2 Companies Trading On Cloud 9, Buy Oracle Instead
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Some of the best investments can be found in secular changes. But some of the worst investments can also be found in this environment. With cloud computing growing in popularity and greater demand for data & applications, the market potential is significant. But separating the truly undervalued stocks from those that have been overhyped is not always easy. I encourage actively investing around the edges and getting into stocks where meaningful market expansion is staying ahead of the competition.
Oracle (NASDAQ: ORCL) Still Undervalued
Over the last six months, Oracle has gained 12.3% in value. Fortunately, it is still cheap. In 3Q12, the software producer yielded $13.4 billion on a TTM-basis. This means it has increased free cash flow by a CAGR of 21.2% from 2004 to 2012, and the yield now stands at an attractive 9.2%. At a respective 14.9x and 10.3x past and forward earnings, this is a compelling deal for a brand name company. Oppenheimer just recently released an "outperform" report upping their price target to $36, a 20% premium to the prevailing market assessment.
Fundamentally, there are several reasons why I am bullish on Oracle. First, the company has grown free cash flow and revenue faster than the competition. During the fourth quarter, Oracle beat expectations with EPS of $0.82. Its growth curve ahead comes from licenses that secure future business and customer loyalty. Sales in cloud computing also look bright as companies make the secular transition towards internet installation over internal server installation. In fact, three cloud computing deals were won in the recent quarter, including a high-end hardware system sale to Facebook. Last, by raising R&D investments by 14%, the company is also directly showcasing confidence over the underlying fundamentals and its ability to create value.
Analysts forecast 11.9% annual EPS growth over the next 5 years. But EPS has gone up 19.3% over the past 5 years, so this estimate strikes me as overly bearish. In the last 5 quarters, management has beaten expectations 3 times--but, generally, consensus has been under actual performance for S&P 500 companies. Even still, with multiples so low and the momentum so strong, I find risk/reward to be quite solid.
How does Oracle compare to related producers CA and Red Hat? I find the larger competitor to be considerably more undervalued. CA may trade at 8.4x forward earnings and 12.1x free cash flow with a 4.6% dividend yield, but analysts are not mistaken rating it closer to a "sell" than a "buy." First, the business has been in transition, and the future is thus highly uncertain. According to the company's own annual report, technological advances have crowded the market and made much of the core mainframe system management products obsolete. This has put a dent in the company's ability to create profitability. Profitability in the new enterprise solution market is much less, and wide-scale secular change poses uncertainty that all of these current R&D investments will be all for naught.
During the second quarter, management also mentioned how "the weakening global economic outlook" has lowered performance. Sales cycles have elongated; deals have fallen. The firm is now "closely inspecting the pipeline" (read: much R&D may have been wasted). To drive value creation, management has had to predictably rely on cutting costs--a traditional strategy when there are few growth opportunities ahead.
And then there's Red Hat, which is in a remarkably different but yet similar position as CA. It's similar in the sense that it is less preferable than Oracle. It's different in the sense that the overvaluation stems from bullish growth prospects. The application software producer now trades at 34.6x forward earnings and is forecasted for 16.9% annual EPS growth over the next 5 years. As optimistic as this projection is, the stock still manages to have a PEG ratio of 3.8x, so the future does not justify the present valuation even at aggressive assumptions. Minimal free cash flow generation (P/FCF is at 25.9x) and rising competition make Red Hat a stock to avoid.
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. Is this post wrong? Click here. Think you can do better? Join us and write your own!