Morgan Stanley sees unfavorable risk/reward for a lot of the "high fliers in software"
Shares of ServiceNow (NOW) and Slack Technologies (WORK) are under pressure on Wednesday after Morgan Stanley analyst Keith Weiss downgraded the former to Equal Weight and lowered his price target on the latter to $28. Weiss believes ServiceNow is facing increasing near-term risks, while mixed second quarter results, increasing competition, weakening IT spending environment, and mixed commentary from management around converting free users to paying ones likely limit the multiple investors are willing to pay for Slack, .
SOFTWARE CORRECTION: Despite solid secular demand trends behind software and generally solid second quarter results, software stocks have pulled back 23% on average from the 52-week highs, Morgan Stanley's Weiss and his colleagues at the firm noted in a sector note. With a combination of high growth software multiples at historical peaks and heavy institutional ownership, prices proved difficult to sustain against a volatile macro environment and sector rotations away from momentum names, the firm said. The analysts see an unfavorable risk/reward for a lot of the "high fliers in software," but also see continued opportunity in several areas of the software group, in particular names with solid support from price-to-earnings or enterprise value-to-free cash flow multiples.
Weiss and the team are bullish on defensive secular growth categories, including cloud computing franchises Microsoft (MSFT) and Salesforce (CRM), as well as the broader analytics and machine learning segment. At the same time, deteriorating CIO results give them pause when it comes to legacy software vendors like VMware (VMW), Oracle (ORCL) and Symantec (SYMC), and ERP software vendors such as Oracle and Workday (WDAY).
MOVING TO THE SIDELINES ON SERVICENOW: In a separate research note, Morgan Stanley's Weiss downgraded ServiceNow to Equal Weight from Overweight, with an unchanged $267 price target. The analyst acknowledged that the company remains "a best-in-class" Software-as-a-Service provider, growing 30%-plus on a $3B-plus subscription base with superior unit economics and free cash flow margins. However, he argued that increasing near-term risks balance the risk/reward.
The analyst sees ServiceNow's risk profile increasing over the next six months given tougher subscription billings compares in the back-half of the year, high expectations with the stock up more than 50% year-to-date, and lack of a permanent CFO and recent sales attrition that may lead to a more cautious initial guide for fiscal year 2020 than most investors expect. Weiss also noted that his firm's recent CIO survey highlighted the increasingly uncertain macro environment, particularly in Europe, which is another concern for ServiceNow.
TOUGHER ROAD TO LARGE OPPORTUNITY: Morgan Stanley's Weiss also lowered his price target for Slack Technologies to $28 from $38, while reiterating an Equal Weight rating on the stock. Mixed second quarter results, increasing competition, weakening IT spending environment, and mixed commentary from management around funnel conversion issues likely limit the multiple investors are willing to pay for Slack today, he contended. While he thinks the long-term opportunity at Slack remains relatively unchanged, the analyst does not think Slack will benefit from expanding multiples, with upside from current levels coming from more gradual outperformance over time.
PRICE ACTION: In afternoon trading, shares of ServiceNow have dropped about 7.5% to $254.12, while Slack’s shares have slid over 6% to $23.18.