As we approach the next set of earnings for software infrastructure companies, we are receiving some signals that overall IT spending is lagging, primarily as a consequence of recession fears and consumer demand slowdown. There is a likelihood of spending pullback, similar but perhaps less acute than what we saw in early 2020. Some software companies have already telegraphed this, with examples like ServiceNow and Microsoft recently commenting on the tough demand environment.

Going forward, as this trend manifests, it will likely impact the valuations of software infrastructure companies. Analyst targets for revenue growth and profitability will be adjusted downward, or will remain static absent the typical beat and raise cadence. I can’t offer any additional insight into macro drivers and how those will play out over the next 12 months. However, I think it is worth considering some characteristics in software infrastructure spend that could help counterbalance overall adjustments to IT budgets. These factors may help some companies limit the impact more than others. Further, as macro headwinds subside, these factors will ensure that well-positioned software companies can return growth to previous levels.

Overall Tailwinds

First, it’s worth level-setting on the foundation driving growth for many cloud-based software infrastructure companies. Software infrastructure is benefiting from enterprise initiatives to modernize their software stack, improve customer service, realize efficiencies through automation and mine data for new insights and costs savings. This use of software as a means to drive competitive differentiation and reduce operational costs is well understood at this point. While we can acknowledge that we may be hitting saturation on some consumer Internet experiences (like grocery delivery or social apps), these large-scale digital transformation and software upgrade efforts within the Global 2000 represent the longer-term driver of spend.

As an example, just in the last week, Delta Airlines signed a new multi-year agreement with AWS. Their primary goal is to make the customer experience faster, smoother and more secure “from the booking process to the flight experience”. In addition to improving the customer experience, they want to upgrade their technology platform and drive efficiencies in operations. As part of this, they are also rolling out a global employee skills training program to “increase cloud adoption and develop new client-facing and internal capabilities.” By making employees more cloud software aware and providing some basic technology skills, new software automation efforts will be increasingly introduced by the employees themselves versus a top-down approach driven by IT.

We’re not just transforming our IT backbone—we’re rallying our entire organization to use leading technology to improve our customers’ travel experience in meaningful ways. Our work with AWS is one of many critical steps we’re taking to modernize our technology platform, empower our employees with the best tools available, and give customers even more control over the way they fly.

EVP and Chief Information Officer, Delta Airlines

In early July, FedEx announced it is planning to close all data centers and retire all mainframes by 2024. This is expected to generate cost savings of $400M. What is important to note is that the move out of data centers and off of mainframes kicks off an application upgrade process that should linger well past 2024. I expect there will be a long tail of enterprise applications that will be refactored from monoliths to service-based architectures. Those refactoring efforts will provide numerous opportunities to consider new data storage models, edge compute deployments and updated DevOps practices. Further, each application will require modern observability and security services to maintain their performance and keep them secure.

We’ve been working across this decade to streamline and simplify our technology and systems. We’ve shifted to cloud…we’ve been eliminating monolithic applications one after the other after the other…we’re moving to a zero data center, zero mainframe environment that’s more flexible, secure, and cost-effective. Within the next two years we’ll close the last few remaining data centers that we have, we’ll eliminate the final 20 percent of the mainframe footprint, and we’ll move the remaining applications to cloud-native structures that allow them to be flexibly deployed and used in the marketplace and business. While we’re doing this, we’ll achieve $400 million of annual savings.

FedEx CIO, FedEx Investor Day

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Addressable Market

This ongoing demand is often measured by software infrastructure companies and industry analysts through estimates of total addressable market. While the calculations aren’t perfect, they are directionally useful. The ideal situation is where the provider’s current revenue is only a small percentage of their estimate of the total market spend. And in many cases, that addressable market spend is still increasing by 10-15% a year. MongoDB provides an example here, where their addressable market is estimated at $138B, while they are targeting about $1.2B in revenue for FY2023. According to sell-side analyst Baird, this should position them for strong growth for many years (compounded by their expanding platform capabilities).

Snowflake provides another example. During their Investor Session in mid-June, they updated their estimated addressable market to $248B by 2026. This spans the major product segments that they address (including some new ones) across data warehouse/lake, data engineering, collaboration, data science, data applications and cybersecurity. Like MongoDB, Snowflake occupies a small percentage of this market currently, targeting over $2B in revenue for this fiscal year.

Consolidation and Reduction of Spend

During economic slowdown and pressure on IT budgets, CTO’s and CIO’s often use these periods to find ways to reduce expenses through consolidation. The example with FedEx demonstrates an expected spend reduction by moving away from software infrastructure that is costly to maintain. While running data centers and mainframes may sound like a way to save costs, it actually doesn’t when taking total cost of ownership (TCO) into account. Managing these data centers and mainframes in-house requires significant (and increasingly expensive) IT staff with expertise in hardware provisioning, network operations, systems and database administration. Due to their scale, the hyperscalers can generally perform these functions more efficiently.

The same argument applies to open source. On the surface, running an open source version of a software infrastructure function sounds like a good idea (it’s free), but the reality is similar to maintaining a data center. Open source software requires staff to install, configure, optimize and operate. In addition, to ensure that they can resolve any unexpected issues with the open source package, many enterprises engage in support contracts for outage escalation. The total cost of these open source projects and similar DIY efforts quickly exceed the cost of simply paying a software service provider for their hosted service. With most open source project sponsors now offering a commercial version that is hosted on the public cloud platforms, the total cost of self-hosting becomes more apparent. This effect explains why we see high demand for cloud-hosted offerings from Confluent, Elastic and MongoDB among others.

