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A Savvy Play on the Red-Hot Software Merger Trend

1 | By Michael A. Robinson

The software sector is about to get a whole lot more profitable.

Here’s the thing. I focus on software firms because so many of them boast very high profit margins.

And in the era of cloud computing, they can upsell products to their clients with very little extra costs – but tons of extra earnings.

But while this is a red-hot trend from which we can profit from years to come, there’s a new dynamic reshaping the whole sector.

Of course, I’m talking about a recent wave of mergers that will mean even more earnings growth for the buyers, not to mention more upside for savvy tech investors.

Consider that two big deals were recently announced just days apart.

In the first, Alphabet Inc. (Nasdaq:GOOGL) said it’s buying privately held Looker for $2.6 billion. The second deal calls for Salesforce.com Inc. (NYSE:CRM) to buy Tableau Software Inc. (NYSE:DATA) for $15 billion.

Today, I’m going to reveal an investment tailor made to capture the software merger trend. I’ll also give you two more market-beating ideas…

Check it out…

Why I Like Software Firms

Now then, you’d be hard pressed to find a bigger software bull than me.

I’ve been recommending software firms for some time now. It’s a lucrative field because well run software firms consistently generate big profits and rivers of cash.

Fact is, these firms don’t have to invest billions in plants and equipment the way hardware companies do.

Plus, with software, it’s like we’re becoming high-tech landlords. See, the industry runs on a licensing model, meaning that software firms often “rent” the use of their products rather than sell them outright.

The sector also has another new trend pushing it forward – cloud computing in which products are delivered via the web. That means no expensive CDs or boxes to ship to clients.

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Let’s be clear about what’s up for grabs here. The Department of Commerce says the U.S. boasts the most advanced software and information technology (IT) services industry in the world.

More than a quarter of the $3.8 trillion global IT market occurs right here at home. The industry accounts for $1.14 trillion of U.S. value-added GDP, and 10.5 million jobs.

Even better for investors, the growing consolidation means that the buying firms are about to boost their profits even further. That’s the beauty of bolt-on buyouts – the results fall to the bottom line pretty quickly.

This dynamic helps explains why there are so many software mergers of late.

Surveying the Buyout Landscape

A recent report by forecasters Jegi/Clarity says software mergers in the first quarter swamped all other sectors. Indeed, software made up 43% of the $80 billion produced by the five leading fields.

We’re talking a total of $54.3 billion. That’s a little more than 10 times the value of second-biggest sector, business media, which comes in at $5.3 billion.

Now then, I have recommended both Salesforce and GOOGL several times in the past. After their announced mergers, I like the stocks even more.

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Salesforce is smart to buy Tableau. That’s because Salesforce rents out software for customer relationship management. In turn, Tableau allows companies to build databases, spreadsheets, graphs and maps right from their data.

It’s a natural marriage that improves the quality of Salesforce’s offerings. The pact also centers on the fact that many Salesforce clients already work with Tableau, which boasts 86,000 customers.

In the Google deal, the merger allows the firm to improve its cloud offerings by helping clients manage the data they store there. Bloomberg says the deal is Google’s biggest since it bought smart-home company Nest Labs for $3.2 billion in 2014.

However, as much as I still recommend both stocks, I’m mindful of the fact that many savvy tech investors want to be able to cover the entire waterfront of software’s busy M&A activity.

A Savvy Software Play

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And that’s why I also suggest taking a stake in the SPDR S&P Software & Services ETF (NYSE:XSW). This is an all-encompassing exchange traded fund (ETF) that gives us a broad play on some very intriguing companies.

Then again, it holds roughly 154 stocks. That’s one of the things I really like about XSW — software in general and this ETF in particular touch a wide swatch of the global tech ecosystem.

Specifically, XSW has invested in firms that are involved in e-commerce, social networking, data processing, internet software, cloud computing and Big Data.

Of course, XSW does hold the obvious big-cap firms like Microsoft Corp. and Oracle Corp. (NYSE:ORCL).

But what makes this such an exciting investment is you get the stability of mega-cap leaders combined with an intriguing mix of smaller, growth-oriented firms. I’m talking about companies like:

  • Blackbaud Inc. (NasdaqGS:BLKB) has a very unusual niche for a publicly traded software firm. The company is focused on providing services for non-profits that includes research foundations and universities. In reality, this is a smart business model because there are thousands of such agencies in the U.S. alone handling billions in fundraising activities.
  • Cadence Design Systems Inc. (NasdaqGS:CDNS). This actually is a great double play that lets the fund and its investors benefit from the semiconductor boom. That means it touches everything from laptops to smartphone and tablets to consumer electronics. The firm is a leader in providing software and other services that help chip makers design and test the quality of their products.
  • Envestnet Inc. (NYSE:ENV). Founded in 1999, Envestnet is a major tech supplier to the nation’s financial service industry. The company’s software products support more than 32,000 professional advisors and some 2.3 million investor accounts that cover combined assets worth more than $570 billion.
  • Science Applications International Corp. (NYSE:SAIC) offers information management solutions that make use of advanced warning sensors, deep computer analytics and electronic records management. The company also conducts computer forensics to look for identity theft, unauthorized network access and to support law enforcement.

Trading at $94, XSW is very cost-effective investment vehicle because it covers the entire software sector in the midst of a consolidation. So, we benefit from both buyers and sellers.

I think the timing for this ETF is particularly good. Since the market rebounded last Dec. 24, the S&P 500 has gained a very nice 23%.

By contrast, XSW is up 34%, meaning it beat the broad market by roughly 48%.

Given the high profit margins and earnings growth software offers, that trend looks to continue for years to come.

In other words, this is a foundational play you will want to hold for the long haul.

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Cheers and good investing,

Michael A. Robinson

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