Short Red Hat And Buy Oracle, CA
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
As the demand for data continues to grow, greater security risk will be felt in the en markets of tech. Oracle (NASDAQ: ORCL) and CA (NASDAQ: CA) both look well positioned close their discounts to intrinsic value through penetrating cloud computing and enterprise solutions. Red Hat (NYSE: RHT), on the other hand, looks substantially overvalued despite forecasts for high double-digit earnings growth. I recommend buying shares in Oracle and CA while hedging against industry downside through shorting Red Hat. Investors could thus benefit by the speed between Oracle & CA and Red Hat. Below, I review the fundamentals of each firm.
Oracle and CA
Oracle may trade fairly high at a 16.2x multiple, but its growth easily warrants the premium - the forward PE multiple is, after all, just 10.8x. This compares to 9.8x for CA and 39.5x for Red Hat. To put this into even more perspective, consider that the historical 5-year average PE multiple for Oracle is 18.4x and 17.4x for CA.
Perhaps most importantly, free cash flow trends are very strong. FCF for the TTM ending 2Q12 was $1.5B for CA versus $1.3B in 2Q11, and $1.1B in 2Q10. Then transformation was even more impressive for Oracle, which has grown FCF steadily from $7.3B for the TTM ending May 31, 2008 to $13.1B for the TTM ending May 31, 2012 - that's a CAGR of 15.7%. The $154.5B software producer $13.1B in FCF for 2012, which puts the yield at 8.5%. Should the yield and growth maintain the same growth rate over the next five years, the future value of the stock will be nearly $300M at a 11x multiple - double the current market assessment.
Leaked files from Oracle reveal that the company planned, and ultimately may, offer Taleo at $15/user/month with differentiation coming from end-to-end HR solution. CA is similarly focused on unlocking value through catalysts. Infosys (NYSE: INFY) recently launched a mix of cloud services in collaboration with CA and other providers. While the company recently lowered expectations from constant currency growth of 2% to 4% down to 1% to 2%, margins are still expected to expand, which pay off big when higher volumes will materialize from a full recovery. Although renewal inventory is lighter, the company started to segment consumers into existing enterprise, new enterprise, and growth market categories.
While CA is hedging against uncertainty, a company can only do so much. At its low multiple, we ought to give the firm the benefit of the doubt. Red Hat, on the other hand, is much too inflated. The firm recently acquired BPM software technology from emerging market producer Polymita Technologies. While I believe the integration will help Red Hat ease its way into the BPM software market by complementing JBoss middleware solutions, competition is still too intense.
Red Hat provides Red Hat Enterprise Linux and is forecasted for 18.5% annual EPS growth over the next 5 years. This implies 2016 EPS of $2.36, which, at a generous 25x multiple, translates to a future stock value of $59 - more or less in-line with the current market assessment. Discounting backwards by 10% yields a present value of $36.63, which is less than two-thirds of the current market assessment. Debt may be at 0 and the business ripe with liquidity, but ROA and ROI are still in the single-digits. This ultimately spells disaster on the multiples going forward. I recommend shorting the stock to hedge, in general, against the industry.
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of 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.If you have questions about this post or the Fool’s blog network, click here for information.