- Oracle is trading at a free cash flow yield around 8%.
- It remains a growth company with strong competitive advantages.
- The CEO continues to own 24% of the company and has not been selling his stock.
Background: Larry Ellison, founder and long-time CEO of Oracle Corporation (NYSE:ORCL), is partly a business icon because he sells so little of his stock in this company. He owns 1.1 billion shares of ORCL, about 24% of all outstanding shares. Going back to late 2012, he has increased his shareholdings slightly, by 5.2 million shares. This is a CEO who eats home cooking and from the posture of the company, is still driven to create great new products and defeat the competition. In my view, he is like Warren Buffett in that you want to invest with him, not against him.
From that starting perspective, I shrug my mental shoulders at the reflex sell-off in ORCL after-hours Tuesday from nearly $39 to under $37 after basically an in-line quarter (i.e., its third quarter ending in February) with lots of growth potential apparent (note the reflex sell-off was rapidly reversed shortly after regular trading resumed on Wednesday).
Introduction: Yours truly feels like a dinosaur. In the good old days of Volckernomics, an earning was something that everyone agreed upon. Analysts and private investors were free to measure free cash flow or any other metric they wanted, but in general, GAAP earnings were the earnings. Now, beating estimates on usually non-GAAP "earnings" is what appears to move a stock price in the short run, but this can obscure the important facts.
Supposedly ORCL "missed" earnings expectations, coming in at $0.68 vs. $0.70 expected (all numbers are per share). Yet who knows what analysts expected regarding a non-cash 2 cent loss from Venezuela's currency problems or other foreign currency translations? Here is Oracle's press release spinning its earnings when taking those factors into account:
Excluding the impact of the US dollar strengthening compared to foreign currencies and excluding Venezuela's exchange loss impact on both reporting periods, Oracle's reported Q3 GAAP earnings per share would have been $0.59, up 12%, and non-GAAP earnings per share would have been $0.71, up 8%. GAAP and non-GAAP total revenues also would have been up 6%. GAAP new software licenses and cloud software subscriptions revenues would have been up 6% and non-GAAP new software licenses and cloud software subscriptions revenues would have been up 5%. Hardware systems product revenues would have been up 10%.
This analysis makes the quarter look perfectly fine, especially given that much of Oracle's business is inherently deflationary.
Why ORCL is suitable for most investors: Depending on how one measures free cash flow, Oracle is currently valued at about 12X forward free cash flow, or about an 8% FCF yield (the reciprocal). (If one removes the company's net cash position from the calculation, one can get close to a 9% FCF yield, but that would imply that the company per se was a riskier company, so I do not look at matters that way.)
Let us look at the past several years for guidance as to the future, before examining the company's prospects. Per S&P Capital IQ:
Oracle has grown from $23 billion revenues in FY 09 to $37 billion in FY 13, for a CAGR of 12.4%. Over the same period, net income increased from $5.6 billion to $10.9 billion, for a CAGR of 18.2%.
Recent sales growth has been dampened by the hardware segment's declining revenues. The hardware segment also places pressure on operating margins. As software is a larger portion of sales than hardware and is growing faster, we expect revenue growth rates to improve in FY 14 and operating margins to also improve.
Well, it turns out that in Q3, hardware grew. In any case, somehow the perception has been that ORCL is a slow-growth company selling at a FCF yield several points above that which the market requires for consumer products companies such as Procter & Gamble (NYSE:PG), Coca-Cola (NYSE:KO) and CVS Caremark (NYSE:CVS). Is such a high FCF yield warranted? I would argue against that. Oracle management did a good job in the Q&A during the conference call to highlight its competitive advantages. I found their arguments compelling.
Oracle's many strengths (conference call points):
Gaining strategically versus SAP:
(Ellison): SAP has not yet begun to rewrite their ERP, HCM and CRM applications for the cloud. This gives the opportunity to become the leader in cloud applications and replace SAP (NYSE:SAP) as the leader in the overall applications in the market place.
Gaining versus IBM:
(Ellison): Five years ago, we delivered our first Exadata Machine, in the next few months, we will deliver our 10,000 engineered system. We believe Oracle's engineered systems are well on their way to replacing IBM (NYSE:IBM) T Series as the leader in high-end computing.
Hardware has a long term strategic focus worthy of a high valuation:
(Hurd): If our customers got a petabyte of storage, we know how to compress that data with Exadata to where they may or may need to use a 100 terabytes. And so this opportunity for us to now change the game in a way people think about how they use their infrastructure is in my opinion long term a very sustainable strategy and we've got differentiation and that's what we are using.
