Tech

Forget 5G: This Tech Stock Trend Is Generating Even Bigger Returns

Many tech investors consider 5G networks, which can be up to 100 times faster than 4G networks, to be the next secular growth story. A wide range of industries will benefit from those faster wireless connections, and myriad hardware and software companies will profit from that expansion.

I’ve covered plenty of 5G companies before, but many of them are mature tech giants that probably won’t satisfy growth-oriented investors. So today, I’ll highlight a hotter tech trend that could generate even bigger returns than 5G stocks: the rise of “silo-busting” software companies.

A worker checks data on a tablet.

Image source: Getty Images.

What are silo-busting companies?

Many large companies store their data across multiple computing platforms and software services, which are often spread across various departments. That practice creates silos, which throttle a company’s efficiency and discourage departments from freely exchanging knowledge, information, and ideas.

In a recent report, ResearchGate calls “silo mentality” the “greatest threat to organizational performance.” The recognition of that threat is sparking intense demand for silo-busting cloud services that shatter those barriers and pull all a company’s data to a centralized location.

A common theme in high-growth cloud companies

That’s why it isn’t surprising that many of the hottest tech IPOs over the past year cited the destruction of silos in their prospectuses.

Datadog (NASDAQ:DDOG), which went public last September, pulls a company’s data from servers, cloud services, apps, software services, and other platforms onto a single dashboard. Its revenue rose 88% last year and 77% year over year in the first half of 2020.

Snowflake (NYSE:SNOW), which went public last month, pulls all of a company’s data onto a cloud-based platform, where it can be analyzed and fed into third-party data visualization software. Snowflake’s revenue surged 174% last year and jumped 133% in the first half of 2021.

JFrog (NASDAQ:FROG), which went public on the same day as Snowflake, lets companies store software updates on a universal platform that can be accessed by any type of computing architecture. Its revenue rose 65% last year and grew another 50% in the first half of 2020.

Similar strengths and weaknesses

Datadog, Snowflake, and JFrog all dazzled investors with their robust revenue growth rates. Since their IPOs, Datadog’s stock has more than quadrupled, Snowflake’s stock has more than doubled, and JFrog’s has nearly doubled.

But all three stocks are trading at nosebleed valuations. Based on next year’s sales forecasts, JFrog trades at 38 times sales, Datadog trades at 43 times sales, and Snowflake trades at a whopping 123 times sales — making it one of the priciest tech stocks on the market.

It’s also difficult for these companies to generate consistent profits, because of high cloud hosting costs, marketing expenses, and limited room for price increases in a competitive market. Snowflake and JFrog remain unprofitable, while Datadog squeezed out a slim profit in the first half of 2020.

A laptop connected to cloud-based services.

Image source: Getty Images.

Another major issue is that many of these companies host their silo-busting services on big public cloud platforms such as Amazon.com‘s (NASDAQ:AMZN) Amazon Web Services (AWS) and Microsoft‘s (NASDAQ:MSFT) Azure.

Amazon and Microsoft are recognizing the disruptive potential of silo-busting services and now bundle similar solutions into their cloud platforms. For example, AWS’s Redshift and CodeArtifact compete against Snowflake and JFrog, respectively.

The bears believe these smaller silo-busting companies could struggle against their larger rivals over the long term, but the bulls will note that these smaller players have already locked in a lot of major customers.

A secular trend that can’t be ignored

It might be risky to chase these high-growth silo-busting companies at their current valuations, but investors can’t ignore this secular trend that’s driving many decisions across the tech sector.

The growth of unified collaboration platforms, such as Slack, Microsoft Teams, and Asana, reflect a desire to eliminate silo-based communications like emails and phone calls. Palantir, which went public last month, breaks down silos across government agencies and helps them collect personal data from disparate sources.

Investors should expect this trend to continue for the foreseeable future, but they should carefully weigh these companies’ inherent weaknesses — including their frothy valuations, poor profitability, and competitive threats — against their disruptive strengths.

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