Third quarter earnings results aren’t yet in for many of the players in the Internet-Software & Services industry, so the outlook remains unclear. All we know is that all four of the companies that have reported thus far have sailed past estimates.

Being the backbone of the digital economy, there’s no way that this industry will do badly over the next year or so. However, overall business levels have fallen significantly this year, which has impacted some of the players. So investing in stocks like Criteo (CRTO - Free Report), ChannelAdvisor Corp. (ECOM - Free Report) and Donnelly Financial Solutions (DFIN - Free Report) could help you make the most of the bounce back.

About the Industry

The Internet Software & Services industry is a relatively small industry primarily involved in enabling platforms, networks, solutions and services for online businesses and facilitating customer interaction and use of Internet-based services.   

Here are three major themes in the industry:

• The overall impact of COVID has been positive for the industry. Although it necessitated work from home for employees, the industry, being by nature tech-centric, had relatively fewer issues with this. On the other hand, business continuity concerns accelerated the shift to cloud-based working for many, while service providers, both work-related and otherwise, also moved to Internet-based channels. Another big segment that did humongous amounts of business online was retail. All of these moves were positive for the industry and offset any negative impact of declining business at brick-and-mortar players. At least some of these trends will outlive the pandemic. In other cases, the return to physical operations will be gradual. But any improvement in the general level of industrial growth will also improve prospects for the industry.  

• The higher volume of business being operated through the cloud and the increasing demand for enabling software and services are however increasing costs for players as they continue to expand their offerings in the race to grab more business. This causes great fluctuations in profitability as more debt is incurred and physical infrastructure built out. However, one positive in this context is the net cash per share, which is showing an upward trend over the past three years. Profitability is likely to suffer again this year as a fallout of the pandemic and infrastructure buildout.

• The level of technology adoption by businesses and the proliferation of connected consumer devices that might help people connect and do business online also impacts growth. As a result of the high penetration of mobile devices among users, it now makes sense for businesses to adopt technology that they earlier stayed away from because of the cost involved.

Zacks Industry Rank Indicates Uncertain Prospects

The Zacks Internet – Software & Services industry is housed within the broader Zacks Computer and Technology sector. It carries a Zacks Industry Rank #228, which places it at the bottom 8% of more than 250 Zacks industries. It includes players like VeriSign (VRSN).

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates that near-term prospects remain bright. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s positioning in the bottom 50% of the Zacks-ranked industries is a result of a negative earnings outlook for the constituent companies in aggregate. Looking at the aggregate negative estimate revisions, it appears that analyst confidence in the group’s earnings growth potential for 2020 has been on a steady decline since May. Overall, the 2020 average earnings estimate is down 41.9%. The estimate for 2021 is down 25.1%.

Before we present a few stocks that you may want to consider for your portfolio, let’s take a look at the industry’s recent stock-market performance and valuation picture.

Industry’s Stock Market Performance Is Impressive

The past year’s performance of the Zacks Internet – Software & Services Industry shows a neck-to-neck race with the broader Zacks Computer And Technology Sector, both of which have performed much better than the S&P 500 index.

The aggregate share price of the industry appreciated 29.4% over this period compared to the broader sector’s increase of 30.0% and the S&P 500’s 10.0%.

One-Year Price Performance

 Industry’s Current Valuation

On the basis of forward 12-month price-to-earnings (P/E) ratio, which is a commonly used multiple for valuing Internet companies, we see that the industry is currently trading at 48.5X (between its median value and 52-week high) compared to the S&P 500’s 21.4X (closer to its median value). It is also overvalued compared to the sector’s forward-12-month P/E 25.7X.

The shares have traded in the annual range of 33.5X to 51.9X, as the chart below shows.

Forward 12 Month Price-to-Earnings (P/E) Ratio

Criteo S.A.: This provider of ad tech solutions has access to 20,000+ advertisers across 100 countries on the one side and customer data relating to $2 billion worth daily online sales and 4 billion product SKUs on the other.

The company is poised to gain from the massive push toward e-commerce in recent years. While the pandemic impacted advertiser budgets and limited spending, with a corresponding negative impact on the company’s results, it’s encouraging to note that business is coming back strongly and the company has also started seeing large multi-year deals. With the e-Commerce opportunity expected to go from 16% of total sales today to 23% by 2023, Criteo, with its ability to provide marketing insights and yield gains, should see steady growth.

This Zacks Rank #1 company has dropped 9.2% over the past year. The Zacks Consensus Estimate for the 2020 EPS increased 29 cents (18.0%) in the last seven days. The estimate for 2021 also jumped 19 cents (12.8%).

Price and Consensus: CRTO

ChannelAdvisor Corporation: offers cloud-based e-commerce solutions and services including marketplaces, comparison shopping, paid search, social campaigns, flex feeds, web stores, and rich media.

The digital/e-commerce boom resulting from the pandemic has been very positive for ECOM and the company is seeing very strong growth trends this year.

This Zacks Rank #3 company has gained 91.5% over the past year. The Zacks Consensus Estimates for 2020 and 2021 earnings remain steady over the last two months (estimate revisions will follow earnings results today). Current expectations are for a 137.5% increase in earnings this year followed by a 2.1% decline in 2021.

Price and Consensus: ECOM

Donnelly Financial Solutions: Donnelley Financial Solutions provides software and services for content creation, management and distribution, as well as data analytics and multi-lingual localization services.

The company is seeing demand return to more normal levels, with a strong IPO market leading the way. Higher volumes of transactions, particular strength in its higher-margin business, and ongoing cost-control efforts are also improving profitability.   

This Zacks Rank #3 company saw its share price rise 46.4% in the past year. Estimates for 2020 and 2021 are yet to be adjusted after the company reported very strong results yesterday. Current expectations are for a 25.6% increase in earnings this year followed by a 4.1% increase in 2021.

Price and Consensus: DFIN