Wave of downgrades sends cloud stocks plummeting

Cloud stocks took a tumble in Tuesday’s trading session after analysts at JP Morgan (JPM:NYSE) issued a slew of downgrades based on valuation concerns. Shares of Adobe (ADBE:NASDAQ) dropped 6.6%, its second-highest drop in a single day. Adobe’s steepest fall of 2021 came just 11 days before when the stock cratered by 8.2%. Other cloud software companies such as Zscaler (ZS:NASDAQ), Datadog (DDOD:NASDAQ), and Cloudflare (NET:NASDAQ), tumbled 7.8%, 6.54%, and 9%, respectively.

In a 2022 outlook report on software technology, JPMorgan analysts Sterling Auty and Jackson Ader lowered their ratings on 13 companies, while upgrading just five. Adobe was downgraded to neutral with its price target set at $680. Datadog and Cloudflare were demoted to underweight. Analysts at the Wall Street bank also downgraded Zscaler to sell from hold.

JP Morgan analysts cited reasons for the downgrades such as limited upside to stick’s price targets, fair value in light of risk from rising interest rates rise in 2022, and revaluation of cash flow expectations.

There has been some caution on these types of stocks given the tremendous 40% plunge in DocuSign (DOCU:NASDAQ) which is an erstwhile pandemic darling. There is an unspoken belief that the pandemic pulled forward a huge chunk of future revenue for these companies, which they would struggle to replicate in the coming fiscal quarters as normalcy returns. Another reason is the deluge of new IPOs in the sector over the past year has also increased the supply of investor options, which has led to fewer investor dollars chasing each individual stock.

The threat of rising interest rates amidst high inflation has been spooking investors from cloud stocks over the past month. The Federal Reserve, as part of its two-day meeting on monetary policy, is expected to announce a major policy change on Wednesday as the market anticipates a tapering of its bond-buying program before rate hikes begin.

Strategists are expecting the central bank to raise rates three times in the next two years, starting from June 2022. High-interest rates tend to harm high-multiple tech companies because they eat into future cash flow projections, which is a key metric in valuing growth stocks.

With rates climbing, this adds risk to cloud stocks most of which are trading over 20 times multiple. Adobe is trading at 21 times its current revenue, while Zscaler and Cloudfare are currently trading at 39 and 61 times multiples.

Given the macroeconomic outlook, it is clear this period of weakness will persist with more pain ahead for investors in this space. As the economy keeps getting stronger, investors would increase their focus to value stocks as they seek more risk-averse assets. With the 10-Year yield beginning to look like a good play, there is a lot of incentive to trim position in high flying technology stocks.

However, despite the downward slide for cloud stocks, most are still up for the year and have outperformed the broader market. Adobe shares are up 31% so far this year, topping the 20% gain in the S&P 500. Zscaler is up 55%, while Cloudflare is 91%

Some strategists are also not willing to throw down the gauntlet when it comes to these names. While consensus on Wall Street is that the coming economic clime does not favour these stocks, some strategists have chosen to focus on the brighter horizon far in the future, away from the cloud of pessimism.

For example, Cloudflare could be the largest generator of revenue in its coverage universe within 10 to 15 years, because it’s positioning itself to be the “fourth cloud” after Amazon, Microsoft, and Google.

With the prospect of long-term gains, investors are willing to bet big on these sticks and are may be willing to average down till the dust stirred by valuation concern in these names subside.