Can Oracle Take Over EMC?

| About: Oracle Corporation (ORCL)

As many may know Oracle's (NASDAQ:ORCL) OpenWorld event is currently taking place this week. This is usually the time and place where Oracle shows off new products and discusses the company's plans for the future. Many Oracle investors have been expecting a shift to cloud computing and big data because Oracle has struggled to keep pace with cloud storage companies. On the other hand, Oracle is in the midst of outlining a cloud computing plan that should be understood by Thursday, October 6th. Part of this plan includes similar products from EMC (EMC). More specifically, Oracle plans to offer virtualization with "better scalability than VMWare (NYSE:VMW) at 'dramatically' lower costs."

While Oracle allowed EMC's Joseph Tucci and Patrick Gelsinger to present an opening keynote for OpenWorld, I believe Oracle is in the process of phasing out EMC. Keep in mind Oracle and EMC have been locked in a healthy partnership for over 15 years, but it appears Oracle is planning to break away. In theory this would allow Oracle to maintain higher margins because the company would no longer be using part of EMC's products and getting help from EMC's staff. On the other hand, Oracle may not be ready to enter cloud computing single handedly.

Up until recently Oracle has been a software application giant with minor endeavors into the hardware space. This has caused Oracle to fall behind other companies that have innovated into cloud computing such as Google (NASDAQ:GOOG) and (NYSE:CRM). The difference is Oracle has become known for application software while the others are known for, among other things, data storage. If Oracle attempts to jump into cloud computing; which is undeniably the future, we may see Oracle struggle compared to EMC and One way Oracle can get into the cloud and big data space directly is by acquiring a cloud computing company. In a previous article I outlined several cloud computing stocks; many of which are strong M&A targets, but EMC would be Oracle's best bet. This may seem farfetched since EMC's fair market value is over $40 billion, but Oracle may be able to put the financing together.

Before I begin with the hypothetical transaction it is important to discuss the background of Joe Tucci and EMC. For at least three years Tucci has been planning to step down as EMC's leader sometime before the end of 2012. It now appears Tucci will step down and become executive chairmen at the end of 2012. Tucci will stay with EMC for roughly two years to help run the company in order to ensure a smooth transition. After which the newly appointed CEO will take over and run EMC by himself. Keep in mind this same succession plan occurred in 2001 which gave Tucci the job. Also, before moving forward it is important to note Tucci has stated he would entertain the idea of selling EMC if the right price is offered to give shareholders a favorable deal.

With that said, the question remains the same; can Oracle make it in the cloud computing space and can Oracle afford EMC? In order to follow the premise of Oracle purchasing EMC, it will be imperative to assume Oracle will not make a dent in the current cloud computing market as a standalone company.

If Oracle were to make an acquisition attempt, the company has roughly $13.16 billion in cash at their disposal as well as $18.5 billion in short term investments. Including this $31 billion, Oracle has about $73.86 billion in total assets. Oracle also has $14.79 billion in debt. However for the time being I will ignore the current debt because it will take a substantial amount of debt in order to make a bid for EMC.

The most important question is how much can and would Oracle be willing to offer for EMC? Since EMC's stock has slid from the 52 week high, Oracle can come out looking like an angel in front of investors by offering a 20-25% premium over the current share price. Of course long term investors of EMC may not be as happy since this will not be a premium to the current 52 week high; which may be eclipsed during the next earnings report if the market can continue a rally. Nevertheless, the table below outlines how much Oracle may offer for EMC; along with how much that offer would cost.

Potential Offer per Share Overall Cost Premium Over Wednesday's Close
$22 $45.43B 1.8%
$23 $47.49B 6.4%
$24 $49.56B 11.1%
$25 $51.62B 15.7%
$26 $53.69B 20.3%
$27 $55.75B 24.9%
$28 $57.82B 29.6%
$29 $59.88 34.2%
$30 $61.95B 38.8%
$31 $64.01B 43.5%
$31.50 $65.05B 45.7%

As you can see the price of EMC will decimate Oracle's cash and short term investments; if Oracle decides to use short term investments. Also, as you can see above in bold, I feel $28-$29 per share would be a fair value for both companies. Even though this value is below the 52 week high, it would enable EMC investors to receive payment for the highest value the stock has seen since June 2001. Furthermore, if a recession does emanate in 2012, long term investors should be happier being paid for their long term standing with EMC instead of withstanding another costly recession.

Assuming Oracle offers $28 per share, the original question remains: can Oracle finance a $58 billion transaction? Due to the lack of cash on hand, the company would have three options: first, Oracle can sell assets to raise money; secondly Oracle can simply take out a large debt offering to finance the acquisition; and lastly Oracle could possibly do a combination of both. I will assume Oracle would take the large debt offering because with EMC providing cash flow Oracle will be able to pay off the debt by 2020. And for ultra long term investors this is a very positive sign.

Before moving on to how EMC would pay off the large amount of debt within a decade, it is important to discuss how Oracle may make the acquisition. If this purely hypothetical situation occurs, I would expect to see Oracle offer $11 billion in cash along with another $9 billion after liquidating half of the company's short term investments. This would leave Oracle with a $38 billion debt offering. This may seem like an exorbitant amount of money, but, as previously stated, Oracle would have no problem paying the debt off in less than a decade.