Competing effectively against salesforce.com:
(Hurd): Our 60% plus cloud booking growth is considerably higher than salesforce.com.
Strong database client retention with strong growth prospects:
(Ellison): We think virtually all of our customers are on their way to moving to 12c... But we think it's very attractive to our conventional customers and to hyperscale customers like Salesforce (NYSE:CRM) and others.
Note that competitor Salesforce.com is a customer.
Finally, a summing up of part of the company's strategy by Ellison in response to another question:
If I could just add one thing to that, with the release of Oracle and memory database with 12c, our data analytics performance is going to increase by more than a factor of 10. In some cases, they are that more than a factor of a 100. So, we think this summer with 12c, our data analytics business is going to take off and of course the intention is to sell a lot of those data analytics products in the cloud as opposed to our premise.
We will give customers a choice, but will offer those data analytics in the cloud, data analytics on premise. It's a big push for us. As Mark said, we see new competitors and an opportunity once again to move to the front of the pack to become the number one data analytics company in the world. We think the new competitors are small and innovative. The old competitors have a lot of market share and we think that market share is there for the taking as long as we can deliver high-quality technology and that's what we will do this summer.
Please note my italicized points. This is a hyper-competitive, motivated CEO who is making these points.
Discussion: Let us go back to the S&P growth data. Oracle has actually been growing rapidly while returning growing amounts of cash to shareholders, and while the CEO has not been selling any stock. The company is arguing publicly and loudly that it is outperforming SAP and IBM, and using its scale to keep up with the smaller competitors. It is doing this while having shrunk shares outstanding by 5% over the past year and paying a dividend that beats cash in the bank or even a 3-4 year T-note.
So in view of the recent past growth and Oracle's many strengths, it is time to model cash flows to investors. Let's assume that forward FCF yield is 8%, and that this can/will grow at a CAGR of 7% for the next 10 years. Thus the terminal FCF yield will be 16%, and let's for simplicity assume an average FCF yield of 12%. The first point is that this is highly attractive in almost any prospective interest scenario over the next decade. It implies that $100 invested in ORCL today will have $120 returned to the investor over the next 10 years, roughly the same as a high quality tax-exempt bond would do. The difference, of course, is that the equity owner of ORCL would retain the stake in the company, and would be the happy owner of a security currently (a decade from now) paying out at a 16% FCF rate. Even if at that point, ORCL were a bond-like security with an uncertain maturity date (i.e. a very mature company that might decline in the future), the stock would have value. However, my belief is that Oracle's fields are secular growth fields, and there is no reason not to expect the company to grow for decades to come, especially when taking inflation into account.
All in all, it's reasonable to assume that under these assumptions, ORCL would continue to trade at an 8% FCF yield a decade from now. This in turn would imply a doubling of the stock price. In turn, this would mean a total return of $220 from every $100 invested in ORCL today.
What share price today is fair for the above scenario, which I view as middle-of-the-road?
Even if for sake of discussion, you accept the above assumptions and scenario, your required return will be different from mine and from that of other readers and actual or potential ORCL investors.
My own "take" is that at a minimum, a 30% higher share price is fair, suggesting to me that fair value for ORCL is around $50 right now. This is a bit higher than the $45 that S&P Capital IQ pegged as fair value for ORCL using its proprietary methods in its late December review of the company.
Note that as part of keeping investing simple, I have avoided spreadsheets or specific formulae. As regular readers know, I prefer to keep price analyses more general and conceptual, as there are so many guesses and assumptions, I am leery of appearing too precise.
Risks: Of course, ORCL is an investment mainstay and is exceedingly well-studied. It may fail to achieve many or most of its goals. The global economy may falter and harm its plans. The generally high valuations of common stocks could fall to historically average or below average valuations.
Mr. Ellison has no financial need to work, and likely most of the company's top personnel can afford to either retire or move on to small companies; so, management may change over the years to the possible detriment of shareholders.
Other risks abound.
Conclusion: ORCL is trading at an unusually low free cash flow valuation for a company with its stellar growth record and evidence of strong growth potential. The founder-CEO remains motivated to see the company on to yet greater success, and I believe that he and top management have presented a strong case that they may be on a path to further business success. If so, the stock is arguably well below fair value and may represent an attractive place for investable funds.