In today's Oxen Group recap, we will be looking at CA Technologies (CA) in our daily deeper look. We want to update our CA 12-month price target as the year ends and 2014 is starting to take shape. In our Company News section, we will delve into our monthly update on Sirius XM (SIRI) as we continue to cover the ups and downs of this stock. Additionally, as always, we will do our typical market overview, important news breakdown, and give our perspective on what's moving the market.
The market was nearly entirely focused on the FOMC developments for Wednesday throughout Tuesday. Early losses were bought up as the market ended mostly flat overall. The market got important CPI data Tuesday morning that showed that inflation was flat month-over-month. Low inflation has been the reason that QE has been able to subsist for so long along with weak jobs creation. This news was seen as positive for non-taper arguments, but a strong NAHB Housing Market Index at 58 versus 55 expectations spurned selling. Too good of news has hurt the market because it means the Fed is more likely to taper. The weeks of taper conversation come to a precipice tomorrow, and we should get our answers. The Dow Jones (DIA) and S&P (SPY) dropped minimally.
Today, we are taking a look at CA. We have had a Buy-rating on CA for much of the year, but we downgraded the company in Q3 to Hold as the stock had made nearly 50% gain YTD. The company has done well getting demand for their software and services. We want to see how things are setting up for 2014.
After our update,
CA operates within the business software and services industry. The company focuses on enterprise IT management software that helps customers manage and secure IT. The company operates in three main segments. The first, Mainframe Solutions, is software-based for mainframe platforms that help with performance, automation, application quality/testing, and help staff be productive. The Enterprise is key to the company right now and is the cloud/virtual space for the company where they offer security and service assurances. Finally, they offer consulting/education/customer support under Services. CA is a business in a lot of change as we will focus in our catalyst section, but how are the trends currently affecting the industry.
Here are some key statistics on the mainframe business and shifting virtual, cloud focus:
- The IDC believes that cloud network spending will increase 25% in 2014 and account for 89% of all IT spending growth.
- The cloud could produce $100B in sales in 2014 as more data centers come online, as well as an increase in cloud infrastructure services.
- According to some studies, 69% of businesses that have separate budgets for cloud computing believe that they will increase that budget.
- Emerging markets are expected to account for $740B of IT spending in 2014
- Online retail will continue to grow with another 10% jump in 2014 and potentially $250B in sales, making up 8% of the entire industry.
For CA, it is critical that the company innovates, moves into the enterprise cloud and virtual business as mainframes start to lose their ability to grow. The company, though, is very much aware of this situation and making the change, which is one of the reasons we liked them so much at the beginning of the year. The company's first move was to hire a new CEO to transform the business. The company brought in Mike Gregoire from California-based software maker Taleo that was bought out by Oracle (ORCL) in 2012.
So far, Gregoire seems to have been doing a solid job and has a plan. We will review that plan for you here and then follow up with how the company is doing so far.
Gregoire's job is to build the company to catch up to digital trends, create more cloud/virtual products, and move the company's revenue makeup away from mainframe - a very similar change that is going on at IBM (IBM) currently. The issue is that mainframe sales are dwindling not profits. The company still is highly profitable at creating software for these large computers, but they are not seeing revenue growth. The company saw revenue drop in 2013FY from 2012 and is likely to see another flat year in FY14. Margins, though, have stayed very strong with a gross margin at 87% in 2011-2013.
The move from more virtual, distributed systems that allow clients and employees to access data and storage remotely has put pressure on mainframes. The company has been solid in distributed systems within servers, but they have been late to the game with cloud. That is where Gregoire wants to attack. He has already shook things up by laying off 1200 employees, redraw commissions, and consolidating research to 40 sites to create nimbler teams to more represent the small, nimble units in California startups.
As for cloud, the key indicator to watch is SaaS, software-as-a-service. The company wants to build SaaS revenue to $5B by the end of FY2016, which is actually just two years away for the company as they are about to end FY2014. The company has seen some success and some issues so far. The company saw growth in SaaS, but enterprise solutions revenue was not as strong as the company wanted. In response, Gregoire commented:
All that being said, we aren't selling new products at a rate and pace I expect. This is why the whole company is focused on product differentiation and growing outside of our install base. It's also why we're going to accelerate investment in the business in the back half of the year.
The company, to accelerate growth, is investing in putting CA in Silicon Valley. The company, based out of Long Island, is not where cloud deals are being done. At that location they will have teams working on mobility, data, cloud computing, and SaaS. The company is going to have to continue to invest in developing here a lot to play catch-up to grow the top line once again. Products, at this point, are crucial as competition is very high. The company has released 19 new products in the past year with 7 SaaS products and 9 mobile user products.
One product that we are most excited about is Snap. Snap is a monitoring device that allows multiple IT monitoring on a single platform for up to their devices. The product allows mid-market organizations to monitors devices, servers, and applications from one device. In the last earnings report, it had 2000 downloads in just two weeks. The company needs to have successful solutions time and again to catch up and find their niche in the fast developing IT world. Additionally, we like this product because it attacks mid-market and even small-market companies. CA has long been doing business with large institutions that can shell out a lot for high tech software for mainframes. Those days are long gone, and a product like this shows the company understands it needs to generate smaller margin subscription earnings.
Moving forward, the company has a lot of question marks, but they also have a strong balance sheet and large pool of clients with which they have done business with for years. That advantage will help them to execute new technology and find clients interested in using it. Further, Gregoire's redesign of commissions to promote new business allows the company to go out and redefine itself in the marketplace.
