Is Software Dead?
What's happening with software in the public and private markets?
Around two months ago, I wrote a piece on reviving software with AI. I’ll be writing another piece on my thoughts on both the public and private markets. I’ll keep these posts more brief and succinct, and hopefully, I can begin to write more during the school year. Here we go…
It goes without saying that AI is the dominant driver of return. 2/3 of S&P 500’s returns are from AI and 90% of NASDAQ’s returns are from AI. This data is updated as of June 2024. My view still stands from the last piece that AI is the new platform shift succeeding cloud and SaaS. However, this begs the question. Is software dead?
Before we answer the question, there are new areas of AI infrastructure beyond semis that are doing better than internet and software companies. Industrials, utilities, and energy companies are driving significant returns while internet and software stocks lag behind.
If we look at the SaaS index vs the Semis index, we’ll notice how we’re entering the era of AI from cloud. So, a couple of next questions that we’ll answer: 1) Is this an AI bubble? 2) Why is software being crushed? Why can’t AI and cloud rise together? 3) And is software dead?
So, are we in an AI bubble?
Short answer: I don’t think so.
During the 2000’s boom, Cisco traded at a 37x 5-year average P/E multiple. At its peak during the dot-com bubble, the company traded at 132x.
So, where is Nvidia trading now? (hint: nowhere as high)
Nvidia is currently trading at 64x P/E and the company has a 10-year average of 50x, reflecting a 1.2x over its historical average. Not a math wiz here, but that doesn’t sound like a bubble to me.
Moving to question 2: why is software being crushed?
If you had read my previous article on software, you would know the answer. But to answer simply, it’s justified by lower growth expectations. New net revenue is harder to come by, and companies have effectively been throwing more S&M spend without achieving impressive growth numbers.
However, why is it harder to get new revenue? There are three main reasons:
Seat growth running out of steam: SaaS vendors have saturated seat penetration. This is to say that there are simply not enough customers out there needing to purchase more seats for software especially in a climate where headcount is being reduced. Here’s a visual: company X has 10 employees who bought 10 seats from company Y. Company Y can’t sell more seats (increase revenue) to company X because there’s only a finite number of employees — and thus their revenue growth declines.
Macro climate dries up IT budgets: IT budgets are under pressure and companies are focused on cost reduction/optimization. This is where we see this shift from growth to profitability, and a way of becoming profitable is to spend less. By extension, this lowers revenue growth.
AI Cannibalization: Markets are investing in anything with “AI.” That said, companies invest more in AI and leave less money on the table for traditional SaaS. Say it with me – less revenue growth.
So, is software dead?
No, software is not dead. My view remains the same on what AI can do to software and SaaS. Software companies will need to become AI companies to survive, and I’ll direct you to my previous article to learn why. That said, to survive, AI is the new software.
Enough about the public markets, what are we seeing in the private markets?
Not surprisingly, AI is also being heavily rewarded in the private markets. We’re seeing funding normalizing, and as of June, there were a total of 200 total AI deals and 7,000 non-AI deals. AI made up around 3% of total deals.
However, 15% of capital was invested in AI. AI companies had 5x the valuation and 6x the round size compared to their non-AI peers. If you’re a startup founder, is this convincing enough to incorporate some form of AI to your company?
We’re also seeing a backlog of unicorns, and not enough tech IPOs. There were more IPOs in 2008 during the GFC than now. But, why is this the case? There are three issues:
Public markets have changed: We’re seeing more passive index and ETF investing, favoring larger companies. Previously, there used to be more mutual funds and active managers looking for opportunities in emerging companies. However, with a decline in active management, emerging companies are not seeing as much interest from public investors. Subsequently, this means the bar to become public has become significantly higher. A company needs to have significant revenue, earnings, and margins — more “buyers” — before they can IPO.
Private valuations could be higher than public markets: I visited Bessemer this past weekend, and one of the investors spoke to the valuation disconnect between the public and private markets. In my view, there’s excess capital (dry powder at an all time of $1T) chasing these deals. As a result, investors begin to bid crazy premiums to win a deal, and thus drive up valuations.
Opportunity costs in public markets are high: There are some stellar companies in the public markets right now that investors are comparing these emerging companies to. If investors can invest in a company delivering growth, profitability, and at a good price — why would a rational investor invest in an emerging company with only one of these traits checked off?
However, if you’re a founder, don’t fret. IPO isn’t the only way to provide liquidity and exit. Other than strategics, sponsor PE can be an exciting exit to consider as well.
Until next time :)
(p.s. this was totally written at 2AM, so please forgive me for any errors)