Is CA an Acquisition Target?

Is CA an Acquisition Target - Let's Look.

CA is one of the largest software companies in the world with a broad product line and highly recurring revenue stream. CA shares moved up almost 27% since late June of 2009, but looking forward the picture is less clear. How does this company generate meaningful returns on a go forward basis? Is it likely to return to its acquisition strategy or has it itself become a target?

What is Next for CA? - Summary - Full text available to subscribers

For investors with interest in CA one key question stands out: How does this company generate meaningful returns on a go forward basis? In June of this year, we were significantly positive on CA shares and highlighted that CA had similar operating characteristics to BMC Software (BMC) and near identical MGI-X measurements but at the time, the company was trading at a discount to BMC’s EV/Revenue multiple.  Since then, CA shares have moved up from $17.62 on June 25^th 2009 to $22.44 on September 23^rd 2009, or a gain of about 27% (+$0.04 dividend) while BMC shares have appreciated by 11% during the same period.

In the past, CA’s growth was based largely off its aggressive and effective acquisition strategy which came to a grinding halt amidst accounting violations. Now, with a completely new management team, the era of relentless acquisitive growth appears like ancient history. Coming out of the trauma of financial restatements and legal drama, the company emerged as a much more stable enterprise, and it has also largely relinquished its mantra of an aggressive software industry consolidator. At the same time, CA has not replaced its growth through economic acquisitions strategy with a new approach that can deliver long-term growth above that generated by cash flows from software maintenance. Partially that was the after-effect of the major legal events that ensnarled the company for years and partially it was due to a lack of meaningfully sized acquisition targets.

Looking forward, we see CA shares as relatively fully valued at their present level of earnings unless a non-linear event takes place. Acquisition of CA, acquisitions by CA or a plain vanilla earnings surprise all fit the bill of the non-linear event. Additionally, the uncertainty generated by retirement of the present CEO John Swainson by CYE 2009 is likely to keep a lid on CA shares until a replacement is announced. This management transition creates both opportunities and risks with regard to CA shares. A potential organizational instability as the company heads into its all-important fourth quarter of FY 2010 is hardly helpful from a timing standpoint. At the same time a choice of a new and dynamic CEO could propel CA shares up. Short-term we see CA shares as vulnerable to a consolidation pullback. 

Who Are the Likely Partners?

The few opportunities that CA has by now has surely considered include a tie up with either Symantec or BMC, but both in our view would look more like mergers. In our first rule of M&A, there are no mergers, only acquisitions and CA management is not likely to be comfortable with either transaction unless they can stay in the driver’s seat. An acquisition of Compuware, McAfee or Quest Software would better fit into the type of transaction that CA would feel comfortable with once its own CEO succession is resolved. In the meantime, CA does remain one of the largest software companies in the world and has ample resources to acquire smaller public private growth companies in areas such as virtualization management and security.

About 24% of CA shares are held by Walter H. Haefner, a Swiss businessman who at the age of 99 happens to be the world’s oldest billionaire. There is a potential for a transaction due to an inevitable generational transition, but at present we believe that the estate taxes would not in isolation trigger a sale of the Haefner stake. The field of companies potentially interested in acquiring CA is somewhat limited. IBM could not acquire CA on anti-trust grounds as the FTC and US DOJ are both likely to further tighten anti-trust regulation in the next 9-12 months. HP could acquire CA and such a transaction would make economic and product sense. Combining HP and CA would propel HP into a stronger competitive position vis-a-vis IBM, but given that HP is currently absorbing EDS we do not expect HP to be back at the major buyers table till at least middle of 2010. It’s worth noting that CA board member Gary Fernandes is a former vice-chairman of EDS, and has worked for EDS for nearly 30 years.   EMC is another potential buyer of CA that could through an acquisition of CA generate meaningful operating efficiencies in R&D, channel and G&A. Microsoft is not a buyer of CA for this kind of combination would not fit its focus and vision. We mentioned Symantec above as a potential merger partner and would place a low probability on Symantec coming after CA in a takeover. Dell could benefit from an acquisition of CA, but we would place less than 5% probability on this scenario as Dell is busy with the Perot Systems transaction and the heavy mainframe component of CA product line would be a turnoff for Dell.  An “out of left field” offer from an on-shore/offshore services provider like Wipro, Infosys, Cognizant or Tata would appear to fall short of resources necessary to pull it off. We would completely discount any chance of SAP buying CA, but we could not make the same prediction about Oracle, even as it appears for now to be tied down with the acquisition of Sun.  While a remote possibility does exist of a private equity firm of a caliber of Silverlake or General Atlantic buying out Haefner’s 24% stake in CA, a more likely but still remote scenario would involve a private equity firm investing into a buyout transaction of CA by an industry player with an established management team.

So the field of potential buyers for CA is relatively short with HP and EMC topping the list and thus one should not expect a large take-out premium in the stock. In the meantime, CA has ample room to improve efficiency and drive earnings growth through internal initiatives. CA’s MGI scores for the Q1 June quarter continued a trend of improvement both for the MGI-X and MGI-CV components. CA’s MGI-X now stands at 1,622 and the MGI-CV has finally turned positive at +16% vs. -10% for the March 2009 quarter, and -16% for the December 2008 quarter.   There was no single driver that stood out behind the improved scores, as CA across the board improved its gross margin and efficiency of its spending both for SG&A and R&D.   Management appears increasingly confident with the relative strength and durability of its revenue opportunity as well as continued improvement in cash flow.   The improvement in MGI scores suggest to us increasing likelihood of a positive earnings surprise in the Sept and Dec 09 quarters although the magnitude may be modest. The downside risk in CA is relatively contained, given the high levels of renewals and the fact that deferred revenue stands at 57% of all reported revenue (vs. 62% in FY08). While on a Y/Y basis both reported and deferred CA revenues were down slightly in June 09 quarter, the rate of decline in deferred revenues is smaller than the decline in reported revenues.

Bottom Line: CA shares have appreciated 27% since we last highlighted them in late June 09. Short of any non-linear event, CA shares appear to be range bound between $20 and $24. As the uncertainty surrounding a new CEO clears, we would expect the shares to rally modestly outside of this range. There is a non-zero probability of CA being acquired in the next 12 months. Chances of CA pursuing any major acquisitions in the near term are not likely given the CEO transition.