3 picks from the recovering Internet software and services industry – November 22, 2022

The outlook for the Internet software and services industry looks mixed. The lackluster performance towards the start of the year is mainly related to the lingering effects of the pandemic, which has hurt a number of players. Estimates have been rising since May as the pandemic recedes. However, some companies have been positively impacted by the pandemic and the resulting trend towards digitalisation. The diversity of players in this group leads to some dissonance.

As the backbone of the digital economy, it’s hard to see this sector do badly over the long term. Overall, some of these long-term trends are playing out this year, even as worries about an economic slowdown in 2023 loom. Negative economic indicators, inflation and geopolitical tensions affect most actors, but some are better equipped than others to deal with the situation.

Despite the beating the sector has taken this year, the valuation still looks rich. But now could be a good time to find down-and-out stocks with better staying power or strong long-term potential. Our picks are NetEase (DETENTION Free Report), RingCentral (RNG extension Free report) and Verisign (VRSN free report).

Industry information

The Internet software and services industry is a relatively small industry primarily involved in enabling platforms, networks, solutions and services for online businesses and facilitating customer interaction and use of web-based services. Internet.

Main themes driving the sector

  • The overall impact of COVID has been mixed for the industry. While it required home working for employees, the industry, being technology-centric by nature, had relatively fewer issues with this. On the other hand, business continuity issues have accelerated the shift to cloud-based work for many companies, while service providers, both work-related and non-work related, have also moved to internet-based channels. Another major segment that has been doing huge amounts of business online has been the retail business. All of these moves have been good for the industry (in terms of revenue) and have partially offset the negative impact of declining business at physical players. At least some of the positives will survive the pandemic. In other cases, the return to physical operations is still ongoing and hampered by new strains of the virus, inflation and other concerns.
  • Geopolitical tensions in Europe affect oil prices and some supply chains, and therefore also large segments of the economy. And most experts fear that the Fed’s actions to contain inflation are pushing us into a recession. As any improvement in the overall level of economic growth improves the outlook for the sector, the current backdrop is contributing to a negative outlook for 2023.
  • The higher volume of business handled through the cloud and the growing demand for enabling software and services means building infrastructure, which drives up costs for gamers. This causes large fluctuations in profitability as new infrastructure is depreciated and debt is paid. So even for those players who have seen revenue growth accelerate due to the pandemic, profitability has remained a challenge. The current inflationary conditions are also worrying.
  • The level of technology adoption by enterprises and the proliferation of connected consumer devices that could help people connect and do business online also impact growth. The high penetration of mobile devices among users and the need caused by the pandemic are driving more companies to adopt technologies they previously stayed away from due to the costs involved. This is good for the industry.

Zacks’ industry ranking points to improving prospects

The Zacks Internet – Software and services the industry is housed within the larger Zacks Computers and technology sector. It carries a Zacks Industry Rank #93, which places it in the top 37% of more than 250 Zacks-rated industries. Our research shows that the top 50% of industries Zacks ranked outnumber the bottom 50% by a factor of more than 2 to 1.

Of the group Zacks Industry Rankingwhich is basically the average of the Zacks Rank of all member stocks, indicates that the industry is currently in recovery mode.

The industry’s placement in the top 50% of Zacks-ranked industries is because the earnings outlook for the aggregate constituent companies is improving. Revisions to aggregate estimates reflect greater analyst optimism since May, and the group’s aggregate earnings are now down just 1.6% over the past year. However, the estimate for 2023 is still down by 35%.

Before introducing some stocks that you may want to consider for your portfolio, let’s take a look at the recent stock market performance and sector valuation picture.

The equity market performance of the sector remains poor

Zacks Internet – Software & Services Industry’s performance last year shows that it has lagged Zacks’ broader computer and technology sector, as well as the S&P 500, during this period. But while the discount to the S&P 500 is substantial, especially in recent months, it traded closer to the sector, which hasn’t had a great run in the face of current macro concerns.

The aggregate sector stock price is down 50.3% over the past year compared to the broader sector’s decline of 33.6% and the S&P 500’s decline of 16.9%.

