One fact about Joel Greenblatt's Magic Formula® Investing (MFI) strategy is that it has a tendency to identify downtrodden industry sectors by screening several competitors at the same time. Such a situation exists today with a number of large enterprise software companies.
This is interesting to us, as enterprise software is a great business. Software is high margin, with operating margins routinely near 30%, and generates effuse free cash flows as capital investment requirements are small. Higher enterprise software sales do not require new factories or distribution networks. These companies also get 50% or more of their sales through recurring support and maintenance contracts that are renewed at over 90% rates, setting up a stable and reliable source of revenue.
Finally, these firms have strong competitive advantages in the form of high switching costs. The decision for a large company to deploy an enterprise-wide software solution is usually a carefully considered one, often taking months or even years of evaluation and implementation. Once in place, it is expensive, time-consuming, and disruptive to business to switch away from it. This helps to explain why all four companies in this article barely saw a blip in their returns on capital or, indeed, their revenues during the 2008-09 "Great Recession".
Unfortunately, these outstanding business characteristics usually come with a higher-than-market earnings multiple. But this isn't the case today. We like the business, but which of the four current MFI companies looks like the best buy?
The four current, large enterprise software makers squaring off in this article are:
Oracle (ORCL): Oracle is about as pure a play on business software as there is. The company's biggest business is selling database software, although it has also acquired its way into middleware (server software), business process applications such as enterprise resource planning (ERP) and customer relationship management (CRM), and so forth. With the 2010 purchase of Sun (JAVA), Oracle is also getting into the hardware business, delivering a closed-loop solution for data center integration.
BMC Software (BMC): BMC produces software that helps companies manage, automate, and respond to IT infrastructure challenges. Revenues are split almost cleanly between mainframe and non-mainframe structures. BMC sells to 90% of the Fortune 100 companies.
CA Technologies (CA): CA and BMC are direct competitors with very similar businesses. Both provide software for managing a variety of IT challenges (application deployment, resource allocation, data backup, etc.), and both get roughly half of sales from the legacy mainframe market.
Microsoft (MSFT): Obviously, Microsoft is unique in this showdown as it has significant consumer sales in its Windows, Online Services, and Entertainment divisions. However, the bulk of the firm's profitability comes from its sales to businesses, with software such as Windows, Office, Exchange, Dynamics CRM/ERP, SQL Server, and application development tools like Visual Studio.
Business Metrics Comparison
Let's first compare the core business metrics of each of these firms:
|5-year Compound Annual Revenue Growth||10.1%||8.5%||2.9%||6.8%|
|5-year Compound Annual Operating Profits Growth||17.2%||16.3%||25.2%||8.0%|
|TTM Operating Margin||37.0%||25.6%||28.1%||38.3%|
|TTM Free Cash Flow Margin||34.7%||36.1%||25.4%||35.2%|
|TTM Returns on Invested Capital||29.7%||20.2%||10.7%||92.0%|
The one thing that stands out here is that the numbers support the attractiveness of the software business. Perhaps the most important line here is returns on invested capital, as all of these firms use large acquisitions as a key growth strategy. Microsoft has been, by far, the most efficient at allocating its capital, despite some very well-documented acquisition misfires. That said, it has also been the slowest grower of the bunch, profit-wise. Oracle has the most solid top-to-bottom record here, with good growth, very high margins, and solid returns on capital. All of these companies carry reasonable debt burdens.
A shareholder friendly company to most investors means: How much importance does the firm put on returning excess capital to shareholders in the form of a dividend or share buybacks?
|Dividend Payout Ratio||9.1%||N/A||7.7%||21.6%|
|5-year Average Reduction in Shares||-0.6%||-3.5%||-2.8%||-3.0%|
Only Microsoft pays any kind of dividend to speak of, and even with a nearly 3% yield, the payout ratio of free cash flow is low at just over 20%. Both Oracle and CA have ample room to expand their dividends, and BMC to instate a meaningful one. All but Oracle have been executed aggressive share repurchase programs in recent years.
We've talked about quality, now let's look at price. How does the stock valuations of these companies match up against each other and against their historical selves?
|5-year Average EV/EBIT||7.4%||6.1%||8.0%||10.4%|
|5-year Average Price-to-Sales||4.9||4.0||2.9||4.1|
Note: EV/EBIT = Enterprise Value to EBIT ratio. See here for an explanation of why I use this instead of P/E for earnings valuation.
As you can see, all of these firms trade well below their own historical averages. Microsoft is the cheapest from an absolute perspective, as it has been for the past 5 years, which makes some sense given its bigger size and slower growth. Oracle's valuation may be the most surprising, given that it has been the fastest grower of the bunch.
So far, this has been a very close comparison. Now, it's time for intangibles - those things that don't show up on the financial statements, but can be just as important to the future success of these companies. Intangibles include things like reputation and management. We rank the firms by intangibles in this order (best to "worst"):
- Oracle - Led by its iconic founder, Larry Ellison, who still has an insane $30 billion tied up in Oracle's equity. Just over a year ago, the firm added Mark Hurd, the former very successful CEO of Hewlett-Packard (HPQ), as President. Oracle is the gold standard for database software, and a fixture in the IT infrastructure of most large companies.
Microsoft - On sheer reputation as the "go-to" vendor for corporate application standardization, particularly in productivity and communications software. Microsoft has been hurt by a poor perception in the investment community.
BMC - BMC has been a Wall Street favorite in the past, carrying a higher valuation than its competitors. Leadership is good, too, with CEO Robert Beauchamp at the helm for over a decade now.
CA - Once described as "The Most Dysfunctional Company in America", CA has come a long way - but old perceptions die hard. This helps to explain CA's lower than peer valuations. Additionally, CA has had some executive turnover within the past few years and is, in general, much less stable at the top than the other three.
You didn't skip to the bottom, did you?! This was a tough comparison. All four companies make solid investments at current levels - there is no obviously poor pick in the bunch.
Overall, though, Oracle looks like the best buy. The stock sold off after its last earnings report, but Q2 weakness seemed to be more a function of timing then ongoing weakness. Oracle has a top notch management team, a focus on growth, an outstanding brand identify with corporate IT managers, and is trading at easily its lowest valuation in the past 5 years. With the recent purchase of Sun, Oracle is set to be an end-to-end provider of data center equipment for the burgeoning cloud computing movement.
Disclosure: Steve owns MSFT.