By Eliot Murray+ Disclosure: I am long ORCL.
Business and Moat
Oracle is the world's largest provider of enterprise software and a leading provider of computer hardware products and services. They make money by selling these products and services to medium and large companies across the globe, including all 100 of the Fortune 100 companies and most of the Fortune 1000 companies.
Oracle is a business with a wide "moat" as Warren Buffett might say, or one with a sustainable competitive advantage as Michael Porter would tell you. This is evidenced by their returns on capital being in the mid 20%s every year for at least the past decade. Whenever a business can consistently earn that type of ROC, they have achieved an economic moat through which their competitors have not been able to traverse.
Oracle's bread-and-butter is software, contributing $27.5 billion of its $37.2 billion in revenues last year. Within the software business, $17B of the $27.5B comes from software updates and product support. The other $10 billion is from new licenses and subscriptions. In other words, Oracle's business model is a very "sticky" one in that its customers can't or don't want to sever the business relationship they have in place. Once an annual software license is up for renewal, most of their customers readily sign up again for the next year of support/maintenance (an estimated 95% of customers renew, according to Trefis.com). Take a look at its most recent 10-K regarding its growth outlook:
"We believe that software license updates and product support revenues and margins will grow for the following reasons:• substantially all of our customers, including customers from acquired companies, renew their software support contracts when eligible for renewal;• substantially all of our customers purchase software license updates and product support contracts when they buy new software licenses, resulting in a further increase in our software support contract base. Even if new software licenses revenues growth was flat, software license updates and product support revenues would continue to grow in comparison to the corresponding prior year periods assuming contract renewal and cancellation rates and foreign currency rates remained relatively constant since substantially all new software licenses transactions result in the sale of software license updates and product support contracts, which add to our software support contract base; and• our acquisitions have increased our software support contract base, as well as the portfolio of products available to be licensed and supported."
From Page 10:
"Historically, substantially all of our customers, including customers from acquired companies, renew their software license updates and product support contracts when the contracts are eligible for renewal.""Excluding the effect of unfavorable currency rate fluctuations, software license updates and product support revenues increased in fiscal 2013 as a result of new software licenses sold (with substantially all customers electing to purchase software support contracts) during the trailing 4-quarter period, the renewal of substantially all of the software support customer base eligible for renewal in the current fiscal year and incremental revenues from recent acquisitions."
Although the above bullets are very enlightening and they reveal the valuable gem that is Oracle's renewal business, I want to reiterate one sentence from the above: "Even if new software licenses revenues growth was flat, software license updates and product support revenues would continue to grow in comparison to the corresponding prior year periods…" This really highlights the solidity and resiliency of Oracle's core business. I will present a scenario below that further illustrates the point that even if new licenses decreased materially, the recurring revenue from renewals and updates would keep Oracle buoyant through even dire economic straits.
Oracle's customers face high switching costs when pondering whether or not to switch to other vendors for their software needs. And why would they? Oracle boasts some of the best enterprise software on the planet, evidenced by its leading market position. Once the software is purchased and in place, employees need to be trained on it to learn the systems. A company would be taking a hit to productivity if it decided to switch to another software platform, once again having to navigate the learning curve instead of adding value elsewhere. The last thing a Fortune 100 company wants to do is inhibit productivity. And as these premier companies continue to grow, Oracle will be there along the way serving their needs (and collecting their renewal and support fees). This type of customer loyalty is reminiscent of Peter's reply to Christ when asked if he too would desert Him: "Lord, to whom shall we go? Thou hast the words of eternal life."
To a lesser degree but also important: even the employees of these companies face high switching costs when changing jobs. All other things being equal, a job candidate who is evenly matched with the next guy, but is not familiar with E-Business Suite, Hyperion, PeopleSoft, Siebel, or (insert business application here), will lose out to the person who is. Oracle has positioned itself in the marketplace as a creator of standards for the IT environment in most companies. There are numerous credentials and certifications that Oracle has developed for IT professionals that are looked highly upon in business circles.
