CITIC Securities: AI commercialization deployment and cloud computing demand drive software performance improvement

According to the Zhitong Finance APP, CITIC Securities released a research report stating that recent market trading narratives regarding "stagflation" in the U.S. economy have led to a significant correction in the U.S. stock software sector, following the market trend. However, the Q4 2024 financial reports of 38 mainstream U.S. software companies indicate that after the demand bubble was cleared over the past three years, the overall software demand from enterprise clients in Europe and the U.S. is stabilizing and may show signs of a slow recovery. The conservative performance guidance for some software companies for Q1 2025 and the entire year of 2025 aligns with the sector's past habits. Nevertheless, recent policies from the Trump administration have raised significant concerns in the market regarding macroeconomic impacts and expectations, necessitating cautious attention.

In terms of investment rhythm, a short-term recovery trend in the market still requires the elimination of macro uncertainties. The commercialization deployment of AI in the enterprise market, combined with the continued upward demand for enterprise cloud computing, is expected to significantly benefit the foundational software sector in H1 2025. Along with the stabilization of macro expectations and the gradual realization of AI commercialization benefits, CITIC Securities believes that the performance of application software is likely to improve significantly in H2 2025.

CITIC Securities' main viewpoints are as follows:

Report Origin:

Based on the overall performance and guidance of the software sector's Q4 2024 financial reports, as well as the statements from various companies regarding the downstream demand environment, we judge that IT spending by enterprises in Europe and the U.S. will continue to show a steady recovery in the short term. However, recent series of measures by the Trump administration regarding tariff policies, government layoffs, and budget cuts are creating ongoing noise and disturbances to U.S. macroeconomic growth and inflation expectations. Additionally, the relatively conservative performance guidance from some software companies has also exacerbated market concerns to some extent. Currently, the sector's EV/S (NTM) has returned to levels seen in 2018-2019. We believe that the market's main focus at this point is: 1) Whether the logic of the recovery in IT demand from enterprises in Europe and the U.S. still holds, and what signals are needed for verification; 2) How to view the pace of AI commercialization and which sub-sectors or companies may first realize financial performance. In this special report, we will analyze and discuss the above issues in conjunction with the Q4 financial reports of 38 mainstream U.S. software companies.

Q4 Performance Review & Demand: Overall performance is robust but guidance is conservative, with enterprise demand stabilizing and slowly recovering.

By analyzing the performance of the three major sub-sectors, we find that: 1) Application Software: Q4 performance was impressive, with mainstream vendors' Q4 revenue and Non-GAAP net profit exceeding expectations by an average of 1.8%/14.3%, but the guidance for 2025 is conservative. 2) Fundamental Software: Q4 performance exceeded expectations, with mainstream vendors' revenue and Non-GAAP operating profit margin exceeding expectations by an average of 1.1%/34%, but the guidance is conservative and differentiated, with companies whose performance is highly correlated with cloud spending growth generally performing better. 3) Information Security: Firewalls are entering an upward cycle, with performance and guidance remaining resilient, and mainstream security companies' Q4 revenue exceeding expectations by an average of 3%.

Combining the statements from various companies during their performance communication meetings, we find that: 1) The software spending of medium to large enterprise clients in fundamental software remains strong and is showing a further acceleration trend. Confluent indicated that the large customer base is continuously expanding its usage scenarios, while Elastic noted that the consumption of some large clients exceeded expectations 2) SMB customer spending on application software shows signs of recovery. Both Fintech and Atlassian indicated that the overall situation for SMB customers remains stable, Bill noted an increase in demand from mid-market customers, and Klaviyo reported strong momentum in both low-end and high-end markets. 3) The demand in the U.S. market is generally optimistic, while there is divergence in the demand outlook for the European market. SAP, Monday, Snowflake, and Elastic all reported rapid growth in the U.S. market, with the European market stabilizing, but Salesforce and Workday still believe that the European market is constrained.

AI Progress: Entering the scale deployment phase, with foundational software expected to benefit first.

Based on the performance communication of mainstream application software vendors in CY2024Q4, we found that several application software vendors have entered the early stage of AI monetization. In earnings analyst conference calls, they are no longer limited to describing AI products & functions but are starting to clarify the timeline for AI application monetization (such as Salesforce, Wix, and Atlassian). We expect that by the second half of 2025, the revenue share from AI for leading application software companies will reach low single digits. During the cycle of application vendors promoting the large-scale deployment of AI applications, we believe that foundational software related to AI revenue is expected to grow significantly in 2025 as more AI applications are practically implemented. At the same time, as more application software companies invest in the R&D of AI application scenarios, the related demands for data storage, management, and computing will also increase. Therefore, regardless of how downstream application scenarios are developed, foundational software companies are expected to benefit first from the commercialization of AI.

Investment Outlook: From foundational software to application software.

We believe that considering the gradual recovery trend in cloud spending, and regardless of how AI application development directions change, the demand for foundational software will always increase with the growth of data volume and load. Therefore, in the early stages of AI application commercialization, cloud foundational software is expected to benefit first. We recommend focusing on foundational software driven by cloud demand recovery + AI deployment in the first half of 2025; in the second half of 2025, based on the judgment that U.S. enterprise software spending has gradually entered a recovery cycle, we believe that previously resilient performance, continuously improving prosperity, and rapid AI progress targets will continue to benefit, including: 1) targets in application software with superior market positions and strong execution; 2) targets with rapid AI integration; 3) the information security sector with continuously strong demand; 4) targets in the general ERP sector that are expected to accelerate performance with the acceleration of ERP cloudification.

Risk Factors:

Risks of AI core technology development falling short of expectations; risks of continued tightening of policy regulation in the technology sector; risks related to policy regulation of private data; risks of global macroeconomic recovery falling short of expectations; risks of macroeconomic fluctuations leading to lower-than-expected IT spending by European and American enterprises; potential ethical, moral, and user privacy infringement risks associated with AI; risks of corporate data breaches and information security; and risks of intensified industry competition, etc Investment Strategy:

Recent market trading around the narrative of "stagflation" in the U.S. economy has led to a significant pullback in the U.S. software sector, following the overall market trend. However, the Q4 2024 financial reports of 38 mainstream U.S. software companies indicate that after the demand bubble of the past three years has cleared, the software demand from enterprise clients in Europe and the U.S. is stabilizing overall, with signs of a slow recovery. The conservative performance guidance for Q1 2025 and the entire year of 2025 aligns with the sector's historical patterns, but the impact and disturbances from recent policies of the Trump administration on macro expectations need to be monitored cautiously. In terms of investment rhythm, a short-term recovery trend in the market still requires the elimination of macro uncertainties. The commercialization deployment of AI in the enterprise market, coupled with the continued upward demand for enterprise cloud computing, is expected to significantly benefit the foundational software sector in H1 2025. At the same time, with the stabilization of macro expectations and the gradual realization of AI commercialization benefits, the performance of application software is expected to improve significantly in H2 2025