KeyBanc Capital Markets software team shares emerging software concepts

In a panel led by Michael Turits, managing director of software investment banking at KBCM, discussions focused on IT budget trends, cloud technologies, and investment in generative AI. Panelists from KBCM included:

• Jackson Ader, Managing Director, software equity research
• Tom Blakey, Vice President, equity research analyst
• Eric Heath, Vice President, equity research analyst, and
• Jason Celino, Director, equity research analyst.

IT budgets remain flat in 2024

CIO optimism waned at the beginning of the year, according to KBCM’s 2024 CIO survey. In June 2023, survey respondents expected IT budgets to grow nearly 4% this year, Ader said. By December, expectations fell to only 2.2% IT budget growth. “That’s not a good trend,” he said during the panel discussion. “It could have been that some optimism in the first half of the year faded into realism in the second half of the year. That was the headline, and it was certainly a disappointing one for IT budgets.”

Celino added that the beginning of the year has been an unkind earnings season, and many industries are pursuing layoffs. However, he remains optimistic that the first half of 2024 is the trough of this current down cycle. “I still feel optimistic about the year, but I am no longer optimistic about the first half of the year,” he said. Heath and Blakey agreed that the year has performed contrary to expectations thus far, with Heath saying that we were “humbled pretty quickly” this year.

Blakey added that there is often a cycle associated with IT spending. In 2020, many companies needed to perform firewall upgrades to support remote work, for example, but other components of the IT stack were not upgraded. “That’s why I think you're seeing a bifurcation in terms of firewall, compared to storage and networking,” he explained.

Cloud optimization takes the spotlight

KBCM’s 2024 CIO survey also revealed strength in cloud optimization strategies. In fact, 90% of CIOs in the survey said that cloud spending would either maintain or accelerate this year. “People were expecting the macro headwinds that they saw in 2022 and 2023,” Heath said about the widespread investment in cloud technologies. “This is one of the breadcrumbs that makes us feel like we have a reason to be more optimistic.”

However, not every company is pursuing optimization, as Heath admitted later in the discussion. Some companies haven’t even started optimization. Instead, they are cutting waste out of their budgets before making further investments. Yet, Heath said, “I think it’s continual optimizations happening. Going forward, companies have to ask who spearheads the optimizations, and how much does optimization account for in the total IT budget?”

Slow adoption of generative AI

Despite the hype, generative AI has been slow to take flight. While many companies have tested AI programs, teams are reporting that they don’t see the value in them. In the CIO survey, 70% of respondents said they are testing use cases for generative AI, but because this has been a top-down directive, many people have been unsatisfied with the results and there has been a problem progressing AI tools from testing to implementation.

“There is a little bit of a worry that if we’re testing so much, when you get to the underlying use case, people are underwhelmed,” says Ader. “That doesn’t bode well.” The top-down directive to explore AI may also lead teams to use generic tools, such as Chat GPT, that have a smaller impact on workflows and processes.

In the long term, the panel agreed that AI can provide greater value by helping companies manage and analyze data. “When generative AI itself starts to become the application, I think there’s a whole new cohort of fragmentation and innovation that we could see in the observability space going forward,” said Heath. However, that might be easier said than done. As Heath added, “At that stage, you have to monitor for a new set of obstacles, like pricing and hallucinations.”

Still, panel participants shared optimism about the future of AI. Software valuations, for one, are up 25%, and enterprise revenue to growth has increased 30%, according to Ader. However, there was fundamental disagreement among the panelists about what is driving that growth.

Noting that interest rates have been stagnant for nearly a year, and the growth rate is down compared to last year, Ader said enterprise revenue growth, and a positive industry sentiment about the future of AI, are driving up valuations.

Celino challenged that assumption, saying that he doesn’t assign value to AI in his models. Therefore, he doesn’t believe that future expectations about AI are impacting valuations.

Heath agreed with Celino that AI monetization was not driving valuation. From his perspective, the corporate adoption of cloud-based tools and software modernization is contributing to higher valuations. As a company builds out its IT stack, Heath said that ancillary companies, like cybersecurity, are going to benefit.

While the source of the valuation growth was up for debate among the panelists, it is a positive sign for the industry, and one of several emerging bright spots for AI applications. Companies across industries are finding valuable uses for AI. The electronic design automation industry, for example, is using AI to build chips faster and more efficiently. And companies like GitLab are using AI to code faster and more efficiently.

Experts learned years ago that technology adoption ebbs and flows. While IT budgets and positive sector sentiments have waned in 2024, the panelists anticipate promising developments in the next cycle as emerging technologies reshape the everyday.

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