In a prior post, I looked at Oracle (NYSE:ORCL) when it was trading at $40.81, because I saw it as a decent value opportunity. The price rose, but not by much, and now, as I write this late on 6/19, following an earnings miss, the stock is down over 5% to $40.38 in the after-hours market. In my view the dip in price presents a very decent alpha generation opportunity.
Oracle reported earnings after hours on 6/19/14. Total revenue was up 3% to $11.3 billion, non-GAAP earnings came in at $0.92. Excluding the impact of currency changes in Venezuela, which were not included in the prior guidance, adjusted non-GAAP earnings came in at $0.94. Analysts were expecting earnings of $0.95, and revenue of $11.48 billion. Oracle had guided earnings for the quarter of $0.92 to $0.99, so $0.95 to $0.96 reflects the mid-point of the range representing analyst expectations. It is clear that Oracle missed expectations for earnings and revenue. They committed the cardinal sin of missing earnings expectations by $0.01, and punishment was meted out by the markets.
For the coming quarter, Oracle has guided revenue growth of 4% to 6%, while analysts expect revenue growth of 5%. Earnings guidance for the coming quarter is $0.62 to $0.66, while analysts expect $0.64. Thus guidance is very much in line with expectations.
In my view, the miss of $0.01 is no big deal. In fact in many ways, there are big positives to the miss. If you run through the post earnings conference call, you will find that the main reason for the revenue miss is a change in the business mix. As Oracle's cloud offerings pay off, we can expect a decline in software sales. And this matters, because while the revenue on a traditional software sale is recognized 100% on sale, the revenue on the cloud offering is recognized over the term of the subscription agreement (which term is not concurrent with the accounting quarter). With the cloud/software sale mix changing as it did, the miss is mostly on account of an accounting event, not a business or operational event. During the period of transition from software sales to the cloud, we can expect to see such misses on revenue until Oracle gets better in predicting the pace of change to cloud.
Acceleration in the pace of the shift to the cloud, as was indicated in the earnings conference call, is a big positive: the cloud sets up a recurring revenue stream, and the cloud will in the long-term provide far higher margins than traditional software sales. The market should, and I expect in time will, reward this change in the mix: instead today the stock is punished. And the price value debate continues.
How do different market participants view Oracle?
A couple of years ago, I had written some code to facilitate stock selection. It would help if you read about the build-out of that system here, as that will allow you to appreciate the model output later in this post better.
AOM Statistical Scores
The AOM statistical scores are a statistical evaluation of thirty-eight key indicators for the company, grouped into value, growth, quality, and momentum categories. It illustrates how the key indicators for the stock perform in comparison to the market capitalization weighted scores for the market, the stock's sector and the stock's industry of operation.
Oracle scores high on quality across the board, regardless of whether we compare the stock with the market, other stocks in its sector of operation, or other stocks in its industry of operation. It scores well on value, particularly in comparison with stocks in the application software industry. Growth scores are on the weak side, however, growth is near in line in comparison with the application software industry. Momentum is neutral, and if the after-hours loss establishes a trend, momentum scores will weaken with the passage of time.
AOM Model Recommendation
This stock appeals strongly to all investor stock selection styles. This includes value, growth and momentum style stock selectors. It also appeals to the balanced investor who considers value, growth, quality and momentum equally. It also appeals to investors with no stock selection style bias. And it appeals to all of the typical capital allocation strategies adopted by investors in that the stock has appeal to all, regardless of whether they allocate capital at sector, industry, or with no sector/industry bias.
Overall, after analyzing fifteen stock selection and capital allocation strategy combinations, the system assigns an AOM Score of 78%, and an AOM Buy recommendation for Oracle.
The AOM statistical scores for each of the fifteen strategy combinations are unique and not comparable with each other. The AOM Score is very different from AOM Statistical scores: it evaluates and rates the AOM Statistical scores for each of the fifteen strategy combinations, and uses a unique technique to make the statistical scores across the strategy combinations comparable. The output is the AOM Score: a quantitative assessment of the output from the fifteen strategy combinations. The AOM Recommendation is a plain English recommendation based on the quintile the AOM Score falls in.
I'll hasten to add that this is a package aimed at generating ideas, it does not intend to, and nor does it replace the due diligence we must do as investors. It is a tool that uses quantitative techniques to understand the behavior of different market participants, and then brings that data together so that users can hear the voice of the market through the noise. The AOM system can guide you where to look, but make no mistake about it - it cannot look for you.
The Case for Oracle:
Why look at Oracle now?