Oracle also enjoys a halo effect in that its enterprise hardware and software solutions, product support, and services all complement each other well. This brand equity will spill over into the Cloud eventually. Oracle knows that the name of the game for the cloud is ease of integration for customers, which was the reason that Oracle and Salesforce.com (CRM) - the largest Cloud player currently - have teamed up to guarantee application integration on both companies' products. To some extent, this lends credibility to Oracle's Cloud efforts, and it extends Oracle's reach in that Salesforce.com will now be standardizing on a lot of Oracle's platforms. In the end, it enhances customer experience, which is a net positive for the customer and for Oracle's brand.
As Oracle's business continues to shift towards a product mix that is more heavily weighted towards software, service, and eventually the cloud, margins will continue to expand. And as the software businesses increases (through organic growth and strategic acquisitions), that recurring "stickiness" of renewals and support revenue will become more and more of a value driver, with direct margins approaching mouth-watering levels of ~100% (see below chart of segment reporting, where current margins are 94%).
100% of $17 billion equals $17 billion. That's efficiency. It's also a lot of moolah.
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Strategic Acquisitions
Oracle has made some sizable strategic acquisitions lately: Acme Packet for $2.1 billion, RightNow for $1.5 billion, Taleo for $1.9 billion (both net of acquired cash and debt), and Eloqua for about $900 million. The latter three expand ORCL's SaaS solutions and fit into the company's longer-term focus of entering the Cloud. Some may have concerns of overpayment for these businesses, and I don't have the real estate in this article to analyze each acquisition in detail. Suffice it to say that shareholders should sit back and trust Larry Ellison's track record of acquisitions over the past decade (Sun, PeopleSoft, Siebel, Hyperion, etc.).
Valuation
For the most part, Oracle has missed out on the 40% two-year rally that the S&P 500 has enjoyed, even though it has grown its cash flows by roughly 40% in the same period. Why is this?
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In March, ORCL fell over 9% after Oracle's earnings didn't meet Wall Street's estimates. Oracle had forecast a 3 to 13% increase in new software licenses and cloud subscriptions for Q3, but the company posted a 2% drop. Overall, the company's revenue fell 1% to $8.7 billion, missing analysts' estimates of $9.38 billion.
In June, shares fell another 8% after another quarter of missed revenue targets. The revenue was off-target by 0.9%. Ever heard of an overreaction? Analysts that expect higher growth may suffer from short-term memory loss, forgetting that last Q2, new license in cloud revenueincreased 18% in constant currency. So, growth from that already-inflated base may be hard to come by, at least in the short term.
While it may be - on the surface - concerning that Oracle has missed its own targets for software and cloud revenues, I chalk this up to timing. As mentioned above, Oracle has made some strategic bets in the area of Cloud services to the tune of $4.5 billion. This means Ellison is very serious about chasing this new frontier. Plus its openness to make mutually beneficial deals with salesforce.com in order to expand their reach and legitimize their offerings lends optimism to the future of their cloud. Also exciting is the fact that Oracle just acquired Nimbula, a leading provider of private cloud infrastructure management software. What makes this exciting is that it also "acquired" Chris Pinkham, its founder, who was also the creator of Amazon's (AMZN) highly successful Cloud product. Pinkham is now employed as SVP of Cloud Development at Oracle and should give Oracle's cloud a shot in the arm.
There is a well-known story about Abraham Lincoln in which after his election, he gave his most vicious opponents seats on his cabinet. When asked why he didn't destroy his opponents, Lincoln replied, ""Do I not destroy my enemies when I make them my friends?" Oracle has a knack for making its enemies (competitors) its friends (subsidiaries). With a cash hoard of $39 billion, Oracle can easily enhance their cloud offerings with any needed tuck-in acquisitions or bigger strategic plays. While salesforce.com and Amazon may be leading the way in the cloud, there is room for Oracle to gain its fair share in a market in which Gartner expects that $677 billion will be spent in the next three years on cloud services worldwide. In a corollary to that, I think salesforce.com is a serious short, and could be a possible takeover target for Oracle with any drastic drop in share price.
All the above being said, there is truly no telling in which specific quarter these bets will pay off, so the stock may languish for a few quarters until growth results are made clear. But at that point, the market will have the cloud priced in and it will be too late to jump in on the alpha.
With quarterly cash flows of $6 billion adding to that already large pile of cash, I consider holding Oracle's stock right now as analogous to a growing annuity (profitability per share is growing steadily even if revenue is currently not) of around $3.00 per share per year (~10% yield and growing, at current prices), with dividends and buybacks on top of that, with an added "option play" on cloud services. The market is clearly not pricing in any success with the cloud, and I consider this a free "option" as an upside when cloud wins are made more visible and earnings are more clearly forecasted.
