Analyst Picks: 2 Software Stocks to Buy, 1 to Hold

Markets Motley Fool

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope.

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2017 has been a great year for investors in the software industry, where shares of Oracle (NYSE: ORCL), Adobe (NASDAQ: ADBE), and Microsoft (NASDAQ: MSFT) have all outperformed the S&P 500 stock market average by a factor of two (or more). And if you ask the tech experts at NYC-based equity research firm MoffettNathanson, these gains are likely to continue over the next year or so -- for Oracle and Adobe at least.

But not for Microsoft. Here are three things you need to know.

1. Soothsaying Oracle

Starting from the top, Oracle won one of two new buy ratings that MoffettNathanson announced today. As explained in a write-up on StreetInsider.com this morning, Moffett has high hopes for Oracle profiting from added scale in its cloud computing business, where sales surged as much as 73% year over year in the company's most recent quarter.

Fantastic growth in cloud computing has driven impressive growth in Oracle's stock price as well, now up 23.5% over the past year (versus just a 12.4% gain on the S&P 500). Most analysts on Wall Street are only looking for Oracle to grow earnings about 9% annually over the next five years, but Moffett is more optimistic, predicting "growth acceleration" in both sales and earnings. Given this, the analyst sees Oracle's present valuation of just 23 times earnings as "too low," and predicts the stock will hit $65 within a year -- a 27% gain from today's prices.

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2. A fan of Adobe

MoffettNathanson has similarly high hopes for Adobe, which the analyst values at $195 per share over the course of the next year -- a 26% gain from today's prices. Chalk that expectation up to a belief that Wall Street is underestimating Adobe's potential.

According to data from S&P Global Market Intelligence, most analysts are expecting Adobe to grow its sales better than 20% this year, grow just under 20% next year, and then start stepping off the growth pedal thereafter. Sales are predicted to rise just 17% year over year in 2019 for example, and decelerate further to sub-13% growth in 2020. Moffett, however, believes that Adobe's New (ish) subscription software business model can sustain "20% revenue growth for a period of time that is longer than the market is currently predicting." Furthermore, the analyst says Adobe will enjoy strong average selling prices on its products, which if correct should help Adobe to grow profits as fast as, or faster than, its sales.

Accordingly, even at a valuation much higher than Oracle's (Adobe shares sell for nearly 54 times trailing earnings), Moffett believes Adobe stock, too, is a buy.

3. But no fan of Microsoft

Last but not least, we come to Microsoft, and it's at about this point that MoffettNathanson finally runs out of optimism.

Although Microsoft has been a strong performer, with its shares up 28% over the past year, Moffett believes that Microsoft's growth days are mostly behind it. As explained in a write-up on TheFly.com this morning, Moffett believes that Microsoft will be unable to hit the profit margin targets that Wall Street has set for it going forward, and furthermore, will grow its earnings only in the "mid-single digits." This "limited earnings growth potential," warns Moffett, means that Microsoft shares are overvalued at 27 times earnings -- even though that valuation is only half the P/E of its preferred Adobe stock.

That's why, even as Moffett initiates coverage of Oracle and Adobe at buy, it's initiating Microsoft stock with only a neutral rating. While the analyst sees Microsoft stock rising perhaps 10% over the next year, to a target price of $81 per share, that's only par for the course for most stocks on average -- and thus apparently unworthy of a buy rating, in Moffett's opinion.

Final thought: Does Microsoft deserve a "buy" rating, too?

Personally, I think Moffett may be giving Microsoft too-short shrift. To understand why, let's consider how Microsoft stock compares to Oracle's on valuation.

From a price-to-earnings perspective, Microsoft costs a bit more than Oracle, carrying a P/E of 27 to Oracle's 23. Growth-wise, both stocks are expected to grow earnings at about 10% annually over the next five years. Both stocks sport strong balance sheets, featuring more cash than debt, a result helped by the fact that both Oracle and Microsoft generate far more free cash flow than GAAP accounting rules permit them to report as "net income."

So at first glance, it appears Oracle's only real advantage as a stock, versus Microsoft stock, is Oracle's lower P/E ratio. Dig a little deeper, though, and you'll see that advantage disappear.

By my calculations, Microsoft generated $31.4 billion in real cash profits (free cash flow) over the past year -- nearly 50% more cash profit than the company reported as "net income" under GAAP. With so much cash rushing into its coffers, Microsoft now boasts a cash surplus of more than $40 billion on its balance sheet, bringing its enterprise value down to just $527 billion, and giving Microsoft stock an enterprise value-to-free cash flow ratio of just 16.7.

Coincidentally, that's precisely equal to the 16.7 EV/FCF ratio of Oracle stock -- also a strong cash producer and bears a cash-rich balance sheet as well. With both stocks also expected to grow at similar 10% rates, therefore, I don't really see any reason for Moffett to recommend Oracle stock but not Microsoft's -- especially not with Microsoft paying the bigger dividend (2.1% versus Oracle's 1.5%).

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Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Rich Smith has no position in any of the stocks mentioned. The Motley Fool owns shares of Oracle. The Motley Fool recommends Adobe Systems. The Motley Fool has a disclosure policy.