4 Stocks in the Sweet Spot of the Software Industry

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

The software industry is cutthroat and difficult to establish a foothold in. However, once a company reaches a certain scale, it's usually about duplicating successes rather than fighting for survival. I won't pretend that I can spot someone running the next Microsoft or Google, but the mid-cap section of the market seems like the sweet spot for software companies. These companies are established enough that you don't have to worry about them disappearing, but they are still small enough that they show good growth potential.

With this in mind, I recently ran a screen on the Fool.com CAPS Screener looking for mid-cap software companies that had at least 10% revenue growth and 20% EPS growth over the last three years. There were several companies to consider, but the following four were the most attractive: TIBCO Software (NASDAQ: TIBX), Rackspace Hosting (NYSE: RAX), F5 Networks (NASDAQ: FFIV), and MSCI (NYSE: MSCI)

TIBCO Software:

According to Yahoo! Finance, TIBCO offers middleware that helps companies with business optimization, process automation, and collaboration. In plain English, TIBCO is in the business of making businesses more efficient. The company is pretty darn good at its job too, based on its results. Not only has the company grown earnings by 20% over the last three years, but analysts expect 16.54% EPS growth over the next few years as well.

In addition, it’s very possible that the company will beat these expectations, since in the last year the company has beaten earnings estimates by an average of 9.5%. What is truly impressive is that in the last few years the company's net income and operating cash flow have grown in lock step by a total of over 80%. If there is a knock on the company, it is that its debt-to-equity ratio is a bit high at 0.71. The stock is neither cheap nor ridiculously expensive at about 23 times forward estimates.

Rackspace Hosting:

Rackspace’s stock has been flying along on the back of the company's cloud computing solutions. While there have been some bumps in the road, the stock has jumped from under $40 a year ago to nearly $70 today. As more and more companies realize the efficiency and ease of upgrading offered by cloud solutions, Rackspace should continue to benefit.

The market certainly has taken notice of the company, and with the stock selling for near 90 times earnings projections this one is not for the faint of heart. However, with analysts calling for almost 34% earnings growth, this multiple could compress quickly. The company also shows a very strong balance sheet, with a debt-to-equity ratio of just 0.11. If there is a big worry about Rackspace beyond its high in the clouds P/E ratio, it has to be the company's cash flow. In the last three years, the company's free cash flow has actually dropped a total of 8%.

That being said, most of this drop has been from huge increases in capital expenditures as the company builds its business. In theory, as the company reaches better scale this expenditure growth will slow, leading to better cash flow growth.

F5 Networks:

F5 Networks is in the business of making the servers and storage facilities better for its customers. With huge growth in not only cloud computing, but also data storage growing at a fast clip, F5 is riding the wave of both of these trends. With analysts calling for earnings growth of about 17.6% over the next few years, the stock is surprisingly attractive at about 22 times forward estimates.

If you look at the company's financials, the hits just keep on coming. F5 spends very little money on capital expenditures, with just 5% of operating cash flow used on capex last quarter. In addition, the company has generated over $100 million in free cash flow in each of the last four quarters, and has repurchased at least $25 million worth of shares. With over $1.1 billion in cash and investments, and no long-term debt, 14% of the company's market cap is just the cash and investments on the balance sheet. I would suggest investors check out this fast growing company today.

MSCI:

If you are an investor, you have to love MSCI. The company provides financial research, risk management, and more to the financial industry. Though the company isn't expected to quite match the growth of its competitors above, the numbers are still impressive. With the stock selling for just 13 times estimates, and expected to grow at about 12%, MSCI appears fairly valued. However, the company has beaten expectations in three of the last four quarters, so it could do better than the projected growth rate.

The one big risk with MSCI is that they are still digesting their acquisition of RiskMetrics. This over $1 billion acquisition added debt to the balance sheet, but management is putting a large chunk of free cash flow toward paying this down. In fact, long-term debt (which was over $1.1 billion a year ago) is down 24.5% to about $833 million in the quarter ended June 2012. The company generates significant free cash flow, and as this long-term debt is pared even further results should improve.

Conclusion:

You can see there is a lot to like about mid-cap software companies. They offer better stability than a small-cap company, and better growth than most large-caps. Of the four we have looked at, F5 Networks seems to offer the best combination of growth and cash flow. However, each of the companies offers attractive traits. Whether you like one company here or all four companies, I would suggest adding them to your personalized Watchlist to keep up with further developments.


MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of F5 Networks. Motley Fool newsletter services recommend F5 Networks, Rackspace Hosting, and TIBCO Software. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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