2019 was a banner year for the software sector, and the sector is already heading higher in 2020.
The IGV iShares Expanded Tech-Software Sector ETF gained 35% last year, and so far this year is already up another 7%.
But after such a big rally, Morgan Stanley says investors need to start getting more selective with software stocks.
“After a strong performance across software in 2019, full multiples and indications of a slowing software spending environment, investors likely need a finer filter to find the really compelling opportunities in the sector,” wrote Morgan Stanley analyst Keith Weiss in a note to clients.
Weiss noted that while most software valuations “appear rich,” there are still names on an enterprise value to free cash flow basis that look more reasonable.
According to Weiss, Adobe has “one of the strongest franchises in software, benefiting from the secular shift towards digital marketing,” and believes the company’s earnings could move higher in the future. He has a $410 price target on Adobe shares, indicating possible upside of nearly 19% over the next twelve months.
Bank of America analyst Kash Rangan agrees, and wrote in a recent note that Adobe’s fundamentals look strong and could achieve 20% revenue growth in 2020.
Moving on to Salesforce, Weiss issued a price target of $216 for the stock, suggesting 18% upside ahead.
“With a cloud-based platform automating and optimizing all stages of the customer life cycle, Salesforce.com looks best positioned to benefit,” the Morgan Stanley analyst wrote.
And as for Microsoft, Weiss says the stock could reach $189 by the end of the year – 14% higher than the current price.
“As the IT conversation shifts from pure Public Cloud towards hybrid Cloud architectures involving enterprises utilizing a mix of on-premise and public cloud resources, Microsoft pulls ahead as the best secularly positioned firm in tech,” Weiss wrote.
Rangan is also bullish on Microsoft and says there are several key growth drivers—including gaming and LinkedIn—moving it forward, and believes its Azure cloud computing service could make up more than 40% of the company’s annual growth in the coming years.
“Given that Azure has still not reached scale in terms of margins, it is still a meaningful driver for gross margins long term,” Rangan said.
The Bank of America analyst also said that Microsoft is “cloud-like in growth,” “legacy-like in margins,” and is “GAARP [growth at a reasonable price]-like in valuation.”