Software: In the AI storm

0:02Raimo Lenschow:Hey, everybody. Welcome back to the Barclays Brief. For equity investors, software is very much in the eye of the AI creative destruction storm right now. We're in the midst of a historic sell-off, and there is a lot of fear about the end state of where this all shakes out. And that makes it a perfect time for us to have Raimo Lenschow join us. Raimo is our head of North American Software Research and Equities. Raimo, welcome to the pod.

0:25Ronnie Wexler:Hey, thanks. Thanks for having me. And I'm really excited to talk to you here about this.

0:28Raimo Lenschow:Everyone cares a lot about what's happening in your space right now, so let's get into it. So the U.S. software space is down about 30 % from the September highs. Year-to-date, it's down around 20 % versus a roughly flattish market, and the valuations have compressed significantly. If you look at bellwethers in the space, like Salesforce, they now trade at something like 10 times forward free cash flow estimates, which historically were reserved for X growth companies in the tech space. Can you please educate our listeners on what sparked this Swift repricing and maybe bring some of these moves to life for us?

1:02Ronnie Wexler:Yeah. And it's really interesting because the ChatGPT is now out for two years. So why does this move only happen now? And two years ago, we started like, who are the AI winners or losers? But then very swiftly, we moved on. What changed now is two things. One is we had first products out from the AI model companies. So they kind of not just came out with models, but they just came out with products that you can use with these models. So it became all a little bit more real and people were a little bit more scared about the impact now on some of the names that I cover. The second thing that came with it was that we still have very huge announcements around investment cycles and the capex that needs to be built, especially from the large hyperscalers like AWS, Google, Microsoft.

1:47Ronnie Wexler:And so we now have that fear on the one hand that we're overspending and overbuilding. On the other hand, we have like more real products out there to make it more real. And so on both sides, people are getting nervous and that kind of didn't create a good setup for software.

2:02Raimo Lenschow:So look, one thing I've learned in my career is these things are never simple, right? There's always a lot of nuance. I love the title of your most recent research report, which is Software is Not Dead, Just Changing. In it, you argue that the space deserves a different level of focus and maybe some greater differentiation than we've seen recently. Expand on that for us.

2:20Ronnie Wexler:Yeah, I mean, the starting point should be like, what are we doing with AI? It's like AI is recreating software, so it's still software. And so from that perspective, the world is not completely different. We just kind of have a kind of a next generation players kind of emerging here. But we also have like the existing guys that are aware of what's going on and will start to react. So the argument that we were trying to make in that note is you can't just throw all of software out. It doesn't make any sense. you really need to start thinking about what is AI standing for? What is it doing? And the generative AI that we're seeing today is basically extremely good and summarizing huge data sets and giving you probabilistic answers of what you probably want to hear next or what the answer should be.

3:05Ronnie Wexler:And so that enables a lot of new things. And we all as consumers and enterprises kind of have worked with this, and it's really exciting. But there's some truths that are still going to be there. There's still a lot of software guys out there that I cover that are actually more around the deterministic flow. That means like, you know, a number needs to be a number. We don't want guesses about what my revenue is. I want a revenue number. And so from that perspective, the point that we are making is don't look at all of software and think all of software is dead. You can, if you spend the time and learn about what Gen.AI stands for, there's really nice and interesting opportunities, especially after this I love.

3:42Raimo Lenschow:So let's get a little granular on the perception currently, which is just blunt force trauma to everything in space versus the reality of what AI will do and mean and how it will impact software. How will it actually impact software and how do you see the evolution of that?

3:59Ronnie Wexler:Yeah, there's going to be smaller players that had like point solutions that, you know, added a few features. There I would be worried about the impact of Gen.AI. But I have these big corporate platforms out there. They're mostly the larger market cap companies that we're covering. They will still be there. And the other thing that usually happens in these cycles when new technology comes up is a small Gen AI company has the choice. Yes, they have a good product or they might have a new product. But do they also have the willingness to scale it up and hire hundreds and thousands of sales guys and build up operations?

4:34Ronnie Wexler:because what happens a lot of the time is that the people that already are scaled up, and it's the big platforms that I mentioned, they will just then subsume some of these new technologies and be able to offer that. And so, as I said, you need to differentiate a little bit more. Maybe one point is to think about the big platform guys. They still will be there. And then on the smaller guys, you just need to take it on a case-by-case basis.

4:59Raimo Lenschow:All right. So for the space as a whole, valuation's compressed a lot. But the pushback I get for people who are hesitant to step in is that we're kind of now at a market multiple for the software space. Does that mean things have gotten cheap enough to stabilize here in your eyes?

5:13Ronnie Wexler:Yeah, look, like true valuations are kind of at market level. But remember also like software is usually growing at above market rate. And that's why people were excited about software for so many years. And so I don't think valuation is kind of necessarily the thing that needs to come down dramatically from here. What we now need is more a catalyst of people realizing what's getting me out of this. And one of the things, well, or, you know, how do I kind of get more confident about what's going on in the space? And here the question is, okay, do I get, you know, revenue estimates that are kind of going up for some of the large-act players driven by some of the AI products?

