The last 15 years have been great for companies developing cloud-based enterprise software solutions. Software companies typically benefit from the transition from a perpetual license sales model to a subscription model. They were also able to simplify their software development because their programs would run on remote servers rather than local machines with a wide range of hardware and operating systems to support.
The market rewarded the good results of many of these businesses, but not everyone was sold on the high valuations of software-as-a-service (SaaS) stocks.
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Value Investors at Harris | Oakmark felt that the market overvalues most of the stocks in the sector, especially because it pays too little attention to the impact of stock-based compensation, which exists in SaaS companies. The market also has a tendency to expect SaaS companies’ revenue growth rates to be linear, given the potential impact of normal competition, analyst Jeremy G. Thames argued.
But the market is starting to consider the possibility that new competitors will seriously eat into the sales of many established enterprise SaaS companies. The potential for artificial intelligence (AI) tools to replace existing solutions is likely to drive stock prices across the industry. In fact, prices have fallen so low that Harris | Oakmark is now looking at some buying opportunities.
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The massive sell-off in software stocks over the past few months has been due to the perceived threat of artificial AI. Tools like CloudCode from Anthropic enable people without a background in software engineering to build custom applications. Anthropic expanded its cloud code agent into general workplace productivity tasks with the introduction of Cloud Workspace earlier this year, posing a direct threat to many established companies. In addition, some see the ability of LLMs to facilitate natural language interaction with software that reduces the learning curve for software and lowers switching costs.
But Thames insists that the fear that AI will completely disrupt the business models of many software companies does not reflect how the industry or large companies operate. He offers two clear reasons why the threat of AI can be eliminated.
The first is that traditional web-coded software is unlikely to replace established enterprise software suites offered by giants such as Sales force(NYSE: CRM ) or SAP(NYSE: SAP ). The reason businesses use these products is not because they have special features or better user interfaces.
“Criminals prefer manufactured players because they are industry standard products,” Timms writes. This status brings with it a level of reliability, support services, a community of users to ask questions and help develop solutions, and a wide ecosystem of software and services that work with it.
In other words, you get more than just software when you use Salesforce, SAP, or any other widely used program. This raises switching costs and provides benefits unmatched by new start-ups or traditional web-based solutions.
Second, Thames argues that implementing a large language model in the workforce may ultimately benefit existing software providers.
“The utility of any AI tool is ultimately limited by the depth and quality of data it can access and handle,” he said. “We believe that current enterprise software companies have a unique advantage here.”
In fact, Salesforce builds its own AgentForce service behind its data cloud, which collects and stores enterprise data. At the same time, it has decades of user-generated data that it can pull from. This supports Thames’ belief that “as AI becomes an integral part of the modern enterprise, it will rely heavily on the structured, reliable data and workflows that are encoded in these core systems.” As a result, AI may actually make software solutions even more valuable to businesses.
Not every software company will be immune to the challenges posed by artificial intelligence, and not all will be able to take advantage of the opportunities the technology offers. But the indiscriminate selloff in software stocks has created many great opportunities for investors.
Harris | Oakmark Memo calls both Salesforce and SAP. Both companies are involved in their customers’ operations, as they have long used a land-and-expand strategy to increase the value their customers deliver to them over time.
SAP continues to transition to the cloud and posted 25% growth in its current cloud backlog last year. However, this was not enough to quell fears that AI would displace its products. Management said the number would be higher, but it was negatively impacted by long-term deals that have had a major ramp-up in recent years.
Salesforce is effectively using AI to increase the value of its entire ecosystem. Its AgentForce platform enables customers to create AI agents that effectively use its software. AgentForce sales increased 169% year-over-year to $800 million.
The software space includes other great opportunities Microsoft(NASDAQ: MSFT ) and service now(NYSE: NOW ). Revenues from Microsoft’s enterprise software segment, which includes the Microsoft 365 suite and Dynamics 365, are still growing at high percentage rates. This growth was driven by the integration of its Copilot AI feature, which now has 15 million paying customers. With a total of 400 million users of Microsoft 365, it still has a lot of room for growth.
ServiceNow has been quick to adopt productivity AI features in its software suite. It sees strong movement from Now Assist; Its annual contract value reached $600 million by the end of 2025 and is on track to reach $1 billion by the end of 2026. The company positions its AI Control Tower platform as the centerpiece for any enterprise agent AI strategy, allowing them to integrate first- and third-party AI agents into their software.
After the decline of these stocks over the past few months, they all present buying opportunities. Their forward P/E ratios range from 15 (Salesforce) to 29 (ServiceNow) and accurately reflect each company’s growth potential while accounting for the risks posed by AI. Importantly, all of these companies have demonstrated the ability to adapt to AI and build moats around their businesses.
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Adam Levy has held positions at Microsoft and Salesforce. The Motley Fool has and recommends positions in Microsoft, Salesforce, and ServiceNow. The Motley Fool recommends SAP. Motley Fool has a disclosure policy.
These Long-Term SaaS Bears See Value in the Beaten Software Sector Now – Here’s What They Say Investors Are Getting Wrong Originally published by The Motley Fool
