3 Software Companies For Growth

Damian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The tech sector is quite unpredictable, and always rapidly changing. Within it, the application software industry has been especially characterized by its constant evolution and strong competition. Only those who can rapidly respond to ever-changing customer demands and needs can truly succeed in this field. Informatica (NASDAQ: INFA), Intuit (NASDAQ: INTU) and Red Hat (NYSE: RHT) seem like interesting options in the industry. Let´s take a look at them in order to find out if they actually fulfill the requirements for a successful software company going forward.

Integration leads to success

Informatica is a leading provider of software solutions that help companies integrate and analyze data, allowing them to set up and manage systems that enable more effective business decision making. As it evolves towards more complex data integration solutions, its growth prospects look promising and analysts expect it to deliver average annual EPS growth rates above 16% over the next five years.

After reporting strong results for its second quarter, this low-profile company caught my eye. Revenue grew considerably in several areas including software, licenses, subscriptions, services and even consulting, reflecting the success of its recent (but quiet) acquisitions. Moreover, these results have put investors at ease, proving that some sales force issues which had once worried them are now part of the past.

Although the company still specializes in data warehousing solutions, it has been making an incursion into the data integration sector, which provides plenty of opportunities, as demand is growing faster than supply and the value of these data-maximization products (like master and big data tools) is quite higher than that of data warehousing products. Moreover, around its widening product portfolio, the company might dig up an economic moat for itself, becoming critical in its clients' operations.

Although it trades at almost 50 times its earnings, about a 25% premium to the industry average, its valuation becomes more attractive in relation to its book value, trading at a 22% discount to the industry average. Furthermore, its forward P/E ratio is only half its trailing values. Overall, I´d say buy and hold onto this stock.

Follow your intuition

Intuit is a $19 billion company that specializes in business and financial software, providing desktop and internet-based services and products as well as software that allows its customers to link and integrate them both. Over the past several years, revenue has been increasing, proving that the company is able to successfully respond and adapt to evolving customer needs. Something similar can be said about its increasing returns on equity and net margins over the long-term.

Recent news has put the company on my radar once more. After announcing a restructuring plan that will focus on its core segments, while divesting its Intuit Financial Services business and selling out its Intuit Health Group, the firm seems poised to outperform its peers in the consumer tax, small business and account professional segments. By abandoning the market segments where its products underperform its competitors, the company will ameliorate its capital allocation strategy, thus widening its margins and returns.

Not only is Intuit attractive on account of its strong growth prospects, economic moat and competitive advantages, the firm also yields a little over 1% of its current stock price ($63.50) in the form of dividends. Trading at about 24 times its earnings, at a 40% discount to the industry average, while offering industry leading margins and returns (all of them, about double the industry means), this is a stock to buy and hold over the long-run.

I take my hat off to linux’s open-source model

Red Hat distributes open-source software and services, including the well-known Red Hat Linux operating system. Since its products can be copied and distributed without major restrictions, most of the company´s revenue is derived from support and services. Actually, the company holds over 60% of the Linux server OS market.

Its open-source model, which may seem unprofitable at a first glance, is actually one of its main strengths, since many third party developers continuously work on ameliorating Linux OS, while Red Hat needs not to make hefty investments. This network effect has helped Red Hat’s Linux beat UNIX OS and other proprietary operating systems, while keeping expenses controlled.

In addition, its model has made it the go-to option for thousands of users worldwide, providing it with an easier entry to the datacenter industry, through other open-source products including storage, virtualization, middleware, and IT management tools.

Although “the evolution of the public cloud will likely be a strong determining factor in the success of Red Hat's strategy [and] those building out their public cloud products such as Microsoft, Google, VMWare, and Amazon have the final say in what software their data centers will use,” I believe that the future bodes well for Red Hat (Morningstar).

Although the firm’s stock trades considerably above industry average valuations, its growth prospects look encouraging. Furthermore, by investing in this firm, you would be supporting developments that might someday be of great use to you or companies in which you hold a stake. Id say Red Hat is not a definite Buy, but certainly an option to consider, not only for its expected returns, but for the spillover effect you could be supporting.

Bottom line

All three companies offer compelling growth prospects and plenty of room for expansion, and have proven successful in constantly adapting to the ever-changing tech-segment environment. As such, I’d consider adding all three to your long-term portfolio. However, if I had to choose only one, Intuit would be my choice based on its scale, competitive advantages, growth prospects and dividend yield.

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Damian Illia has no position in any stocks mentioned. The Motley Fool recommends Informatica and Intuit. The Motley Fool owns shares of Intuit. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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