Adobe, Cloudflare lead plunge in cloud stocks after JPMorgan issues wave of downgrades on valuation concerns

Adobe’s stock had its second-worst day of the year on Tuesday, and shares of other cloud software companies like Cloudflare and Zscaler plunged after JPMorgan analysts issued a series of downgrades, citing high valuations.

In a 2022 outlook report on software technology, JPMorgan analysts including Sterling Auty and Jackson Ader lowered their ratings on 13 companies, while upgrading just five.

“The reasons for the downgrades include a combination of limited upside to our price targets, valuation in light of risk that interest rates rise in 2022, adjusting discount rates for the current rate environment and re-evaluating reasonable cash flow expectations,” the analysts wrote.

The threat of rising rates in an environment of high inflation has been spooking tech investors for 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. A CNBC Fed Survey predicts the central bank will raise rates three times in each of the next two years, starting in June 2022.

Higher rates tend to have an outsized impact on 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 higher multiple software stocks trading over 20x revenue,” the JPMorgan analysts wrote.

Adobe is trading at 21 times revenue, according to FactSet. Prior to Tuesday’s 6.6% drop, Adobe shares were up 31% this year, topping the 20% gain in the S&P 500. That rally pushed the stock to $658.30, just shy of JPMorgan’s $680 price target, leading the firm to reduce its rating to neutral from buy.

“Adobe has been one of the better performers across our coverage in 2021, especially in the large-cap category, as improvement in the economic environment coming out of the pandemic motivated companies to purchase digital marketing/advertising solutions to generate top-line revenue growth,” the analysts wrote. “The stock now stands less than 10% from our target price, and, as such, we are downgrading to a Neutral rating.”

Adobe’s steepest drop of 2021 came 11 days ago, when the stock plummeted 8.2%.

The two biggest declines following Tuesday’s report were in shares of cybersecurity companies Zscaler and Cloudflare, which tumbled 7.6% and 9%, respectively. Zscaler had been up 55% for the year, prior to Tuesday, and has an enterprise value to revenue multiple for 2022 of 39. Cloudflare was up 91% and trades at a multiple of 61.

“We appear much closer to a rate tightening cycle as the Fed looks to catch up with inflation, and we do expect that will have an impact on our highest valuation names, especially as growth begins to normalize,” JPMorgan wrote, in explaining its downgrade of Zscaler to sell from hold.

For Cloudflare, JPMorgan said that the company 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.

But, because Cloudflare “is the most expensive stock in our coverage,” and multiples in software are expected to compress, JPMorgan said it was reducing its rating to sell from hold.

Datadog shares dropped 6.5% on Tuesday after JPMorgan issued a similar downgrade. The firm said that lowering its rating on the data analytics and monitoring company is “purely a valuation call.”

The stock was up 75% this year before Tuesday’s slide, and trades for 61 times revenue, according to FactSet.

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