We recently published a list of Jefferies’ Top Crowded Software Long Positions: Top 10 Stocks. In this article, we are going to take a look at where SAP SE (NYSE:SAP) stands against other Jefferies’ top crowded software long positions’ stocks.
After the post-pandemic rush and the subsequent inflation and glut-driven crash experienced by technology stocks, the sector is now fully bathing in the tailwinds and headwinds generated by artificial intelligence. Yet, unlike the pandemic, inflation, and interest rate-driven effects, AI has grown the addressable market for technology companies and shaken up several of them as well.
Within technology, one sector that has been shaken by AI is the software industry. Before AI, software firms were content with generating stable subscription-driven recurring revenue, but with AI, investors are not only focused on their ability to deliver AI products and monetize them but also on the fact that the firms themselves might be made redundant because of the new technology.
Nowhere else is the latter effect clearer than on software as a service (SaaS) stocks. These stocks offer software products on a subscription basis, and their narrative is based on their ability to deliver technologically complex products that businesses are unwilling to develop because of costs. The impact that AI has made on the SaaS sector is driven by the opinion that as AI enables users to easily create their software, several SaaS companies might not be needed in the business world.
To understand how AI has impacted software stocks, consider data from hedge fund Coatue Management. It shows that booming AI interest has led to software stocks taking the back seat as semiconductor stocks bask in investor attention. During the SaaS peak of 2022, the difference between the returns offered by a SaaS stock index and the semiconductor index were at their highest for the past decade. But, as of June 2024, the difference between the semi and the SaaS index is at the highest for the past decade in a 180-degree paradigm shift driven by AI.
These returns have also been driven by the beefy margins delivered by the semiconductor firms. Margins are a key valuation driver of SaaS stocks, and one popular valuation tool among investors is the Rule of 40. This rule sums up a SaaS stock’s revenue growth rate and profit or operating margin and checks whether the new value is greater than 40. As a result, margins play a key role in SaaS valuation, as a 40% or higher margin means that the firm can get away with little to no growth.
Why is 40% important? Well, according to Coatue, as of June 2024, Wall Street’s top AI GPU stock pick and the stock that ranked 6th in our list of the 10 Most Profitable Stocks of the Last 10 Years had operating margins of 65% and 49%, respectively. On the flip side, the largest software company in the world known for its Windows operating system had a margin of 44%. For chip stocks, new products drive margins since they can charge a premium through high prices. Whether these margins are sustained is another matter, and it was also part of the reason that the GPU firms’ shares fell by 6% as its full-year margin gross guidance of mid-70 % fell short of analyst expectations of 76.4%.
Coming back to software stocks, another metric used in their valuation is the price-to-sales ratio since several software and SaaS firms are unprofitable. In the era of AI, the SaaS index quoted by Coatue is trading at 5.5x price to forward sales. This is well below the long-term median of 7.2x and just a quarter of the 2021 peak of roughly 22x. This valuation compression is accompanied by lower revenue growth estimates. As mentioned above, growth is a fundamental tenet of SaaS and software valuation, and as of June 2024, just one percent of software companies had a next twelve-month revenue growth rate greater than 30%. At the peak of the software boom, 30% of firms faced similar expectations. Digging deeper, several factors are driving this trend.
AI is affecting SaaS stocks by making them shift to a consumption-driven model that charges customers for the services used instead of seat-based packages that simply sell capacity. Additionally, software stocks are also reckoning with the fact that their customers might end up using AI to cost-effectively develop their software instead of relying on expensive third-party options. As Jensen Huang shared in a 2021 interview with Time Magazine, well before his firm’s stock posted 1,100% in share price gains:
“AI is a watershed moment for the world. Humans’ fundamental technology is intelligence. We’re in the process of automating intelligence so that we can augment ours. The thing that’s really cool is that AI is software that writes itself, and it writes software that no humans can. It’s incredibly complex. And we can automate intelligence to operate at the speed of light, and because of computers, we can automate intelligence and scale it out globally instantaneously. Every single one of the large industries will be revolutionized because of it. When you talk about the smartphone, it completely revolutionized the phone industry. We’re about to see the same thing happen to agriculture, to food production, to health care, to manufacturing, to logistics, to customer care, to transportation. These industries that I just mentioned are so complex that no humans could write the software to improve it. But finally we have this piece of this new technology called artificial intelligence that can write that complex software so that we can automate it. The whole goal of writing software is to automate something. We’re in this new world where, over the next 10 years, we’re going to see the automation of automation.”