5:54Ronnie Wexler:Do I get new product announcements? and also time will be a big factor here because at the moment we have a lot of share price reactions from just product announcements from the large AI players but those products still need to come into the market so that usually takes much, much longer and a lot less exciting.

6:12Raimo Lenschow:Let's spend a little bit of time on the things that make software difficult to rip out. You talk about system of record often. You wrote a lot about it in your most recent report. Why don't you educate us on what system of record is as it relates to software?

6:27Ronnie Wexler:Yeah. So if I run a company, I need to have like a certain sense of truths. Like, you know, this is who we are. This is what we do. These are the numbers that we're all discussing. And those numbers are in the system of record. So think about it on the accounting side. You have vendors like SAP, Workday, et cetera, that are having your financial numbers. You can't have a Gen AI thing there that probabilistically gives you some number. You want the number, okay? And so these systems are, you know, you need them. They can't go away. The one where I have the most debate about is around Salesforce because, you know, at face value, you'd think like, oh, well, they're like a tool to help sales guys sell better.

7:12Ronnie Wexler:Salesforce is so much more a system of record than people give it credit for. And so that would be another example for that.

7:18Raimo Lenschow:So the way I think about this, and I've spent a lot of time on it, is we're going to go through this period of turbulence. And at some point, we're going to come through the other side. And when we get there, you're going to have several companies in the space that prove durable and irreplaceable. How do you start to think about those now? How do you start to position ahead? Because it feels like there are going to be big winners and losers. What's the right formula to focus on the winners?

7:42Ronnie Wexler:So the way I think about it, or we kind of talking with our clients about it is, so system of record companies will always be there. And whatever anyone is saying, it's going to be close to impossible to replace that. So that will always be there. The other thing is then to look and think like, okay, where are things that Gen AI actually needs input from our side? And so one of the big areas is data. So the old truth is still true with Gen AI as well as garbage in, garbage out. And so if you don't have clean data, then you can't deliver good AI. So all of my vendors that I cover that are in that data space and data preparation space are still going to be very, very valuable.

8:26Ronnie Wexler:So what you need to do is at some point as you go through this journey, there's going to be more people emerging and there's going to be more IPOs. But for the guys that are already public, think about who is very, very sticky and who has something that Gen.E.I. actually needs to function well.

8:41Raimo Lenschow:On this topic, when I think about staying power, I think about the duration of the contracts in the space. Can you spend a little bit of time on how these are generally structured and I guess how much safety and margin of error these companies have from a time perspective?

8:56Ronnie Wexler:Yeah. So most of my companies by now are subscription companies. So the contract lines is usually it starts at one year, then you have three year and five year contracts. So that gives you already a decent level of visibility. The other thing is also if you want to replace a big IT system, you usually run things in parallel because you need to see if the new system is actually doing what you kind of wanted it to do. So that adds a few more years. What's interesting is if you think about the examples of the past, even the companies that we forged 15, 20 years ago that they would kind of go away, they're still out there.

9:30Ronnie Wexler:and they're still there. We still have mainframes, you know? And so from that perspective, these things run in very, very long cycles and people, you know, and AI will maybe shorten it a little bit, but it's still going to be a very, very long journey.

9:44Raimo Lenschow:Let's spend a little bit more time on that. I think what you're bringing up is very important for people and deserves focus. This feels like the first crisis we've gone through in the space. In actuality, it hasn't been.

9:57Ronnie Wexler:Yeah, so this is my 25th year in equity research on software. So we've been through a few of these cycles, so it's not like totally new here. Just a couple of recent examples. Remember 10 years ago, AWS came out and started doing software products. Every time there was an announcement, software sold off because people thought AWS is going to kill the world. Before that, we had the whole open source movement where we had open source companies or open source offerings. And then why would you pay for commercial software when you have open software? And what we saw was that, yes, there were a couple of guys that kind of suffered, but the vast majority of software companies adopted and are still doing extremely well.

10:35Ronnie Wexler:And actually what happened a lot of the time was that the market actually grew and so everyone benefited.

10:41Raimo Lenschow:Feels like we're living in historic times. I think we should expect a lot of two-way volatility going forward. It was great to have you here. We're clearly going to have to have you back as this evolves. But thank you so much for your time.

10:52Ronnie Wexler:Hey, thanks for having us. It's really nice to talk at a moment.

10:55Raimo Lenschow:To sum up our conversation, software is in the eye of the storm right now and there's a lot of uncertainty. This should give way to the opportunity, but it's going to take time and patience and we're going to need to wait to see how it all plays out. If you enjoyed this conversation with Raymo, please hit subscribe wherever you listen to your podcasts. And for Barclays clients with access to Barclays Live, you can read more of Raymo's research there.