The table below shows how EMC's cash from operating activities will allow Oracle to pay off the $38 billion in debt within a decade. Please keep in mind this is arbitrary because interest rates are not known and the typical merger and acquisition fees would make the overall price of a merger higher. With that said, I will detail three scenarios of EMC's cash flow that would directly flow into Oracle's coffers. The first is a conservative approach that takes into account a growing cloud computing and big data market. Therefore EMC's cash from operating activities will not grow at exponential levels. The second column is based upon the mean difference in cash from operating activities from year to year over the last four years. The third column is a highly bullish estimate based upon the mean of the percent increase from 2006 to 2010. In other words, the final column takes the mean of 113% over five years; which is roughly 22% per year.

Year Conservative Estimate Fair Estimate Bullish Estimate
2011 $4.4B $5.1B $5.6B
2012 $5.1B $5.7B $6.8B
2013 $6.0B $6.3B $8.3B
2014 $6.6B $7.0B $10.1B
2015 $7.3B $7.6B $12.3B
2016 $7.8B $8.2B N/A
2017 $8.5B N/A N/A
Total $45.7B $39.9B $43.1B

One note to make regarding the chart above is the conservative estimate is listed as the highest cash return, however the premise of the table is to show how long it would take each trend to reach at least $38 billion; therefore the conservative estimation needed to go to 2017 to fulfill that duty. If you expand the "fair estimate" column one more year the total equates to $48.5 billion and the "bullish estimate" equates to over $76 billion in net cash from operating activities. Even with the additional M&A fees and interest rates if EMC brings in $76 billion for Oracle, the company will be debt free in 2017.

With that said, we have not discussed several important factors regarding the transaction. First, EMC's cash ($3.89 billion) and debt ($3.45 billion) would virtually cancel out leaving Oracle with no additional debt problems. Secondly, and most importantly, EMC's near 80% stake in VMWare will provide Oracle with a proven virtualization company that has a very bright future. The problem with this argument is the fact that Oracle has stated they are planning to offer a more scalable product than VMWare. With that said, if Oracle has control of VMWare, Oracle will be able to produce an already proven product and not take a chance on their own technology.

Now that we have discussed EMC's stake in VMWare, we can now discuss one final option for Oracle. Since EMC owns roughly 80% stake in VMWare, if Oracle buys EMC, Oracle will inherit VMWare. If Oracle wishes, the company could sell the 80% stake and rake in anywhere from $25-$30 billion. This would substantially decrease the amount of debt owed by Oracle in a very short period of time. If Oracle does not feel the need to sell the entire stake, the company could obviously leave itself with a smaller share. This would be a good idea for two reasons. First it would give Oracle a substantial amount of cash to pay down debts. And secondly it would allow Oracle to still own a smaller fraction of VMWare to sell later as the stock continues to rise in the future.

Now that we have gone over the possibilities of Oracle buying EMC, it is also important to take a look at Oracle's recent financial results to determine whether Oracle needs a major change. As I stated in the first paragraph, Oracle investors have been hoping for a new innovation from Oracle and the step into cloud computing will be that innovative step. However will it be enough to turn the company around? Lately we have seen past giants such as Research in Motion (RIMM) and Cisco (NASDAQ:CSCO) dive due to innovation concerns and a lack of profits. Also, over the last 10 years we have seen Microsoft's (NASDAQ:MSFT) stock fall ill to a stagnation pattern. This raises another question: is Oracle headed down the same path as Microsoft unless a major move is made?

By viewing the last five quarters, there is a trend forming that is approaching a "crisis" point. I call this a crisis point because if Oracle is unable to bring in strong revenue, net income, and EPS during Oracle's fiscal second quarter we may see the share price take a dive. As you can see below in the table, Oracle's revenue, net income, and EPS failed to surpass the levels seen during the three previous quarters. The one good note to make is year over year Oracle beat revenue, net income, and EPS by 11.6%, 36.1%, and 33% respectively. This is good because it shows under similar market conditions the company performed well.

Oracle's Financials

Revenue $8.37B $10.77B $8.76B $8.58B $7.50B
Net Income $1.84B $3.21B $2.16B $1.87B $1.35B
EPS 0.36 0.62 0.41 0.37 0.27

One of the more difficult aspects in gauging Oracle's stock is the fact that the chart shows a strong company. Since the bottom in 2002, the stock has continued an upward trend with no slowdown in sight. This brings up a question of whether the stock can continue this trend in the future or is the stock about to begin a long stagnation phase? The only way to answer this is by waiting 3-5 quarters and seeing if Oracle's earnings are able to continue moving forward year over year. With that said, if Oracle does indeed make a bid for EMC, I expect to see Oracle's stock climb to the moon over the next decade as data storage is set to grow roughly 44 times by 2020.

Hopefully I have given ample time to digest the hypothetical buyout of EMC by Oracle because now it is important to discuss how likely this is to happen. At the beginning I stated this may sound like a farfetched proposal because it is highly unlikely. It may not be something to rule out, but I would not expect to see plans begin for a buyout until Oracle gets the chance to discern their own cloud computing business. If it flounders over the next year the buyout would become more of a possibility. The downside to this is EMC's stock is likely to rise higher over the next year; assuming a recession does not begin.

One of the key points to take home that was not explicitly stated is big data and cloud computing are going to be one of the fastest growing markets over the next decade. In order for Oracle to stay competitive the company will need to innovate new products or make a major buyout. By Thursday evening we will know the exact plans of Oracle's cloud computing and virtualization endeavor. I am not expecting to see EMC or VMWare products at the OpenWorld presentation of Oracle's cloud plans because Oracle is attempting to use what EMC has taught the company over the years to better suit themselves. While this may seem disrespectful, keep in mind EMC is one of the most friendly and non offensive companies on the market and I expect Tucci and EMC to be happy seeing Oracle embark on their own cloud dreams.

Disclosure: I am long EMC.