Going For The Cloud: 1 Stock To Buy, 1 To Short

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

Cloud computing has ushered us into an open-source tech era where application users can freely access software saved from different systems on one platform. While aggressive growth in data has furthered this secular trend, it has created a bubble in some instances. The value-creating strategy has been to scale up operations through acquisitions that support cloud solutions. Again, in some instances this has worked, in others it has not. Below, I review 2 software producers with these thoughts in mind.

Adobe Systems (NASDAQ: ADBE) Heading For The Cloud

This software producer has brought you design products like Photoshop and rich digital media editors. It is used by professionals, marketers, and consumers in need of delivering and managing content. In recent days, it bought out Behance, a sharing network for creatives, for an estimated $150 million. Behance provides a portal for graphic design artists and marketers to share ideas and collaborate. The integration fits coherently with Adobe's artistic community and helps the company expand its cloud platform and social networking capabilities.

Specifically, Behance will be integrated into Adobe's "Creative Cloud" subscription and will add north of 1 million subscribers to Adobe's current 1 million subscribers--around a third of which are paid ones--on the Creative Cloud. With the company looking to migrate Creative Suite into the Creative Cloud platform as soon as possible (following the much expected roll out of Photoshop to the cloud), momentum will be meaningfully sustained by this buyout. Behance makes sense, since it secures a "community" behind Adobe's products. Trends at Creative Cloud have already been accelerating: net additions are up 25% sequentially to 10,000 per week.

Adobe trades at 24x past earnings, which is a bit expensive. Analysts forecast 11.8% annual EPS growth over the next 5 years, which is down from a rate of 10.4% over the past 5 years. Gross margins have expanded to 89.2% despite the rise in competition. And while Behance is a meaningful buyout, it represents just less than 1% of Adobe's market capitalization. If nothing else, it still indicates a positive shift in the corporate strategy that have sent shares to their 52-week high and up 37.6% from the lows.

Why You Should Short Red Hat (NYSE: RHT)

Red Hat has been traditionally thought of as an open-source software producer, but that's about to change with the buyout of ManageIQ for $104 million. This acquisition helps undermine the competition that has failed to successfully innovate in cloud services. It is particularly a noticeable takeover aimed at combating VMWare's (NYSE: VMW) dominancy.

VMWare owns data management technology, known as server virtualization. This allows all of the storage in a data center plus the servers can work together through the Internet on a private cloud. Has made little progress in the public realm. But the CEO of Red Hat has a strong reason to be optimistic about companies preferring open-source software in light of the popularity of Facebook, Twitter, Dropbox, and ManageIQ's support of Amazon Web services.

But both stocks look overvalued--even more so than Adobe--at today's prices. Assuming VMWare successfully grows at a rate of 22.8% over the next 5 years, 2016 EPS will come out to $6. At a multiple of 17x, this translates to a future stock value of $102 by 2016--not much higher than the prevailing price. Discounting backwards by 10% yields a present value of $63.33, which implies that the stock is around 33% overvalued.

Red Hat's shares are near their decadal high. Under a 10% discount rate, 17x multiple, and 16.9% 5-year EPS growth rate, Red Hat should be worth $23.41 per share today. Instead, it is worth $55, which implies it is more than 50% overvalued. I encourage possibly shorting Red Hat and going long on VMWare to benefit from the return spread between the two. As long as VMWare outperforms Red Hat, and its momentum and growth is in that direction, you will see a positive result. Since these stocks are 33% - 50% more volatile than the broader S&P 500, the upside could be strong from the strategy.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of VMware. Motley Fool newsletter services recommend Adobe Systems and VMware. 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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