5 Software Stocks With Upside Potential

The 10% decline in software stocks from their September 2018 highs, despite the market's January rebound, has presented investors with an opportunity to buy companies with strong long-term revenue streams at a discount. Among several analysts’ top picks include beaten-down companies such as Ultimate Software Group Inc. (ULTI), RingCentral Inc. (RNG), Palo Alto Networks Inc. (PANW), Salesforce.com Inc. (CRM) and Microsoft Corp. (MSFT).

“We remain bullish on the demand environment for our enterprise-worthy Cloud vendors, analytics and cyber-security leaders,” wrote Stifel analysts in a research note posted on Wednesday. The investment firm’s top software picks include RingCentral, Ultimate Software and Microsoft, per Barron’s. “In fact, we would argue the group is merely in the midst of a multi-year renaissance for software, sparked predominantly by AWS [Amazon Web Services] and [Microsoft] Azure-led Digital Transformations.” 

Morgan Stanley, which recommends several stocks including cybersecurity vendor Palo Alto Networks and CRM leader Salesforce, suggests that, “demand behind strategic digitalization efforts should prove durable even in a slowing macro environment, supporting growth for well positioned software vendors.” Analyst Keith Weiss added that, “with the recent pullback, we see attractively priced opportunities in strong secular growers,” per Barron’s. 

Ari Wald, head of technical analysis at Oppenheimer, echoed the bullish sentiment in an interview with CNBC’s “Trading Nation,” noting that his firm’s “overall macro view is that a premium is going to continue to get placed on these high-growth companies in a low growth world.” He pointed to the technical charts for Salesforce and PayPal, suggesting that both are positioning for a breakout.

Palo Alto Networks ranks among the tech giants listed in Morgan Stanley’s top picks for 2019. Weiss has a $266 price target on Palo Alto stock, representing a near 30% upside from current levels. Closing up 1.3% on Wednesday at $205.72, Palo Alto shares reflect a 9.2% gain year-to-date (YTD) versus the S&P 500’s 5.3% return. 

“With a solution portfolio expanding from the network to endpoints and into the Public Cloud—Palo Alto Networks leads in the race towards a comprehensive Intelligent Security Platform,” wrote Weiss. He expects the Santa Clara, Calif.-based tech company to grow its revenue base by at least 20% per year. 

Analysts at Stifel highlighted cloud-based phone systems provider RingCentral as one company set to post revenue growth over 25% annually in the coming years.

 “Enterprise CIOs have finally begun to migrate mission critical workloads to the cloud (ERP, analytics, and corporate performance) and we believe communications are now front and center with the rise of videoconferencing, mobility, and team chat/collaboration,” wrote the Stifel strategists.

Stifel’s $102 price target on this lesser-known software play reflects a 14.2% upside from Wednesday close. The Belmont, Calif.-based company has a market capitalization of $7.1 billion, having returned 7.7% in 2018 to date, outperforming the broader market.

Stifel also highlighted $8.3 billion Ultimate Software, a high-quality payroll-processing company, forecasting the firm to post top line growth of more than 20% annually.

“Based on this fundamental backdrop and a relatively attractive valuation, Ultimate remains one of the more interesting names in SMID-cap software,” the team wrote. The analysts’ $340 price target implies a near 28% upside over 12 months. ULTI stock has also outperformed this month, up 8.7% YTD.

It’s important to note that while these companies have long-term revenue streams, they can quickly be disrupted by new rivals, and by new technologies. So while they may be more equipped to survive an economic downturn, that does not mean they won't face other negative headwinds. Further, as market choppiness persists, the tech industry at large could suffer another downdraft as investors circle out of growth plays, back into cash, value stocks and other defensive strategies.