What Makes A Good Software Stock?

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If you are looking to buy software producers ahead of a recovery, you can get in now at an attractive price. Tech companies have been notorious for high multiples in the past due to excellent growth opportunities. But recent market disappointments and investor uncertainty has caused multiples to lag ordinary levels. Before buying just based on multiples, I recommend considering the corporate strategy towards acquisition, market share gains, and organic product innovation. Below, I review three software producers by this criteria.

Complementary "Buys": Oracle (NYSE: ORCL), Microsoft (NASDAQ: MSFT)

Over the last 12 months, Oracle has risen 27.2% in shareholder value despite missing 2 out of the last 5 quarters--a period where most tech company beat analyst expectations. Though I still find it undervalued, the software maker faces several headwinds. First, IT spending has been forecasted by Gartner to grow only a scant 2.5% in 2013 to $2.7 trillion. Furthermore, SAP has been penetrating the market with a series of accretive acquisitions and product innovations. While Oracle retains a majority of the market share in database software and #1 in the application server category with a share of 43.1%, the fight with SAP in enterprises is becoming tough. In enterprise resource planning ("ERP") software, SAP has 22% of the market, which is 700 bps more than what Oracle has.

With that said, management is taking important steps to build shareholder value. The decision to acquire a producer of on-premise (ie. not cloud-based) portfolio management software, Instantis, and integrated it in its cloud-based Fusion project. Furthermore, even though hardware sales dropped by 19% y-o-y in August, CEO Larry Ellison is still guiding for positive growth off of expensive engineered systems by next May. A series of major product announcements--a new cloud-based flagship database platform, app development platforms, an upgrade of Exadata that dwarfs SAP's Hana--have strengthened the upside.

The company is producing value with a ROIC of 18%--around 90 bps greater than the industry average. The current ratio of 2.6x is also above the industry average 2.4x, so there is plenty of room for more accretive takeover activity (Larry Ellison has said Oracle could do a major acquisition in a few years). At only 10.9x past earnings and a free cash flow yield of 8.7%, Oracle is very compelling. 

Ultimately, to hedge your bets, I recommend also making an investment in Microsoft (NASDAQ: MSFT). Microsoft is also engaged in software production--creating servers, intelligent devices, and a variety of server applications. But the company is also a producer of consumer goods, such as phones. Windows Phone 8 has been selling out across domestic stores and several international regions, which has caused Nokia to soar in value. Surface has yet to be realized at the time of this writing, and I expect similarly strong results. With a ROIC of 23.4% and a free cash flow yield of 12.7%, Microsoft looks substantially undervalued--even to Oracle. Surface may very well be the catalyst.

CA (NASDAQ: CA) Also Compelling

CA has gained 8.8% in the last 12 months and, in my view, is also undervalued. It trades at a respective 11.3x and 8.7x past and forward earnings. Analysts forecast 9% annual EPS growth over the next 5 years. Assuming expectations are met, 2016 EPS will come out to $3.33. At a multiple of 13x, this translates to a future stock value of $43.29. Discounting backwards by 10% yields a present value of $26.88. This is at a "good enough" premium to the current market cap when you factor in a 4.5% dividend yield.

In the recent quarter, CA missed revenue expectations by $50 million with $1.15 billion generated. Management also guided for FY2013 EPS of $2.36 - $2.44, which was meaningfully below $2.48 consensus. But even though free cash flow has started to dip, it pays out your investment in just 7 and a half short years. The return on invested capital stands at 14.3%, so management is also creating value as it grows. Multiples this low can't depress any more to hold the share price steady. Accordingly, CA remains a highly compelling investment opportunity.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Microsoft and Oracle. Motley Fool newsletter services recommend 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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