Economic slowdown and anti-corruption: two reasons to stay away from software stocks

Investors told IT services sector now provides a more stable and recurring revenue stream

PUBLISHED : Monday, 04 July, 2016, 3:23pm
UPDATED : Monday, 04 July, 2016, 10:11pm

China’s once high-flying software sector continues to suffer from the country’s prolonged economic slowdown and the government’s extensive crackdown on corruption, and analysts are now warning those two pressures combined could be about to result in a sharp correction in some overvalued stocks.

Software industry revenue grew 14.9 per cent in the Jan-to-May period, down from 17.1 per cent in the same period in 2015, China’s Ministry of Industry and Information Technology (MIIT) reported recently.

All sub-sectors, including software products, operational services, ID design and embedded software, were hit by slower revenue growth.

“The most important factor is always the economy,” said Archibald Pei, an analyst for UBS Securities.

Despite a recent policy-driven rebound in real estate and construction, China’s overall private investment languished at a record low in the January-to-May period, with growth dropping to 3.9 per cent from 5.2 per cent in the January-to-April period.

A slowdown in private sector investment indicates that private companies are more reluctant to spend, usually due to lack of confidence in the economic outlook.

Some analysts are now expecting China’s second-quarter growth to come in below expectations, after first quarter national GDP expanded 6.7 per cent, the slowest quarterly growth in seven years.

“China’s software industry growth is highly correlated to GDP growth,” said Pei.

“Because most software revenue is from enterprise clients, when they are hit by an economic downturn, the software sector is also hit.”

Because most software revenue is from enterprise clients, when they are hit by an economic downturn, the software sector is also hit
Archibald Pei, an analyst for UBS Securities

He also said the administration’s anti-corruption drive, a crusade against “extravagant” government spending, could affect state spending on IT as government officials and state-owned enterprise leaders avoid spending money on new projects, for fear of being seen as corrupt.

And in addition, investment in very-early-stage business models, such as cloud computing, could drive a sharp increase in development costs for software companies, he added.

In light of all those risks, Pei said the valuations of software sector A-shares look too high.

By the end of June, software stocks in A-shares markets were trading on average at 80 times their estimated 2016 P/E ratio, and 58 times their estimated 2017 P/E.

UBS still expects the A-share software sector to deliver 20 per cent earnings CAGR (compound annual growth rate) in the next three years.

“We suggest investors remain cautious at the moment,” Pei said.

“Current valuations look demanding. We do not expect any rebound for the software sector in the second half of 2016, unless there is a rebound in the economy,” he added.

In particular, he recommends investors avoid software producers and put more focus on companies with a higher proportion of revenue from IT services, as the latter provides a more stable and recurring revenue stream in an economic downturn.

Central China Securities analyst Tang Yue also says the industry fundamentals of software stocks “are not supporting” the high share prices.

“The sector’s revenue growth peaked in 2012 and since then it has been on a straight decline. Net profitability has also fallen,” Tang said.

“We expect risks to persist in the near future, as the economic reality is harsh. ”

Besides, the Chinese securities regulator has reportedly moved to curb a speculative bubble in the tech sector, Tang said, with media reports in early May saying the regulator had banned listed A-share companies from selling new shares to fund their investments in non-core businesses, such as internet finance, online gaming, movie and TV production, and virtual reality.

“The authority didn’t officially respond, but there’s no smoke without a fire, you know, ” she said.

“We expect rising expectations of policy tightening could curb future M&A deals in the industry.”

The software industry has seen its valuations on a steep rise since 2013, driven by a wave of acquisitions , Tang said.

However, “if the policy direction changes, the sector could see this bubble of high valuations bursting”, she said.