It's Time to Go Sour on This Software Company

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

Adobe Systems (NASDAQ: ADBE) got a nice 5.5% pop in its stock last week, even after reporting fiscal 2Q EPS that fell 66% year-over-year. Although earnings were down due to weak product sales and rising operating expenses, the software company managed to beat consensus by 5% and reiterated positive news on its move from packaged software to the cloud. 

Adobe now offers the Creative Cloud, which allows customers to to pay a monthly fee to subscribe to applications, such as Photoshop, Illustrator, Dreamweaver and others. This new model offers flexibility for its users and Adobe announced it had 700,000 paid Creative Cloud subscribers at the end of the quarter, a 221,000 increase from the end of 1Q. 

As a result, the digital-media segment saw revenue down 17.5% as users shifted to subscriptions from perpetual licenses. The move to a subscription base does have its downside. Adobe will now be collecting revenue over a period (i.e. monthly) versus a lump sum. 

Following 2Q results, analysts lowered their fiscal 2014 EPS by $0.04, from $1.75 to $1.71. With the transition, it doesn't appear that Adobe should trade at a premium valuation to the industry, which it currently trades at. 

Adobe might not be the best of investments following the run up in the stock price; let's have a look at some investment ideas for gaining access to the popular tech software sector. 

Virtualization

Citrix Systems (NASDAQ: CTXS) is a leading developer and supplier of access infrastructure software and services. The company should continue to grow nicely over the interim as more and more companies turn to real-time collaboration services. Revenue is expected to be up 14% in 2013 thanks to Citrix's strong presence in the cloud computing and desktop virtualization space.

Citrix is a leader in remote connectivity, this includes a service that you've probably used before, GoToMeeting. Its product and license updates/maintenance revenue should be  pushed higher thanks to a growing customer base. Citrix also has partnerships with some of the largest tech companies in the world, including Cisco, Dell, HP and Microsoft. 

The stock did pull back following weak 2Q results, now down over 15% during the past three months, but I view this as a great buying opportunity. The stock trades at a trailing P/E of 32 times, but its forward ratio is only 16.5 times, suggesting investors might be underestimating Citrix's EPS growth. 

Design 

Autodesk (NASDAQ: ADSK) develops, markets and supports design software, specifically for the manufacturing and construction industry. Autodesk, like its software peers, is looking to adopt cloud and mobile computing. The company plans to offer its software via a could-based model. 

However, this transition could take more time than say Adobe's, where Autodesk caters to the manufacturing and industrial markets, which can be laggards in technology adoption. Management has a lackluster outlook for fiscal 2014 given the weakness in spending on technology. 

Autodesk also posted weak 1Q EPS results, where earnings fell 30% year-over- year. Operating margins were also down from 16% to 14.3% year-over-year. Since the announcement, analysts have lowered their consensus fiscal 2014 EPS by 8%, now expected to come in at $1.95, basically flat year-over-year from fiscal 2013. 

Big Blue

International Business Machines (NYSE: IBM) operates three major segments, global services, software and systems. IBM, also known as Big Blue for its blue packaging, is looking to move away from low-margin hardware to the higher-margin software and services business. In 2012, hardware only accounted for 17% of sales, and its services segment accounted for 56% and software 24%.

The other big positive for IBM shareholders is the company's ability to return cash to shareholders. From 2000 to 2012, IBM returned some $150 billion to shareholders in the form of dividends and share repurchases. I like IBM as a long-term buy, in part because of its solid record for buybacks, which has helped boost the tech company's return on equity to over 80%. 

BIg Blue expects to buyback some $50 billion in shares and $20 billion worth of dividends over the next five years. So what will support these strong returns for shareholders? IBM expects key contributions from its Smarter Plant line and SaaS solutions. Management targets profits from software to make up 50% of total profits over the long term. 

What do hedge funds think?

Coming into 2013, there were 47 hedge funds long IBM, which includes billionaire Warren Buffett. Buffett's Berkshire Hathaway had a $13 billion position, which made up a whopping 17.3% of its 13F portfolio (see Buffett's top picks).

Heading into 2Q, 34 hedge funds were bullish on Adobe, which was a 11% from the previous quarter. Most notably, Jeffrey Ubben's ValueAct Capital had the largest position among major hedge funds, worth $1.4 billion and accounting for 15.4% of its total 13F portfolio (check out ValueAct's top stocks).

Meanwhile, Citrix had more hedge fund interest than Adobe with 36 hedge funds long the stock. This includes Partner Fund Management with the most valuable position, accounting for 7.9% of its portfolio (see Partner's new stocks).

Valuation

Here's where we run into problems with Adobe, but we do find another possible solid investment opportunity. Adobe trades well above its major software peers and other major tech companies on a P/E and P/S basis:

  Adobe Citirx AutoDesk IBM
P/E 31.8 19.8 18.1 21.1
P/S 5.4 4.3 3.5 2.2

However, I don't find the premium valuation justified. Adobe has under-performed the likes of Citrix and IBM over the past five years in terms of EPS and operating cash-flow growth:

  Adobe Citrix AutoDesk IBM
Historical 5-yr. EPS Growth 6.5% 10.3% -6% 14.5%
Historical 5-yr. Operating Cash Flow Growth 1.4% 13.6% -1.8% 6.4%
Expected 5-yr. EPS Growth 10.5% 16.5% 13.4% 9.7%

What's more is that Citrix has the best expected five-year EPS growth rate at 16.5%, but trades below Adobe on a multiples basis.

Bottom line

I like Citirx more than Adobe, especially after Adobe saw its stock pushed higher by over 5% last week. Now the software giant appears to be too expensive. Yet, Citrix has impressive expected EPS growth that should be driven by the rise in demand for desktop virtualization and cloud computing technologies. 

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Marshall Hargrave has no position in any stocks mentioned. The Motley Fool recommends Adobe Systems. The Motley Fool owns shares of International Business Machines.. 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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