Software Heavyweight Fight

By Chad Henage - October 18, 2012 | Tickers: ADBE, CTXS, ORCL | 0 Comments

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There is no question the software industry is a tough business. Companies that make revolutionary products can be supplanted in a second by a startup that has a better solution. In some industries, bigger is better, and you can make the argument that this is the case with software companies. They generally are well established and have significant cash flow to spend on research and development to come up with “the next big thing”. I routinely look for large companies that show both good earnings growth and good revenue growth. With this idea in mind, I ran a screen on the Fool.com CAPS Screener for large-caps with at least 10% revenue growth and 20% or better EPS growth over the last three years. Though a few companies made the cut, I've narrowed the choices down to three to see who might be the software heavyweight champion.

The three companies I selected are Adobe Systems (NASDAQ: ADBE), Citrix Systems (NASDAQ: CTXS), and Oracle (NASDAQ: ORCL). Each of these companies meets the above criteria and also is expected to show at least 10% EPS growth going forward. Though their businesses range from design and publishing (Adobe) to on-demand IT (Citrix) to database management and cloud solutions (Oracle), they each essentially are in the business of software solutions primarily aimed at business customers. They each face the continued challenge of adapting their offerings to the move of businesses toward cloud services, and they all generate huge cash flows that allow them to create new products. Let's get started by comparing each of their valuations and growth rates to see which one might represent the best current value. 

Ironically Oracle, which is the largest of the three, also is valued the lowest on a PEG basis. While it's possible analysts could be off in their projections, that's true across the board. With the lowest P/E ratio and the second highest growth rate, Oracle wins this round. (Adobe – 2, Citrix – 1, Oracle – 3)

Trying to determine how fast a company will grow in the future is challenging, but sometimes historical performance can serve as a guide. Companies that beat earnings expectations in the past tend to continue this trend. Looking at each company's performance over the last four quarters, we find that Citrix Systems has been the most consistent, exceeding analysts expectations in each quarter. In addition, Citrix also is beating expectations by the largest percentage with an average beat of 12.23%. In second place is Adobe Systems with an average beat of 3.35%, and Oracle comes in last with an average beat of 2.63%. While Citrix wins this round, the good news for investors is all three are beating analysts expectations overall, which means that future growth projections should be more believable. (Adobe – 2, Citrix – 3, Oracle – 1)

Earnings performance gives us a glimpse of what's going on at each company, but for many investors free cash flow is a more accurate picture of what a company really makes. While earnings per share can be manipulated, free cash flow is more difficult to fool (small f) with. The software industry is known for its large margins, so it's no surprise that each company generates significant free cash flow. To compare, I use free cash flow per $1 of sales to give us an apples-to-apples look at different sized companies. Using this measure, Oracle is our winner with $0.35 of free cash flow per $1 of sales over the last full year. Adobe Systems comes in a close second at $0.32, and Citrix comes in last with a respectable $0.26. Higher free cash flow per each $1 of sales means, in theory, Oracle is more efficient at turning sales into usable cash. More cash flow means more money for dividends, share repurchases, investments, and more. (Adobe – 2, Citrix – 1, Oracle – 3)

When it comes to dividends, I have to say each of these companies disappoints the income investor inside of me. Neither Adobe nor Citrix pays a dividend and with their significant free cash flow generating capability that's a shame. Oracle wins this round by default with a yield of just 0.77%. Though Oracle itself could certainly return more to shareholders, the company is at least paying something back. (Adobe – 1, Citrix – 1, Oracle – 2)

Last but not least, let's take a look at each of the companies' balance sheets to see if they are well positioned for future growth. It's not unusual for software firms to have very low debt and a lot of cash, and we certainly find that to be the case with these three. In fact, both Citrix and Oracle have so much cash that they have a positive net cash position. This round is really close because as a percentage of their market cap., Citrix barely beats out Oracle with 11.83% represented by cash and investments. By comparison, Oracle has 11.37% of their market cap. in cash and investments, which leaves Adobe far behind with a debt-to-equity ratio of 0.26. A higher level of cash and investments to market cap could mean that investors are undervaluing the shares, since they are actually paying less for the company than it first appears. (Adobe – 1, Citrix – 3, Oracle – 2)

Adding up the scorecards we find Adobe – 8, Citrix – 9, and Oracle – 11. It looks like Oracle is our winner. Given the fact that Oracle has the most reasonable valuation and pays the only dividend, this is not too surprising. Since the company also generates the most free cash flow per $1 of sales, this is yet another argument for buying the shares. If you add in the fact that because of cash and investments, you are actually buying the company's operations for about 89% of the stock price, then this seems like a very good deal indeed. Oracle is a software heavyweight that packs a real punch; use this information as a starting point for your own research. Oracle might be just the company to give you knockout returns.

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