Overview

As every software investor is acutely aware of, the software sector has de-rated materially over the last few months. While it seems clear that software spending has weakened, what is far less obvious is why – the root cause and a critical input. In this article we lay out the possible explanations and more importantly, offer the initial unvarnished feedback from 12 of our Fortune 500 CIO/CTO contacts with whom we regularly swap thoughts.

What Did We Learn?

According to the feedback from our CIO/CTO checks, there is not one singular cause of the weakness across the software sector in the last few months, but rather a combination of multiple issues. The most widely-acknowledged explanations were in order of the below:

  1. Software Spend Rationalization: A more concerted rationalization of software spend – especially at the software as a service (SaaS) layer – in reaction to “excessive” price increases and following an over-investment phase.
  2. AI Crowding Out: AI is beginning to crowd out other software spend, both in terms of the need to free-up dollars as well as hesitation/de-prioritization as CIOs/CTOs consider AI impacts.
  3. Budget Mix Shift: A mix shift within budgets, with certain SaaS projects being de-prioritized and budget dollars shifting to cloud infrastructure, cyber-security and even to open source solutions.
  4. Cyclical/Macro: While further down on the list than many might expect, some CIOs/CTOs did highlight that macro uncertainty (rates, consumer spend weakness) may have caused some incremental weakness that cascaded into their software spending budgets.
  5. Not a single CIO/CTO cited any unusual 4Q-1Q seasonality.

Spend Rationalization Trends

As noted, if there was anything new and surprising about the feedback above, other than the number of CIOs/CTOs flagging that AI could be de-prioritizing non-AI spend, it was the repeated messaging that customers have over-bought (suffering from enterprise license agreements fatigue) and that software firms have over-played their hand on price increases. As a result, these customers were now more actively rationalizing their spend in a still-tight budget backdrop. Basically, companies are now doing to their SaaS budget what they optimized-away in their AWS/Azure (virtual network) budget over the last 18 months. On the margin, these “spend rationalization” anecdotes appear to be directed to the SaaS/application software budget, where perhaps enterprises have historically overprovisioned (relative to infra, data and security spend), where the price increases have been sharpest (in part because SaaS firms have seen pressure from weaker customer headcount growth and therefore seat expansion, which they’ve attempted to offset via pricing/bundling) and where the AI stories are still evolving or unclear.

We have two questions about this trend:

First, why would this be happening now/in 1Q?
It’s tough to say, but we wonder if:

  • an uptick in such efforts could be timed with the start of the new year and/or be a response to aggressive sales efforts upon contract renewals in 4Q, and;
  • many large enterprises have now largely finished optimizing-away the waste in their AWS/Azure spend (a process that took 4-5 quarters) and enterprises are now more tightly managing other areas of the budget, and/or;
  • some customers are beginning to move their AI initiatives from small proof-of-concepts into production, and as a result the “AI crowding out” thesis is just now beginning to play out.

Second, why could this be hitting some and not others?
Again, tough to say, but we’re trying to screen SaaS stocks based on:

  • how much shelfware there may be out there;
  • which firms appeared to be pressing hard on pricing/bundling, and;
  • which firms are viewed as premium-priced versus a relatively low price per seat that likely would get rationalized last, not first. Adobe is not immune, but it may have bucked the trend in its May quarter given less creative software over-provisioning, the absence of real competition and the fact that Adobe has a credible AI story with Adobe Firefly.