Should You Follow Elliott Associates to Detroit?

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On January 25, technology services company Compuware (NASDAQ: CPWR) disclosed a recent $11 per share cash offer from investment company Elliott Associates, which was subsequently rejected.  Instead, the company’s board initiated a dividend and announced plans for an IPO of Covisint, the company’s application software unit.  While Compuware seems intent on going it alone, its long term performance indicates a lack of competitiveness against larger peers, including IBM (NYSE: IBM) and CA (NASDAQ: CA).

Times are changing

Much like its home city, Compuware has some valuable assets, but it is moving too slowly for the changing times.  Founded in 1973 as a designer of productivity software for mainframes, the company still gets over 40% of its revenues from this declining segment.  With customers switching to distributed and cloud computing platforms, Compuware has invested in other areas, including website performance analysis and transaction monitoring through the purchases of Gomez in 2010 and dynaTrace in 2012.  However, virtually all of its profits continue to come from the legacy mainframe business.

In FY2013, Compuware has beaten low Wall Street expectations, although its overall business remains in a state of decline.  Through the first nine months of the year, it reported declines in revenues and operating income of 5.3% and 18.8%, respectively, versus the prior-year period.  While revenues rose in its growing performance analysis and application software areas, the core mainframe business logged a steep 25% decline in operating profit.  On the upside, though, the Covisint business finally reached operating profitability, just in time for a potential public offering in 2013.

Searching for an identity

While Compuware would like to be an all-inclusive technology firm, it doesn’t have the resources and capital to play with the big boys, including IBM.  Despite economic pressures in various parts of the world, Big Blue reported higher profits in FY2012, with a 7.2% increase in adjusted operating income on total sales of $104.5 billion.  The company used its continuous efficiency initiatives to further improve its profitability, as both gross and adjusted operating margins rose slightly on the year.

IBM develops dominant positions in technology and services businesses that have a high return on capital, while buying businesses that aren’t cost effective to build, including acquisitions of Tivoli, Lotus, and Rational Software.  It also bundles its leading software and systems development services into packages and uses its financial strength to finance customers’ purchases, with over $25 billion in customer receivables on its balance sheet.  Compuware doesn’t have the strength to compete here.

As for the mainframe segment, it is a high-margin business with recurring revenues, but has been in a state of decline due to the wide ranging benefits of newer technologies.  CA is the leader in the segment with annual revenues of $1.8 billion compared to Compuware’s $400 million.  In FY2012, CA has also felt the economic pressures in its markets, with declines in all of its operating segments.  However, the company has used the downturn to restructure its activities, which has led to a slight rise in operating profitability during the period.   CA doesn’t seem to want to relinquish the crown as king of mainframes.

Take the first train out of town

Since Compuware’s restructuring is a work in process and it is not too agreeable to a buyout, investors should look elsewhere in the sector for investments.  Given the industry’s continuing shift to the cloud computing service model, investors might want to look at the owners and operators of data centers that provide the backbone for the service.  One of the leaders in the space is Rackspace Hosting (NYSE: RAX).

Founded in 1998, Rackspace focuses on providing web hosting services, with over 197,000 customers that utilize space on servers in its eight global data centers.  In FY2012, the company has continued its strong growth of the past few years, with increases in revenues and operating income of 28.9% and 47.1%, respectively, versus the prior-year period.  The future is also looking bright, with increasing customer adoption of the cloud computing model and Rackspace’s development of OpenStack, its fast-growing development platform that allows customers to choose from a variety of different services and data centers.

The Bottom Line

The Compuware story is interesting, but it could take some time to create a happy ending.  In contrast, despite a high valuation and competition from the tech industry’s giants, Rackspace is well positioned for future success.  While investors might want to wait for a better entry point, it is a company to own.

rghanley owns shares of Compuware and Rackspace Hosting. The Motley Fool recommends Rackspace Hosting. 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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