U.S. software stock crisis persists! Citibank: AI impact could wipe out a third of terminal value

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Citigroup points out that the software and services sector is experiencing a sharp revaluation triggered by "AI disruption fears."

According to Windy Trading Desk, in its latest US equity strategy report released on February 6, Citigroup believes that the current market sell-off is not due to a deterioration in short-term fundamentals, but rather because investors are aggressively repricing the industry's "terminal value."

The report notes that the market is factoring in a structural decline in future profit margins, and current stock prices have already fully reflected a 10% compression in terminal multiples and are nearing a reflection of 20% compression. However, if the impact of AI on business models leads to a 30% compression in terminal multiples, stock prices could fall to "liberation day lows" or even lower. For investors, although a rebound may occur in the short term due to oversold conditions, long-term uncertainty brought by AI means the era of "easy wins" for software stocks is over, and the sector will enter a stage of fierce individual stock differentiation going forward.

"Terminal Value" Shrinks Sharply Due to AI Disruption

The Citigroup report highlights that the core driver behind the software and services sector's plunge (down 20% year-to-date, and down 28% since October 29, 2025) is concerns about AI-related disruption. Although this concern has not yet fully shown up in short-term earnings reports, it is already evident in stock prices—in the form of "terminal multiple compression."

Microsoft, as the sector's core heavyweight (accounting for 55%), has led the entire sector's decline with a 17% drop since its earnings release on January 28. Citigroup believes that the market is rapidly pricing in expectations of lower future profit margins, leading to a reassessment of long-term growth prospects. Despite fundamentals remaining strong in the near term, valuation headwinds have already formed. The current decline shows the market believes that AI is not just an enhancement tool, but also a potential disruptor of current business models, directly impacting the long-term valuation premium investors are willing to pay for these companies.

Profit Margin Peak Risk: Returning to the Mean from Historic Highs

The report shows that the pre-tax profit margin of the software and services industry has reached a historic high (about 30%), an element that has already been fully, even overly, factored into valuations. Citigroup warns that once margins return to the trend line or fall below it, valuations will take a heavy hit.

If profit margins return to the trend level of 28% from the current 30% over the next three years, this means the terminal P/E will need to compress by 10%. If margins slide further to 26% (one standard deviation below the trend line), the terminal P/E will need to compress by 20% to 30%.

Citigroup's model analysis shows that current prices have already fully factored in a 10% terminal multiple compression and are approaching the 20% compression pricing level. This means that a significant portion of the expected business model deterioration is already reflected in prices.

Valuation Sensitivity Analysis: Downside Still Exists

Citigroup analyzed the current pricing logic using a reverse DCF (Discounted Cash Flow) model.

Already Priced In: Current market price levels more or less reflect a 10%-20% cut in terminal multiples.Pessimistic Scenario: If investors eventually believe that AI disruption requires a 30% cut in terminal multiples, the current stock prices still have significant downside risk. In this extreme case, the software sector would retreat to price levels seen in mid-2023.Growth Threshold: If we assume terminal multiples fall 30%, then companies must deliver results far exceeding the consensus in the short term to support current stock prices. The market currently expects a compound annual EPS growth rate (CAGR) of 19% over the next three years, which is reasonable under a 10% compression scenario, but lacks a safety margin under 30% compression.

Relative Valuation and Trading Signals: Capitulation May Signal Short-term Bottom

In terms of relative valuation, software and services' premium to the S&P 500 index has dropped sharply.

EV/Sales (Enterprise Value/Sales): The premium has returned to early 2023 levels.EV/FCF (Enterprise Value/Free Cash Flow): The premium has returned to early 2021 levels.Forward P/E: The premium is approaching ten-year lows.

Although these metrics suggest the valuation correction has been quite severe, Citigroup warns investors not to take them at face value, because when fundamentals are disrupted, these low valuations can turn into "value traps."

On the trading front, Citigroup has observed that the trading volume and implied volatility for major software ETFs (such as IGV) have soared. Such extreme trading activity is typically a sign of a "capitulation climax". Citigroup strategists believe that this panic selling may signal the market is entering a more stable period, or even a short-term rebound.

Farewell to Across-the-Board Gains, Welcoming Idiosyncratic Differentiation

Citigroup concludes that although the adjustment since the start of the year has been painful, it has rapidly released some structural risks. With 10%-20% terminal multiple compression having been priced in, the market may see a breather in the short term.

However, the "terminal value crisis" brought by AI will not disappear out of thin air. Citigroup emphasizes that future trading features will no longer be sector-wide rallies or declines, but rather highly idiosyncratic performances. Investors need to distinguish which companies can use AI to enhance their businesses and which companies' business models will be completely disrupted by AI. As Citigroup said in its 2026 outlook, this is a "more volatile bull market," and software stocks are experiencing the most extreme part of this volatility.

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