Commtouch provides security and antivirus software for deployment on routers and other network equipment. As the company has been growing revenue and earnings steadily at excellent levels of ROIC, it trades at a price to book ratio above 2. As such, potential investors in this stock should be sure to ascertain the sustainability of the company's earnings before jumping in; if earnings collapse, there aren't enough assets (e.g. cash, land, inventory etc.) to fall back on to protect the investor on the downside.
How sustainable are earnings in the software industry? The answer varies considerably from company to company. Because hardware improvements (both in performance and price) occur quickly, software companies must constantly keep programs up to date to keep pace with competitors. In this sense, software is one of those fast-changing industries that is best avoided.
But at the same time, certain software applications have a customer stickiness to them that provides incumbents the ability to remain leaders while enjoying strong capital returns. Oracle's databases may be such an example, as the integration of Oracle's systems with the rest of a company's infrastructure would create large costs for a company looking to switch. Microsoft's Office enjoys a different type of advantage, with the same effect of customer stickiness. Users are loathe to switch to a new or different application, as it is a priority to be able to create documents in formats that can be easily shared, creating a network effect.
So where does Commtouch fall on this scale? Commtouch's numbers clearly suggest a competitive advantage is present. However, from what I can tell, Commtouch doesn't appear to integrate deeply into its customers' infrastructure with the majority of its offerings. It sells its software to original equipment manufacturers that then sell solutions to network customers. If a competitor came out with a better mousetrap (i.e. one that filters spam in a more customized way or recognizes malware more quickly with fewer false positives) or the same mousetrap at a better price, I'm not sure what prevents the customer from switching.
But just because Commtouch may be out of my circle of competence doesn't mean it's out of yours. If you can spot an advantage that Commtouch is exploiting that is allowing it to earn outsize returns, this stock may be worthy of your portfolio at its current price. The company trades at less than 10x this year's earnings (ex-cash), suggesting shareholders will make out very well if its earnings are sustainable.
Disclosure: No position