While we are excited about the developments here, we also realize that we are just starting to see the right moves. Now, the company will be judged on execution. Share prices have jumped on the expectations, and the company has to come through now. The stock is still only at 13x future earnings and 2.5x book, so there is definitely some caution from investors. Therefore, there is still room for upside if the company can execute. The issue for analysts is understanding what that execution might look like moving forward as we will address in the next section.
Revenue - The company is projecting the current fiscal year to see a 2-3% dip in revenue from the prior year at about $4.5B. It is hard to expect more than 1-2% increase in 2015 as the company will still be in a long-term transition, but we expect to start to see some positive synergies coming through. From there, the questions really begin for CA. If the company can execute in the manner they want, we should be able to see them get into the industry growth levels, which are expected to be about 6-8% CAGR. Therefore, something in that range should be expected for the next couple years after that on the high side and 3-5% on the low side.
Operating margins - We would anticipate to see these consolidate some. The cloud, SaaS business is not as high margin, and the company will have to perform more volume, have higher R&D, and see less % of sales in the mainframe industry. Operating margins have already been dropping from 29% in FY13 to 26.7% in the TTM. We can see that in the latest quarter when Mainframe had 63% operating margins but Enterprise was at 15%. We will likely see a 24-25% operating margin settle out.
Taxes - These should maintain around 30-32%.
CapEx - Capital expenditures are likely to stay high with so much transition occurring. We would expect to see them around $200 - $250M consistently for the next few years.
When we use this information, we get a price target of $40 on the high side. In a conservative model, we come up with a price target of $32. For us, we still need to see more actualization of sales from SaaS and Enterprise that can spurn top-line growth before we can make our model considerably stronger.
Since Sirius' last earnings report on October 24, the company has shed over 15% of its value. Before that report, we told investors to sell shares of the stock as we saw the company's overvaluation as starting to become too extended. Last month, we did our first update since that earnings report, reiterating our sell. Since then, shares have dropped 10%. So, today, we want to look at this stock again. In each article, commenters have attacked us, but in both instances, thus far, we have been spot on. In our first article, we noted that we would be interested in buying closer to $3, and we are starting to get near that level. Today, we want to take a look at what 2014 has in store for Sirius and move our projections to 2014-2018 in our model.
One of the biggest hits to the company on its last report was that it missed analyst estimates for 2014. One potential snag for the company is the movement of Apple with "iOS in the Car" that will allow people to use Apple software right in their car. Apple Radio and iTunes are part of the features, and that is a definite threat to Sirius XM, especially as the company is set to raise their prices $6 in 2014. How that battle plays out will be crucial to Sirius in 2014, and pressure there could be hurtful to the company's bottom line.
Yet, 2014 for Sirius will be about several things. First off, adding more customers. As Sirius continues to be optimized for vehicles, and those vehicles become used cars, the company's potential customer base rises. Another 2M user adds in 2014 is definitely probable. Costs, though, will stay relatively flat in 2014 through 2015. Howard Stern and the NFL are set, and the company does not see music royalties rise until 2017. So, margins should expand in the coming year as well. Additionally, more users means fixed costs have a smaller impact.
The automotive market will be crucial to Sirius once again in 2014. The more new cars that are bought, the better for SIRI. The company has about 70% of new cars with their service already in it. As more people buy new cars, the user car market has more Sirius ready cars:
Currently, the company has satellite offerings in 50M cars through their production in new cars. In the next ten years, that rate should go from 50M to 150M. Tripling the revenue in ten years is a great long-term revenue stream. On top of that, SIRI will benefit as new cars move into the used car industry. As new owners own those cars, they have the ability to instantly turn on the satellite radio. In 2013, the company will see 1.5M gross additions in 2013 to satellite radio. Here is the company's CFO talking about the user car potential:
The next phase is as those cars begin to turn over into the used car market and, by the way we continue to build the new car production, so in the next, we have gone from zero to 50 million cars in the first 10 years of factory installed radios. In the next 10 years, we'll go from 50 million to a 150 million enabled vehicles. But the real story and I think the next 10 years is going to be about access to the previously owned car buyer. 80% of the households in the countries have a previously owned car in them and 70% of the cars sold in the country every year are previously owned vehicle. So, it's a market that we have not really tapped in this first 10 years of execution and I think we are going to have a great long-term growth story in the next 10 years.
Revenue - We continue to look at a CAGR of 9% for Sirius. We do believe that the growth of Pandora (P) and Apple Radio will have some negative impact, even if small.
Operating margin - We are looking at this rising in 2014 through 2015, but it will likely drop back down in 2016 as the company will have to pay large contracts to Stern and the NFL to keep them on. We would gather the operating margin could hit 30% in 2015 before likely dropping back to 28% in 2016-2017.
Taxes - We will leave at zero to account for NOLs.
With this adjustment, we come up with a price target for 2014 of $5. We are now moving back to buy, which is where we were at the beginning of the year. This target is a year-end target, so we do still think that some up/down period could occur for the next 2-3 months.
Wednesday is the biggest day of the month and likely sets up several weeks of market action. If the Fed tapers, we will likely see some correcting, and it will be hard to imagine us seeing more upside from there. At the same time, if we don't taper, then the market will likely see some rallying and sets up to end the year strongly. The FOMC Rate Decision and following comments are the key to watch for at 2PM ET. The market should stay quiet and fairly flat before that announcement.