In a more nervous market, highly valued cloud growth stocks are pulling back. And that might well create an opportunity.
After all, this has been a market where growth stocks have outperformed value stocks for years. And cloud stocks have been among the best performers of them all. The BVP Nasdaq Emerging Cloud Index, which tracks mostly younger, “pure-play” cloud names, as of last month had gained 435% in six years. That return dwarfed the 117% gain in the Nasdaq Composite.
Those returns have come down of late, however. The index has pulled back 16% from July highs. Some components — most notably Shopify (NYSE:SHOP), whose bubble seems to have burst — have fallen even further.
Admittedly, to some investors, the pullback seems like a long-awaited and much-needed correction. Revenue multiples of 10x and even 20x are not uncommon among cloud growth stocks. The opportunity in software-as-a-service is enormous. The valuations remain equally so.
But for those who favor growth stocks, the pullback might well seem like an opportunity. Cloud stocks aren’t cheap — but they shouldn’t be. Growth should continue for years, if not decades. The operating model depresses near-term profits as new customers are acquired, but it results in predictable, “sticky,” high-margin revenue for years to come.
These 10 cloud growth stocks all are components of the Emerging Cloud Index. And all 10 look at least more attractive after the sector-wide weakness. Admittedly, none seem notably cheap — and there’s no reason selling pressure can’t continue in the near term. Still, for those who have missed out on the gains so far, the new lower prices do create more attractive entry points to finally hop on board.
Cloud Stocks: Square (SQ)
Square (NYSE:SQ) admittedly is a somewhat odd choice for this list. SQ stock isn’t quite the pure-play SaaS stock that many others in the index are. Its payment processing revenues are more cyclical and lower margin.
SQ stock also saw its selloff first. Cloud stocks on the whole fell during the market-wide selloff in last year’s fourth quarter. Square stock wasn’t immune: It fell by roughly half over that stretch. But unlike other cloud growth stocks, it hasn’t recovered. SQ stock still sits 40% below last year’s highs.
All that said, I wrote a month ago that Square stock was an intriguing choice among growth stocks. I still believe that’s the case. Investors repeatedly have punished SQ for supposedly disappointing guidance — and failed to reward the company for beating that guidance each time.
Here, too, valuation isn’t necessarily cheap. But there’s an obviously enormous opportunity. Square can grow into a current roughly 50x forward multiple (backing out cash). SQ still trades at a substantial discount to SHOP, its fellow small-business-focused play. I’d be surprised to see the stock re-test December lows of $50 — but if it does, I’d see that as a potentially compelling opportunity.
I’ve recommended Adobe (NASDAQ:ADBE) going back to 2017 and I don’t see any reason to stop now. This remains one of the best companies not just in software, but in the entire market. The shift to cloud offers one potential driver for growth. Moves into new end markets create another.
A long-rumored mega-acquisition by Microsoft (NASDAQ:MSFT) still makes some sense. And thanks to a 15% pullback since late July, ADBE now looks cheaper than it has in some time. It trades at just 28x forward earnings — only a few turns higher than MSFT, whose growth is far lower. A return to May levels, at which the stock looked like a buy, seems like a gift.
Like so many stocks on this list, ADBE already has soared, which might suggest the gains should be coming to an end. But Adobe has earned the upside in its stock — and this still looks like an excellent pick going forward.
Salesforce (NYSE:CRM) is the granddaddy of cloud stocks. And of late, it’s become a barometer for the many “great company, questionable valuation” growth stocks in this market, both in SaaS and elsewhere.
Like many of those stocks, CRM has pulled back. It touched a seven-month low in August, and is threatening to re-test those levels. Valuation still is a concern, with CRM stock trading at almost 48 times forward earnings.
Still, as with ADBE, there’s a quality business underpinning the stock. Salesforce has grown revenue at a 20%+ clip like clockwork. It was the fastest enterprise software company ever to reach $13 billion in revenue. Its well-respected CEO sees $30 billion “right around the corner.”
The case here is simple: If an investor wants exposure to the cloud, it’s simplest, and maybe best, to stick with quality. Both ADBE and CRM qualify.
In looking at the 49 components of the BVP Nasdaq Emerging Cloud Index, one name jumps out: online education software provider 2U (NASDAQ:TWOU). 2U stock trades at less than 2x revenue on an enterprise basis. The only stocks in the index remotely comparable are Box (NYSE:BOX), Carbonite (NASDAQ:CARB) and LogMeIn (NASDAQ:LOGM). Those three companies all have seen a dramatic deceleration in growth already — yet all three trade at a premium to TWOU on an EV/revenue basis.
Of course, the reason for TWOU’s low revenue multiple is a disastrous second-quarter report at the end of July. The stock fell a shocking 65% in a single session the following day.
As I noted in calling out 2U as one of the quarter’s biggest losers, there are risks in trying to time the bottom. There’s a real question as to whether the online education space will be as profitable as hoped. 2U is throttling back its growth to get spending in check. The issue with Q2 is not that the company’s results “missed” estimates. The concern is that the very business model is threatened.
But in a space with few, if any, true value plays, TWOU stock is an intriguing and high-risk play. It’s still the leader in its industry. An acquisition by a publisher like John Wiley & Sons (NYSE:JW.A, NYSE:JW.B) wouldn’t be a shock, given Wiley’s so-far-unsuccessful efforts to enter the space at scale. On an EV/revenue basis, TWOU admittedly is the cheapest stock in the index for a reason — but don’t ignore the fact that it’s the cheapest stock in the index.
