What happened
Shares of leading software-as-a-service stocks Snowflake (SNOW 0.60%), DocuSign (DOCU 0.08%), and Atlassian (TEAM 4.30%) were all down on Friday, falling 3.8%, 4.1%, and 5.3%, respectively, as of 12:00 PM.
When SaaS stocks fall in tandem, there is a good chance the culprit is inflation, and fears of higher interest rates. Sure enough, inflation appears to be rearing its head again today as more January data came in this morning, showing a reacceleration after softer numbers over the prior three months.
So what
Today, an important metric of inflation, the Personal Consumption Expenditures index (PCE) for January was released. The "core" number, excluding volatile food and energy prices, came in higher-than-expected at 0.6% month-over-month, higher than the 0.4% anticipated, and up 4.7% from a year ago, higher than the 4.5% expected.
The PCE is a slightly different measure than the Consumer Price Index, in that PCE sources its data from businesses and the CPI sources data from consumers. Yet some say the Federal Reserve actually tracks PCE closer than CPI, as it accounts more for consumers "trading down" to adjust for higher prices. So while last month's CPI had already been released earlier in February and also came in hotter-than-expected, today's number, while not unexpected, was still a bit of a disappointment.
Another data point on consumer spending also came in hotter-than-expected, with U.S. household spending rising 1.8% month -over-month – that's the highest increase since March of 2021, and significantly higher than the 1.3% increase that was expected by economists polled by Reuters.
While robust consumer spending would normally be a good thing, it's actually the opposite when inflation is above the Federal Reserve's target. The Fed has been trying to tamp down inflation, which would likely require holding down economic growth. Therefore, this "good news" on spending is actually bad news in the fight against inflation.
The result is that investors are likely pricing in higher interest rates for longer. While expectations for short-term rate increases from the Fed have gone up, so have expectations for longer-dated bonds, such as the 10-year Treasury Bond yield. Today, that yield rose more than 2% to 3.97% as of this writing, much higher than the 3.4% lows seen as recently as February 1.
Higher longer-term bond rates have an outsized effect on unprofitable growth stocks like those seen across much of the SaaS sector. This is because the intrinsic value of any stock is the present value of future cash flows, discounted back to the present. Investors tend to use longer-term Treasury yields as a base rate, then add an equity risk premium, in order to discount equity cash flows.
Snowflake, DocuSign, and Atlassian are all unprofitable on a GAAP basis today, making each susceptible to rising rates, despite these not being the worst offenders in the space on that front. In fact, both Snowflake and DocuSign have each shown signs of profit improvement in the higher-rate environment. On the other hand, Atlassian's management apparently feels comfortable spending through this deceleration.
Snowflake had an operating income loss of ($206 million) last quarter, but that operating loss margin did improve to (37%) from (47%) in the year-ago quarter. So Snowflake, a favorite in the cloud space, appears to be improving margins with scale. Notably, it reports its fiscal fourth quarter earnings next week.
Under new management, DocuSign is being more proactive, as its growth has slowed markedly. The company recently announced another round of layoffs, its second in the five months since new CEO Allan Thygesen took the helm in September. The move actually received a thumbs-up from Wolfe Research analyst Alex Zukin yesterday, who believes the cost-cuts are part of a broader transformation that will increase profitability. The positive note caused the stock to rise yesterday. However, today's inflation data is pulling DocuSign back down to earth as investors remain skeptical. DocuSign reports earnings on March 9.
Finally, Atlassian was actually profitable in 2021, but has fallen back into operating losses in 2022 as growth slowed and company kept up its investments in R&D and sales & marketing. While cognizant of the changing environment, it appears that Atlassian's management is leaning into spending through a slowing demand environment while raising prices. In an even bigger show of confidence, management also recently initiated a $1 billion share repurchase program.
SNOW 1 Year Total Returns (Daily) data by YCharts
Now what
The software sector has certainly taken its lumps over the past 18 months as inflation and interest rates have surprised to the upside, resulting the massive stock price declines seen above. And yet, many of these stocks still don't look "cheap," as their ultimate profitability metrics remain somewhat of a wildcard, making them difficult to value based on future earnings.
Still, even value investors may find attractive opportunities in the sector, given how large some of these declines have been. DocuSign is an interesting special situation, down 80% from all-time highs, as the company still has a leading product in electric e-signature, with a brand new CEO looking to make his imprint on the business.
Meanwhile Snowflake and Atlassian are both extremely well-run companies still sporting impressive growth metrics in a slowing environment. Still, investors have to pay a higher multiple of sales for these stocks, which is becoming more difficult as inflation and interest rates continue to remain stubbornly high.
