Are These Software Makers Ripe for the Picking?

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As information technology becomes continually more integral to businesses’ operations, the technology sector’s profits have become less variable and more predictable. The sector produces profits throughout the business cycle, which has attracted the attention of the big investment funds. In the mainframe segment, both BMC Software (NASDAQ: BMC) and Compuware (NASDAQ: CPWR) have been targeted by hedge fund Elliott Management, as well as gaining interest from other private equity firms. So, are these companies worth watching?

BMC Software

Despite getting half of its revenue from the declining mainframe segment, BMC has been able to find limited annual revenue growth by taking market share from rivals and adding functionality to its software offerings. It ended 2012 with a backlog of $2.2 billion, flat versus the prior year, and the company counts 95% of the 100 largest corporations as clients. Naturally, with its corporate customers spending an increasing percentage of their IT budgets on cloud computing offerings, BMC has also invested heavily in this area.

In FY2012, BMC generated record financial results, although top line growth was hard to come by. For the period, the company reported increases in revenues and adjusted operating income of 5.2% and 6.4%, respectively, versus the prior year. While product sales growth was weak, BMC gained traction in its professional services segment that advises customers on ways to gain efficiencies in their IT investments.

Looking ahead, BMC is pursuing opportunities to sell software to the small and mid-sized company market, which was its rationale for the acquisition of Numara Software in February 2012. Despite lower margins, this segment opens the company to a much larger customer base and provides the opportunity to cross-sell its professional services. In addition, BMC is partnering with consulting firms to improve its sell-through rate, including a recent agreement with CapGemini to distribute BMC's software products to the consulting giant's clients.

Compuware

Compuware has similarly felt the effects of the shrinking mainframe market, with a revenue base that has declined over the past five years. More so than BMC Software, Compuware has attempted to shift its focus away from the mainframe market, with investments in the web performance, web security, and collaboration software areas. However, virtually all of the company’s annual profits continue to come from the mainframe segment.

In FY2012, Compuware reported fairly weak financial results, with decreases in revenues and operating income of 5.3% and 18.8%, respectively, compared to the prior year. The company’s sales were hurt by a steep decline in its mainframe segment, as customers continue to lower their usage of mainframe computer systems. In addition, Compuware’s newer software offerings have been unable to reach the critical mass necessary for improved profitability.

Looking ahead, Compuware is looking to build on its early success in the collaboration software space, where its Covisint unit has built a strong customer base in the healthcare and automotive sectors. However, the company is planning an initial public offering of the unit, in a bid to avoid losing its corporate independence. Unfortunately, the move seems to be a short-term attempt by management to keep their jobs, rather than a strategic move to improve the overall company’s investment profile.

The 800-pound gorilla

Any competitor in the mainframe space has to contend with the 800-pound gorilla that is IBM (NYSE: IBM). Despite refocusing its business on the software and services areas, IBM continues to invest in the mainframe segment as a key component of its systems and technology unit. Indeed, the company’s latest mainframe product, the system Z server, has been gaining increased customer adoption and usage rates, despite overall declines for the industry.

In FY2012, IBM reported solid profitability, although its overall sales slipped slightly due to economic pressures in various markets around the world. For the period, the company reported a 2.3% decline in revenues, while its adjusted operating income rose 4.0%. IBM’s operating profitability benefited from its ongoing efficiency initiatives, as well as double-digit growth in its targeted areas of data analytic and cloud computing software. Looking ahead, the company expects to use its technology services and financing cost advantages to continue driving sales of high-margin software, an area that management expects will account for 50% of sales by 2015.

The bottom line

Investment funds are attracted to the mainframe software makers’ historical profit streams and large base of installed users. In the future, though, BMC and Compuware are at a cost disadvantage to IBM, as both companies spend much more of their revenue on marketing activities and overhead. Despite recent business diversification moves, their days as independent companies are likely over. As such, investors looking for long-term investment ideas should keep looking.


Robert Hanley owns shares of BMC Software and Compuware. The Motley Fool owns shares of BMC Software and 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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