Price performance over one year

Zacks Investment Research
Image source: Zacks Investment Research

Current industry rating

While many of the players are still making losses, the industry as a whole continues to generate profits. Therefore, on a 12-month price-earnings (P/E) basis, we see that the sector is currently trading at a multiple of 30.7x, well below its median level of 52.6x in the last year. However, the P/E of the S&P 500 is only 17.7 times (the median value in the last year is 17.9 times). The sector is also overvalued relative to the sector’s 12-month P/E by 21.1X (at its median level over the past year).

The sector has been trading in the year-to-date range of 75.1X to 29.0X as the chart below shows.

12-month forward price/earnings (P/E) ratio

Zacks Investment Research
Image source: Zacks Investment Research

3 titles to consider

NetEase, Inc. (DETENTION free report) : Hangzhou-based NetEase provides online services focusing on diverse content, including games, music, other services, and education (dictionary, translation, and including a range of smart devices) in China. Its products and services are focused on community, communication and commerce.

NetEase is currently building its international business through new gaming content that appeals to an international audience. To this end, it has also established studios in Japan, Europe and North America and is building creative talent in these regions. It is also expanding the reach beyond PCs and mobile devices to consoles and facilitates seamless gameplay across all devices which further helps in growing the user base. Its educational tools are highly regarded, as evidenced by the high revenue growth rate. The music business continues to grow with daily and monthly users holding steady even as the ad-supported level returns. Also, the content library continues to grow.

Shares of this Zacks Rank #2 (Buy) company are down 41.5% over the past year. Zacks’ consensus estimate for 2022 EPS loss is up 37 cents (8.5%) over the past 60 days. The earnings estimate for 2023 increased by 35 cents (7.6%).

Price and consensus: NTES

Zacks Investment Research
Image source: Zacks Investment Research

RingCentral, Inc. (RNG extension free report) : RingCentral, headquartered in Belmont, CA, provides software-as-a-service solutions that enable North American businesses to communicate, collaborate and connect. The company offers enterprise cloud communications and contact center solutions. It caters to businesses, SMBs, professionals, and others across a broad range of industries including financial services, education, healthcare, legal services, real estate, retail, technology, insurance, construction, hospitality, and state and local government.

RingCentral is growing on the back of several megatrends, including the pandemic-induced shift to hybrid work, growing enterprise adoption of mobility solutions, and an increasingly distributed workforce, all of which are driving the growing need for unified communications and contact center solutions. When these are cloud-enabled, everything is better integrated, more secure, more efficient, and cost-effective. With an ecosystem of over 75,000 developers, over 150 out-of-the-box telephony apps, and over 330 out-of-the-box apps such as unified communications and contact center solutions, it’s no surprise that Gartner has RingCentral in the leadership quadrant of its latest report. The company is already generating a recurring revenue rate of $2 billion and looks set to easily eclipse that next year.

All of this of course doesn’t mean that the company isn’t seeing the economic slowdown and labor cost inflation that the rest of the market is seeing. Management rationalized the workforce to align it with the changed market scenario. But that doesn’t mean it’s a rapidly growing market worldwide with a very low (single-digit) penetration rate, according to Synergy Research. Additionally, Synergy estimates RingCentral to be the leader in UCaaS with over 20% market share based on paid seating, which is double the second and third largest vendors. So, there’s a huge room for growth.

Shares of this Zacks Rank #2 company are down 83.5% over the past year. Its estimate for 2022 has increased by 4 cents (2.1%) in the past 60 days. The estimate for 2023 increased by 28 cents (11.2%) over the same time period.

Price and consent: RNG

Zacks Investment Research
Image source: Zacks Investment Research

VeriSign, Inc. (VRSN free report) : VeriSign, headquartered in Reston, Virginia, provides Internet infrastructure services, primarily including domain name registry services as well as infrastructure assurance services.

Verisign benefits from price increases of up to 7% under the Third Amendment to the .com registrar agreement with ICANN and up to 10% on .net registrars. The stable nature of the business related to digital transformation leads to relatively stable cash flows. However, like every other company, rising costs, the broader economic slowdown and weaker business in China are also weighing on it. Competition from Google’s free public domain name service is also a cause for concern.

The shares of this Zacks Rank #2 company are down 19.1% over the past year. Zacks’ consensus estimate for 2022 EPS is up a cent while that for 2023 EPS has remained flat for the past 60 days.

Price and consent: VRSN

Zacks Investment Research
Image source: Zacks Investment Research