Mediaboss Marketing

The current earnings season is very likely to be rough for software makers. But you can still help clients by directing them to the stocks of software firms with not only decent growth but also positive free cash flow, both of which have become essential to investors looking for sustainable businesses.

The third-quarter reporting season gets underway the week of Oct. 24, with some major names such as Microsoft (ticker MSFT), SAP (SAP), and ServiceNow (NOW) announcing results. The key point to observe is how much worse things have gotten since the last round of reports.

Multiple software vendors warned during their last quarterly reports, in July and August, of seeing what they call deal slippage. Thats when a customer takes longer to scrutinize a software sale, slowing the deals closing, and thereby delaying the vendors revenue in that period.

That pattern was just bubbling up but could now be coming to a full boil because fall is traditionally budget season for most enterprises. If customers are planning on reducing overall spend in 2023, you may start to see that reflected in what software makers tell the Street about their outlook, not just for a quarter ahead but for next year.

Given that risk, Barrons Advisor sorted through 147 U.S.-listed software stocks and looked for free cash flow, first and foremost, not just revenue growth. If growth starts to break down because of dwindling budgets, investors may be reassured that such companies are already able to sustain themselves profitably.

Before the IPO window collapsed this year, a lot of software companies came public with no profitand no prospect of profit for years into the future. Investors patience for that kind of behavior has vanished. They now want a plan for when software makers will make money.

We filtered those 147 names to find only those with positive projected free cash flow over the next 12months. We also sought a sizable actual dollar amount of projected free cash flow. A company that has a mere $1 million in projected free cash flow may be going in the right direction, but its ability to be profitable could also be easily reversed.

We then filtered those companies for double-digit projected revenue growth in the next 12months because growth does still matter to software investors.

The result was a short list of 10 companies with a combination of above-average projected free cash flow and decent revenue growth.

These 10 names each have meaningful projected free cash flow and a stellar average projected rate of revenue growth of 36.4% in the coming 12 months. They also have a decent free cash-flow yield of 3% on average.

The names span industries. Microsoft is well worth including because of its sheer resilience. With a projected $70 billion in free cash flow in the coming year, it is simply in a class by itself. Its revenue growth rate of 14% is among the lowest in this group, but considering Microsofts size, even that growth is rather remarkable.

Salesforce (CRM)is another name at the top of the list in terms of sizable free cash flow. Its growth rate of almost 20%, after 23 years in business, is respectable.

Intuit (INTU) seems to mint cash with its reliable sales of tax software and accounting programs. Its projected growth of 30% is also notable for such an established company.

Three security software firms are among the top picks: Fortinet (FTNT), CrowdStrike (CRWD), and Zscaler (ZS). These companies products tend to have a stickiness that helps create a nice steady stream of cash flow. They also have very healthy rates of projected revenue growth.

The Trade Desk (TTD) is a relatively younger company that is making a pile of money in the modern advertising market, including streaming video. Its revenue growth may be more resilient than that of some other firms in this category.

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Zendesk (ZEN), ZoomInfo (ZI), and Hubspot (HUBS) can all be grouped into the emerging field of experience management. This gigantic rubric used to be just about sales, marketing, and customer support, but it now has to do with every aspect of how corporations interface with the public, both prospective and existing customers. So their software sales may be able to hold onto some of next years corporate budgets.

None of these companies will be immune to belt-tightening, of course. Plus, the rising U.S. dollar will continue to dampen reported revenue.

But starting with a focus on positive free cash flow is the right way to look for good software stocks in these suddenly more treacherous times.

Tiernan Ray is a New York-based tech writer and editor of The Technology Letter, a free daily newsletter that features interviews with tech company CEOs and CFOs as well as tech stock news and analysis.

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10 Software Stocks That Could Power Through These Tough Times - Barron's