Ronnie (00:00) 
Hey, everybody, welcome back to the Barclays Brief. For equity investors, software is very much in the eye of the AI creative destruction storm right now. We're in the midst of history of a historic sell-off. And there is a lot of fear about the end state of where this all shakes out, and that makes it a perfect time for us to have Raimo Lenschow join us.

Ronnie (00:20) 
Raimo is our head of North American software research and equities. Raimo, welcome to the pod.

Raimo (00:25) 
Hey, thanks. Thanks for having me. And I'm really excited to talk to you here about this.

Ronnie (00:37) 
Everyone cares a lot about what's happening in your space right now, so let's get into it. So the US software space is down about 30% from the September highs. 
Year to date, it's down around 20% versus a roughly flattish market. And the valuations have compressed significantly. If you look at bellwethers in the space like Salesforce, they now trade at something like ten times forward free cash flow estimates, which historically were reserved for ex-growth companies in the tech space. Can you please educate our listeners on what sparked this swift repricing, and maybe bring some of these moves to life for us?

Raimo (01:02) 
Yeah. And it's really interesting because ChatGPT is now out for two years. So why does this and why does this move only happen now? And to, you know, two years ago we started like, who are the AI winners or losers? But then very swiftly we moved on. What changed now are two things. One is we had first product out from the AI, the AI model companies.

Raimo (01:25) 
So they kind of not just came out with models, but they just came out with products that you can use with these models. So it became all a little bit more real, and people were a little bit more scared about the impact that one on some of the names that I cover. The second thing that came with it was that we still have very huge announcements around investment cycles and the CapEx that needs to be built, especially from the launch of hyperscalers like AWS, Google, Microsoft.

Raimo (01:46) 
And so we now have that fear, on the one hand, that we are overspending and overbuilding. On the other hand, we have more real products out there to make us want more real. And so on both sides, people are getting nervous and that kind of didn't create a good setup for software.

Ronnie (02:04) 
So look, one thing I've learned in my career is these things are never simple, right? 
There's always a lot of nuance. I love the title of your most recent research report, which is Software is Not Dead, Just Changing.’ In it, you argue that the space deserves a different level of focus and maybe some greater differentiation than we've seen recently. Expand on that for us.

Raimo (02:21) 
Yeah. I mean, the starting point should be like, what are we doing with AI? 
It's like AI is recreating software. So it's still software. And so from that perspective, the world is not completely different. And we just kind of have a kind of a next generation players kind of emerging here. But we also have the existing guys that are aware of what's going on and will start to react.

Raimo (02:45) 
So the argument that we were trying to make in that notice, you can't just throw all of software out. It doesn't make any sense. You really need to start thinking about what is AI standing for. What is it? What is it doing? To generative AI that we're seeing today is basically extremely good. And summarizing huge data sets and giving you probabilistic answers of what you probably want to hear next or what the answer should be.

Raimo (03:05) 
And so that enables a lot of new things. And we all, as consumers and enterprises kind of have to work with this. And it's really exciting. But there are some truths that are still going to be there. There's still a lot of software guys out there that I cover that are actually, more around the deterministic flow.

Raimo (03:22) 
That means, like, you know, a number needs to be number. We don't want guesses about what my revenue is. I want a revenue number. And so from that perspective, the point that we are making is don't look at all of software and think all of software is dead. You can if you spent a time and learn about what GenAI stands for, there's really nice and interesting opportunities, especially after the sell off.

Ronnie (03:44) 
So let's get a little granular on the perception currently, which is just blunt force trauma to everything in the space versus the reality of what AI will do and mean and, and how it will impact software, how will it actually impact software, and how do you see the evolution of that?

Raimo (03:59) 
Yeah, there's going to be smaller players that had like point solutions that, you know, added a few features. There I would be worried about the impact of GenAI, but I have these big corporate platforms out there are these are mostly the more launch, you know, the larger market cap companies that we're covering. They will still be there. And the other thing that usually happens in these cycles when new technology comes up, a small GenAI company has the choice.

Raimo (04:27) 
Yes, they have a good product and they have a might have a new product. But do they also have the willingness to scale it up and hire hundreds and thousands of sales guys and build up operations? Because what happens a lot of the time is that, the people that already are scaled up and, you know, it's the big platforms that I mentioned, they will just subsume some of these new technologies and then be able to offer that.

Raimo (04:46) 
And so, you know, as I said, you need to differentiate a little bit more. Maybe one point is to think about the big platform guys. They still will be there. And then on the smaller guys you just need to take each, you know, on a case-by-case basis.

Ronnie (05:00) 
All right. So for the space as a whole valuations compressed a lot.

Ronnie (05:03) 
But the pushback I get for people who are hesitant to step in is that we're kind of now at a market multiple for the software space. Does that mean things have gotten cheap enough to stabilize here in your eyes?

Raimo (05:13) 
Yeah. Look like true valuations are kind of at market level. But remember also software is usually growing and above market rate.

Raimo (05:21) 
And that's why people were excited about software for so many years. And so I don't think valuation is kind of necessarily the thing that needs to come down dramatically from here. What we now need is a catalyst. If people are realizing, what's getting me out of this? And one of the things of, well, or, you know, how do I kind of get more confident about what's going on in the space?

