Which Software Stock is a Good Buy?

The COVID-19 pandemic has sent software stocks to all-time highs. Software company fundamentals explain whether this is just an event-driven rally or this growth here to stay.

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The COVID-19 pandemic has created a once-in-20-years opportunity for software companies. Because of the pandemic-driven lockdown, many businesses have closed their physical offices and moved to virtual work arrangements. As a result, enterprise software stocks have risen to new all-time highs.

Tech stocks are considered growth stocks because of their high valuations. Generally, only the risk takers care to invest in such stocks. But in the wake of the pandemic, software stocks have attracted attention from all types of investors.

Perhaps you are thinking of investing in a software stock trading near an all-time high. If so, it is essential to understand the fundamentals of a tech company, as they are different from traditional companies.

Fundamentals of a software company

A software company sells a perpetual license to use its software to enterprises, and gets an additional fee for any upgrades. The company also earns revenue from professional services like integrating the software into customers’ systems and training their employees. However, a software company’s major source of income is maintenance and customer support services. These contracts are renewed periodically and generate recurring revenue.

The software-as-a-service (SaaS) model converted the above licensing model into a subscription model. Now, customers subscribe to cloud-based software. The SaaS model integrates licensing, support, and professional fees into one subscription and enables a software company to earn a higher amount of recurring revenue.

In both cases, the key performance indicators are customer acquisition and retention. A software company, in its early growth stage, focuses on increasing revenue through customer acquisition. When growth is steady, it focuses on growing its recurring revenue through customer retention. As it matures, it focuses on maximizing profits by upselling to existing customers. These indicators are visible in its revenue growth rate, percentage of recurring revenue, and adjusted EBITDA.

Stock Returns  Descartes
Kinaxis Constellation
Year-to-Date 12.3% 68.4% 19.7% 23.3%
1 year 26.2% 127.6% 32.6% 89.7%
5 years 232.5% 454.7% 188.5% 124.4%

Descartes vs Kinaxis

Descartes Systems (TSX:DSG)(NASDAQ:DSGX) and Kinaxis (TSX:KXS) provide supply chain management software both on-premise and on the cloud. Both companies have diversified customer bases across different industries and geographies.

Descartes is a more significant player with a broader portfolio, and is in the mature stage of growth. It is the world’s fifth-largest provider of supply chain management system, which means it has a significant market share. At this stage, it depends on acquisitions to boost revenue. Its primary focus is on increasing adjusted EBITDA by 10% to 15% every year. Kinaxis is a smaller, growth-stage player. Its focus is on boosting revenue through new customer acquisition.

Between 2015 and 2019, Descartes’s and Kinaxis’s revenues grew at CAGRs of 12% and 16%, respectively. They reported adjusted EBITDA margins of 37.6% and 30%. Kinaxis’s high growth helped it outperform Descartes, with most of the stock price gains coming in April and May. However, Descartes’s stock price has risen steadily over the last five years.

Constellation vs Enghouse

Enghouse Systems (TSX:ENGH) and Constellation Software (TSX:CSU) have adopted a growth-by-acquisition model. They both acquire small vertical-specific software vendors that serve niche markets and have limited competition. Of the two, Constellation is bigger and has a more diverse customer base. It also only acquires software vendors that use the license model. In contrast, Enghouse acquires companies that use both SaaS and license models. However, its customer base is more limited.

Unlike other enterprise companies that aim to gain market share in a particular software segment, Constellation and Enghouse aim to broaden their software offerings. Both companies grow by increasing their recurring revenue share.

Between 2015 and 2019, Constellation’s and Enghouse’s revenues rose at CAGRs of 14% and 7%, respectively. Last year, around 70% and 57% of their total revenues were recurring. Constellation’s high growth rate helped it outperform Enghouse in the long term. In the last 10 years, Constellation’s and Enghouse’s shares rose over 3,600% and 1,200%, respectively.

Which software stock is a good buy

When looking at a software stock, a good buy is the one that has a higher revenue growth rate than its peers. In the first quarter, Kinaxis’s revenue rose 15% compared to Descartes’s 7%. Similarly, Enghouse’s first-quarter revenue rose 58%, while Constellation’s revenue growth was flat. Kinaxis and Enghouse are good buys in the current market environment.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Puja Tayal has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Constellation Software. The Motley Fool recommends Enghouse Systems Ltd. and KINAXIS INC.

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