Future Looks Bright for Computer Associates

January 28, 2004 - TheStreet.com: Street Insight

• I'm satisfied with CA's performance in the latest quarter; plus, its organic growth numbers look good.
• I love companies with recurring revenues -- they have less operational volatility and usually have to do less to grow.
• CA has an attractive valuation, an improved corporate and financial profile -- and, likely, a brighter future.

I received several emails asking if my views on Computer Associates (CA) have changed. I believe CA at $27 is more attractive than it was at $29 or $30. I am satisfied with CA's performance in the latest quarter -- its revenues and cash flows showed solid growth. (Remember that the EPS number is meaningless since it doesn't depict economics of the business; my understanding is that the stock is trading on operating or free cash flows). Organic Growth Numbers Look Good CA's organic growth numbers look good. CA reported 8% growth in revenues; however, the weakening dollar and the Netegrity acquisition contributed 5% to sales growth. Thus, year-over-year organic growth was 3%. In addition, last year CA changed the way it recognizes revenues in its channel business, so last year's results had more up-front revenues. After adjusting for that, organic growth in revenue in constant currency was 6%. I am not looking for excuses to bump CA revenues higher, however, in my analysis I always look for core operational results that would help me to predict future performance. Subscription revenues are up to 68% of sales from 60% last year. A larger portion of subscription revenues make CA's overall revenues and operating performance more predictable. I love companies that have recurring revenues since they have less operational volatility and usually have to do a lot less to grow their businesses. Plenty of Growth Lies Ahead The balance sheet has never looked better. CA issued $1 billion of long-term debt and will use the proceeds to pay off a bond that is maturing in April 2005. The company ended the quarter with no net debt and a net cash position of $28 million (debt minus cash). Recent acquisitions are a success and integration is on track. The Netegrity acquisition was closed 45 days ahead of schedule. PestPatrol will give CA valuable experience selling software to retail customer through traditional retail channels or online. Interestingly, CA expects PestPatrol to generate $10 million in annual profits. CA only paid $39 million for the company, so that's a very nice return on investment. There is plenty of growth ahead. CA expects to grow revenue in mid-to-high single digits -- I believe those numbers are achievable in the long run. Cash flows should grow at a faster pace due to significant operational leverage that the software business brings. Retail Channel Will Be Important Driver CA is expanding sales to new uncharted geographical areas (i.e. the Middle East). In addition, other geographic areas such as China, Asia-Pacific and Japan showed nice growth in the quarter. I believe the retail channel will become a very important driver of future growth, as some (not all) of the CA products are a perfect fit for the retail channel. Also, though the mainframe business is perceived as a no-growth business, the latest IBM numbers showed that mainframe business is up and kicking, thus there is plenty of growth left in mainframes for CA. I believe acquisitions will become a very important part of the CA growth strategy; however, I don't expect CA to make acquisitions of enormous proportions. Netegrity and PestPatrol are good examples of the types of acquisitions we will see in the future -- small and strategic. Given CA's attractive valuation, lack of huge stock options expense, much-improved corporate and financial profile and a fairly predictable and brighter future, I am still a buyer of CA stock. (not a recomendation)

Vitaliy N. Katsenelson, CFA

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