2 Stocks to Defy the Internet Software and Services Industry – November 24, 2021

The outlook for the Internet software and services industry looks negative based on the trend of the revision of estimates from the past year, largely driven by the pandemic. However, some companies were positively impacted by the pandemic and the rush to digitize trend it sparked. The diversity of players in this group is the reason for this dissonance.

As the backbone of the digital economy, it’s hard to see this industry underperforming in the long run. However, the short-term outlook could have been better. To make matters worse, the ratings are through the roof. Under the circumstances, Criteo (CRTO) and Donnelley Financial Solutions (DFIN free report) are the only ones that warrant a closer look.

About the industry

The Internet Software & Services industry is a relatively small industry primarily concerned with enabling platforms, networks, solutions and services for online businesses and facilitating customer interaction and the use of Internet-based services.

Three themes driving the industry

  • The overall impact of COVID is mixed for the industry. While it required working from home for employees, the industry, which was naturally tech-centric, had relatively fewer problems with this. On the other hand, business continuity concerns accelerated the shift to cloud-based working for many companies, while service providers, both work-related and otherwise, also moved to Internet-based channels. Another large segment that did massive amounts of online business was retail. All these movements were positive for the sector (in terms of turnover) and partly offset the negative impact of the declining turnover at physical players. At least some of the positives will survive the pandemic. In other cases, the return to physical surgery will be positive as that segment returns to normal. Any improvement in the general level of economic growth will also improve the outlook for the industry.
  • However, the increased volume of business managed via the cloud and the increasing demand for supporting software and services brings with it the build-up of infrastructure, increasing costs for players. This causes large swings in profitability as new infrastructure is depreciated and new debt is paid off. The pandemic exacerbated this situation, leading to weak profitability in 2020, with 2021 growing from 2020 levels, but not quite up to 2019 levels.
  • The level of technology adoption by companies and the proliferation of connected consumer devices that can help people connect and do business online are also impacting growth. The high penetration of mobile devices among users and the pandemic-driven necessity are driving more companies to adopt technology that they previously stayed away from due to cost.

Zacks Industry Rank Indicates A Recovery Is Underway

The Zacks Internet – Software & Services industry is housed in the broader Zacks Computer and Technology sector. It has a Zacks Industry Rank #95, placing it in the top 38% of more than 250 Zacks-rated industries. Our research shows that the top 50% of Zacks-ranked industries outperform the bottom 50% by a factor of more than 2 to 1.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all member stocks, indicates that while the industry is recovering from pandemic-induced problems, certain problems remain.

Despite the industry’s positioning in the top 50% of Zacks-ranked industries, the earnings outlook for its constituent companies overall continues to deteriorate. Looking at the aggregate revisions to the estimates, it appears that analyst confidence in the group’s earnings growth potential for 2021 has fallen more or less steadily since last November. Over the past year, the average profit estimate for 2021 has decreased by 63.2%. The estimate for 2022 is not much better, down 42.3% from November last year.

Before we present some stocks you may want to include in your portfolio, let’s take a look at recent stock performance and the valuation picture of the industry.

The stock market performance of the industry suffers

Last year’s performance of the Zacks Internet – Software & Services Industry shows that it has largely lagged the broader Zacks Computer and Technology sector, as well as the S&P 500. After a brief peak in February, it declined sharply, widening the gap by both groups has since broadened.

The sector’s overall stock price appreciated just 2.6% over the past year, compared to the broader sector’s rise of 32.6% and the S&P 500’s rise of 30.0%.

One year price performance

Zacks Investment ResearchImage Source: Zacks Investment Research

Current industry valuation

While many of the players are currently making losses, the industry as a whole continues to generate profits. So based on the 12-month price-to-earnings (P/E) ratio, we see that the sector is currently trading at 77.57X, close to its highest multiple of 77.60X in the past year. The P/E of the S&P 500 is 21.99X (at the median value). The sector is also overvalued compared to the sector’s 12-month forward P/E of 29.36X (at last year’s high).

The sector has traded in the annual range of 57.71X to 77.60X as the chart below shows.

Forward 12 Month Price-Earnings Ratio (P/E)

Zacks Investment ResearchImage Source: Zacks Investment Research

2 stocks worth a closer look

Donnelley Financial Solutions Inc.: Donnelley Financial provides software and services for content creation, management and distribution, as well as data analysis and multilingual localization services.

Continued strength in capital markets, customer acceptance of new recurring software products, strong demand for Arc Digital and ActiveDisclosure compliance software, as well as the transaction software Venue. In addition, a stronger mix of software solutions continues to drive profitability.

This Zacks Rank #1 (Strong Buy) company is up 206.7% in the past year. The Zacks Consensus Estimate for the 2021 EPS is up $1.05 (25.8%). The estimate for 2022 increased by $1.25 (28.2%).

Price and consensus: DFIN

Zacks Investment ResearchImage Source: Zacks Investment Research

Channel Advisor (ECOM free report) : This provider of cloud-based e-commerce solutions and services, including marketplaces, comparison shopping, paid search, social campaigns, flex feeds, web stores and rich media serves traditional retailers, online retailers, brand manufacturers and advertising agencies.

The company has benefited from investments that facilitate the digital transformation of its brands, as well as its focus on product innovation, channel expansion and revenue retention. It also continues to grow its customer base, adding Master Lock, Detroit Diesel, Sennheiser, Xiaomi and Natural Balance Pet Foods in the last quarter.

This Zacks Rank #2 (Buy) company is up 82.1% over the past year. The Zacks Consensus Estimate for the 2021 EPS is up 8 cents (9.3%). The estimate for 2022 increased by 7 cents (7.8%).

Price and Consensus: ECOM

Zacks Investment ResearchImage Source: Zacks Investment Research

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