- Oracle has missed sales and EPS expectations.
- Yet, the stock is a free cash flow king, and is fighting to gain ascendancy in high-growth areas.
- Founder and CEO Larry Ellison rarely sells, and I want to invest alongside him.
Background: It's nothing new that Oracle Corporation (NYSE:ORCL) has sold off after reporting earnings. Three months ago, Seeking Alpha was kind enough to publish my view that "Oracle Appears Undervalued", following a post-earnings sell-off to the $37.50-38 range. Anyone who sold on that "disappointment" was quickly in turn disappointed, as the shares mounted a quick rally to a multi-year high above $41. The shares then pushed higher to above $43. Due to rampant bullishness in the overall market, I took a guess and sold all my ORCL this week in our trading accounts (i.e., IRAs). Right now I'm seeing the same pattern emerge as occurred three months ago. While I'm more cautious on the overall market now than I was then, my stock-specific reaction is the same: Oracle is one of today's new blue chips, and is, quite simply, too cheap.
Introduction: Oracle is the last of the major Silicon Valley Mohicans. Lawrence Ellison, a close friend of Steve Jobs, is the only CEO of the large tech companies to continue in that role. Not only is he a stalwart by remaining at the helm, but he rarely sells stock. With Oracle busily shrinking its shares outstanding (while maintaining a strong balance sheet), he is, as it were, very slowly taking the company private. At last count, he owns an absolutely amazing 25% of ORCL. This high-and-rising ownership percentage is an extraordinary vote of confidence. It exemplifies the Warren Buffett principle of non-diversification, writ very large. It is also an example of the Peter Lynch principle of investing in what you know.
It is impossible to argue with the success of ORCL. Here is its long-term chart:
According to Yahoo Finance, ORCL has gone from 6 cents in March 1986 to the current price, which I'll call $40, assuming it opens down as indicated in after-hours trading. (Note, the 6 cents number is adjusted for numerous splits.) This is an astounding 26% compound annual return over 28 years, dividends not included. It is difficult to appreciate the degree of success this represents. One way to do so is to compare ORCL to the chart of Ellison's great friend Steve Jobs's company:
It's barely a contest - ORCL all the way. Of course, Apple (NASDAQ:AAPL) suffered in SJ's absence in the 1980s-'90s period, so the comparison is not even-handed. Relatively unheralded Oracle, so often criticized for being behind this curve or that trend, has been a far better investment than the most famous stock of our era. (Not shown, ORCL has also outperformed Microsoft (NASDAQ:MSFT), which itself has outperformed AAPL.)
Even the ridiculous late '90s bubble in ORCL looks, with the benefit of the passage of so many years, like a mere deviation from an inexorable uptrend. ORCL is within hailing distance of its Y2K high, and I want to think that exceeding it is inevitable.
My guess is that because Oracle markets to businesses and other organizations, such as governments, but not especially to individuals, its stock is less publicized than that of consumer-facing AAPL or even MSFT. I continue to believe that ORCL is a compelling relative value. Please understand that I use the term "compelling" with the understanding that I believe that this is true only because of the lack of "normal" alternative investment values, all related to the past decade's financial crises and the Fed's responses thereto.
The latest quarter - really, not bad at all: I'm paying little attention to Wall Street's latest temper tantrum that ORCL not only missed whisper numbers, it also missed published numbers - a no-no both to day traders and to algos. But what matters is whether the shares are simply undervalued. What is the present value of future cash flows that ORCL can be anticipated to return to investors? All the rest is game-playing, gambling, short-term thinking, etc. Let us assume the stock can be bought Friday for $40. What have we learned about Oracle's recent past and probable future from today's earnings report?
First, we learned from the earnings report that in constant currency terms, sales rose, and prospects for acceleration in the key cloud category are poised to continue to accelerate in the current quarter and, it is hoped, beyond that, per corporate guidance. Overall sales grew 3% yoy, both nominally and in constant currency. Expenses also grew 3% yoy on non-GAAP measures. (Because amortization charges for intangibles and goodwill are more than triple the more relevant charges for stock options expense, I am going to use non-GAAP measures herein.) So, margins were fairly stable. Income tax rates dropped (again, non-GAAP) 0.8 percentage points, and net income rose 1% yoy. Given substantial share shrinkage, non-GAAP EPS rose 5% yoy.
Now, there is nothing dynamic in this quarterly report. However, Oracle is in the midst of a major business transformation. As we know, it is battling not only the usual heavyweights, but also various contenders/pretenders who have made great strides in the cloud. And as usual, Oracle has fought back with acquisitions and internal product development. As always, it has done so with determination and bravado -- but also with real products. Not a shy company, it wants investors to ignore the fact that it is chasing, and not leading, this trend. It titled its Yahoo Finance press release as follows:
Oracle Becomes the Second Largest Cloud SaaS Company in the World
While this is making a virtue out of a problem, the facts and hope are impressive for this come-from-behind effort. From the press release:
"Our cloud subscription business is now approaching a run rate of $2 billion a year," said Oracle President and CFO Safra Catz. "As our business has transitioned, more software revenues are being recognized over the life of a subscription rather than upfront. We're making this transition to cloud subscriptions and ratable revenue recognition while continuously increasing our top-line revenue and our bottom-line profits year-after-year."...
