Don't Buy Red Hat, Buy CA Instead
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Growing demand from data has increased security risk within the tech sector. CA (NASDAQ: CA) is positioned to penetrate this market through enterprise and cloud computing services. While Red Hat (NYSE: RHT) may target a similar market, much of its growth has already been factored into the stock price and thus there is little room for upside right now.
Red Hat has built a particularly strong niche in the open source software market. The stock has more than doubled in value during the Great Recession, but the fundamentals won't necessarily deliver the same momentum during the recovery. What made Red Hat stand out from all of the software producers back then was its complete offering of low-cost middleware applications that undercut the competition.
Going forward, however, I am uncertain about how the company can deliver under very high expectations. Management planned JBoss to be a huge success, but it ended up not working nearly as well as what was expected. Investors are now expecting Red Hat Storage to be a huge hit, but there is little proof thus far that innovation off of the legacy business can drive value. RHS is going to be launched first in the EMEA and then the APAC. That's some time off before it enters domestic markets and, presumably, the economy will have achieved full employment by than and investors would have missed out on the upside should they have placed their bets on Red Hat.
At forward multiples north of 35x and a PEG ratio 3.6x, there is little to gain and much to use. Even the forecast for 18.5% annual EPS growth over the next 5 years will not be enough to increase value - in fact, it is too small and does not even justify the current price. That is to say, the stock is overvalued.
In my DCF model, I forecasted 18.7% annual growth, consistent operating metrics, a 10% discount rate, and a generous 2.5% perpetual growth rate. Based on those assumptions, I found the fair value of the equity to be $27.75 per share - around less than half the current valuation. Aside from high capital expenditures that average around 4.6% of revenue, operating margins are too low. High SG&A expenses warrant cutting, but they have nevertheless been more than 2.5x as high as R&D (as a % of revenue) over the past 3 years - indicative of something structural rather than temporal.
If there is one thing to be optimistic about Red Hat, it is namely that market excitement can go a long way to drive up the strong price. CA may be in an attractive position to generate the same sort of excitement. Less known than software producers Microsoft (NASDAQ: MSFT) and Oracle (NASDAQ: ORCL), CA has a surprisingly large economic moat. While CA has done well, growing free cash for the TTM from $1.1 billion in 2Q10 to $1.5 billion in 2Q12, Oracle has nevertheless done even better by growing free cash flow for the TTM from $7.3 billion to $13.1 billion over four years. For that reason, CA is still at a discount to Oracle's multiples.
However, Oracle is a tried-and-true tech producer while CA is more speculative and this means more reward with more upside. Infosys (NYSE: INFY) will be collaborating with the firm in the development of cloud services. At the same time, margins are expected to increase as the company begins to target consumers based on type, either existing enterprise, growth market, or new enterprise. This will be balanced with guidance for lower constant currency growth than originally forecasted. In my view, the company may even consider pursuing takeover activity to further increase its economic moat and spread out fixed costs. Either way, the company is in a favorable position of its growth curve and has delivered the past momentum necessary for optimistic forecasts to appear genuine. This will dually serve to keep shares from entering low multiples while pushing the market's outlook on the optimistic side.
If you are looking for the safest software producer, I recommend none other than Microsoft. The stock has been beaten down from talks that it is outdated due to the rise of competitor Apple. Technology, however, has few barriers to entry, and there is nothign stopping Microsoft from releasing the next major product. If anything, success at Apple will drive greater revenue potential for Microsoft, such as by compelling the latter to release a tablet product that it, Apple, created the demand for! Microsoft has consistently grown earnings throughout the years and retains an almost monopoly position in the PC market. It has the greatest audience to cross-sell new products to and thus is less vulnerable to emerging entrants. All of the other firms do not have such market power and thus carry greater risk.
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