2 Software Stocks To Buy, 1 To Avoid

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 a period of major innovation, investors should eye software producers. These companies provide an infrastructure that computer and tablet users need in order to function. While I believe the industry is generally undervalued, there are some companies 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, each with different upsides.

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 the patents on it's "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. It's tablet is reminiscent of Windows 7 in its box-like layout, and its connection with the world's most popular operating system provides a huge reason to buy it on Christmas day.

On the secular trend side, there are two reasons to be optimistic about Microsoft. First, PC and emerging markets have held up. Second, Microsoft-powered 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. By providing the operationg system for these quality products, 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. According to RBC Capital Markets, Red Hat is supposedly developing breakthrough solutions in middleware, storage, cloud, OS, and virtualization. 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 the mainframe sector, free cash flow is substantial and provides considerable financial support to back takeover activity into new markets. At the same time, CA will be benefiting from recent restructuring, which 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.


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Microsoft. 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.

blog comments powered by Disqus

Compare Brokers

Fool Disclosure