Oracle Corporation (ORCL) sells a wide range of enterprise IT solutions, including databases, middleware, applications, and hardware. Software license and product support, the most profitable segment of the company's operations, accounts for about 67% of total revenue. An active acquisition program is a fundamental component of the company's overall strategy. Oracle has spent more than $38 billion on acquisitions since fiscal 2005.
Due to its large stack of products and solutions offerings, it competes with a very large set of companies, however International Business Machines Corporation (IBM) and SAP AG (SAP) are its closest competitors in terms of a match in the offerings, reach and the scale.
I. Qualitative Analysis
Each of these companies is a quality business with a seasoned management team and has grown its revenue, income and the free cash flow consistently over the last decade. Take a look at the following graphs showing the revenue, net income and free cash flow per share (after dilution) for ORCL, IBM and SAP, post the dot-com era.
Free Cash Flow/share, Earnings/share and Revenue/share
Following table shows the compounded annual growth rates (CAGRs) for the three companies:
Effective Tax Rate (12 years)
Diluted Shares Outstanding
* Effective tax rate shown for SAP is for last 8 years.
What you observe is the following:
A. Consistent revenue growth: The revenue is not easy to manipulate so this is a good sign.
B. Net income growing faster than revenue: This is generally a good sign indicating better expense management although sometimes the net income may have an artificial bump due to unconsolidated subsidiaries.
C. Free cash flow growing faster than the net income: For large tech companies it's very important to have lots of free cash flow so that they can supplement their organic growth by acquiring companies with innovative technologies. Excess free cash flow can also be used to enhance shareholder returns via stock repurchases and by issuing the dividends. The free cash flow growing faster than the net income usually means that the investment needed to sustain and grow the income is less than the non cash accounting charges (DD&A) on the income statement. It's especially true in the case of Oracle, whose modus operandi has been to acquire (software) companies with more of the intellectual property, intangible assets and less of the tangible assets on their balance sheets. As a result, the acquisition price has a large chunk allocated to intangibles, which are amortized and thus resulting in higher DD&A, as compared to Capex.
D. Consistent decline in the effective tax rate: For a big multinational company, this usually indicates that the company is effective in sourcing its income utilizing low tax geographies.
E. Consistent decline in the diluted shares outstanding: Ideally you want a company to purchase its shares when the stock is undervalued but despite the management possessing an edge in the state of the company affairs, they do not have a crystal ball to identify the bottom. Most companies purchase more shares when the stock is expensive because they consider themselves rich during such times. And when the going gets tough, most companies like to preserve the cash fearing the unknown when they should ideally be doing the opposite. The second best thing to 'share buybacks at low prices' is when the companies regularly repurchase the stocks, a bit like dollar cost averaging only on a much bigger scale. Oracle, IBM and SAP have been buying back their shares at regular intervals and ramped up the buying whenever the opportunity arrived.
As you can see from the above, it can't get better than that. All three companies displaying the qualities a shareholder wants. Where these companies differ is the extent to which they have been doing the good thing. We'll see more on this in the next section.
Switching Costs: Lots of customers have important sensitive data in Oracle databases. They have customized, stabilized and matured their applications and IT systems over many years and in a lot of cases over many decades. Any major change to such a setup has significant switching costs and the risks of unforeseen and unpredictable chains of events. You see, the CIOs risk losing their jobs in unleashing an unsuccessful switch. As a result, Oracle has over 90% customer retention rate and close to 100% of its customers pay for its reliable and quality support services. To be fair, a similar claim can be made for IBM and SAP, i.e. their customers also face significant costs and risks associated with switching, therefore once a customer is heavily invested into the ecosystem of one of these companies, they remain invested for a long time. For this reason, you see a lot of companies still using 20th century technologies such as COBOL, DB2, cics, VMS based systems and mainframes.
II. Quantitative Analysis
As you can see from the previous section, Oracle has been growing its revenue at 13.3% which is more than twice as fast as that of IBM (5.3%) and 60% faster than that of SAP (8.3%). Moreover IBM has been repurchasing its shares at 3.6%, so a large part of its RPS growth of 5.3% is really supported by its stock repurchases.
Look at the following graphs comparing current Price/Earnings, Price/Free Cash Flow and Price/Sales ratios of Oracle, IBM and SAP to their respective 7 year averages.
As you can see, Oracle, IBM and SAP are all trading at historical low valuations, however Oracle is the only company which is trading below its 7 year averages on all three valuation measures: P/E, P/FCF and P/S.
Now let's look at the current valuations of Oracle, IBM and SAP using P/E, P/FCF and P/S ratios.
As indicated by the graph above, this is how the measures stand out:
- P/E: IBM currently has the lowest P/E ratio (13.7), followed by Oracle (15) and SAP (22.8). Based upon the P/E, Mr. Market is valuing Oracle slightly higher than IBM, and SAP a whole lot higher than both Oracle and IBM.