Best Case
Since 2009, Oracle has grown its free cash flows by around 15% per year. Working capital is a contributor to Oracle's free cash flow because of the nature of up-front cash payment for licenses and renewals, but nevertheless is a marginal amount of its FCF (in the single digit percentages), so the FCF is well-representative of Owner Earnings, Buffett's famous measure of true profitability. Plus, it doesn't hurt that this is paid up front in cash to Oracle.
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If this growth was continued into the next few years at 15%, then gradually decreased to 5% by 2023, with net cash of nearly $15 billion, this would yield an equity value of nearly $60 per share (at a discount rate of 10%, the market's long-term average).
This scenario assumes no more acquisitions for the future. So, is this reasonable? Probably not, considering that acquisitions are part of Oracle's core competency.
Base Case
If acquisitions were thrown into the picture, the situation would look more like this:
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The scenario assumed here is that acquisitions cause a drag on total FCF, as well as growth in FCF. On the flip side of the same coin, though, the future growth of FCF is assumed to be constant at 12% into 2023, assuming that strategic acquisitions help sustain the growth of the business (in other words, no tapering off of growth like in the first scenario).
This would yield a value of $46.50/share:
Worst Case - Decline in New Licenses
In putting together a scenario in which the market's fears come true (no growth in new software revenues), renewals from the existing customer base still serve to protect the downside. The list of assumptions in this scenario includes:
- New software license and cloud revenue decreases by 3% per year from levels of $10.4 billion in '13 to $9.4B in '16
- Renewals continue on at their 3-year CAGRs of ~7% (this is not unrealistic assuming that price increases due to CPI make up a large percentage of this increase, perhaps 2-3%, not to mention the fact that Oracle possesses pricing power due to high switching costs for their customers)
- Hardware revenues continue to decline at rates of -13% per year
- Service revenues continue to decline at -3% per year
- SG&A expense increases from $10 billion per year in '13 to $10.9B in '16 (this is probably too draconian because incremental software business renewals does not require much in terms of added back-office support; also, less Opex will be needed because of declining hardware and service segments)
- Tax rates hold steady at 24% (average of last 3 years)
- Share count remains steady at 4.7 million, although this may be conservative because of Oracle's recent $12 billion buyback program)
The resulting picture is an aggregate growth rate of only 2% for revenue, while direct margins grow at 4% to reflect higher margin software renewals as a higher mix of revenue.
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This pessimistic scenario is that the slow-growth-rate business may command an 11x multiple (its lowest multiple in 10 years) on its shares, yielding a value of $28.80 in 2016. However, is this realistic? The share count represented above is probably too conservative, with the $12 billion in buybacks already announced. This would reduce shares outstanding to around 4,300 (adding over $2.40/share in value). Also, as mentioned, Opex will probably not need to be increased by that much ($10B to nearly $11B). If Opex is held constant at $10B, it would add $1.46 per share in upside to the above scenario. And finally, Oracle has a treasure trove of cash that will enable them to buy themselves into the Cloud market if their internal product development does not do the job. So the decrease in new software licenses in the above scenario may be too drastic. If the scenario were tweaked to show this segment growing at historical 3-year CAGRs, it would add upside of $1.69 per share. All of the above addbacks to this scenario equal an upside of $5.55 to the $28.80 value, yielding a total equity value in this scenario of $34.35. I consider this to be a floor for the value per share of Oracle, which happens to be 4% above ORCL's current stock price.
Catalysts
- Larry Ellison, the founder and CEO of the company, is at the helm and doing what he has always done: creating shareholder wealth by allocating capital well. His interests are aligned with other shareholders, as he owns 28% of the company.
- Steady dividend increases.
- $12 billion approved buybacks.
- Cloud services are a growth area for the company and should see above average growth, as well as higher margins. This will be nice incremental growth layered over a base of recurring revenue from renewals and updates.
- Increased institutional activity. Donald Yacktman has increased his holdings of Oracle in the most current quarter.
- Source:http://seekingalpha.com/article/1751572-oracle-40-upside-and-more-for-patient-investors
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