3 Software Giants With High Upside Potential

 |  Includes: ORCL, RHT, SAP
by: Mel Daris

The growth outlook in the software sector was deteriorating at the end of 2011, brought into the spotlight by the high profile earnings miss by Oracle (ORCL). In December 2011, Oracle posted a 6% gain in non-GAAP earnings per share, missing expectations and casting doubts on the prospects for calendar year 2012. Analysts had been expecting Oracle's earnings per share a full $0.03 higher than reported. In the report Oracle increased sales, earnings, and margins-- just not as much as expected.

Investors may simply be asking too much of Oracle, because a similar situation occurred with the company's third quarter release. Non-GAAP earnings per share increased by 15%, and the stock traded down from resistance on heavy volume. Other software makers are doing remarkably well in comparison. Lowered expectations helped Redhat (RHT) surprise investors and gain roughly $10 when it released full year fiscal 2012 earnings results.

Redhat, the leader in Linux based open source software, has been making huge improvements in organic growth, sales and revenue. The software giant is one of only a few companies that earns over $1 billion annually. Quarterly 2012 earnings statements were in line with the actual fiscal 2012 results, which came as a surprise for many traders. Concerns over global growth in 2012, coupled with Oracle's earnings miss in December 2011, helped drive the stock down on concerns over weak fourth quarter performance. Redhat regained the lost value during its fiscal fourth quarter, which ended February 29th. The results, which sent the stock up over 18% in one day, came as a surprise and left the company richly valued at over 76 times earnings.

Full year EPS was reported at $0.76 per share, compared to $0.56 in the previous year, a gain of 35%. GAAP earnings per share increased by 6% in the fourth quarter alone. Revenue has been steadily increasing on a quarter by quarter basis, up 21% in the fourth quarter of 2012, and 25% on a full year basis. This marks the second year of revenue growth over 20% for the company. At the same time the company is increasing revenue, it is also improving margins. Operating margin in the fourth quarter was 16.3%. Full year margin was 17.6%, an improvement of over 1.5% from the previous year.

Redhat, in its statements, referred to 2012 as a "strong year for business". The company has been focused on improving its "global sales footprint" and its sales force. By targeting experienced sales people with industry and product specific knowledge, Redhat has been able to improve new sales and increase organic growth, which improved by 25% in fiscal 2012. The gains made by Redhat are based on widespread use of the software across geographic and industry borders that is expected to increase in fiscal 2013. A number of new, large scale deals signed in 2012 will help Redhat maintain revenue growth into fiscal 2013.

Redhat's recent move up came on high volume and bullish technicals. Short term momentum is at a multi-year peak, and suggests a continuation of the bull trend that began at the first of the year. Long term technicals are also bullish and still moving up. The stock is firmly above $55, and will stay there even though it is trading at such a high multiple. A recently announced $300 million stock repurchasing program will help to support the price.

Competitor SAP (SAP) is expected to release first quarter 2012 earnings on April 25th. The software firm is currently trading around $70, with a P/E around 17. The stock is just above short term support and near multiyear highs that it set in the last few weeks. The trend in this stock is bullish long term and could benefit from a positive surprise similar to Redhat's.

SAP had its best year ever in 2011. Software revenue increased by 25% in the year, surpassing the company's own guidance for revenue and operating profits. The company increased earnings per share by 23% and operating cash flow by 29%. The company cited increased leadership in enterprise and mobile applications, cloud computing and data base management as sources of revenue growth. The co-CEOs of the business, Jim Hagemann and Bill McDermott, said in the statement that the company had "significant momentum going into 2012".

SAP made double digit increases in all three of its revenue sectors; software, support and software-related services. Total revenue gains for fiscal 2011 increased by over 14%, while expenses only increased by 13%. The business recently closed a deal that will help it to provide the same great results in 2012. The acquisition of SuccessFactors will enhance SAP's cloud computing infrastructure. The company is expecting to increase 2012 revenue by 10-12%, with as much as 2% being added by SuccessFactors. The business also closed some major contracts in Europe, Asia and the Americas which will help generate the expected revenue increases.

The SAP Executive board has recommended a dividend increase of 83% based on the strong results in 2011. This special dividend would also include a special one time dividend for the company's 40 year anniversary. Strong results and increased dividend yield will help take SAP to a new high.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.