Should You Buy or Sell This Software Producer?

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

For some time, Adobe’s creative service has shown a great potential for growth. It should thus be of no surprise that Adobe is strategically acquiring companies that will enable it to broaden its product portfolio. Red Hat is using the same tactics and has similar interests in cloud management. Here are some facts about Adobe and Red Hat that might come in handy when choosing which company to invest in.

Why You Should Buy Adobe (NASDAQ: ADBE)

In recent days, Adobe announced that it had acquired Behance in an estimated $150 million buyout. Behance is a site where creative professionals can interact with one another on a social network and display their project portfolios. Behance will be integrated into Adobe’s creative cloud service, which will create synergistic value given the software developers current programs for graphic designers, rich media developers, and other creatives. Adobe will also absorb Behance’s CEO and 32 employees. It looks forward to investing about $100 million in acquiring private companies that will leverage their already existing technologies, such as Adobe AIR. 

Behance, after all, has a great potential. In November alone, it recorded 90 million views. It is estimated that the union will lead to an increase in subscribers by 1 million. Already, in just its creative cloud service, Adobe has 1 million subscribers, out of which 30% have paid subscriptions. The company expects to have $685 annually from Creative Cloud Service. Adobe has also introduced a monthly subscription of $50 for its CS6 creative cloud platform. More than 60% had a negative reaction to this pricing, but Adobe has bought itself more time through integrating related products like Behance. 

Fortunately, organic momentum has been very strong. In the recent quarter, total creative units increased by 13%, which was substantially above expectations. They are also planning on bringing new features that will come with the CS7. The most notable benefit attached to the subscriptions is that Adobe will have revenue that is relatively predictable, and, therefore, the trading multiple should be at a premium to speculative peers. Subscribers will not have to pay an extra dime for a new release of a product; it will simply be available through continued subscription. Adobe also has experienced a positive revenue growth over the years. This, together with its reasonable debt levels (debt to equity ratio is 0.23) has enabled Adobe to overcome a not-so-strong return on equity. With investors focused on the upside from Adobe entering enterprise-based creative cloud, I do not see the multiples deteriorating any time soon.

Red Hat (NYSE: RHT): A Stock to Avoid

Red Hat offers open source software, such as operating systems and other visualization solutions. It is particularly remarkable that 29.5% of the revenue generated last year was turned into FCF. Red Hat is continually exercising calculated acquisitions of relevant technologies to broaden its products portfolio and face competitors like Microsoft. Recently, Red Hat acquired ManageIQ for $104 million, as the company targets improvement in hybrid cloud operations. This move is expected to improve cloud management and enterprise visualization beyond just expanding Red Hat’s IaaS. Red Hat CEO is convinced that the popularity of social media, ManageIQ and Dropbox, is a clear indication that open source software will become increasingly critical for Internet companies. VMWare (NYSE: VMW), which owns server visualization (a technology used to manage data), is seen to be the number one enemy to Red Hat. 

VMWare offers a data storage center. Servers are also provided with a private cloud that enables broad content access and distribution. But at 28.4x forward earnings, the question now turns to whether the stock is overvalued. Analysts forecast 22.8% annual EPS growth over the next five years. Assuming the company only grows by a 20% y-o-y rate, 2016 EPS will come out to around $5.60, which, at a multiple of 17x, translates to a future stock value of $95.20. Discounting backwards by 10% yields a present value of $59.11, which implies that the stock is roughly 35% overvalued. For this reason, neither VMWare nor Red Hat are attractive investments for the time being.

TakeoverAnalyst has no position in any stocks mentioned. The Motley Fool recommends Adobe Systems and VMware. The Motley Fool owns shares of 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. This article was written by the staff of TakeoverAnalyst, which does not intend on opening a position in the next 48 hours.

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