Why I’m Selling This Stock Ahead of Earnings
Richard is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
BMC Software (NASDAQ: BMC) has always been an underrated name in the constant battle for cloud real estate. Despite the recent M&A activity seen from rivals such as Oracle (NASDAQ: ORCL) and IBM, BMC has decided to go in a different direction – choosing instead to focus on internal R&D.
While its recent partnership with Salesforce.com (NYSE: CRM) was designed to mutually benefit both companies, it's been one-sided and investors have become aggravated. Ahead of BMC's Q3 report on Monday, investors are looking for evidence to support their faith that the stock's premium P/E of 21 is still deserved.
Losing Share to Friends and Enemies
As excited was the Street when BMC announced that it would integrate its Service Desk with Salesforce.com’s developer platform (Force.com), enthusiasm waned after BMC announced Q2 results revealing double-digit declines in its enterprise service management and mainframe service management business.
But then again, that the mainframe business grew slower than other segments was not unusual. What scared investors was the company’s declining profitability coupled with an 11% jump in expenses. Meanwhile, all of this occurs as Oracle continues to expand and steal market share – posting $8.2 billion in revenue in the comparable quarter.
Unlike BMC, Oracle had no issues with the bottom line -- posting net income of $2 billion, which represents a year-over-year profit increase of 11%. Oracle’s strong Q2 was helped by better than expected performance in software licenses and cloud subscription revenue, which grew 11% to $1.6 billion.
Also complicating matters was the strong surge that Salesforce.com has seen in its performance that has not translated to BMC as expected. For instance, Salesforce.com recently posted 35% revenue growth – reaching $788 million -- helped by better than expected showing in its subscription business, which grew 35% year-over-year.
Equally impressive was Salesforce.com’s 20% growth in operating income which surged 20%. Conversely, although BMC’s operating margins have remained consistent, the trend has not made a great case for BMC’s valuation. While Salesforce.com continues to grow each business segment by 30% and generating 18% increases in operating income, BMC is posting (as noted) double-digit declines in its two primary business segments.
Understandably, these issues have led to concerns about the company’s strategic direction. In other words, BMC has plenty to prove in its upcoming report. In Q3, analysts want to also see that the company is able to expand its customer base into emerging markets.
Expectations for the Quarter
For the quarter, Wall Street is expecting a profit of 85 cents per share, which would represent 23% growth year-over-year. Though estimates have remained steady over the past month, it has increased by 1 penny over the past 90 days. This means that analysts are growing more optimistic about this quarter with full fiscal year earnings expected to arrive at $2.86 per share.
In terms of revenue, analysts will be looking for $587.4 million. The company is expected to top last year’s mark of $548.2 million, which would represent year-over-year growth of 7.1%. While this would reverse a 1.5% revenue decline in Q2, it would still lag significantly behind leaders Oracle and Salesforce.com. Nonetheless, revenue is projected to reach $2.25 billion for the full fiscal year.
While the growth in revenue will be welcomed, I’m nonetheless intrigued by what the company will do in terms of profitability. While Oracle saw a 6% increase in operating income in Q2, BMC has posted three consecutive quarters of profit declines, including a 14% drop in net income in Q2. If the company is unable make money, rumors of M&A always emerge. For that matter, I think the time is right.
The Case for an Acquisition
It is clear that the company is struggling to compete with the bigger names on the market. With profitability being one key issue, one of BMC’s biggest shareholders, Elliot Associates, has been a big advocate for the sale of the company. There’s no question that BMC has value. The wonder though, is to who?
At the top of my list is Microsoft (NASDAQ: MSFT), which has its own cloud and customer relationship management (CRM) solution that competes with both Salesforce.com and Oracle. A deal with Microsoft makes sense as the software giant could also capitalize on BMC’s mainframe database tools.
Plus, while Microsoft has made some recent improvements in key areas, its enterprise and cloud businesses remain under attack. This is a concern, especially since the cloud business presents higher profit margins. BMC would become a solid addition to Microsoft’s offerings, making it more nimble and better prepared to take on Oracle.
For that matter, Cisco (NASDAQ: CSCO), which made nine cloud-based acquisitions last year, would also be a great candidate. Aside from the same reasons presented for Microsoft, BMC would allow Cisco to leverage its existing enterprise footprint to grow beyond its network switch and router hardware solutions.
Besides, with the cloud market expected to grow to $177 billion over the next three years, it would be foolish for Cisco to not execute in that direction. BMC would present that extra competitive advantage it needs to support its service business, which is already growing annually at 12%. Plus, with BMC’s market cap of only $6.9 billion, it would only cost Cisco 15% of its $45 billion in cash.
Bottom Line
BMC is the perfect example of a good name that is struggling to build a presence in a changing market. While I do believe there is value in the business, the long-term prospects remain a concern. It costs money to grow. For BMC however, that the company is already struggling with profitability hurts its chances of having the sort of cash needed to spend on growth opportunities.
This means BMC will have to take on additional debt on top of the $856 million it already has, which represents 60% of its cash. Plus, the stock is expensive compared to Oracle and Microsoft – names that are more profitable, market leaders and offer a dividend.
I would be a seller here ahead of earnings as the company has given investors no compelling reason to believe in the stock – at least not until management fixes chronic profitability issues or the company is acquired.
rsaintvilus has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems and Salesforce.com. The Motley Fool owns shares of BMC Software, Microsoft, and Oracle.. 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!
