly in today’s AI era–Palantir Technologies Inc. (NYSE:PLTR) benefits from the fact that it has set up teams that work directly with customers to assess their needs and develop specific solutions. This is important for software firms particularly in the AI era as firms might find it difficult to tailor AI to their specific needs. Palantir Technologies Inc. (NYSE:PLTR)’s approach has yielded results as well since the software company grew its commercial revenue by 70% in the second quarter. This was on the back of lucrative deals, with Palantir Technologies Inc. (NYSE:PLTR) adding 96 contracts worth more than $1 million each and 27 contracts worth more than $10 million each.
Scout Investments mentioned Palantir Technologies Inc. (NYSE:PLTR) in its Q1 2024 investor letter. Here is what the fund said:
“The top contributor to return for the quarter was Palantir Technologies. Sentiment improved on Palantir after it reported stronger than expected commercial customer revenue and free cash flow. U.S. commercial growth was especially encouraging, as U.S. commercial revenue was up by a large percentage year over year for the fourth quarter and U.S. commercial customer count grew nearly as much. We expect Palantir to become one of the premier artificial intelligence (AI) software providers, built on its Foundry and AIP platforms.”
Overall PLTR ranks 2nd on our list of crowded software shorts according to Jefferies. While we acknowledge the potential of PLTR as an investment, our conviction lies in the belief that some AI stocks hold greater promise for delivering higher returns and doing so within a shorter timeframe. If you are looking for an AI stock that is more promising than PLTR but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.
