3 Software Stocks To Buy, 1 To Ignore

While it is no secret that technology is hot on the Street, there are some industries where the upside is particularly strong. Ironically, some of the greatest upside can be found where it doesn't glitter - that is, businesses with boring, but strong fundamentals. With the next wave of growth likely to come from cloud computing, I strongly recommend investors back software. With the tech market making bullish calls on Apple Inc. (AAPL), one ought to consider buying shares in cheaper, but still undervalued companies. In my view, BMC Software, Inc. (BMC), Microsoft Corporation (MSFT) and Symantec Corporation (SYMC) all look attractive. These firms have compelling positions within software and a solid economic moat, but nevertheless trade at low multiples. By contrast, Red Hat, Inc. (RHT) is more of a speculative and expensive investment based on growth prospects. Below, I review the fundamentals of each company.

Red Hat

Within the software industry, Red Hat specializes in open source software solutions and applications. It is one of the less known mid-cap firms in the space, but has gained respect as a momentum play. As data demand takes off against rising consumer interest and emerging market growth, Red Hat will continue to be a prime beneficiary. Over the last 5 years going through the Great Recession, the stock more than doubled - appreciating by 133.7%. But, at this point, I don't believe the fundamentals and earnings power is not enough to justify the valuation.

Before I emphasize my bearish stance, I think it is only fair to highlight the firm's strengths. Red Hat may attract some investors for how it is building out a comprehensive solution from middleware to cloud applications that will be available at a low cost against legacy technology. Red Hat Storage is an important catalyst for value creation, and management is working on increasing its sales overlay team to meet demand - something that they failed, and hoped to do, with JBoss. This product will first be unveiled in EMEA and APAC before landing in the domestic markets. In addition, the RHEL expansion will move forward with staff expansion in Columbia, Indonesia, Turkey, and Poland, which are leaders in UNIX installs. With RHEL 7 heading towards beta in H1 2013, speculation may keep valuation elevated.

With that said, a lot of growth will be needed to maintain the firm's sky-high multiples. The firm trades at a respective 67.3x and 36.5x past and forward earnings with a PEG ratio of 3.64, indicating investors have been overly bullish on growth. Analysts currently anticipate the company boosting EPS by 18.5% annually over the next half decade, which means 2016 EPS of around $2.36. At a 15x multiple, the company would be worth $35.40 in 2016. Discounting backwards by 10% yields a present value of $22 - less than half of the current valuation. Accordingly, too much hope over momentum is being priced into the stock. This may pay off for short-term investors, but I advise going with the established software producers in the long-term.

BMC Software

BMC is also relatively unknown on the Street. Unlike Red Hat, however, it looks undervalued and has not had its growth curve fully appreciated. Analysts forecast 9.6% annual EPS growth over the next half decade, which puts the forward PE multiple at 10.2x. Fundamentally, there are several reasons to be bullish on the firm's prospects:

Activist investor Elliott Associates had acquired a 5% stake in the software producer and threatened to nominate five directors to the board to force BMC to explore a sale. After friendly discussions, management agreed to increase its board size to 12 directors and appoint 2 of Elliott's nominees. This decision showcases the firm's improved willingness to be receptive towards shareholder interests. Elliott is nominating Jim Schaper and John Dillon to the board, who come equipped with a rich experience in the industry. Most importantly, I think these appointments signal greater interest in strategic alternatives.

Software has been in an acquisitive mode of late, and I believe that BMC's ESM business will generate valuable revenue synergies for suitors. The mainframe business, which accounts for roughly two-fifths of sales, would also enhance sluggish producers catalyze momentum. On the other side, BMC has not really been successful in takeover activity by itself. Remedy and BladeLogic may be exceptions, but the general M&A record has failed to excite investors.

Ultimately, I find the company attractively priced. The best way to look at software producers is to consider the amount of free cash flow they generate, and in that regard, BMC is doing stellar. The $6.3B firm generated $641M in free cash flow last year versus just $484M in FY2009. Capex trends are concerning, but it will be restrained in the event of a sale. Accordingly, I recommend buying the shares now.

Microsoft

Microsoft has a virtual monopoly on the PC market, document processing, and is making meaningful attempts to diversify. The company recently had a disappointing $492M loss in the second quarter, which was largely the result of a major write-off for acquiring aQuantive. Long-term contracts for software were, however, slightly higher than expected at $20.1B. Growing market share on the business level will also de-risk the business away from more unpredictable consumer trends. While competitor Apple is busy building the "next big thing," Microsoft is good at doing what it does best: consistently growing earnings, proving its brand, and investing around the edges.

What do I mean by "investing around the edges?" A lot of bears, in my view, have criticized Microsoft for failing to succeed in multiple expansive efforts. Mobile and search have all been disappointing. And the acquisition of Skype has come under competition and be regarded as value destroying. For a company as successful as Microsoft, it can be expected that shareholders will begin to poke at the holes. The truth is that management is making an effort and may very well be the best equipped in the sector to explore growth opportunities. Technology has few barriers to entry, but Microsoft has a major foundation to work with.

I am particularly optimistic about the company's introduction of a tablet. Its device leverages the attraction of its upcoming Windows operating system. Note how the sleek touch-screen tablet was showcased with a keyboard when it was first unveiled. This was a nice way of leveraging a strength in PC to take away potential consumers of Apple. I know I have held up on buying a tablet in anticipation of Microsoft's commercialization.

Symantec

Most well known for its anti-virus software that refuses to allow users to easily uninstall, Symantec also provides security and storage solutions for businesses across the world. In fact, "Consumer" is just one of five segments. As a whole, the business is incredibly undervalued at a respective 8.4x and 7.3x past and forward earnings.

Growth has also yet to be fully factored into the stock price as indicated by the PEG ratio of 0.9 against the expectations for 9.3% annual EPS growth over the next five years. According to FINVIZ.com, however, the stock is only rated around a "hold." In my view, this is unwarranted given the firm's impressive fundamentals and free cash flow generation.

The $9.5B company generated $1.9B in operating cash flow last year with only $286M in capital expenditures. Operating cash flow has steadily grown from less than $1.7B in 2009 while Capex growth has been less than momentum. Put differently, Symantec has plenty of incoming cash to fund R&D and start paying dividends or buying out shares. News of either of these three options would be major catalyst for value creation for a firm that has, frankly, bored investors for over half a decade. Like Microsoft and CA, the excitement has been lost after the economic moat has been established. If management can launch greater takeover activity, for example, and showcase the areas of synergistic value, it can shed light on the vitality of its existing business.

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