CA Technologies (CA) is a provider of enterprise software operating in three segments: Mainframe Solutions, Enterprise Solutions and Services.
Software in the Mainframe Solutions segment comprises a suite of small utilities that aid technicians in the maintenance of mainframes. These utilities may deal with a optimizing the performance of a database, providing security to a mainframe or managing storage.
Enterprise Solutions products move beyond the mainframe to provide services such as task automation and data management in a distributed network environment. The company also produces a host of security products for use outside of the mainframe environment and project management software.
The services segment is principally engaged in supporting CA's software sales through implementation projects, consulting and training.
CA currently trades at an 11.2x PE multiple and generates a dividend the yield of 4.5% on a roughly 50% payout ratio. Certainly the stock looks attractive based on these valuation metrics.
However, in order for the stock to be attractive, the profitability needs to be sustainable and there are some areas of worry here. From the company's FY 2012 10-K:
During the past several years, many new technological advancements and competing products entered the marketplace. The distributed systems and application management markets in which we operate are far more crowded and competitive than our traditional mainframe systems management markets.
What this is saying is that new revenue opportunities are not quite as great as the old, but the question is how much worse they are. A look at the company's segment breakdowns provides an answer:
As the table shows, the slower growing and older technology Mainframe Solutions business produces about 10x the profitability of the Enterprise Solutions business which is the growth segment where competition is greater.
The mainframe market is mature with only slow growth occurring in new system installs. On the brighter side, it does not seem to be a market in decline as IBM, the primary producer of new mainframes, continues to sell a respectable amount of new systems each year, although revenue has been largely flat in recent years.
In the best case scenario, CA can grow profitability in the Enterprise Solutions segment while using the Mainframe Solutions segment as a cash generator to fund development. However, it is unclear whether Enterprise Solution will ever have the same type of economics that Mainframe Solutions have now. The mainframe business is characterized by little competition and virtually zero threat of new entrants at this juncture. This has allowed a high level of pricing power for CA in this business which may never translate to other more competitive businesses. While Mainframe Solutions should continue to generate good cash flow, it is not likely to grow much and over time customers may be able to bargain down prices.
Given the attractive valuation, investors may be willing to take a bet on CA being able to transition its business, but they should understand the risks inherent in the process.