By Jacob Sonenshine

Software stocks are trying to recover. The companies can help themselves on coming earnings reports.

The iShares Expanded Tech-Software Sector Exchange-Traded Fund, home to names such as Microsoft, Oracle, Salesforce, Adobe, Palantir and others, dropped as much as 13% from its record high of $110 to its low point -- $96 -- earlier this month.

It had already seen a double-digit gain for the months leading up to the high. Then long-dated bond yields popped, making future profits less valuable. These rapidly growing software companies are valued on the basis that much of their profit will come years in the future.

Now, the software ETF is up to $101, but has more work to do to reclaim the high. Bond yields have dipped recently from highs, a relief to tech valuations. If yields drop more, software stocks will rally further. Absent such fortunes, these companies could help themselves when they report earnings in the coming weeks.

Software investors want to see reaccelerating sales growth. Aggregate sales for the software fund grew 8% in 2024, down a couple points from the growth seen in the prior two years, according to FactSet. Software have adopted artificial intelligence software products gradually, not rapidly, as they observe how the technology makes their businesses more efficient.

The technology should prove more valuable in time, and customers will adopt it. It deeply analyzes data quickly, enabling companies to hire fewer employees in areas such as marketing and engineering. Total customer spend on just the cloud infrastructure segment of software is expected to hit almost $1.5 trillion over the long-term, according to Bank of America analysts, versus a few hundred billion in combined total revenue for Microsoft and Oracle. That indicates plenty of growth ahead.

As customers see more evidence that the AI enhancements will boost efficiency, analysts expect 13% aggregate revenue growth for the software ETF this year.

"Several variables suggest growth could reaccelerate in the sector...including 1) vendor skew toward product-led, growth-driven algorithms, which are likely to be reinvigorated as macro pressures ease, " writes Bank of America analyst Alkesh Shah.

Customers have adopted AI "co-pilots," which analyze data, make suggestions and help teams identify business opportunities. Now, software companies are rolling out AI agents, which go a step further by analyzing more data and complete tasks independently.

Some vendors, such as Microsoft, have disclosed higher pricing for their AI products. Others like Adobe haven't thoroughly disclosed the extent to which AI is unlocking additional sales. Adobe has badly underperformed the software ETF in the past year.

The point: More proof of concept would go a long way in bringing software stocks higher. It would solidify market confidence that the AI can support sustained long-term growth for software companies.

"Enthusiasm around agentic AI and how software vendors can potentially more materially start to monetize GenAI" is key for the stocks, writes Deutsche Bank analyst Brad Zelnick.

Look at Microsoft, which reports quarterly earnings on Jan. 29. Analysts expect 11% growth to $68.9 billion for the fourth quarter, according to FactSet, but 13% for calendar year 2025 to $298.6 billion, driven mostly by 31% growth for Azure, the company's cloud computing platform that helps customers manage their applications.

The estimates look beatable. Melius Research analyst Ben Reitzes points out easy comparisons from last year, when Azure growth decelerated. So if customer adoption of the new products is robust, the company could easily continue its record of beating sales expectations, which it has done the majority of quarters in the past five years.

Earnings would grow quickly. Microsoft has to ramp up marketing and other expenses, including depreciation because of its recent capital spending, so profit margins won't rise much. But earnings per share could grow in the midteens, given the company's share buybacks.

Such growth could boost the stock, which trades at 30 times expected EPS for the coming 12 months, almost six points below the software fund's multiple.

Microsoft could emerge as a clear self-help story within a software group that has a bright future.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

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January 22, 2025 02:30 ET (07:30 GMT)

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