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Ticker: CA Tech (CA)

Secondary Tickers: Microsoft (MSFT), Oracle (ORCL), Salesforce.com (CRM), and F5 Networks (FFIV)

Rating: Upgrade from Hold to Buy

Ticker

New Price Target

Old Price Target

New Rating

Old Rating

New Buy/Sell Range

CA

$29

$30

Buy

Hold

$23/$32

Thesis:

CA Technologies has been upgraded to Buy from Hold as the stock has come down in valuation and looks solid at this point. CA has redefined itself as a cloud service/server company. The industry is quite crowded, but with a PE ratio at 11 and future PE at 8, the stock has very strong value and looks good to purchase at its current level. We have slightly dropped our price target from $30 to $29 on the back of the company's latest quarterly results that brought down our expectations just slightly and saw the company increase its tax rate from 30% to 31%. The company has benefited from their reboot into the cloud industry, and the company has been a consistent cash flow generator that also holds an attractive 4.5% yield.

The company's profitability potential is definitely the question mark for CA as more competition enters the market. The company earns a larger pie of their business from their mainframe products than enterprise products, which include task automation, data management and security products. The enterprise business, though, is the area seeing more rising competition, while the mainframe business has less rising competition and remains a consistent revenue generator. The company's ability to grow profits would be in the more specialized enterprise products, but that business is competitive. The company holds no economic moat in that area, and while this area can grow a lot, it's definitely the risk for CA's stock. Interestingly, with all the fear around CA's profitability, the company's margins have increased YoY (profitability discussed further below).

We believe, however, the market is pricing in a lot of that fear into the stock already with its 11 PE. In a high-growth cloud industry where many competitors hold much higher PE ratios and also have much higher risk, we like CA as a great investment. They have the consistency of the mainframe business that companies like CRM and FFIV do not possess as well as a high yield. The company is much less risky than expensive options like CRM and FFIV, but they have more growth prospects than mainframe-heavy companies like IBM. Finally, the company's FCF margin has increased every year since 2006 and now sits at an extremely solid 25.5%. Buy this company for their dividend, potential enterprise growth, and a stock that has fully priced in weakness.

Price Target:

The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.

Here is how to calculate price targets using discounted cash flow analysis:

(all figures in millions)

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2012 Projections

2013 Projections

2014 Projections

2015 Projections

2016 Projections

Operating Income

1430

1520

1555

1560

1585

Taxes

443

471

482

484

491

Depreciation

418

418

436

444

424

Capital Expendit.

-226

-270

-330

-370

-450

Working Capital

40

40

40

40

40

Available Cash Flow

1139

1157

1139

1110

1028

For CA, we have kept our projections fairly conservative. With only around 10% growth in operating income in the next five years, the stock is still vastly underperforming. We believe that the company could see slowing growth due to the higher competition in their enterprise business. Additionally, strong growth in mainframes cannot be expected as well.

Tax rates were configured with a 31% tax rate.

Depreciation should remain fairly flat as we do not foresee a lot of major changes in their business model.

We have increased the capex consistently as we believe that the company will have to continue to use more cash flow towards organic and inorganic growth through acquisitions to remain competitive on the enterprise side.

Taking ten-year averages configures working capital changes.

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).

WACC for CA: 9.88%

2012

2013

2014

2015

2016

PV Factor of WACC

0.9101

0.8283

0.7538

.6860

*

PV of Available Cash Flow

1036

958

859

762

*

* For 2016, we are going to calculate a residual calculation, as we believe that the market tends to value companies with around a five-year projection of where business will be. This is the common projection for discounted cash flow analyses.

Step 3.

For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out the residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for the industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you cap rate.

Cap Rate for CA: 7.88%

2016

Available Cash Flow

1027.65

Divided by Cap Rate

7.88%

Residual Value

13041.24

Multiply by 2016 PV Factor

.6860

PV of Residual Value

8946

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

3615

PV of Residual Value

8946

Cash/Cash Equivalents

2086

Interest Bearing Debt

1294

Equity Value

13353

We have added in current cash/cash equivalents as of the latest fiscal quarter along with debt levels.

Step 5.

Divide equity value by shares outstanding:

Equity Value

13353

Shares Outstanding

459.29

Price Target

$29

In the end, we have found that CA is worth around $29, which we believe accurately reflects the company's five-year projections.

Profitability:

Q1-Q2 2012

Q1 - Q2 2011

Operating Margin

31.3%

28.6%

Gross Margin

86.4%

82.1%

Return on Equity

8.7%

8.4%

Despite the company's potential issues with profitability, CA has some very strong profit indicators with a 31% operating margin, 86% gross margin, and 9% ROE. Further, the company has improved profitability in the past two quarters in comparison to the first two quarters of the previous FY. Profit expansion should mean higher prices. How do these stats compare to competitors?

Competitors for the company include Microsoft, Oracle, Salesforce.com, and F5. For MSFT, operating margin is at 28%, gross margin is at 75% and ROE is at 24.5%. ORCL has operating margin at 38%, gross margin at 79%, and ROE at 24%. CRM is operating with 0% operating margin, 78% gross margin, and -2% ROE. Finally, FFIV's operating margin is 30%, gross margin is 82%, and ROE is 23%. As we look at those levels in comparison to CA, the company has an operating margin that is only beat out by ORCL. They have the highest gross margin, but the company has the lowest ROE. Profitability issues are clearly overstated in the company's price and present opportunity.

Value:

Current

Industry Average

P/E

11.1

18.9

Future P/E

8.5

N/A

CA has very strong value, and the market is definitely overly discounting this stock. Looking at CA in comparison to competitors like CRM and FFIV shows this. The company operates in the same enterprise industry, but drastically lags these companies. This discrepancy is an opportunity.

MSFT operates with a PE of 14.4 and future PE at 8.2. ORCL operates with a 15 PE and 9.8 future PE. CRM does not have a current PE but operates with a 96 future PE. FFIV operates with a 16.5 PE and 16.5 future PE. As we can see, CA has much stronger discounting than their competition, but they seem to have profit and growth that match most of the competition.

Source: CA: Application Software Company Should Improve 30% In 2013