While Oracle is no longer as cheap as it was when I last posted, valuation remains a good reason to look at Oracle now. The stock trades at a trailing twelve month P/E below the market P/E. The forward P/E is at a level that suggests that there is gain potential from earnings growth, as well as from an expansion in the multiple. The PEG ratio is also better than the market, the technology sector, and the application services industry.
And while the dividend yield is shabby in comparison with the market and technology sector, it is attractive in comparison with the application software industry. This is great when considering the additional value typically returned to owners via buybacks. The company has reduced annual average shares outstanding by 4.51% over five years: an annualized rate of 0.92%. Keep in mind that a reduction in annual average diluted shares outstanding represents the value returned to shareholders after employee and other issuances. Taken together with the dividend yield, the combined buyback plus dividend yield is over 2%.
Except for growth over the past five years, growth is weak. Growth can be exciting - but don't let its absence depress you. In fact high growth expectations can be dangerous when they are not rightly priced, as is often the case. It is most common to see superior long-term returns generated via a combination of slow and steady growth, alpha, and dividends. The key questions to ask are (1) what growth does the current market prices anticipate for Oracle? And (2) is a 10.45% annual growth rate for the coming five years too high? In my view, the market is pricing low growth expectations for the stock, and the growth expectations for the coming five years are not unreasonable.
Oracle also continues to display characteristics consistent with a high quality company. There is sound ownership quality reflected by high insider ownership and institutional commitment to Oracle. Return on assets, equity and investments are all strong in comparison to the market, the technology sector and the application software industry, as are gross, operating and profit margins. Quality is nothing short of impeccable.
Of late, momentum has been just about okay. With the after-hours negativity, it is possible that momentum scores will deteriorate over the coming days.
Is Oracle a suitable pick for alpha hunters?
Analyst price expectations
Recently Oracle traded at $42.51. From Yahoo Finance, we know that thirty-one analysts expect an average price target of $43.68 (median $45.00), with a high target of $50 and a low target of $30. This is a wide dispersion in expectations, which suggests risks are high. So far, the bulls have it. But with an earnings miss, perhaps the bears will grab the ball.
One of the classic conundrums for value investors is that value stocks tend to go from being very cheap to being rightly valued and back to being cheap. When a stock is rightly valued, it is priced to hold. When it is cheap, it is priced to buy. And one way to determine whether it is cheap or not is to estimate the alpha available with the stock as currently priced.
Alpha is the difference between actual returns and risk adjusted returns an investor should expect from a stock. So we will really never know the extent of alpha created until the actual return is earned. But we can always try to estimate alpha.
Mathematically, the worth of Oracle is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate]. If you do use the above formula, please read this explanatory note.
So let us have a closer look at the different parameters used to determine value.
Beta, co-efficient of determination and alpha intercept considerations
Value Line reports a beta of 1.05 for Oracle. The Value Line beta is calculated as a five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the market, adjusted for beta's tendency to converge towards one.
I calculate the raw beta based on the five-year regression of weekly closing prices of the stock, relative to weekly closing prices of the S&P 500 at 1.07, and I adjust it to 1.05 on account of the beta's tendency to converge towards one. This low beta adds defensive characteristics to the stock, which is always nice in what is perceived as an over-valued market.
The coefficient of determination for Oracle is 47.10%. This suggests that only 47.10% of the price movement in Oracle is explained by movements in the market: the residual price movement is based on company-specific factors. This average coefficient of determination suggests that the market related risks are average. And because company specific risks can be diversified, Oracle is a great pick for most portfolios at the present time.
Disappointingly, Oracle has an alpha intercept of (0.01%), which means that if the S&P 500 returns 0%, the stock can be expected to return (0.01%). But because of the average coefficient of determination, the raw beta and alpha are less meaningful.
Over the past five years, the average weekly price change on Oracle has been 0.38% (median 0.61%). The standard deviation over the period has been 3.47%. Thus for Oracle, the range of normalcy (average plus or minus one standard deviation) for weekly returns is between a gain of 3.8% and a loss of 3.1%. With an earnings miss, we can expect volatility in the coming week. In my view a weekly decline of 4.86% to 6.59% (average minus 1.5/2 standard deviations) from the close of $42.51 (buy target $40.44 to $39.71) on 6/19 represents a solid if not compelling buying opportunity.