"Oracle is now the second largest SaaS company in the world," said Oracle CEO Larry Ellison. "In SaaS, we're in front of everybody but salesforce.com. In IaaS we're larger and more profitable than Rackspace. We have by far the most complete portfolio of modern SaaS and PaaS products in the industry: CRM: Sales, Service & Marketing; HCM: HR, Payroll & Talent; ERP: Accounting, Procurement, Supply Chain & more. All these SaaS products run on the world's most powerful PaaS: the Oracle in-memory multitenant database and Java. We plan to increase our focus on the Cloud and become number one in both the SaaS and the PaaS businesses." (Emphasis added.)
I'm certain that it plans to do so, and I don't doubt that it will do it. In other words, it plans to accelerate earnings; it is "promising" that the current slow growth is transient.
In the meantime, the company is a huge free cash flow generator, and this remains the same, no matter whether sales or earnings are marginally below official Street expectations.
Let's look at Value Line's FY 2015 expectations (all data per share, except where noted). VL predicted $3.45 for cash flow and only 15 cents for capital spending. That suggests that at $40, ORCL is trading at little more than 12X free cash flow for the 12 months ahead. This would be an FCF yield of 8.3%; let's call it 8%. Where can you get 8% these days? All Oracle has to do to justify an investment is keep returning 8% a year, i.e. not grow at all. However, it's unlikely in my view to fail to grow at some measurable rate, given its many growth drivers plus general inflation. Pick your growth rate. Let's say it's 5% a year, on average, until the 2025-2030 time frame. This unchallenging expectation projects an FCF yield of 16% in 2028. Where can you come close to getting that sort of yield? You cannot, not even in the deep junk category.
General considerations: The investment world has changed to reflect the realities of today's economy. Things invented in the 1800s, such as primitive automobiles, have had their growth-y day in the sun. Databases and applications that sit on top of them, and outsourced cloud functions, are ascendant. For this reason, ORCL receives a #1 rating for Safety from Value Line, largely because of an A++ financial strength rating. Long-term interest payments are a tiny $900 million annually, against what may be $14 B in net profit this fiscal year. Oracle does almost twice the sales as SAP AG (NYSE:SAP), and has much higher operating margins than its larger competitor in some spheres, Microsoft.
As occurs routinely when an industry is gaining in importance in the economy, leaders such as Oracle have many ways to grow. Currently, the company is touting its latest database; no matter that it is playing catch-up to SAP technologically in some respects. In hardware, I think that Oracle deserves some credit for toughing out the troubled Sun Microsystems acquisition to reach the current level, where there is something to crow about:
"We have transformed Sun's commodity hardware business into a profitable and growing Engineered Systems business," said Oracle President Mark Hurd. "Our overall hardware business grew 2% in constant currency this past year. We saw record levels of Engineered Systems shipments and expect to deliver our 10,000th unit in Q1."
Not too shabby, and vastly better than the humiliating hardware results that it reported quarter-after-quarter, having over-hyped the acquisition.
Risks: As noted, Oracle is in multiple dog-fights, both with giant competitors that have immense resources, as well as with smaller, innovative, and quite ambitious cloud and other companies. In addition to all the usual market risks, the Oracle bears make much of its current slow growth, reliance on bolt-on acquisitions, and such chronic problems as maturity of its core database business. From a broad market standpoint, we are now in a seasonally weaker time of the year, and the overall market is approaching three years with only an occasional weak spot. Even in the case that my overall optimism for ORCL is correct, I have no special sense that over the next day or two, a spike bottom will occur as occurred three months ago. My trading sense is more cautious now.
Another risk is that long-term interest rates rise strongly, which would make Oracle's prospective earnings years from now less valuable.
Summary: Oracle has emerged as a legitimate blue chip in the greatest secular growth area of our time, information technology (biotech being more dynamic right now, but much smaller). That macro positioning means, in my view, that investors are undervaluing its likely future cash flows. So, I am happy to own the shares along with Mr. Ellison, accumulating them on little earnings hiccups as occurred Thursday, and flipping some periodically if my trading sense so guides me. Oracle's latest Q4 does reflect some growth issues as its business transitions to the cloud. Overall, I see this name as a low-risk, high-quality investment opportunity that is well-positioned to grow for years to come, while remaining a strong free cash flow generator. Thus, I believe that investors can achieve the combination of rising cash flows being returned to them while the underlying equity can have a rising P/E: the classic double-barreled win that underpins most dynamic equity investments. However, as shown above, even a static or even mildly dropping P/E can allow for very competitive total returns, given the extraordinarily low interest rates available as alternatives.
I anticipate being in the market to buy back the ORCL shares I sold just a day or two ago, and possibly to increase my holdings if the shares sell off vigorously enough.
Additional disclosure: Not investment advice. I am not an investment adviser.