The software slowdown is here: here’s how investors can deal with it (NASDAQ:APPN)

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Khanchit Khirisutchalual

Tech stocks have borne the brunt of selling in 2022 as investors worry over matters such as rising interest rates, geopolitical upheaval, inflation and prices that just keep rising. But now, investment firm Morgan Stanley said that they are seeing the “first signs of moderation” in demand for software.

A group of analysts, led by Sanjit Singh, noted that going into the second quarter, the demand picture was healthy. But as the quarter has gone on, that has not always been the case.

“Heading into [second-quarter] results, our channel conversations picked up signals of slowing demand across the sector,” the Morgan analysts wrote. Singh’s team said that view was consistent with their recent chief information officer survey that indicated a moderation in expected growth in software budgets for 2022. For now, the downturn is believed to be modest compared to the first quarter and the environment is still “quite solid.”

That said, the analysts downgraded several software companies, including Digital Ocean (DOCN), Fastly (FSLY) and New Relic (NEWR), and noted that stocks such as Appian (NASDAQ:APPN), JFrog (NASDAQ:FROG) and Alteryx (AYX) have “better setups.”

Additionally, the firm is still long-term bullish on the prospects for Datadog (NASDAQ:DDOG) and Atlassian (NASDAQ:TEAM).

“With growing signs that the slowdown is beginning to materialize, we think the tactical playbook for investors heading into [the second quarter] favors companies selling mainly into larger enterprises and who operate subscription pricing models,” said the Morgan analysts, who also highlighted the opportunities for companies that specialize in multi-year contracts such as ServiceNow (NOW), Alteryx (AYX), Appian (APPN) and JFrog (FROG).

Morgan Stanley added that companies that operate usage-based models with mixed track records of execution and outsized exposures to risk are viewed as less favorable, hence the downgrades to Fastly (FSLY), Digital Ocean (DOCN) and New Relic (NEWR).

The analysts noted that the company managers have to figure out a way to communicate a potential slowdown to investors but still show that their businesses are strong.

Those that are seen as “best positioned for success” in the second-half of the year are likely the ones that can show solid fundamentals with no signs of rising competition or pricing pressures, as well as taking into account a weaker spending environment in the second-half and giving guidance that does not show “growth is not correcting violently and that the model is not de-leveraging significantly.”

Companies like MongoDB (MDB), Salesforce (CRM) and Domo (DOMO) recently demonstrated these tactics and the analysts noted that Datadog (DDOG), JFrog (FROG) and Alteryx (AYX) are best poised “to deliver such a narrative.”

Last month, Goldman Sachs upgraded Atlassian (TEAM) shares, noting it is incrementally more positive as the company reaches a “pivotal moment” in its cloud transition.

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