Avoid These 2 Overvalued Software Producers

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 cloud technology, you may want to start buying shares of software producers. But before you rush to hit the "buy" order, consider whether the hype will last. Especially, if you are a "buy-and-hold" investor, I wouldn't recommend spending your time looking after cloud producers, since there is going to be a lot of unpredictable market movement. Instead, I encourage buying shares of consistent producers that are large, diversified, and trade at a discount to decelerating peers.

Why Adobe (NASDAQ: ADBE) Looks a Bit Overvalued

Adobe is a global designer of computer software. In 2008, the amount reduced to $18 billion and in 2011 it went further down to $17 billion. In late 2012, Adobe acquired Behanc, which offers an online platform where designers can showcase, publish and share their work. Behance already had some one million members at the time of acquisition, and Adobe is hoping to further its creative cloud endeavors. 

Adobe's Creative Cloud enables members to access Adobe’s sophisticated tools and use them in design creation. They can then share these creations. It has already proven tremendously successful: At the end of this financial year, paid subscription for the Creative Cloud was 326,000 ensuring that the company received some $153 million each year. In the Document Service sector, the annual revenues amounted to $786 million. The company’s marketing cloud had an annual revenue of $777 million which was a 35% increase compared to the previous year. 

The fourth quarter saw Adobe’s revenue shoot to $1.2 billion, which was way above the expectation of $1.075 billion to $1.125 billion. During this quarter, Adobe continued to insist on improving its creative cloud services. For the 2012 financial year, Adobe generated some $4.404 billion in revenues. During this quarter, cash flow was $473.7 million while net income hit the $307.9 million mark. Deferred revenue totaled $619.6. There were about 10,000 subscriptions per week for the creative cloud compared to 8,000 in the previous quarter. Annual operating revenue was $1.18 billion while the annual net income was $833 million. Total cash produced during the 2012 fiscal year amounted to $1.5 billion. During this fiscal year, Adobe bought back 11.5 million shares worth $372. The company is planning to have a webcast to discuss targets for the 2013 financial year.      

If the company already has had tremendous success in where it is endeavoring to grow, to what extent should we be skeptical? While the growth momentum is undeniably high, much of the upside has already been priced into the stock. It now trades at a respective 22.9x and 21x past and forward earnings. By contrast, the much larger and more diverse Oracle (NYSE: ORCL) is valued at only a respective 16.6x and 11.9x past and forward earnings. It is also on a sharper-than-recognized growth curve with a growth rate of 11.8% expected annually over the next five years. This divergence in multiples appears overdone both on a theoretical level and empirical level--the gap has seldom been this large historically.

Red Hat (NYSE: RHT): The Good & Bad

Like Oracle and Adobe, Red Hat is a multinational software making company. It focuses on producing open source software for personal computers. What makes Red Hat stand out from the competitions is that it is the biggest producer of open source software. Red Hat recently acquired Manage IQ hoping to improve its cloud computing experience. ManageIQ will bring with it Hybrid Operations Management. The company is really working hard towards expanding in 2013 through some channel changes. In an environment where tech investors are going wild over "cloud services," this could mean a lot of hype.

But if you thought the optimism was overdone at Adobe, just take a look at Red Hat. At 39.2x forward earnings despite deceleration, the stock smells a bit like the dot-com era. With that said, there are several reasons why the market is so optimistic: In January 2013, Red Hat announced the availability of Linux 5.9. This release marks the beginning of the second face of production of Linux 5. Red Hat seems committed to constantly add features to the Linux platform, a clear indication that the company respects the investment that people have made in this operating system. The new operating system is enhanced to perform well with the latest hardware such as chipsets and CPU. It also has better security and additional developer tools. 

In the third quarter of 2012, Red Hat reported revenue growth of 18% compared to the previous quarter. Subscriptions revenues also increased by 19% and hit the $294 million mark. The total revenue was $988 million, which is also an increase of 21% from the previous year. The operating cash was $100.2 million compared to $96.6 million in the previous year.


TakeoverAnalyst has no position in any stocks mentioned. The Motley Fool recommends Adobe Systems. 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. 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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