Bull/Bear Mix-up for 2 Software Stocks

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

In previous articles, I have articulated my optimistic outlook on Microsoft and pessimistic outlook on Red Hat. While I see the former as an unreasonably beaten-down leading software producer, I see the latter as an over-hyped cloud producer. In this article, I will attempt to look at the other side, since the best investments come from challenging the initial thesis. Below, I present the bull case on Red Hat and the bear case on Microsoft.

Red Hat (NYSE: RHT): The Bull Case

Red Hat is an American company that produces open source software. It is noted for being the creator of the Linux operating system. The company has been making a number of acquisitions to facilitate growth. The most significant of these was made in 2000 when Red Hat acquired Cygnus Solutions for $674 million. In this year alone the company acquired five other companies. Other leading tech companies have gained exposure to Red Hat, including IBM, Intel, Novell, Compaq, Netscape and Dell. They have all bought some amount of minority shares in Red Hat. 

In June 2012, Red Hat reported its first quarter earnings, a 5.3% beat. It had revenue worth $315 million, which represented a 19% increase from the previous years. The operating cash was $124 million which was a 38% increase y-o-y. The second quarter earnings of 2012 were reported in August 2012. The revenues rose to $322 million which represented a 15% increase from the previous year’s second quarter. The operating cash was $104 million, a 35% increase y-o-y. Revenue from subscription was $279 million, representing a 17% increase.

Red Hat’s third quarter results indicated that the operating cash was $97 million, which represented a 36% increase compared to the same quarter in the previous year. For the fourth quarter of 2012, the revenue was $297 million, which was a 21% increase while that of the whole year was $1.13 billion, representing an increase of 25%. The operating cash was $128 million, which is a 35% increase compared to the previous year. From this data you can clearly see that Red Hat has been making quite some progress year after year.

All in all, the main benefit of investing in Red Hat is that the company rides on the backs of well established companies such as Facebook and Twitter, which will continue to require open source software. With strong momentum, no debt, and even some accelerating trends, Red Hat merits a premium to competitors.

Microsoft (NASDAQ: MSFT): The Bear Case

Microsoft is a well known software giant that is famous for making Windows operating systems. It also makes other software and is the leading software company in the world. Microsoft has acquired several companies, and the latest acquisition( also the most expensive) is that of Skype Technologies in 2011. The deal was priced at $8.5 billion and widely regarded as a waste of money. To put this into perspective, consider that Microsoft could have acquired all of Red Hat and still had some cash left over.

And while Microsoft has $41 billion in terms of asset value and only $8.5 billion in debt, its failure to execute in R&D and acquisitions of late has put pressure on the downside. Core revenue has also eroded due to declining sales of personal computers, and Microsoft’s online business has been making losses since 2006. Surface sales have been weak; Bing was a total flop; and Windows Phone holds less than a 5% market share against the likes of Android and iOS. What is it about Microsoft, the company that modernized computing, that it has to continually fail in next-generation systems?

In 2Q12, Microsoft announced that it actually bled ~$500 million. In 3Q12, net income stood at $4.5 billion, which was around 22% below the same quarter last year. There has been a shift from PCs to mobile devices, such as tablets and smartphones. And as a matter of portfolio strategy, Microsoft isn't exactly high on the list of priorities. With peer Apple (NASDAQ: AAPL) down 30% from the 52-week high and now under $500, investors may start to grab shares of the world's largest electronic producer, a company that has become associated with leading innovation. After all, Apple trades at only a respective 11.3x past forward earnings despite high double-digit EPS growth over the past five years and expectations for a 19.6% growth rate over the next five years. By contrast, Microsoft trades at 14.7x past earnings, "only" delivered a growth rate of 7% in the past five years, and is expected--perhaps too optimistically--to have a 9% rate over the next five years. This could mean more downward momentum for Microsoft, particularly in the short-term.

TakeoverAnalyst has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of 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. 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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