Though we prefer Microsoft (NASDAQ:MSFT) as one of our favorite big-cap software ideas, Oracle (NYSE:ORCL) is still worth looking at in its own right. The company is trading at the low end of our fair value range, implying upside potential, and its future free cash flow generation is expected to be stunning in coming years, which should pave the way for dividend growth. Let's walk through how we derive the firm's cash-flow-based intrinsic value estimate and run the company through the 'Valuentum style of investing' framework.
But first, a little background to help with the understanding of some of the terminology in this piece. At our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Oracle posts a Valuentum Buying Index score of 7, reflecting our "fairly valued" DCF assessment of the firm, its attractive relative valuation versus peers, and bullish technical. Though we generally prefer firms that score a 9 or 10 (a "we'd consider buying" rating), a 7 is better than average across our coverage universe. As we outline below, Oracle can achieve such a score should its stock price trade below the fair value range, which would suggest that the market is unfairly pricing shares. With that said, let's dig into Oracle's report.
Oracle's Investment Considerations
• Oracle's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively. The company has a strong Economic Castle.
• Oracle is shifting the complexity from IT, moving it out of the enterprise by engineering hardware and software to work together-in the cloud and in the data center. Its software, hardware systems and services businesses represented 74%, 14% and 12% of total revenues, respectively, in fiscal 2013.
• Oracle has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 38.7% in coming years. Total debt-to-EBITDA was 1.1 last year, while debt-to-book capitalization stood at 29.3%. We think the company's strong cash flow dividend and solid balance sheet will pave the way for future dividend growth in coming years. Oracle registers a very impressive 5.8 on the Valuentum Dividend Cushion. What does this mean? Click here.
• Though revenue growth at Oracle remains subdued, free cash flow generation does not. Shares currently trade at the low end of our fair value range, and while we prefer Microsoft in the software arena due to its strong enterprise presence and huge return of capital to shareholders (namely its significantly higher dividend), we think investors should keep the name on their watch lists.
• In terms of pure investment ideas, it's difficult for Oracle to compete with the likes of Apple (NASDAQ:AAPL) and Microsoft -- two companies that offer investors strong and growing dividends and valuation upside as well. We think this is one of the impediments for price-to-fair value convergence at Oracle, as most investors looking for either big cap tech or big cap software exposure may find themselves holding Apple or Microsoft instead. We can't necessarily disagree with this view as we're big fans of both Apple and Microsoft (click here and here, respectively).
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Oracle's 3-year historical return on invested capital (without goodwill) is 139.6%, which is above the estimate of its cost of capital of 10.3%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Oracle's free cash flow margin has averaged about 34% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Oracle, cash flow from operations increased about 27% from levels registered two years ago, while capital expenditures expanded about 44% over the same time period.
Our discounted cash flow model indicates that Oracle's shares are worth between $38-$56 each. Shares of Oracle are trading at just above $40 per share, near the low-end of the fair value range. Though we tend to like stocks that are trading below the fair value range, Oracle's valuation opportunity is still present. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $47 per share represents a price-to-earnings (P/E) ratio of about 20.8 times last year's earnings and an implied EV/EBITDA multiple of about 12.3 times last year's EBITDA. Though these multiples may seem a bit high, Oracle's free cash flow generation and balance sheet supports them.
Our valuation model reflects a compound annual revenue growth rate of 4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 11.5%. Our model reflects a 5-year projected average operating margin of 51.6%, which is above Oracle's trailing 3-year average. We think the firm, while the top-line continues to face pressure, will be able to drive productivity gains to achieve margin expansion during the next five years. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Oracle, we use a 10.3% weighted average cost of capital to discount future free cash flows.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Oracle to peers Microsoft and Adobe Systems (NASDAQ:ADBE). On a normalized forward EV/EBITDA basis, Oracle's shares are quite tempting.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $47 per share, every company has a range of robable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Oracle. We think the firm is attractive below $38 per share (the green line), but quite expensive above $56 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Oracle's fair value at this point in time to be about $47 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Oracle's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $62 per share in Year 3 represents our existing fair value per share of $47 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: MSFT and AAPL are included in Valuentum's actively-managed portfolios.