European Software: Application software drawdown deepens amid AI boom; industry view remains In-Line

Overview

This report is Morgan Stanley's weekly snippet research on European software and services, with a core focus on sector divergence under the AI theme. On one hand, it uses long-term share-price drawdown visualization to highlight valuation and performance pressure in application software; on the other hand, it reviews adoption progress and financing events for AI in accounting, legal, financial services, marketing, and data infrastructure. The overall tone is neutral: software stocks as a whole remain in deep drawdown, but AI infrastructure, compliance workflows, and specific regulatory catalysts bring localized opportunities.

Core views

Core views include: first, the application software sector has been weak since last August, and an equal-weight basket of more than 50 mid- to large-cap software stocks has gone nearly 1,700 days without making new highs since its late-2021 peak, with current drawdowns exceeding 35%; second, AI adoption in the tax and accounting industry is accelerating, but incumbent vendors still retain moats through compliance infrastructure, customer workflows, and trusted systems; third, data infrastructure software is relatively stronger, with Databricks financing rumors and recent gains in Snowflake, MongoDB, and Datadog reflecting renewed investor interest in this sub-sector; fourth, UK digital filing regulatory changes are a modest positive for Sage but not a major group-level driver; fifth, enterprise AI is still at an early implementation stage, and ROI, governance, token budgets, and model routing will be key areas to watch going forward.

Analysis framework

The report combines event tracking with sub-industry comparison: it uses a long-term equal-weight stock basket to observe drawdowns in the software sector, uses financing and share-price data to identify relative strength and weakness in AI and data infrastructure, uses regulatory changes to assess potential incremental demand for Sage, and uses conference observations from London Tech Week to judge the stage of enterprise AI adoption.

Methodology notes

• Market Performance AnalysisEqual-weight software stock drawdown visualization

  Measure drawdown depth and the number of days without new highs from the latest all-time high

  The report selects more than 50 mid- to large-cap software stocks listed since January 2005, aggregates their long-term share-price performance on an equal-weight basis, and observes the magnitude and duration of drawdowns from the latest all-time high to the present.

• Industry Competition AnalysisAI adoption and incumbent moat assessment

  Assess the competitive relationship between AI-native startups and incumbent software vendors in workflows, compliance, and infrastructure

  In tax and accounting software, AI-native companies may penetrate individual workflow steps, but the report believes that core tax engines remain protected by incumbents' compliance systems, customer embeddedness, and infrastructure.

• Event-driven AnalysisRegulatory and financing catalyst tracking

  Use regulatory timelines, financing valuations, and conference observations to identify short-term industry catalysts

  The report tracks the UK's digital filing requirement for company accounts, financing information for Databricks/Lovable/PhysicsX, and AI adoption signals from London Tech Week to assess opportunities and risks across sub-sectors.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• European software and services sector

  Core sector under coverage

  Strengths

  AI adoption, regulatory digitalization, and demand for data infrastructure provide structural opportunities.

  Weaknesses

  Application software share-price performance is weak, with deep long-term drawdowns and an extended period without new highs.

  Comparison

  The current drawdown depth is close to levels seen during the Global Financial Crisis and the post-pandemic rate-hike valuation-compression phase.

  Risks

  Slow realization of returns on AI investment, continued valuation compression, and tightening enterprise budgets.

• Application software sector

  Main source of drawdown pressure

  Strengths

  Long term, it is still supported by enterprise digitalization and automation demand.

  Weaknesses

  Price performance has been weak since last August, with drawdowns of more than 35% from the highs.

  Comparison

  Compared with sub-sectors such as data infrastructure and cybersecurity, application software has been weaker recently.

  Risks

  AI substitution, intensifying competition, slowing growth, and multiple compression.

• Data infrastructure software (Snowflake, MongoDB, Datadog)

  Relatively strong sub-sector

  Strengths

  AI and data workloads are lifting market attention, and recent share-price rebounds have been significant.

  Weaknesses

  Valuation and growth expectations may already partly reflect optimism.

  Comparison

  Against a backdrop of broad weakness in application software, this sub-sector has shown greater resilience.

  Risks

  Cloud spending optimization, intensifying competition, and failure of AI demand to translate into sustainable revenue.

• Wolters Kluwer and Thomson Reuters

  Incumbent beneficiaries of AI automation in tax and accounting

  Strengths

  They possess core tax engines, trusted compliance systems, and embedded customer workflows.

  Weaknesses

  AI-native companies may gradually attack individual workflow segments.

  Comparison

  Compared with startups, incumbents are stronger in compliance and customer trust.

  Risks

  Insufficient product innovation, commoditization of AI features, and customer migration to lower-cost tools.

• Sage

  Potential beneficiary of UK digital filing regulatory changes

  Strengths

  From 2028, UK company accounts will need to be filed using commercial software, helping drive software adoption among long-tail enterprises; the report forecasts UKIA FY26-29e CAGR of about 9%.