Source: MaxKapital Beta Calculator
We might believe that Oracle is attractively valued. But thus far, its attractiveness has been viewed relative to other stocks in its sector, industry or the coverage universe in the analysis of the perception of different market participants. We also know that Oracle is cheap relative to the broad markets. What we do not know is whether the stock is priced to deliver a long-term return in line with our long-term expectations on a standalone basis and regardless of broad market valuations.
Mathematically, the worth of Oracle is estimated as [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate].
What is our long-term return expectation for a stock with a beta of 1.05, a long-term risk free rate of 4.50% and an equity risk premium of 5.75%? You can read more about where I get my estimates for long-term market returns and equity risk premium here. It is calculated as Risk Free Rate plus Beta Multiplied by Market Return less Risk Free Rate. Thus for Oracle, we should be targeting a long-term return of 10.54%. Is the stock priced to deliver that return?
Earnings tend to be volatile from year to year over the course of the economic cycle. When I speak of sustainable earnings, I mean the level of earnings that can be expected to occur over the course of an economic cycle, which can be grown at estimated growth rates over a long period of time. This chart below displays normalized trailing twelve month earnings over the past five years, together with analyst expectations for the current and coming three years. It also shows Oracle's historic revenues over the past five fiscal years.
Thirty nine analysts included on Reuters data estimate average operating earnings of $3.19 (High: $3.34, Low: $3.06) for the year ending May 15. Nine analysts assess long-term growth rates at 10.01% on average, with a high estimate of 15% and a low estimate of 6.5%.
I am comfortable with $2.87 (year ending May 2014 operating earnings) as a fair estimate of sustainable earnings.
The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution on account of employee and other issuances. I expect Oracle will pay out approximately 60% of earnings via dividends and buybacks (approximately 15% to 20% via dividends and another 45% to 40% via buybacks) over the long term. An adjusted payout ratio of 60%, assuming nominal earnings growth of 6.23%, implies a return on incremental equity of 15.575%: the 40% of earnings retained, invested at a 15.575% return on equity, delivers the required 6.23% (40% * 15.575%) growth. This return on incremental equity is not a challenge, considering that the recent return on equity is 25.25%, and it has averaged 23.78% over the past five years. Indeed, Oracle's payout ratio could rise higher still.
If we use a very long-term growth expectation of 6.23%, Oracle is worth $42.51. Oracle Value = [1 + Long-term Growth Rate] * Sustainable Earnings * Adjusted Payout Ratio / [Long-term Return Expectation-Long-term Growth Rate] = 106.23% * $2.87 * 60% / (10.5375%-6.23%) = $42.47. At this price, it is likely that an investor with a return expectation of 10.5375% will be satisfied.
The growth estimate implied by the current market price of 6.23% is low.
Alpha is estimated as the difference between actual returns and the risk adjusted return expectation. If we accept analyst estimates of forward five year growth of 10.01%, we get a composite very long-term (fifty-year) growth rate of 6.62% assuming that following five years growth at 10.01%, growth reverts to a 6.25% growth rate for the next forty-five years. If Oracle grows at a long-term rate of 6.62%, we have growth alpha of 0.39%. And an investor buying at present levels can expect a long-term return of 10.93%. The fair value implied using these assumptions is $46.87 (106.62% * $2.87 * 60% / (10.5375%-6.62%) = $46.87).
Oracle is capable of sustaining a composite very long-term growth rate of 8%, which is essentially in line with global potential nominal GDP growth rates. But to achieve this they must retain their competitive advantage through innovation. And this, given that they are positioned at number 1 or number 2 in all of their markets, is something they appear to be doing, and doing well. To err on the side of caution, I will work with a 7.13% composite very long-term growth rate. This rate is made up of a forward five year growth rate of 15.4% (16.3% past five years growth rate less 0.90% being the extent of growth driven via buybacks), with growth reverting to a 6.25% for the next forty-five years. A 7.13% long-term growth expectation gives me growth alpha estimated at $0.90% and expected long term return of 11.44%.
If we use a very long-term growth expectation of 7.13%, Oracle is rightly valued at $54.16 [107.13% * $2.87 * 60% / (10.5375%-7.13%) = $54.16]. So at present, we have 0.90% of long-term alpha, which translates to a 27% upside to "rightly valued", after which you can expect a very long-term total return of 10.5375% from the stock.
I don't believe a $54.16 fair value estimate is overly optimistic. However, it must be noted that the path to this level could be a long one. The 90 basis points of alpha may not be captured in days or even a year, it could take several years: better to look at the opportunity as one offering a total long-term annualized return of 11.44%, than a 27% short-term upside. A target for an investor with a shorter investment horizon would be near $47.
Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in ORCL over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.