1 Software Stock To Avoid, 2 To Buy
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
With tech markets going through major innovation, investors should eye software producers. These companies provide an infrastructure for computer and tablet users to function. While I believe the industry is, in general, undervalued, there are some that "work" in the long-term, some that "work" in the short-term too, and some that don't "work" at all--"work" being defined as "attractive from an investment perspective." Below, I review the fundamentals of three notable brands with different upside.
Microsoft: Possibly The Most Under-Appreciated Near Monopolist
You would think that after years of maintaining a near monopoly share on the PC market, Microsoft (NASDAQ: MSFT) wouldn't be so dwarfed in valuation by lawsuit-minded Apple. While Apple has to go out and sue companies for breaching on its "breakthrough" ideas, Microsoft is safe in its current state. This speaks volumes to not only the company's sustainability but also leading ability to penetrate new markets.
The decision to launch a tablet was particularly well timed. After several other companies have modeled what I see as rip offs of the iPad, Microsoft comes along and introduces something very different. Their tablet is very reminiscent of Windows 7 in its box-like layout, and if it can have a connection with the world's most popular operating system, then that provides a huge reason to buy it on Christmas Day.
On the secular trend side, there are several reasons to be optimistic about Microsoft. First, PC and emerging markets have held up moment. Second, ultrabooks are likely to make a better-than-expected sustained impact following renewed marketing. Ultrabooks are just what they sound like: cool. They have reduced weight, quicker boot time, and optimized battery life--very much like the MacBook Air. Through providing these product qualities, Microsoft will be able to eat a chunk out of Apple's market.
Red Hat Way Overvalued; CA More Attractive
Sometimes, as in the case of Red Hat (NYSE: RHT), software producers can be significantly overvalued. The company is developing supposedly breakthrough solutions in middleware, storage, cloud, OS, and virtualization, according to RBC Capital Markets. Yet, at the same time, management is unwilling to discuss outlook. What they have expressed, however, is that budgets are strained. At a high multiple of 35x, I would take management at their word and thus hold. Simply too much growth is being factored into a company that has suggested both through performance and silence that the future will be challenging.
By contrast, CA (NASDAQ: CA) is, like Microsoft, a meaningfully undervalued software producer. The company will be able to ride out the challenging mainframe market by penetrating virtualization and the cloud. As IT solutions become more varied, consumers will place greater demand on businesses, like CA, that offer a comprehensive solution. While I believe the firm is still too exposed to mainframe, free cash flow is substantial and provides considerable financial support to back takeover activity into new markets. At the same time, CA will benefit from recent restructuring that has allowed for high margin operations.
All in all, I recommend CA more for long-term investors and Microsoft for long-term and short-term investors. CA is still in the transition state given its small economic moat. As a steady earner, the stock offers reduced risk and has been overly factored in for slow growth from mainframe. The under-appreciated shift towards new segments will drive value creation in the years ahead.
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