Consolidation of spend can be applied to multiple point solutions that proliferate in software stacks as well. Like DIY efforts, point solutions for a particular segment of a software infrastructure function can be appealing to engineering teams, where they assume they can squeeze extra performance out of the solution or anticipate benefiting from a broader set of features. In periods of IT budget expansion, it is easy for technology leadership to greenlight these kinds of projects to keep engineers happy. As budgets start to come under pressure, however, the opposite effect applies. CIO’s and CTO’s will pull back on DIY efforts, open source experiments and point solution sprawl. They will seek to consolidate these functions under the umbrella of fewer vendors, with the expectation of costs savings through volume discounts and less overhead. While the engineers may be disappointed that they lose access to the extra 10% of features (that they probably wouldn’t have used anyway), they are happy to keep their jobs.

This consolidation effect benefits software providers who offer a broader set of services in a category or span multiple categories. The effect is most pronounced where the software provider has a strong foundation in one core category and can make a “good enough” argument in an adjacent one. The two categories should be related and leverage some aspect of the IT investment already made, whether in software component deployment (single agent), training or common interfaces. This consolidation effect can be pronounced and result in an acceleration of spend expansion for entrenched software providers.

I’ll provide a few examples of consolidation opportunities. In cybersecurity, Crowdstrike offers 22 individual modules at this point and regularly reports on rapid customer expansion into subscriptions for multiple products. In Q1, they revealed that the number of customers adopting six or more and even seven or more modules grew more than 100% year over year. This expansion increased ARR by 61% year/year. During the earnings call, management spoke to this trend towards multiple module adoption and provided the explanation that customers want to consolidate their spend onto a single platform for security.

And in fact, when you look at the current environment, we have customers saying we want to consolidate more. We want to go all in with CrowdStrike. We want to get rid of this extra spend that we have in other areas, too many agents. And we can upsize our deals while decreasing the overall security spend by consolidating things like vulnerability management, by consolidating log management capabilities, etc. We can put it together and give them a much more effective technology with better outcomes, lower cost, and lower management concerns.

Crowdstrike CEO, Q1 Earnings Call

Datadog provides another example of consolidation. In their Q1 earnings call, the leadership team cited several examples of customers replacing homegrown, open source and commercial point solutions with the Datadog platform.

We signed a seven-figure upsell with a leading payment company. Earlier this year, this customer’s open source logging tool went down making them blind, but they were able to regain visibility by getting Datadog log management up and running within a few hours of that crash. Not only did this customer regain log visibility very quickly, they were also able to use the Datadog platform to scrub personally identifiable information to meet security and compliance requirements. And as they have expanded with Datadog, they have been able to cut the number of engineers who maintain homegrown and point solutions in half and reassign engineers to other products to work in the organization. With this renewal, this customer now uses 13 products from Datadog.

Datadog CEO, Q1 Earnings Call

It is worth noting that during their Q2 2020 spending reset due to Covid IT spend reductions, Datadog had far fewer products in market. At the end of 2019, they offered 6 separate monetized products. Now, their pricing page displays 17. While it’s likely that enterprises will cut back across the board, I think having more products in market (including 5 for security) should spread out the impact of customer utilization adjustments.

Beneficiaries of enterprise spend consolidation will likely manifest in other areas. MongoDB is making the case that their multi-model database can address application workloads outside of document-stores, like key value, time series, search, analytics and even a reasonable replacement for relational. Zscaler is expanding their Zero Trust platform to secure not just user-to-app communications, but also app-to-app and machine-to-machine. And while they are at it, customers can protect their cloud workloads. Snowflake wants to become a single repository for all enterprise data, spanning not just traditional data warehouse analytics workloads, but also machine learning and even real-time data applications.

While consolidation will be an important influence on IT spending, pure cost savings can be another driver of new business for some providers in a budget-constrained environment. Cloudflare frequently publishes case studies of companies that lowered their spend on hosting infrastructure simply by caching more content and reducing bot traffic. One of Mexico’s highest circulation newspapers reported a 95% reduction in bandwidth consumption and better web application threat protection by putting Cloudflare’s platform of services in front of their web site. From these initial engagements, Cloudflare can then expand spend by cross-selling their other network, application and security products. This motion explains Cloudflare’s increasing DBNR, which reached 127% in Q1, up from 117% two years prior.

Finally, while enterprises may reduce IT spending as part of an overall effort to manage costs, there is a counterforce related to the high cost of labor. Companies are increasingly trying to find ways to utilize software solutions and automation to decrease the need for staff. In a low unemployment environment (two open jobs for every applicant), this investment makes sense and is easy to justify. Examples can be found everywhere. Restaurants are increasingly turning to online ordering to replace the human taking orders over the phone. Most fast casual restaurants have eliminated front-line cashiers by offering kiosks for ordering. Insurance companies are turning to AI-driven solutions to reduce the number of claims adjusters needed. Bank branches are a shell of their former selves – most have a just couple of agents who handle all functions. Many other examples exist in manufacturing, transportation, shipping, health care and even entertainment.

This isn’t to say that the next 12 months won’t be rocky for software infrastructure companies. Investors should ensure they are positioned for further declines in valuations, if forward estimates trend downward. However, the forces of digital transformation, cost savings, IT spend consolidation and labor automation should provide tailwinds for leading software infrastructure providers over the long term.

NOTE: This article does not represent investment advice and is solely the author’s opinion for managing his own investment portfolio. Readers are expected to perform their own due diligence before making investment decisions. Please see the Disclaimer for more detail.