Oracle Should Get A Post Earnings Pop

| About: Oracle Corporation (ORCL)

Oracle Corporation (ORCL) will announce its fourth quarter financial results as trading closes today (Thursday). Oracle is one of the world's largest and most profitable business-software companies. The company's software, hardware systems, and services businesses develops, manufactures, markets, hosts and supports database and middleware software, applications software, and hardware systems, with the latter consisting primarily of computer server and storage products. These products and services are used by enterprises and public organizations of all sizes around the world.

Its closest competitors are International Business Machines Corp. (IBM), SAP AG (NYSE:SAP) and Microsoft Corporation (MSFT). It actually seems like Microsoft might be the best positioned of these four tech companies with its impressive earnings in various businesses. There will be a lot of web-based growth with more people coming online in the future and this will make Bing Search and Microsoft's social media ventures like Socl increase in popularity.

Nonetheless, Oracle has tremendous potential as well. Wall Street expects the Redwood City, CA-based tech company to earn 87 cents a share, according to analysts polled by Thomson Reuters. The consensus estimate implies a rise of 6.1% from 82 cents a share in the same quarter last year.

The database software giant's earnings have managed to beat Street view twice in the past four quarters. Quarterly revenue is anticipated to increase by 1.6% to $11.13 billion up from $10.95B in Q4 2012. It is true that earnings have been weak in the past two quarters, but this will change as the business software firm reports on the performance in the seasonally strong fourth quarter.

Let us now examine Oracle using a DuPont Analysis and see how it compares to MSFT and IBM.

'DuPont analysis' is named after the U.S. chemical company that created this method of analysis in the 1920s to gain more in-depth knowledge of Return on Equity [ROE]. In a DuPont Analysis, the ROE is deconstructed into factors that can be further analyzed. These factors are commonly a profitability measure, a turnover measure, and a leverage measure.

Three-Step DuPont

The three-step equation breaks up ROE into three very important components:

ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)

Click to enlarge

These components include:

  • Operating efficiency - as measured by profit margin.

  • Asset use efficiency - as measured by total asset turnover.

  • Financial leverage - as measured by the equity multiplier.

Let me briefly touch on the math here.

Taking the ROE equation: ROE = net income / shareholder's equity and multiplying the equation by (sales / sales), we get:

  • ROE = (net income / sales) * (sales / shareholder's equity)

We now have ROE broken into two components, the first is net profit margin, and the second is the equity turnover ratio. Now by multiplying in (assets / assets), we end up with the three-step DuPont equation.

  • ROE = (net income / sales) * (sales / assets) * (assets / shareholder's equity)

This equation for ROE, breaks it into three widely used and studied components:

ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)

ROE

=

Net Profit Margin

×

Asset Turnover

×

Equity Multiplier

May 31, 2012

22.85%

26.89%

0.47

1.79

May 31, 2011

21.30%

24.00%

0.48

1.85

May 31, 2010

20.10%

22.87%

0.44

2.00

May 31, 2009

22.28%

24.05%

0.49

1.89

May 31, 2008

23.71%

24.61%

0.47

2.05

Click to enlarge

Source: Oracle Corp Annual Reports

As you can see, the ROE has increased and it can be attributed to the increase in profitability as measured by the Net Profit Margin. The asset turnover and equity multiplier have been quite stable and these are two very encouraging signs for Oracle.

Oracle's ROE is above average and it is well backed-up by the sound net profit margin, asset turnover and equity multiplier values over the last 5 years. Oracle's values compare well with the industry leader MSFT over the last 5 years.

Five-Step DuPont

This is called the Extended DuPont Analysis.

As we have seen:

Net Profit Margin = Net Income / Sales

  • 26.89% (2012 value) = $9,981 / $37,121

This can be rewritten using another mathematical identity:

Profit Margin = (Net Income / Sales) = (Net Income / Earnings Before Taxes) * (Earnings Before Taxes (EBT) / Earnings Before Interest and Taxes (EBIT)) * (EBIT / Sales)

Tax Burden = (Net Income / Earnings Before Taxes)

  • $9,981 / $12,962 = 77.00%

Tax Burden is an indication of how much the company is paying in corporate taxes, or how much of the profit is falling to the bottom line. This calculation indicates that as of the most recent fiscal year, ORCL kept 77% of every dollar it makes after expenses.

Interest Burden = (Earnings Before Taxes / Earnings Before Interest and Taxes)

  • $12,962 / $13,728 = 94.42%

Interest Expense reduces Net Income and therefore, lowers ROE. ORCL's tax burden and interest burden are almost the same as Microsoft's.