- P/FCF: Oracle currently has the lowest P/FCF ratio (12.5), followed by IBM (18.7) and followed by SAP (31.7) i.e. Mr. Market is valuing SAP 250% and IBM 50% higher than Oracle.
- P/S: IBM has the lowest P/S ratio (2.1), followed by Oracle (4) and closely followed by SAP (4.2). In other words, Mr. Market is valuing both Oracle and SAP almost at par and IBM almost at half of these two. Regarding the lower P/S ratio for IBM, note that IBM has a higher operating leverage whereas the majority of Oracle and SAP's businesses have higher margins.
Now if you back out the cash these companies have, the ratios look like the following:
As indicated by the graph above:
- Cash-adjusted P/E: Oracle currently has the lowest cash-adjusted P/E ratio (11.9), followed by IBM (12.9) and followed by SAP (21.4). Based upon this measure, Mr. Market is valuing Oracle slightly lower than IBM, and SAP a whole lot higher than both Oracle and IBM.
- Cash-adjusted P/FCF: Oracle currently has the lowest cash-adjusted P/FCF ratio (9.9), followed by IBM (17.6) and followed by SAP (29.8) i.e. Mr. Market is valuing SAP 300% and IBM 77% higher than Oracle.
- Cash-adjusted P/S: IBM (with higher operating leverage) has the lowest P/S ratio (1.9), followed by Oracle (3.2) and closely followed by SAP (4).
The following graph compares a few other valuation measures e.g. Enterprise Value to Sales, Enterprise Value to EBITDA and Enterprise Value to free cash flow ratios.
As indicated by the graph above:
EV/Sales: IBM (with higher operating leverage) has the lowest EV/Sales ratio (2.25), followed by Oracle (3.51) and followed by SAP (4.14).
EV/EBITDA: Oracle has the lowest EV/EBITDA ratio (7.63), followed by IBM (8.89) and followed by SAP (11.96) i.e. Mr. Market is valuing IBM 16% higher than Oracle and SAP 57% higher than Oracle.
EV/FCF: Oracle has the lowest EV/FCF ratio (9.86), followed by IBM (14.96) and followed by SAP (25.37). In other words, Mr. Market is valuing IBM 53% higher than Oracle and SAP 260% higher than Oracle.
Considering the growth rates Oracle has achieved in the last 10 years, Oracle is clearly undervalued and SAP is overvalued among the three.
Intrinsic value of a firm is derived by the streams of the cash flow it brings in the future. We'll do a DCF analysis based upon the free cash flow. We make the following assumptions, which honestly speaking, are pessimistic for Oracle, IBM and SAP, considering the growth expected from them in the future and the kind of growth they have achieved in the last 5-7 years, a period which included the largest recession since the Great Depression.
Assumptions for DCF calculation
Growth Rate Year 1-5
Growth Rate Year 6 onwards
DCF calculation based upon Free Cash Flow per Share
Year 6 onwards
Intrinsic Value (Sum of Future FCF)
Discount to Intrinsic Value
Once again, Oracle is clearly undervalued and SAP is overvalued.
With such a strong free cash flow engine and a massive $32 billion in the war chest, I do not share the worry some market participants have that Oracle has lost in the cloud race. Oracle has faced threats in the past and in some instances multiple threats at the same time, but has not only survived all those onslaughts but has emerged as a respectable winner. At some time in the last decade each of the following companies posed a threat to Oracle: PeopleSoft, Siebel, BEA systems and Hyperion. What happened? They all were gobbled up by Oracle before the threat actually made any serious dent in Oracle's business.
With the recent acquisitions Oracle has made in the cloud arena such as Rightnow, Taleo, SelectMinds, Collective Intelligence, Involver, Virtue, Endeca, ClearTrial, InQuira and Xsigo etc, its cloud revenue has reached $1 billion per annum, lagging only behind the cloud leader Salesforce.com (CRM). Talking about Salesforce, with the forward P/E of 71, it is priced for perfection. If Salesforce fails to meet those expectations, the stock will crash. And if the history is any guide, it's only a matter of time before Salesforce feels the heat and when that happens, Oracle will be waiting with open arms and $40-50 billion in its pocket. I have a feeling that the day of reckoning for Salesforce is coming sooner than later.
To conclude, out of the three software, hardware and services providers Oracle, IBM and SAP, all of which are quality businesses, Oracle looks the most undervalued. The case for Oracle can be summarized as following:
- Oracle has immense competitive advantage in terms of high switching costs for its mature enterprise class long-time customers.
- For the newer customers and for those wanting to delegate part of their IT systems to the cloud model, Oracle has impressive and growing cloud offerings. Dealing with Oracle, the existing customers deal with an existing vendor i.e. they don't have to update their phone books and they have a less painful migration as the new products come from the same ecosystem.
- And last but not least, Oracle currently is undervalued on both a relative and absolute basis.
Disclosure: I am long ORCL.