Raimo (05:43) 
And, here the question is, okay, do I get, you know, revenue, estimates that are kind of going up for some of the largest players driven by some of the AI products. And do I get new product announcements? And also time will be a big factor here because, at the moment we have a lot of share pricing reactions from just product announcements from the launch AI players, but those products still need to come into the market.

Raimo (06:09) 
So that's usually takes much, much longer. And a lot less exciting.

Ronnie (06:14) 
Let's spend a little bit of time on the things that make software difficult to rip out. You talk about ‘system of record’ often. You wrote a lot about it in your most recent report. Why don't you educate us on what ‘system of record’ is as it relates to software?

Raimo (06:29) 
Yeah. So if I run, if I run a company, I need to have a certain set of truths, like, you know, this is who we are. This is what we do. These are the numbers that we all discussing. And, and those numbers are in the system of record. So think about it. On the accounting side, you have vendors like SAP, Workday, etc., that are having your financial numbers.

Raimo (06:49) 
You can't have a GenAI think there that probabilistically gives you some number. You want the number. Okay. And so these systems are, you know, you need them. They can't go away. The one where I have the most debate about is, is around Salesforce because, you know, at face value, you'd think like, well, they're like a tool to help sales guys sell better.

Ronnie (07:19) 
So the way I think about this, and I've spent a lot of time on it, is we're going to go through this period of turbulence, and at some point we're going to come through the other side and when we get there, you're going to have several companies in the space that prove durable and irreplaceable.

Ronnie (07:33) 
How do you start to think about those now? How do you start to position ahead? Because it feels like they're going to be big winners and losers. What's the right formula to focus on the winners?

Raimo (07:42) 
The way I think about it or we kind of talking with our clients about it is so system of record companies will always be there.

Raimo (07:53) 
And whenever anyone is saying it's going to be close to impossible to replace that and that will always be there. The other thing is then to look in and think like, okay, where are things that, GenAI actually need input for now from our side. And so one of the big areas is data. So the old truth is still true.

Raimo (08:12) 
And without GenAI as well as like, garbage in, garbage out. And so if you don't have clean data, then you can deliver good AI. So all of my vendors that I cover that are in that data space and data preparation space are still going to be very, very valuable. So what you need to do is like, you know, at some point as you go for this journey, there's going to be more people emerging and there's going to be more IPOs.

Raimo (08:33) 
But for the guys that are already public, think about who is very, very sticky and who has something that GenAI actually needs to function well.

Ronnie (08:43) 
On this topic, when I think about staying power, I think about the duration of the contracts in the space. Can you spend a little bit of time on how these are generally structured, and I guess how much safety and margin of error these companies have from a time perspective?

Raimo (08:57) 
Yeah. So most of my companies, by now, are subscription companies. So the contract lens is usually it starts at one year and then you have three year and five-year contract. So that gives you already a decent level of visibility. The other thing is also if you want to replace a big IT system, you usually run things in parallel.

Raimo (09:15) 
Because you need to see if the new system is actually doing what you want it to do. So that adds a few more years. What's interesting is if you think about the examples of the past, even the companies that we thought 15 or 20 years ago, that they would kind of go away. They're still out there, and they're still there.

Raimo (09:35) 
We still have mainframes, you know. And so from their perspective, these things run in very, very long cycles. And people are, you know, I will maybe shorten it a little bit, but it's still going to be a very, very long journey.

Ronnie (09:44) 
Let's spend a little bit more time on that. I think what you're bringing up is very important for people and deserves focus. 
This feels like the first crisis we've gone through at the space. In actuality, it hasn't been. Can you illustrate what some of the most recent sort of issues and existential issues for the space have been?

Raimo (09:59) 
Yeah. This is my 25th year in equity research on software. So we've been through it, through a few of the cycles.

Raimo (10:04) 
So it's not totally new here. Just a couple of recent examples. Remember ten years ago AWS came out and started doing software project products. Every time there was an announcement, software sold off because people thought AWS is going to kill the world. Before that, we had the whole open source movement where we had open source companies or open source offerings.

Raimo (10:23) 
And then why would you pay for commercial software when you have open software? And what we saw was that, yes, there were a couple of guys that kind of suffered that the vast majority of software companies adopted and are still doing extremely well. And actually what happened a lot of the time was that the market actually grew, and so everyone benefited.

Ronnie (10:41) 
It feels like we're living in historic times. I think we should expect a lot of two-way volatility going forward. It was great to have you here. We're clearly going to have to have you back as this evolves. But thank you so much for your time.

Raimo (10:53) 
Hey, thanks for having us. It's really nice to talk at a moment.

Ronnie (10:55) 
To sum up our conversation. Software is in the eye of the storm right now, and there's a lot of uncertainty. This should give way to opportunity. But it's going to take time and patience. And we're going to need to wait to see how it all plays out. If you enjoyed this conversation with Raimo, please hit subscribe wherever you listen to your podcasts. And for Barclays clients with access to Barclays Live, you can read more of Raimo's research there.