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Some Alternatives to the Application Software Giants
Posted by: Damian Illia (IP Logged)
Date: October 23, 2013 10:19AM

While most of you investors might know a few application software companies, such as Sap AG ADR (SAP), Salesforce.com (CRM) or Adobe Systems (ADBE), the three largest in that order, there are other big players in the industry worth watching. But, with analysts expecting Salesforce.com to deliver average annual EPS growth rates around 27% to 28% over the next five years, is it possible for other companies to do better?

I take a look into Fair Isaac Corp (FICO) and Dassault Systemes SA ADR (DASTY), two large application software firms, in order to find out if they can outperform the leading corporations in the industry.

Network Effects and High Switching Costs

Dassault is the larger of the two firms here analyzed, with a market capitalization of almost $15 billion. After the company released its preliminary third-quarter results for 2013 on the week of Oct. 7, the stock plummeted substantially. However, it started to recuperate on Wednesday, Oct. 16, regaining some of the lost ground. Now trading around $120 per share, or 33 times its earnings, the stock looks fairly valued, especially when compared to its industry mean of 48.3x.

One thing to highlight is Dassault's shift towards a recurring revenue model. Actually, about 70% of group revenue is already recurring. This provides the company with greater earnings predictability and consistency.

Although future competition might concern you, high switching costs and network effects should help the company maintain its leading market position over the long term. In addition, both acquisitions and internal development are expected to drive revenue going forward. Particularly, strong investments in the company’s new 3DExperience platform are expected to strongly contribute to revenue growth in the years to come. Additionally, the development of cloud-based applications bodes well for the company as more people chose to migrate to this platform.

Dassault becomes particularly attractive when its fundamentals are compared with its peers (although Fair Isaac's valuation and return on equity are better):

Dassault Ind. Avg. Fair Isaac Salesforce.com
Price/Earnings TTM 32.9 48.3 25.1
Price/Book 4.3 5.0 3.9 11.7
Price/Sales TTM 5.3 4.4 2.8 9.1
Rev Growth (3 Yr Avg) 17.5 12.8 2.4 32.7
Net Income Growth (3 Yr Avg) 25.4 23.4 12.2
Operating Margin % TTM 23.8 13.9 20.6 -4.6
Net Margin % TTM 16.1 9.1 11.2 -6,7
ROA TTM 8.5 5.5 7.4 -3.7
ROE TTM 14.1 10.3 18.0 -9.9
Debt/Equity 0.1 0.3 0.9 0.5
Source: Morningstar

Ken Fisher´s Fisher Asset Management holds $5,809,000 of this stock. The question is, should you?

Valuation and Value

Even more attractively valued than Dassault is Fair Isaac. However, this reflects less confidence from the market. Actually, analysts expect the company to deliver average annual EPS growth rates around 8.5% over the next five years, less than half its peers´ average.

A few days ago, the company released preliminary revenue and EPS figures for the quarter, which will come in below expectations. Although this does not affect the long-term outlook, “It does help confirm our view that the growth rate implied by the current stock price is overly optimistic” (Morningstar).

Debt levels are also worrying at Fair Isaac. With a 0.9 debt-to-equity ratio, its situation is much worse than most of its peers. Moreover, the company´s high dependency on the banking and insurance industries (about 80% of its revenue comes from them) makes it particularly susceptible to the swings in the financial world, reducing earnings predictability. Finally, competition from other companies like VantageScore (which is being backed by some of the company´s database partners) raises more eyebrows.

Investment gurus seem to have picked up on this a while ago. Ken Fisher (Fisher Asset Management LLC) reduced his stake at the company by more than 28% a few weeks ago, while Joel Greenblatt (Gotham Capital) sold more than 55% of his shares during the previous quarter. However, other hedge funds Israel Englander´s Millennium Management and Steven Cohen´s Sac Capital Advisors increased their shares over the last quarter.

Although the aforementioned factors dissuade me from buying this stock at the time, I would still keep track of it: an interesting investment opportunity could emerge. A new management took over after the financial crisis and seems to be putting the firm in the right track. Other segments focused on predictive analytics are not as attractive and need some fine tuning. Overall, the company shows potential but needs some fixing before it can rise.

One Pick in the Application Software Industry

Dassault offers better fundamentals than both Fair Isaac and Salesforce.com. Although the latter´s growth projections are much more encouraging, Dassault looks like a safer choice that offers value for money. Enjoying strong network effects, high switching costs and good prospects for its current investments, this is a company that you should consider adding to your long-term portfolio.

Disclosure: Damian Illia holds no position in any stocks mentioned.



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