AI software stocks begin to progress

Perspectives from BofA Global Research’s Leading Analysts

November 22, 2024

Josh Shanker

Brad Sills, Senior Research Analyst, Large Cap Enterprise Software

Software stock performance has finally improved after a difficult first half of 2024. Recently, we’ve witnessed stability in the spending environment after the weakness seen in the first half of the year, and there’s evidence that some AI product cycles are starting to gain traction. AI success stories were scarce at the same time that certain semiconductor and tech hardware companies were benefitting from significant profit uplift from AI product cycles. Comparatively, that made for a difficult backdrop for software, but now there’s evidence that benefits are beginning to broaden. 

While the S&P trades at a price-to-earnings multiple that’s well above average, software stocks trade closer to average multiples based on the metric that many software investors use — enterprise value to free cash flow. And while interest rates are likely to be structurally higher post COVID, the 10Y appears to have peaked in the fall of 2023. The BofA rates team believes that 10Y rates are likely to remain within the current range and that, while declining rates would provide more of a boost, rate stability is still a positive. Additionally, our semi-annual software spending survey has pointed to improvement in 2H24 and 2025. Election results have rekindled interest in smaller-cap equities and there are several software companies with disproportionate exposure to the small business end market. 

Agentic AI, which is autonomous AI requiring little to no human input, is the next wave in the technology and already it’s being offered by some of the largest and most advanced enterprise software companies. We believe Agentic AI could mean that technology disruption expands from areas such as coding and the analysis of trends to operating industrial machinery and restaurant equipment. Autonomous vehicles are a prime example of Agentic AI, as they can make independent decisions based on their environment. Whether it’s generative AI or Agentic, we expect monetization to begin in 2025 for our software companies and for it to become meaningful in 2026, at least for the majority of our companies that have already released AI-powered products. It’s important to remember that AI offerings from software platforms launched just a year ago. Enterprises have been evaluating these use cases, ROI and pricing models since then. The adoption phase should follow this discovery phase. And in addition to boosting client revenues, AI remains an opportunity for software companies to boost internal efficiency. Certain companies are generating as much as 25% of new software code from AI-powered coding apps. 

We continue to see opportunities in software stocks, and though AI benefits won’t come immediately, investors who can take a slightly longer view should be encouraged that, for many of our covered companies, the benefits are still largely ahead.