Pundits, analysts, and miscellaneous haters have been down on Oracle's (NYSE: ORCL) 2010 acquisition of Sun Microsystems since the deal was announced. Indeed, glancing at the raw financial statement numbers (such as the first quarter earnings announced last week), Sun's hardware business looks like a stone around Oracle's neck. Segment revenues have been shrinking, and the single- to low double-digit segment margins are paltry compared to Oracle's software business.
The thing that the haters miss with a cursory look at top-line stagnation or segment-level profits is the fact that ever since Oracle acquired Sun, operational leverage in its crucially important software updates segment has climbed every year.
One look at a graph of an estimate of the software updates segment's operational leverage makes this point clear.
(click to enlarge)
Estimate of Oracle software update segment operational leverage
Source: Company statements, IOI analysis
(Note that FY2010 has been redacted from the graph for reasons of clarity. This was the year that Oracle acquired Sun, and timing of the acquisition created a misleading data artifact. The nominal value of operational leverage in FY10 was -80%, but this number has little economic meaning due to the acquisition.)
This chart is saying that for every extra dollar of revenues coming into the software updates segment, the segment is generating more than a dollar worth of extra profits. By our estimate, the segment generated an extra $1.04 in 2011, $1.17 in 2012, and $1.24 in the most recently reported year.
This increase in operational leverage matters because the software updates segment is the engine of Oracle's business model and by far the most important component of its profit structure. For instance, in fiscal 2013, fully 74% of Oracle's operating profits were attributable to this business unit. The fact that this business is generating greater and greater marginal profits every year since the Sun acquisition suggests that Ellison was not lying when he said that Sun was the most profitable acquisition he has ever made.
The paring back of the legacy Sun business and the shift to what Oracle is calling "engineered systems" (servers designed to run Oracle's software very efficiently) is causing revenues to appear weak, but the story underlying the superficial numbers is very good indeed.
Why This Matters
Investors like to see growth and are disappointed when it falls short or fails to materialize. However, it is not clear that investors always know what growth to focus on.
Growth in start-ups is easy to recognize because revenues are rocketing upward for the first few years. Investors tend not to worry about profitability as much for a start-up because it's a given that a quickly growing, small company sometimes sacrifices profitability to build its customer base.
Growth in mature firms is also easy to recognize because profitability is more or less stable, so if revenues are growing while profitability stays the same, profits are growing as well.
However, for a company in transition like Oracle, it is sometimes hard to spot the kind of growth that should matter most to investors: the growth of profits generated on behalf of shareholders.
A good company makes smart investments. A smart investment is one that generates more wealth than some hurdle rate. The most sensible hurdle rate to use when assessing the investments of a large company like Oracle is that of the economy at large. If Oracle's investments do not allow it to create more profits for shareholders than shareholders could generate by owning a diverse basket of firms, Oracle should receive a growth multiple that is no higher than the market at large.
IOI uses a definition of profit similar to that of Warren Buffett, then we compare the growth of this measure of profits to the growth of nominal GDP. We assign a higher multiple to companies shown to consistently generate marginal growth over and above GDP. Thinking of growth in this way, and graphing the measure out over time, we get the following:
Estimated marginal growth in profit vs. GDP for owners of Oracle
Source: Company statements, IOI analysis
Oracle's FY 2003 included the tech bubble burst and its FY 2010 shows a data artifact due to the timing of the Sun acquisition. However, looking at the graph, it is clear that Oracle's acquisition and product strategy has allowed it to generally grow at a faster clip than the rest of the economy and sometimes at a much faster clip.
It is true that marginal profit growth fell somewhat in the most recent fiscal year. However framed in relation to revenues, it is impressive that even a year that saw Oracle's revenue growth flatline still saw the firm create profits more quickly than the economy at large to the tune of 200 basis points.
We believe the increasing profitability in the software update segment is largely responsible for this growth and think that this growth bodes well for the firm in the future.
Certainly, Oracle's record of generating profits on its historical investments, and the positive trends in operational leverage continuing for a third year in a row suggest the firm should be trading for more than its present 14 times TTM P/E.
Additional disclosure: I am long ORCL calls, struck at $20 and $37, expiring in January 2015.