Anaplan (NYSE:PLAN) seems like the quintessential cloud growth stock at the moment. The opportunity for the company’s connected planning platform seems enormous. It hits on so many of the drivers of SaaS growth: the need for better modeling, the exponential increase in the amount of data and the importance of cross-department communication.
But the stock also hits on many of the risks in the space. Competition will be intense. Valuation seems a potential question mark, even after a 25% pullback. PLAN stock still is up almost 188% in less than a year from its IPO price of $17.
At the moment, the long-term rewards seem to outweigh the risks. But further near-term weakness would hardly be a surprise. At 22 times revenue, PLAN isn’t cheap. Investors have been willing to pay expensive multiples for these kind of opportunities — but the question at the moment, for both Anaplan stock and the group as a whole, is whether that’s still the case.
Dropbox has an enormous base of users — well over 500 million at the end of the second quarter. The number of paying users continues to grow, as does average revenue per user.
That growth should get DBX stock to a reasonable valuation relatively soon. At 34 times forward earnings, it’s not like the stock is shockingly expensive. And that user base and the obvious utility of its service makes Dropbox an intriguing acquisition target, with Microsoft and Salesforce among the speculated buyers.
Of course, that opportunity is a bit of a double-edged sword at the moment. The long-running fear for Dropbox — and a key reason why the stock trades well below its post-IPO highs from last year — is that ostensible acquirers could choose simply to outcompete Dropbox.
Microsoft, Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL) and Amazon (NASDAQ:AMZN), in particular, can go after the company’s market share simply by marketing existing products to their own massive user bases. Indeed, InvestorPlace’s Will Healy made that case last year in comparing Dropbox to America Online, which is now part of Verizon (NYSE:VZ).
That said, that competition already exists and Dropbox still is growing nicely. Demand for its services isn’t going to wane. In this kind of market, at a price not far from all-time lows, the rewards seem worth taking on the competitive risk for a potentially defensive stock.
Paycom Software (PAYC)
Even by the standards of SaaS stocks, Paycom Software (NYSE:PAYC) has been a stunning success. The human capital management software developer went public in 2014 at $15 per share. By late August, the stock was at $259.
It’s not hard to see why. Growth has been fantastic. The company has been an earnings report juggernaut: It hasn’t missed Street expectations once, on either the top or bottom line, since going public. It’s provided everything investors want from growth stocks — including enormous upside.
That hasn’t been enough to insulate the stock from selling pressure in recent weeks, however. PAYC has pulled back some 21%. That’s enough to make the stock look at least interesting.
Admittedly, PAYC still looks hugely expensive on a revenue basis, at over 18 times trailing twelve-month revenue. But its margins already are enormous, bringing profit-based valuations in. PAYC trades at less than 50 times 2020 earnings per share estimates. And that consensus suggests 25%+ year-over-year growth. Assuming the recent trend of earnings beats continues, those multiples will come down.
And Paycom is a potential acquisition target, with Oracle (NYSE:ORCL) and ServiceNow (NYSE:NOW) among the logical buyers. For growth stock investors who see the category weakness as an opportunity, PAYC stock would be an attractive way to take advantage.
PayPal Holdings (PYPL)
PayPal Holdings (NASDAQ:PYPL) is yet another attractive “buy the dip” candidate. PYPL has dropped 19% since late July — on really very little in the way of news.
The revenue outlook given with second-quarter earnings was cut, but only modestly. Adjusted EPS guidance actually came up. PYPL now trades at about 31 times the midpoint of that guidance — hardly an onerous multiple given valuations in the payment space.
That sector still has years, and maybe decades, of growth ahead — and PayPal should be able to capitalize. The loss of eBay (NASDAQ:EBAY) will hurt, but this looks like a short-term pullback before the long-term rally resumes.
Interestingly, PFPT stock has dodged the general weakness afflicting SaaS stocks. It actually briefly touched an all-time high last week. Resistance has held repeatedly around current levels, but a strong Q3 report this month could lead to a breakout — and more upside.
Like most cloud growth stocks, Proofpoint stock isn’t cheap. But a 60 times forward price-to-earnings multiple, against a nearly 30% EPS growth rate, means the company can grow into that valuation. Strength in both Proofpoint products and the industry as a whole suggest Proofpoint should easily be able to do so.
Investors might do well to put enterprise software developer Workday (NASDAQ:WDAY) on their watch lists for the time being. WDAY stock looks like a classic falling knife, with a 27% decline in less than three months and no sign, yet, of a bottom.
Meanwhile, as InvestorPlace’s Luke Lango pointed out last month, Workday posted a beat-and-raise fiscal Q2 report — and still sold off in response. That reaction from the market suggested, Lango wrote, that WDAY was overvalued heading into the release.
Of course, WDAY was threatening $200 before the Q2 report and hit $225 in July. It’s now at $170 and falling. The company still receives an 12x multiple to 2019 sales even after the decline, but valuation at the least is more reasonable.
If that valuation continues to come in, WDAY looks like a strong play. The company is one of the largest SaaS plays out there, with revenue clearing $3 billion. Its diversified reach should keep it a behemoth for years to come. And Workday could be an acquisition target down the line, even at a current market cap of $39 billion.
Again, WDAY looks like a falling knife and that’s always dangerous from a trading standpoint. But once the stock bottoms, the rally should resume.
As of this writing, Vince Martin has no positions in any securities mentioned.