What’s the true state of the software sector as AI evolves?
Nate Mahrer: AI continues to dominate headlines and drive enthusiasm at the index level, yet much of the software sector has struggled to keep pace. That’s fueled a narrative that AI will be the death of software.
Investors have gravitated toward the more tangible parts of the AI story such as semiconductors, hardware, and infrastructure — areas where demand, earnings, and capital intensity are easier to see and value.
Matthew Hedberg: There are certainly categories that are benefiting from AI, like consumption software and specific cybersecurity names, as well as vertical software. Others, notably horizontal software and aspects of the infrastructure stack, have struggled.
We think AI is the fourth shift in technology, following the cloud, the internet and SaaS. The next several years will be critical for software companies to evolve, to pivot, to change the way they think about delivering tech, about value and ROI.
As in the shift from on-premise to cloud, there will be winners and losers. But make no mistake, software is not dead — it's just evolving.
“Make no mistake, software is not dead — it's just evolving.”
Matthew Hedberg, Head of Global TIMT Research
Which types of vendors are best placed to thrive?
Hedberg: This space is moving so rapidly, and I think a lot of end customers are still uncertain about what the AI future holds.
Cybersecurity is always a hot topic. Many times, as companies think through an AI digital transformation, they often have to think about a cyber transformation as well. So we're seeing some early benefits for some of these cyber names.
Mahrer: The report outlines three tiers of AI leadership: current leaders, those next in line, and some emerging contenders. How do you think about those distinctions?
Hedberg: Tier one would be those seeing very early tangible benefits from AI, whether in software or services. The tier two category includes companies we think have the right ingredients to be AI winners longer term, spanning cyber, infrastructure, and vertical software.
The tier three category includes names the market hasn’t yet recognized as AI winners, but our analysis suggests they have the right characteristics to become AI-relevant.
Tier one names will likely be compounders in the space. Some of the tier three names could become increasingly interesting from an M&A perspective, as bigger companies think about how they want to bolt on some features to their broader stack.
How are software companies turning AI into revenue?
Mahrer: AI monetization is still in the very early innings. While capex and R&D costs are easy to quantify, the narrative around value creation has been much more fluid.
Hedberg: We’re taking a lot of cues from the ‘AI natives.’ We often hear from VCs and early-stage investors that it’s easier to invest in companies that are a year or two old than in companies five to ten years old, because they've been built in this AI era. They're often built not on a seat-based model but based on consumption or ROI or a value-based pricing mechanism.
Theoretically, even if seats were to compress, the money being spent with these vendors could go up. The opportunity is for vendors to show that they're delivering tangible ROI that may not be tethered to seats.
Historically, companies used to think about moats like software and code, but in the future all software could be open source.
“While capex and R&D costs are easy to quantify, the narrative around value creation has been much more fluid.”
Nate Mahrer, TIMT Strategist
How is agentic AI likely to influence business models in future?
Hedberg: I think this is the most exciting element of this era – thinking about how agents will interact with humans. In a lot of enterprise software, user interface is not the most intuitive. We think an agentic front end could even improve the end user experience and make it much more profound. Organizations that embrace this will be disruptors in the core economy.
What’s the outlook for M&A in the space?
Hedberg: We’re seeing an increased cadence of M&A activity. There will certainly be hyperscaler or large software platform vendors looking at smaller AI startups as a way to stay in front of their peers.
Private equity could very well be in a position to stitch together a number of software assets, and ultimately bring that back to market in the form of an IPO.
Plenty of software companies may not survive the next wave of disruption — they just don’t know it yet. M&A, both strategic and private equity, will certainly take care of some of that, but some companies are going to be effectively left without a dance partner.
I feel like there’s a flywheel of M&A, IPOs, and consolidation that's going to be an ongoing narrative for the next several years.
“A flywheel of M&A, IPOs and consolidation is going to be an ongoing narrative for the next several years.”
Matthew Hedberg, Head of Global TIMT Research
