2 Stocks from the Struggling and Overvalued Internet Software & Services Industry – August 5, 2022

The outlook for the Internet-Software & Services industry appears negative going by the estimate revision trend over the past year, driven largely by the pandemic. Some companies were however positively impacted by the pandemic and the rush-to-digitize trend that it gave rise to. The diversity of players in this group is the reason for this dissonance.

Being the backbone of the digital economy, it’s hard to see this industry doing badly over the long term. However, the near-term outlook has deteriorated given the negative economic indicators, rising inflation and geopolitical tensions. To make matters worse, valuation remains high. Under the circumstances, none of the players look exciting, but we have picked Squarespace (SQSP Free Report) and Verisign (VRSN Free Report) for a closer look.

About the Industry

The Internet Software & 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 Internet based services.

Top Themes Driving the Industry

  • The overall impact of COVID has been mixed for the industry. Although it necessitated work from home for employees, the industry, being by nature tech-centric, had relatively fewer issues with this. On the other hand, business continuity concerns accelerated the shift to cloud-based working for many companies, while service providers, both work-related and otherwise, also moved to Internet-based channels. Another big segment that did humongous amounts of online business was retail. All of these moves were positive for the industry (in terms of revenue) and partially offset the negative impact of declining business at brick-and-mortar players. At least some of the positives will outlive the pandemic. In other cases, the return to physical operations is still ongoing, and hindered by new strains of the virus, inflation and other concerns.
  • The geopolitical tensions in Europe have a bearing on oil prices and certain supply chains, and therefore, also on large segments of the economy. And most experts fear that the Fed’s actions to contain inflation are pushing us into a recession. Since any improvement in the general level of economic growth improves prospects for the industry, the current environment is contributing to the negative outlook.
  • The higher volume of business being operated through the cloud and the increasing demand for enabling software and services involves infrastructure buildout, which increases costs for players. This causes great fluctuations in profitability as new infrastructure is depreciated and fresh debt is serviced. So even for those players that have seen revenue growth accelerate as a result of the pandemic, profitability has remained a challenge. The current inflationary conditions are also a concern.
  • The level of technology adoption by businesses and the proliferation of connected consumer devices that might help people connect and do business online also impacts growth. The high penetration of mobile devices among users and the pandemic-driven necessity is driving more businesses to adopt technology that they previously stayed away from because of the cost involved. This is positive for the industry.

Zacks Industry Rank Indicates Continued Challenges

The Zacks Internet – Software & Services industry is housed within the broader Zacks Computer and Technology sector. It carries a Zacks Industry Rank #152, which places it in the bottom 40% of more than 250 Zacks classified industries. Our research shows that the top 50% of the Zacks-ranked industries outperform the bottom 50% by a factor of more than 2 to 1.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates that while the industry is recovering from pandemic-inflicted problems, certain issues remain.

The industry’s positioning in the bottom 50% of Zacks-ranked industries is because the earnings outlook for the constituent companies in aggregate continues to deteriorate. Looking at the aggregate estimate revisions, it appears that analyst confidence in the group’s earnings growth potential for 2022 has been on a more or less steady decline since last July although it has been firming in the last two months. Over the past year, the 2022 average earnings estimate is down 42.2%. The 2023 estimate is down 39%.

Before we present a few stocks that you may want to consider for your portfolio, let’s take a look at the industry’s recent stock-market performance and valuation picture.

Industry???s Stock Market Performance Is Suffering

The past year’s performance of the Zacks Internet – Software & Services Industry shows that it has lagged the broader Zacks Computer and Technology Sector, as well as the S&P 500 for most of the year. But while the discount to the S&P 500 is substantial, and especially in the last few months, it has traded closer to the sector, which hasn’t had a great run in the face of current macro concerns.

The aggregate share price of the industry dropped 29.2% over the past year compared to the broader sector’s decline of 21.0% and the S&P 500’s decline of 6.9%.

One-Year Price Performance


Image Source: Zacks Investment Research

Industry’s Current Valuation Is Rich

While many of the players are still making losses, the industry as a whole continues to generate profits. On the basis of forward 12-month price-to-earnings (P/E) ratio, we see that the industry is currently trading at 44.7X, well below its median level of 61.8X over the past year. The S&P 500’s P/E is however just 18.0X (median value over the past year is 20.2X). The industry is also overvalued compared to the sector’s forward-12-month P/E of 22.4X (below its median level over the past year).

The industry has traded in the annual range of 78.0X to 41.7X, as the chart below shows.

Forward 12 Month Price-to-Earnings (P/E) Ratio

Zacks Investment Research
Image Source: Zacks Investment Research

2 Stocks Worth A Closer Look

Squarespace, Inc. (SQSP (Free Report) : Squarespace operates a platform that allows businesses and creators to open an online store front from where they can manage their online presence and brands including across websites and domains, e-commerce operations, marketing and scheduling. It also provides tools for managing social media presence.

While the current environment isn’t ideal for a stock that facilitates online commerce and digitization, this is definitely where the world is headed and where consumers and businesses (especially the small and medium-sized organizations that are likely to require its services) will end up up over the next few years. There is also a growing number that need to seamlessly coordinate their online and offline operations. Therefore, the long-term growth prospects for Squarespace are bright. Near-term challenges remain however that will likely continue to pressure the stock.

Shares of this Zacks Rank #3 (Hold) company have sunk 55.1% over the past year. The Zacks Consensus Estimate for the 2022 loss per share has dropped 16 cents (64.0%) in the last 60 days. The 2023 earnings estimate has also dropped 16 cents (66.7%).

Price and Consensus: SQSP

Zacks Investment Research
Image Source: Zacks Investment Research

VeriSign, Inc. (VRSN (Free Report) : VeriSign provides Internet infrastructure services, including primarily domain name registry services and also infrastructure assurance services.

Verisign is benefiting from a growing trend in new domain name registrations as well as price increases of up to 7% pursuant to the Third Amendment to the .com Registry Agreement with ICANN and up to 10% in the .net registrations. The steady nature of the business that is tied to digital transformation leads to relatively steady cash flows. However, like every other company, rising costs and the broader economic slowdown are also weighing on it. Competition from Google’s free public domain name service is also a concern.

Shares of this Zacks Rank #3 company have dropped 8.3% over the past year. The Zacks Consensus Estimate for the 2022 and 2023 EPS is unchanged in the last 60 days.

Price and Consensus: VRSN

Zacks Investment Research
Image Source: Zacks Investment Research

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