Software's $2-for-$1 Problem

Editor's note: Software stocks were once market darlings. But today, they may be among the most vulnerable to new artificial-intelligence alternatives. In this issue, Joe Austin, senior analyst of our corporate affiliate Chaikin Analytics, explains how AI is pressuring the software landscape... and whether the recent sell-off is a warning sign or an opportunity.

Plenty of folks worry about AI eating their businesses...

Software companies have already found out just how painful that is.

In January, the benchmark S&P North American Technology Software Index fell 15%. That marked its worst monthly performance since 2008.

Investors are running scared. They don't know if the pullback is a short-term blip... or a death knell for the sector.

But to gauge the real risk to this industry, you need to understand the economics of how software companies make money.

The new software business model depends on customer retention... And while growth prospects for this industry look pretty good, cracks are starting to form.

The Power Gauge saw the pain coming for software...

The Power Gauge is a tool we use at Chaikin Analytics to analyze the markets. It gathers investment fundamentals and technicals into a simple rating of "bullish," "neutral," or "bearish."

In our system, we measure the software space with the State Street SPDR S&P Software & Services Fund (XSW).

The Power Gauge first turned "bearish" on XSW back in mid-November. And the fund has collapsed in recent months. Take a look...

However, the industry is still showing healthy growth...

Late last year, IT consulting and research firm Gartner projected that global software spending would grow by more than 15% this year.

Industry forecasts project software sales will grow from around $900 billion in 2025 to about $2.9 trillion by 2035. That's a compound annual growth rate of more than 12%.

So is the current panic in the space creating an opportunity to "buy low"... or are investors right to worry?

Why the SaaS Model Is Breaking Down

I started covering software stocks in the 1980s.

Back then, software was a product that you bought. I even remember when it came in a box, with CDs you had to install.

But today, companies sell most software via subscriptions. Customers rent rather than buy.

This is called Software as a Service ("SaaS"). And today, SaaS is the way the industry does business. It's expected that SaaS accounted for 85% of all software sales last year.

It's easy to see why this model is popular. There's no massive upfront capital expenditure. Customers pay monthly or annually instead. That shifts the software costs from a capital expense (hard to approve) to an operating expense (easy to approve).

But for software companies, this model comes with two unique risks...

The first is customer acquisition cost ("CAC"). That's how much money a company spends to acquire a new customer.

The second is the payback period on that investment. That's how long it takes for those monthly subscription payments to cover the CAC.

That can create a big gap between when software companies book revenue... and when they actually make money.

This model works as long as growth continues. New customer revenue keeps flowing in. That covers ongoing expenses... And it creates what looks like healthy cash flow. The software company uses new customer money to fund operations while waiting for older customers to repay those acquisition costs.

But when growth stops, the results are brutal.

Let's say a company needs 18 months to recover what it spent on a customer...

If people start canceling after 12 months, the company is stuck. It poured millions into customers with no payback.

And CACs for software companies have soared in recent years. They're up more than 200% since 2017.

For top-quartile software companies (the most efficient companies), the average payback period is now 15.9 months. That's up about 30% from 12.3 months in 2020.

Today, software companies spend about $2 for every dollar of recurring revenue. That's a two-year breakeven timeline before factoring in ongoing service costs.

The payoff is still positive for most companies. But margins are shrinking fast. The gap between what companies spend and what they earn back keeps narrowing.

The SaaS model works well so long as customers stick around. But AI threatens to break that assumption – by either offering cheaper alternatives or letting companies build solutions in-house.

And that's exactly what has been sending investors running for the exits...

To keep an eye on this, I'm monitoring XSW. But for now, the Power Gauge says to stay on the sidelines...

XSW gets a "very bearish" rating in our system right now. Looking at its individual holdings, 53 companies are "bearish" or worse... and 74 are in "neutral" territory. Meanwhile, only 10 are "bullish" or better.

Everyone worries about AI eating their business. But software companies might have the most to lose, because their entire model depends on customers sticking around for years.

It's a problem that won't resolve itself quickly. Until we see how AI reshapes customer-retention patterns, software stocks remain higher-risk.

I'm not saying that every company in the space is doomed. But right now, the Power Gauge sees much better opportunities elsewhere.

Good investing,

Joe Austin

Editor's note: A brutal rupture is fast approaching AI stocks. According to Chaikin Analytics founder Marc Chaikin, less than 2% of stocks will be spared. This split could either cost you all your gains since 2022... or potentially double your money if you understand what's coming. And with the Power Gauge's help, you can get positioned before it all unfolds.