Is Macro Finally Catching Up With Enterprise Software? - 7investing

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Is Macro Finally Catching Up With Enterprise Software?

Anirban checks in on enterprise software behemoths Microsoft & Salesforce to see how they are managing macroeconomic headwinds...

September 10, 2022

In June, I wrote about the strength in the enterprise software market, given the worsening of the broader economic environment. At that time, while many businesses were feeling the pain of inflation, supply chain disruption, and foreign exchange headwinds, the enterprise software behemoths were traveling just fine. At that time, it appeared enterprise software demand hadn’t slacked, and while they were buffeted by the strengthening of the US dollar, they were also getting some benefit from that strengthening. Why? Because while topline growth suffers because of a stronger US dollar, there’s some natural hedge in the form of regional spending, which moves down. 

My June commentary was based on company reports in the first 3 (or so) months of the year. As the second quarter reports have now rolled in, we can go back and see what the enterprise software world is now saying about the demand environment. 

It isn’t good news if you are in for the punchline. These businesses are now starting to feel the macro pain, resulting in more deal scrutiny, longer sales cycles, and generally shorter-term deals. That translates into sharply lower growth for the year’s second half.

Microsoft Says The Enterprise Is Strong

Let’s first look into what Microsoft is saying about the current environment. For the quarter ending June 2022, Microsoft reported year-over-year revenue growth of 12% and earnings per share (EPS) growth of just 3%. Amy Hood, Microsoft’s CFO, started her prepared remarks by noting “the impact of the macroeconomic environment” on the results. In Microsoft’s case, the strong US dollar, reduction in advertising budgets, and a slowdown in deals from small/medium businesses were the biggest detractors. 

Looking at Microsoft’s guidance for the next quarter and management’s commentary during their recent Q4 2022 conference call, it appears that the softness in some of their segments is being more than compensated by the more robust performance of their cloud business. Azure, in particular, is going strong, and its core commercial offerings are also delivering solid results. 

However, as I have already mentioned in my cloud computing checkin, the cloud computing hyperscalers, including Azure, have also experienced some pullback in their growth rates, although they remain strong especially considering the scale at which they are growing.

Salesforce Suggests Demand Softening

Let’s next look at how Salesforce, the granddaddy of software as a service, is saying about the current environment.

Salesforce’s second quarter fiscal 2023 results were strong, with revenue growing year-over-year by 22%. Constant currency growth at 26% highlights how much pain foreign exchange impacts. 

Co-founder and co-CEO Marc Benioff once again emphasized how digital transformation remains the number one priority of business managers. Still, CFO Amy Weaver had many words of caution about the demand environment.

According to Salesforce, they started to notice deal cycles getting stretched, including a lot of additional scrutiny being added, in July. Management says they see a significantly more measured approach from all their customers. 

The conservatism seen in July meant Salesforce had to reduce its fiscal 2023 guidance to around $31 billion. And if we do simple digging, based on the company’s Q3 2023 guidance of $7.82 billion, a further contraction in growth is baked into Q4, which I think is looking for around a 7% year-over-year sales growth.

Scrutiny on deals, elongation of sales cycles, and generally shorter-term deals mean that contracted revenue is also growing at a much slower pace. For Q2 2023, the remaining performance obligation (RPO) increased by just 15% to $41.6 billion. Of course, nearly $42 billion in contracted revenue that will be recognized in the future is undoubtedly fantastic and shows the depth and breadth of Salesforce’s products and services.

So Who’s Right?

So, who do you believe? 

It’s worth noting that Salesforce’s quarter ends in July, while Microsoft’s ends in June. And Salesforce specifically points to July being the starting point of weakness. And furthermore, while Microsoft’s earnings call was late in July, Salesforce’s call was in the last week of August. If things changed sharply in July, Salesforce had a better view of the situation and thus could incorporate it into their guidance.

The 7investing Takeaway

The above is interesting but also points to the futility of reading too much into the tea leaves. Based on the earnings calls just 3-months ago, one could say – as I alluded – that enterprise software remains in demand. One could say enterprise software and cloud computing are more in the evergreen category than other sectors. While that statement is true, it doesn’t mean they are immune to macroeconomic factors.

More broadly, I think it helps to take a long-term view and look for companies in the enterprise software industry that are likely to keep growing for years to come. We know this business model has high margins and gushes cash at scale. Right now, perhaps the best thing we can do is look carefully at these secular compounders and focus on those getting sold off because of macro worries. If a secular compounder becomes too cheap, it should perhaps move high up on our watchlist. 



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