As anyone following Apple Inc. (NASDAQ:AAPL) could tell you, tech companies rise and fall often based on fickle investor emotion. It’s all, in my view, a behavioral game, one that even Warren Buffett doesn’t want to dabble in. The best tech investors can do is to be cautious on short selling and look for growth opportunities that the market has overlooked. Below, I look at Red Hat, Inc. (NYSE:RHT) and Microsoft Corporation (NASDAQ:MSFT) with this in mind.
What Red Hat Is Doing to Excite the Market
Red Hat provides open-source software. It is particularly famous for its Linux operating system. In the third quarter, Red Hat’s revenues increased by 18% y-o-y to hit the $344 million mark, which was in-line with expectations. Subscription revenues experienced a 19% increase that enabled them to hit the $294 million mark. Billing also grew by 18%. More importantly, in the third quarter, the company announced the acquisition of ManageIQ. ManageIQ specializes in cloud management and automation. The acquisition is expected to be a long term gain for Red Hat. It is also an attempt to take on VMware, Inc. (NYSE:VMW) , a company that has managed to make inroads into enterprise through its vCloud platform but failed to enter the public cloud.
I believe the CEO of Red Hat is ultimately right: Companies are looking increasingly for open-source software. ManageIQ already supports great brands like Amazon Web Services, so it has the reputation necessary to lock away competition (read: VMWare). The market apparently has taken on the same attitude, boosting the stock price by 6% despite management guiding slightly below consensus.
Major emphasis is being placed on the cloud business, since this segment is seen as the next great cash cow. Many companies have invested in cloud technology, and Red Hat has seen this as an opportunity to upgrade the platforms of such companies. To succeed in these efforts, the company recently introduced several open source products for hybrid cloud computing. VMWare has similar software, which will compete with Red Hat’s, but I expect Red Hat’s will prevail because of its ability to support on-premise versions.
What Microsoft Corporation (NASDAQ:MSFT) Is Doing to Excite the Market
In my view, Microsoft Corporation (NASDAQ:MSFT) has taken too much of a beating in recent days. Its Surface tablet has been characterized as “dead in the water” before demand could even build up. To be clear, what the market doesn’t understand is that Microsoft is a global leader in software development and licensing. Like Red Hat, Microsoft Corporation (NASDAQ:MSFT) is also looking to invest in cloud computing yet they are not able to achieve the same premium multiple that Red Hat commands due to their image as an “overly mature” tech company.
Well, the market is wrong. Microsoft Corporation (NASDAQ:MSFT) can leverage its Office products into the cloud while launching new offerings. The company is in the final stages of working on Azure, which is a combination of IaaS and PaaS. Azure allows for cloud hosting and provides turnkey solutions that allow for scaleable app development, media distribution, and data management, among other options.
Microsoft Corporation (NASDAQ:MSFT) has seen a decline in its share value from around $31 to as low as $26. Some investors are positive that the value will increase soon and are seeing this as a golden opportunity to buy this blue chip stock. There are also prospects that the current CEO may be kicked out of office, and this may bring a wind of change. I believe this will benefit the company, since so much of the company’s discount is due to poor past execution. There really is little doubt, in my view, that Microsoft will find its forte with its current resources. If it can pay strong dividends and still maintain a healthy balance sheet, it has the capability of investing in the next “big thing.” Microsoft has $66 billion in cash, which, to put into perspective, is enough to acquire Netflix, Inc. (NASDAQ:NFLX) seven times. Remember, Microsoft was the same company that brought you Xbox, so it knows how to execute if given enough chances.
Microsoft earlier acquired Skype, which has millions of followers and generates billions in earnings. And Windows 8 is also doing better than what the market recognizes, since it has already sold some 60 million copies. Its sales have been affected by substitution of tablets. In my view, the weak sales of Surface were due to the heavy price tag of around $500 to $600 compared with others that cost as little as $159. But, now that Microsoft has learned from its mistakes, it can now focus on opportunities.
Conclusion
In my view, Microsoft is a much more attractive stock than Red Hat. While the former is undervalued, the latter is overvalued. Only in public stock markets could companies like Red Hat command a multiple many times that of Microsoft despite having much less cash resources to expand in a market with few barriers to entry. At only 8.7x forward earnings, Microsoft is simply a bargaining waiting to be jumped on by value investors. Certainly, few are short the stock–only 1.1% of the float is being shorted. Free cash flow is now yielding nearly 10% while volatility is just under that of the S&P 500. This sounds like a lot of value for little cash commitment.
The article 2 Tech Firms Trying Desperately to Excite the Market originally appeared on Fool.com and is written by David Gould.
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