Shares of Oracle Corporation (ORCL) have returned 26.9% over the past 12 months. At $35.15, the stock is trading at its 52-week high. Should investors ride on the price uptrend? My valuation analysis discussed in this article may assist you in formulating the investment decision.
Sell-side analysts on average estimate Oracle's revenue, EBITDA, and EPS to grow at 2-year CAGRs of 6.3%, 8.4%, and 12.6%, respectively, over the next 2 fiscal years (see comparable analysis chart below). Those consensus growth estimates are markedly below the averages of 12.2%, 12.0%, and 13.7%, respectively, for a peer group consisting of Oracle's primary competitors in the software sector. However, Oracle's EBITDA margin is forecasted to expand by 2.1% over the same period, compared to an average estimate of just -0.3% for the comparable companies. On the profit side, Oracle has demonstrated a superior margin performance as all of the firm's profitability and capital return metrics are above the par. The company carries a relatively higher level of debt as reflected by the above-average debt to capitalization and debt to EBITDA ratios. In terms of liquidity, Oracle has a robust free cash flow margin and is well above the peer average. Due to the higher leverage, the firm's interest coverage ratio is below the group average but remains at a healthy level on an absolute basis. Both Oracle's current and quick ratios are considerably above the par, reflecting a very healthy balance sheet performance.
To summarize the financial comparisons, Oracle's relatively weaker growth potential would likely be the primary drag on the stock's valuation. However, given the company's superior profitability and liquidity performance, I believe the valuation discount would not be very significant. Nevertheless, Oracle's current valuations at 7.9x forward EV/EBITDA, 12.5x forward P/E, and 1.0x PEG are trading at a substantial discount relative to the peer-average trading multiples at 14.3x, 24.9x, and 1.5x, respectively, suggesting that Oracle is likely undervalued.
Moreover, Oracle's forward P/E multiple of 12.5x is currently trading at 12.4% discount to the same multiple of the S&P 500 Index, which stands at 14.1x now (see chart below). The trading multiple discount appears to be exaggerated from my view provided that 1) Oracle's long-term estimated earnings growth rate at 12.4% is significantly above the average estimate of 8.0% for the S&P 500 companies; 2) Oracle has a leading profitability and cash flow performance in both the software sector and the overall market; and 3) Oracle also has a leading market position in the software application sector.
I also performed a DCF analysis to support my view (see DCF chart below). The DCF model incorporates the market's consensus revenue and EBITDA estimates from fiscal 2013 to fiscal 2015. The revenue growth from fiscal 2016 to the terminal year is assumed to gradually decrease to 2.5% in the terminal year, and the EBITDA margin throughout same period is set to be constant at 50.0%, which is slightly below the market's average estimated margin of 51.1% from fiscal 2013 to fiscal 2015. Other free cash flow items including depreciation, tax expense, capital expenditure, and net working capital investment are projected based on their historical ratios to the revenue.
To account for the above financial projection risk, a company-specific risk premium of 4.0% is applied in the cost of equity calculation. Instead of using the currently depressed 10-year Treasury Bond yield, a normalized 10-year risk-free rate is employed. As such, based on a WACC of 11.6%, a terminal growth rate of 2.5%, and an implied terminal forward EV/EBITDA multiple of 7.3x (currently at 7.9x as mentioned earlier), the model yields a stock value of $38.83, which is 10.5% above the current share price at $35.15. Since the assumptions used in the model appear to be somewhat conservative, the DCF analysis indicates an attractive valuation level. Additionally, the DCF sensitivity tables suggest that a somewhat extreme combination of 13.1% WACC and 1.5% terminal growth rate would drag down the stock value to $31.90. On the other hand, a mix of 46.0% terminal EBITDA margin and 1.5% terminal growth rate would result in a stock value at $34.30. Both scenarios represent an average downside of just 5.8%, which does not appear to be substantial.
Oracle's Q2 earnings released in December 2012 topped the market's consensus estimates. Credit Suisse' research analyst, Philip Winslow, elaborated on his bullish view on the stock in a recent research note (sourced from Thomson One, Equity Research):
"Oracle's strong result in the applications segment reinforces our thesis on the software sector that enterprises are focused on boosting revenue growth and improving productivity and are willing to spend on applications addressing these goals-despite the uncertain macroeconomic environment. Furthermore, we believe that upgrade and expansion cycles are underway across multiple enterprise application segments, and we continue to view Fusion Applications as a positive driver for Oracle that Wall Street continues to underestimate…We expect Oracle's stock to benefit from several near-term drivers, including (1) a lessening negative impact from changes to the sales organization made during 2011, (2) growing traction in Oracle Fusion Applications, (3) the introduction of a complete Oracle cloud stack and a new database, (4) continued growth in engineered systems (finally) beginning to offset the decline in traditional Sun hardware, and (5) the release of new M4 and T5 processors in 2013. Therefore, we continue to view of Oracle as our top large-cap pick heading into 2013."
Bottom line, Oracle's valuation continues to be attractive despite the recent price appreciation. Given the solid long-term growth prospects, the stock deserves a buy rating.
The comparable analysis and DCF charts are created by the author, all other charts are sourced from Capital IQ, and all historical and consensus estimated financial data in the article and the charts is sourced from Capital IQ unless otherwise specified.
Disclosure: I am long ORCL.