  Weaknesses

  The remaining opportunity is concentrated in micro businesses, dormant companies, and low-complexity entities, with lower ARPU.

  Comparison

  This catalyst supports Sage UKIA, but is unlikely to become a major group-level tailwind.

  Risks

  Implementation delays, low customer conversion rates, and limited contribution from low-ARPU customers.

• Databricks, Lovable, PhysicsX

  Indicators of financing momentum in AI and data infrastructure

  Strengths

  Rising financing valuations show that private markets are still willing to pay high valuations for AI infrastructure and AI application platforms.

  Weaknesses

  Some financing information comes from unconfirmed media reports, and commercialization quality still needs to be verified.

  Comparison

  In contrast to the drawdowns in listed application software, private AI assets still maintain strong capital-market momentum.

  Risks

  Excessive valuations, changing financing conditions, and revenue growth failing to match market expectations.

Key data

• Software stock drawdown depth>35%The sample basket is down more than 35% from its latest all-time high.
• Duration without new highsNearly 1,700 daysThe sample basket has gone nearly 1,700 days without reaching a new all-time high since its late-2021 peak.
• Sample scope>50 mid- to large-cap software stocksThe sample consists of mid- to large-cap software stocks listed since January 2005, aggregated on an equal-weight basis.
• Organizational GenAI deployment rateAbout 34%Thomson Reuters' 2026 AI in Professional Services Report shows that about one-third of both tax firms and corporate tax departments have deployed GenAI at the organizational level.
• Potential Databricks valuation$165bn+An unconfirmed report from The Information said Databricks is in talks to raise funding at a valuation above $165bn, higher than its $134bn valuation in February.
• Snowflake share-price performance over the past monthAbout +58%The report says data infrastructure software has rebounded against the backdrop of broader weakness in application software.
• MongoDB share-price performance over the past monthAbout +15%The report cites it as a recent case of relative strength among data infrastructure-related software.
• Datadog share-price performance over the past monthAbout +17%The report cites it as a recent case of relative strength among data infrastructure-related software.
• Potential Lovable valuation$12bnAn unconfirmed Forbes report said Lovable is in talks to raise funding at a $12bn valuation, above its $6.6bn Series B in December 2025.
• PhysicsX financing$330m Series C, valuation about $2.4bnPhysicsX announced completion of a $330m Series C at a valuation of about $2.4bn, above its previous valuation of close to $1bn.
• Timing of UK digital filing for company accountsApril 2028Companies House confirmed that from April 2028 all UK companies must submit annual accounts using commercial software.
• Number of active registered UK companiesAbout 4.9mThe report states that there are about 4.9 million active registered companies in the UK.
• Existing software filing penetration>65%Companies House indicated in 2023 that more than 65% of companies were already filing using software.
• Sage UKIA growth forecastFY26-29e CAGR about 9%The report believes regulatory changes support Sage UKIA growth, but do not constitute a major tailwind at the group level.
• Harvey token processing volumeFrom 1 trillion per month to 15 trillionObservations from London Tech Week show that the Harvey platform's monthly token processing volume has risen from 1 trillion at the start of the year to 15 trillion currently.

Impact & implications

The investment implication is that the software sector cannot simply be treated uniformly through the AI theme. Application software still faces pressure from valuation compression, failure to make new highs, and insufficient validation of enterprise AI ROI; data infrastructure, compliance-oriented workflow software, and incumbents with embedded customer bases are relatively more resilient. For investors, it will be important going forward to distinguish among AI narratives, real adoption, revenue conversion, and valuation digestion.

Risks

• The application software sector may continue to be affected by valuation compression and downward revisions to growth expectations.
• Enterprise AI adoption is still at an early stage, and widespread validation of daily usage, training, and measurable productivity improvements has not yet occurred.
• AI-native startups may challenge incumbents' point workflows and pricing power.
• Some information in financing and valuation news is unconfirmed and may overstate true demand in private markets.
• Implementation of the UK digital filing regulatory catalyst is delayed until 2028, and many of the remaining customers are micro or low-complexity entities, so the commercial contribution may be limited.
• The research report discloses that Morgan Stanley has business or potential business relationships with multiple covered companies, and investors should pay attention to conflict-of-interest disclosures.

What to watch

• Whether the equal-weight software basket can again approach or break above the late-2021 all-time high.
• Whether the relative performance gap between application software and sub-sectors such as data infrastructure and cybersecurity continues to widen.
• Whether GenAI deployment rates in the tax and accounting industry can translate into revenue growth and improved customer retention.
• Whether AI-related financings such as Databricks, Lovable, and PhysicsX are ultimately completed and whether valuations hold.
• Sage's customer conversion, ARPU, and UKIA growth performance ahead of the UK's 2028 digital filing requirement.
• Progress in implementing ROI, governance, token budgets, and model routing for enterprise AI in financial services, legal, and marketing scenarios.