The purpose of this article is to calculate the returns one can reasonably expect by buying Oracle (ORCL). I thought Oracle was attractively priced last week, but then the stock fell 10% and I recalculated my numbers and I am convinced it offers tremendous value at these levels. My estimates suggest an annualized gross return of 16.8%.
IDC expects technology spending to grow by 5.3% annually from 2013-2016. See chart below. So the market fundamentals should be strong for Oracle for the next few years.
When we look at Oracle's ratio of revenue to invested capital (see below), we can see that it peaked in Q1 2012. Oracle acquired Sun Microsystems in January 2010. This acquisition has been the main cause of Oracle's slowing in growth rates. Year-over-year revenue growth rates in Oracle's Hardware division started to decline in Q4 2011 and the trend has worsened (currently negative 17.1% YoY). The Services division has also been very weak since Q4 2012, currently declining at 6.2% YoY. The largest division, Software, is growing around 4.6% per year. This is more than compensating for the weakness in Hardware and Services.
Let's now take a look at the more general trends in the company. In Chart 1 below, we can see how ORCL has consistently grown its earnings and cash flows over the last 11 years. The earnings manifest themselves as an ever increasing level of operating cash flow generation.
In Chart 2 below, it is evident that ORCL has been reinvesting its cash flows. We can see a growing capital base of the company. This has been a significant driver of historical growth in Net Income and Oracle continues to make smart acquisitions in its Software division.
Chart 3 below shows the trailing 12-month Return On Invested Capital for Oracle. The weakness in trend in the last 4 quarters is coming from negative revenue growth in the Hardware and Services divisions.
ROIC Return On Invested Capital is driven by NOPAT (Net Operating Profit After Tax) Margin and Revenue/Invested Capital. In Chart 4 below, we can see that ORCL has been pretty consistently improving its margins.
The pie chart below shows how ORCL deploys the operating cash it generates.
Valuation / Calculation Of Expected Returns
Earnings Per Share Estimate
There are four building blocks to our earnings per share estimate: Organic Growth, Increase in NOPAT from Invested Capital, Earnings Per Share Uplift from Share Buybacks and Earnings Per Share Dilution from stock compensation.
1. Organic Earnings Per Share
The table below sets out my analysis of the Revenue Trend for Oracle. I went through all of the 10Q filings to calculate how much of Oracle's revenue gains came from acquisitions. By stripping out revenues from acquisitions and comparing the YoY growth rates, we can see what the core organic growth trends are for the three divisions. Software (74% of revenues) has an organic growth rate of 4.6%. Hardware (14% of revenues) has an organic growth rate of -17.1%). Services (12% of revenues) has an organic growth rate of -6.2%). My findings are as follows.
- Excluding currency effects, expect 0.3% revenue growth YoY next quarter.
- Expect annual growth in revenues of 1.4% over the next 5 years (excluding acquisitions).
- If we use Oracle's constant currency YoY % growth numbers, then we can probably add 1% to both of these numbers.
In the two tables below you will find our full assumptions and IRR calculations for Oracle.
2. Increase in NOPAT from Invested Capital
As can be seen above, we expect Oracle to grow its NOPAT by 13.7% from its acquisitions alone. Over the last 5 years, Oracle has invested 43% of its cashflows in acquisitions. Given their current ROIC of 23.7%, these continued investments should grow NOPAT at the suggested rate.
3. Earnings Per Share Uplift from Buybacks
We have estimated how much we anticipate Earnings Per Share to grow based on the % of Adjusted Operating Cashflow used for Share Buybacks. Based on the current market capitalization, we estimate the company can sustain buying back 2.1% of its stock every year. In addition the company has a $14Bn cash pile which, it could in theory use to be more aggressive with buybacks (in fact it did this in the last 12 months buying back $10.6Bn of stock). I suspect it may well do this again this year given the recent weakness in the stock price.
4. Dilution from stock compensation
In the second table above, we have estimated the dilutive effect on earnings of the company's stock compensation plans. Over the last 5 years, the average annualized dilution to the basic share count was 1.5%
Based on these 4 variables, we calculate 16.0% expected Earnings Per Share growth over the next 5 years.
The trailing 12 month P/E ratio of the company is 14.94. Over the last 5 years, on average the company's P/E has traded at 1.08x the S&P 500's P/E, which would imply a P/E of 16.50. The current trailing 12-month P/E of the S&P 500 is 15.32.
We calculate the 5-year Internal Rate of Return of holding Oracle's stock based on three scenarios. Scenario 1 assumes that in 5 years, the stock still trades on its current P/E ratio of 14.94. Scenario 2 assumes that in 5 years, the stock trades based on its average relative P/E to the S&P 500 of 1.08, which would be 16.50x. Scenario 3 assumes that in 5 years, the stock trades on a market multiple currently 15.27x (for the S&P 500).
In conclusion, we believe that for patient investors a gross annual return of 16.8% will be realized. This is based on zero multiple contraction/expansion. If Oracle reverts to a market multiple then the return would be 17.3% and if it reverts to its mean relative P/E then we are looking at 19.1%. We recommend going Long Oracle at these levels with a market hedge as we have some concerns regarding a mid-cycle slowdown.