Why You Should Buy These 2 Undervalued Tech Stocks

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 optimistic about the tech market, I encourage buying shares in software producers. These companies are more engrained in the secular trends than what the markets recognize. Their products can be found in smartphones, tablets, PCs, you name it. However, in many instances, they trade at a discount (in terms of multiples) to the broader market. Below, I review two stocks that I have a bullish outlook on for different reasons.

Why You Should Buy Microsoft (NASDAQ: MSFT)

Over the past 5 years, Microsoft has grown EPS and dividend distribution by a CAGR of 7.1% and 12.7%, respectively. The dividend yield now stands at a very higher 3.5% in light of a still-strong 9.6% growth rate ahead. Despite this, shareholder value has fallen by 27% during this time period. At only 8.3x forward earnings and a free cash flow yield of 10%, Microsoft looks cheap at current prices. Surface and Windows 8 sales may have been disappointing, but the future still looks bright when you consider that Microsoft still has $50 billion in net cash to spend on accretive takeover activity.

With exposure to smartphones, laptops, and tablets, Microsoft has established strong enough inroads into these high-growth markets. It then distributes its Windows 8 software through several of these mediums. Too much attention has thus been put on Windows 8 tablet sales and not enough has been put on whether it will enable Microsoft's operating system to gain market share against Apple's (NASDAQ: AAPL) iOS and Google's Android. It has helped keep Intel in line, because this chipmaker depends on sales from the software. But with Windows 8 selling slower than the highly-criticized Windows Vista and much slower than Windows 7, the market is focused on downside factors. Windows 8 was featured on 1.6% of all Windows PCs as of December 22 versus 2.2% for Vista and 6% for Windows history in a similar point in the life cycle. In addition, plenty of enterprises have expressed a disinterest in upgrading to the new software. The company is planning on releasing an updated modification of Windows 8, called "Windows Blue," that will retain the new "metro" user interface, but it is unlikely to be a big attraction.

Microsoft, however, has showcased confidence over the future. It has opened 51 stores in the United States and Canada in 2012 and plans on opening 6 more the start of next year. While foot traffic is well below what has been experienced at Apple stores, growth trends still look strong enough to drive value creation. Assuming Microsoft meets expectations, 2016 EPS will come out to $4.22. At a multiple of 13x, this translates to a future stock value of nearly $55. This provides for nearly 25% average annual returns when you factor in dividend distributions--clearly more than enough to justify an active investment. To put that into perspective, Apple would have to turn into a $1.1 trillion company by 2016 to generate the same kind of returns! This would be a valuation that is 26.5x Apple's earnings over the twelve trailing months.

Oracle (NYSE: ORCL): Pros & Cons

Oracle is another relatively cheap stock, but it is no longer so beaten down after a rally sent shares up 32.3% from the 52-week low. It trades at a respective 15.6x and 11.2x past and forward earnings with a small dividend yield. Analysts forecast 12.3% annual EPS growth over the next 5 years, which is well above the 5% rate that is expected for the S&P 500. But while 26 of 40 reporting analysts rate the stock a "buy," a still large minority of 14 say "hold."

There are several reasons to still be optimistic about Oracle. First, its return on invested capital of 18% is still more than 100 basis points above the industry average, which indicates that the software producer is creating value. Further, its price/book value of 3.7x is well below the 5.1x industry average (P/E and P/CF multiples are also sizably below the average). Further, the company has experienced solid momentum. In the fiscal second quarter, licensing revenue grew 17% y-o-y and was largely driven by acquisitions. In addition, the recent decision to purchase Eloqua for $871 million represents a step in the right direction. This cloud marketer has access to 1,200 customers that could use Oracle's products while enabling the software producer to build upon Eloqua's existing product offerings.

going forward, management is guiding for as low as 1% y-o-y growth to as much as the mid-single digits. This is disappointing relative to the 4.3% growth consensus. Since stock prices react to the reality benchmarked against expectations, this higher-than-internally-guided forecast adds downside risk. While management did beat revenue and earnings expectations las quarter, much of this has already been factored into the rally. Thus, while I still find Oracle to be a value play, I recommend preferentially buying shares in Microsoft.


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Microsoft, and Oracle. Motley Fool newsletter services recommend Apple and 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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