Does BMC Software Offer Durable Value?

By Stephen D. Simpson, CFA | September 13, 2012 AAA

I've said it plenty of times, but some ideas are worth repeating - value-priced tech stocks seldom outperform in the absence of growing investor confidence regarding growth or significant returns of capital to shareholders. While BMC Software (Nasdaq:BMC) looks undervalued by many different standards, the company's growth is unimpressive and there are growing questions about the competitiveness of its product offerings. As a high-value buyout doesn't seem especially likely, BMC is going to have to figure out a new path to growth if this stock is going to work well.

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Sluggish Performance Still a Problem
It's been quite a while since BMC has posted robust revenue growth (the average compound revenue growth rate over the past decade is below 6%), so the minimal reported growth in the second quarter really isn't a new development. That said, the double-digit organic declines in licenses in both enterprise service management (ESM) and mainframe service management (MSM) are problematic.

The declines in profitability are more troubling. Expenses rose by 11% in the second quarter, with double-digit increases in marketing and cost of maintenance revenue and a single-digit decline in R&D spending.

Although operating margins have been quite healthy in recent years, it's worth asking if that's sustainable. There's been a lot of sales turnover (especially in ESM) and that doesn't help margins, nor does the potentially flagging competitiveness/attractiveness of the company's offerings.

A Buyout May Not Be Likely or Rich
Whether or not BMC can (or will) sell itself is a significant topic of discussion. Investors Elliott Associates acquired a significant stake with the intention of agitating for a sale of the company. In response, the company adopted one of those so-called "shareholder rights" plans, while also reaching a compromise with EA where the company increased the size of the board by two members in exchange for EA no longer publicly pushing for a sale.

SEE: Analyzing An Acquisition Announcement

I just don't know if hopes and expectations for a sale are well-founded. I don't believe that there are many strategic buyers that would pay much for the company. IBM (NYSE:IBM) could certainly leverage BMC's position in mainframe database tools, but there could be antitrust problems. I wouldn't think that EMC (NYSE:EMC), Oracle (Nasdaq:ORCL), Cisco (Nasdaq:CSCO) or Hewlett-Packard (NYSE:HPQ) would have all that much interest, I don't think CA (Nasdaq:CA) would want such a big deal, and Dell (Nasdaq:DELL) now has to close and integrate its deal for Quest (Nasdaq:QSFT).

Speaking of Quest, I think that's an illustrative example of the issue. I bought Quest in part believing that the stock was significantly undervalued on the basis of its maintenance revenue stream. Unfortunately, tech acquirers just don't pay rich premiums for low-growth cash flow streams; Quest's buyout only got interesting when Dell came into the picture and outbid the original private equity acquirer. So while BMC may eventually attract a private equity buyer that sees the gap between the value of its cash flow and today's market value, the premium may leave shareholders dissatisfied.

Can BMC Be Better?
The good news for BMC investors is that the company is cash-rich (over $850 million in net cash) and generates a lot of cash every year. Now if there are, in fact, real issues with the company's products that cash flow may start to fade, that's a longer term risk at present. My point is that BMC has (and generates) the capital to reinvest in the business and/or buy in growth if management wants to go that route. I don't think investors will necessarily welcome that news in the short term (since it would be seen as a sign that the company is not looking to sell), but that may be the best chance for the company's management to drive better long-term value for owners. After all, if companies like IBM and Oracle can boost/sustain their growth with acquisitions, why can't BMC?

The Bottom Line
If BMC can just sustain 3% free cash flow growth, the stock's fair value would seem to be in the mid-$50s. Clearly there are no guarantees, as companies like IBM, CA, Oracle and HP are doing their best to take away business. The question, though, is whether the stock can outperform and realize that value in the absence of a bid from a strategic buyer or a significant capital deployment towards growth. I have real doubts about that, and so while I do think these shares are undervalued, it's hard to get excited about owning them today.

At the time of writing, Stephen D. Simpson has owned shares of EMC since September 2012

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