So, as the software industry undergoes a once-in-a-generation shift, it’s important to see how institutional investors are positioning their trades. Its latest survey is historic as it shows that just 19% of institutional investors are overweight in software stocks, the lowest reading recorded since the survey started. The figure sat at 51% in January and dropped to 28% in July. Yet, even though investors are less overweight, they’ve also reduced their short exposure as they’ve shorted 54 software stocks as of October 11th – down from 73 in July. So, let’s take a look at the stocks that they persist to be long in.
Our Methodology
To make our list of Jefferies’ top overcrowded software long positions, we ranked the top ten crowded long 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).
A data centre room with cloud technology, illustrating the enterprise application software services.
SAP SE (NYSE:SAP)
Number of Hedge Fund Holders In Q2 2024: 31
Shares Short % Of Outstanding: 0.14%
SAP SE (NYSE:SAP) is a key player in the global enterprise resource computing industry. Gartner believes that the firm holds 24% of the global enterprise resource planning industry. This provides SAP SE (NYSE:SAP) with a wide moat, as firms typically do not change their ERP software unless forced to do so because of the high costs and high risks of business disruption involved. Consequently, at a time when non-AI cloud-driven stocks have struggled in a sluggish business environment, the software company has held its own. SAP SE (NYSE:SAP)’s shares are up 54.7% year to date as consistent performance on the earnings front has kept investors bullish. Its second-quarter earnings in July set the shares soaring by 7% after its operating profit jumped 33% annually to touch €1.94 billion and beat analyst estimates of €1.81 billion. A 33% growth is nothing short of incredible in today’s industry where some of the biggest software firms have struggled. To top it up, October was a historic month for SAP SE (NYSE:SAP) as it became the most valuable company in Europe after chip manufacturing equipment provider ASML slipped by a whopping 19.9% following a weaker-than-expected sales outlook. SAP SE (NYSE:SAP)’s third-quarter results saw it grow revenue by 9% to €8.47 billion. Its backlog jumped by 29% to €15.4 billion, with revenue also surpassing analyst estimates of €8.45 billion.
During the Q2 2024 earnings call, SAP SE (NYSE:SAP)’s management commented on why it’s seemingly immune to the headwinds that the broader industry is suffering from:
“I mean, Mark, indeed, I mean, we have seen a fantastic performance in half year 1, and now entering half year 2, we see very healthy pipeline. And pipeline means sales pipeline but also I see a very strong innovation pipeline.
Now when you sit together with our product owners and see what we are delivering on GenAI use cases and the customers who are sharing their feedback early on, it’s pretty exciting. I mean they see a ton of value, and you have seen now in Q2 already the first impact of Business AI on our numbers.
And then second, what I also see clearly working now is the best of suite. I mean 4 years back, we were rightfully criticized for having a bunch of best-of-breed solutions. But when you want to have a high-quality AI, when you want to steer your business end to end, when you want to connect your commerce and your omnichannel with supply chain and when you want to connect your procurement with the warehousing, I mean, that all comes together on BTP.
And I would say we are also just at the beginning. I mean please don’t forget, when customers are using their ECC solution, so their on-premise monolithic ERP solution today, that doesn’t mean that they use all the modules in the past. And now with our land-and-expand strategy, we have really, I mean, a motion that customers are really landing. And then they get that they have to connect the different parts of their company and the different parts of the supply chain. And that’s why we also stay confident for the second half of the year.”
Overall, SAP ranks 1st on our list of Jefferies’ top crowded software long positions’ stocks. While we acknowledge the potential of SAP 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 SAP but that trades at less than 5 times its earnings, check out our report about the cheapest AI stock.
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Disclosure: None. This article is originally published at Insider Monkey.