Sales Margin = (EBIT / Sales)

  • $13,728 / $37,121 = 36.98%

Sales Margin is yet another way of looking at how profitable each dollar of revenue is after deducting operating expenses but before deducting interest and taxes. The sales margin and the net profit margin are lower than that of Microsoft.

So again, putting the three ratios together we get:

Net Profit Margin = Tax Burden * Interest Burden * Sales Margin

26.89% = 77.00% * 94.42% * 36.98%

And finally, the complete Extended DuPont Analysis:

ROE1 = (Net Income / EBT) * (EBT / EBIT) * (EBIT / Sales) * (Sales / Assets) * (Assets / Equity)

22.85% = ($9,981 / $12,962) * ($12,962 / $13,728) * ($13,728 / $37,121) * ($37,121 / $78,327) * ($78,327 / $43,688)

ROE = Tax Burden * Interest Burden * Sales Margin * Asset Turnover * Equity Multiplier

1 Values are for 2012

ROE

=

Tax Burden

×

Interest Burden

×

Sales Margin

×

Asset Turnover

×

Equity Multiplier

May 31, 2012

22.85%

77.00%

94.42%

36.98%

0.47

1.79

May 31, 2011

21.30%

74.90%

93.39%

34.30%

0.48

1.85

May 31, 2010

20.10%

74.43%

91.62%

33.55%

0.44

2.00

May 31, 2009

22.28%

71.39%

92.56%

36.40%

0.49

1.89

May 31, 2008

23.71%

70.47%

95.21%

36.68%

0.47

2.05

Click to enlarge

The ROE has increased and it can be attributed to the rise in profitability as measured by the Sales Margin and the decline in financial leverage, which is a very good thing.

Three-Step Net Profit Margin

You can take your analysis further by taking individual components of the DuPont Identity and breaking them down to gain additional insight.

Net Profit Margin

=

Tax Burden

×

Interest Burden

×

Sales Margin

May 31, 2012

26.89%

77.00%

94.42%

36.98%

May 31, 2011

24.00%

74.90%

93.39%

34.30%

May 31, 2010

22.87%

74.43%

91.62%

33.55%

May 31, 2009

24.05%

71.39%

92.56%

36.40%

May 31, 2008

24.61%

70.47%

95.21%

36.68%

Click to enlarge

I hope you get the idea by now. It can be clearly seen that the Sales Margin has had the biggest impact on the Net Profit Margin and its rise from 2011 to 2012.

The Bottom line: Will Oracle be able to hold off SAP?

Investors are always on the lookout for companies that generate profits more efficiently than their rivals. ROE is a key indicator that signifies to investors that a firm is a profit creator and not a profit burner. A DuPont analysis helps in painting a true picture about the ROE value obtained. It was a very helpful exercise indeed to perform the Extended DuPont Analysis on Oracle Corp. going back over time to see how the trends have been going with the individual components over time.

The other thing that was very useful was to compare Oracle with MSFT and IBM. These large cap tech firms are all major players in the database field. Oracle is the market leader for databases with its world famous Oracle database followed by IBM's DB2 and Microsoft's SQL server. But it will be SAP AG that will provide the most competition for Oracle in the future. SAP has some ambitious plans for its HANA database with hopes of becoming the second largest database vendor in the next two years.

This spells trouble for Oracle Corp. Oracle's database is its flagship product and the company generates just over 34% of its sales from the database segment. Any decline in market share would hurt the firm's earnings pretty badly. Oracle will now be forced to make some moves to protect its market share. Oracle (along with IBM's database) has been known to be pricey. So Oracle will have to offer a cheaper product to prevent SAP from inevitably taking the orders from the small and mid-sized companies.

Oracle's primary business is being threatened by SAP and Microsoft that are offering database solutions to customers that are increasingly looking to save money. What is more, ORCL's stock has been an under-performer in 2013, up only 1% year-to-date. Still, Oracle trades at an attractive forward P/E of 11.58 in comparison to SAP's 19.47 P/E.

Oracle has proven to be a good long idea in the past and should be so even in the future. However, if the tech firm sees a decline in market share on its main products, earnings estimates will be downgraded and this will negatively affect the stock price.

Note: All material is sourced from Morningstar and MSN Money.

Disclosure: I am long ORCL, MSFT, IBM.

Business relationship disclosure: This article was written by a research analyst at Investor Aide. Investor Aide is not receiving compensation for it (other than from Seeking Alpha). Investor Aide has no business relationship with any company whose stock is mentioned in this article.