As I have stated earlier, tech is a key sector to invest in if you are optimistic about a recovery. Perhaps nowhere will these gains be strongest than in small software producers. ARI Network Services (ARIS.OB) and Cicero (CICN.OB) are two significantly undervalued firms. Given my background in investor relations, I can say with confidence that these firms are discounted primarily due to the fact that they are under-followed. As press coverage improves (and I plan on publishing focus articles on them), so too will their stock prices.
In the meantime, the attention will center around giants like Oracle (ORCL). In this article, I will run you through my DCF analysis on Oracle and then triangulate the result with an exit multiple calculation and a review of the fundamentals relative to Microsoft (MSFT) and Adobe Systems (ADBE). I find that the firm is incredibly cheap.
First, let's begin with an assumption about revenues. Oracle finished FY2011 with $35.6B in revenue, which represented a 32.8% gain off of the preceding year. This accelerated off of 15.3% growth in 15.3%. Despite these improving trends, I bearishly model growth trending from 12% to 6% over the next six years. In light of the fact that analysts are expecting around 10.6% per annum growth for the S&P 500 over the same time period, my estimate is extremely conservative. No matter, this will underscore just how undervalued Oracle really is.
Moving onto the cost-side of the equation, there are several items to consider: Operating expenses, capital expenditures and taxes. I expect cost of goods sold to eat 22% of revenue versus 22% for SG&A, 12% for R&D and 1.5% for capex. Taxes are estimated at 27% of adjusted EBIT.
We then need to subtract out net increases in working capital. I model this figure to hover around 1% of revenue.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of $42.67, implying 41.8% upside.
All of this falls within the context of impressive recent performance:
"We had a very solid quarter, as new software license revenue was up 7%, $2.4 billion, and that's really on top of the enormous 29% increase last year. As I said last quarter, all we really needed to do was focus on our execution and that we did. We exceeded our forecast for new license guidance, we met our forecast for total revenue and we beat the high end of our EPS guidance. Technology new license revenues were $1.7 billion, up 10% in constant currency, 9% in U.S. dollars. Applications were $658 million, up 3% in constant currency and U.S. dollars. As you recall, we saw 34% growth in apps last year and 21% the year before that."
From a multiples perspective, Oracle is equally attractive. It trades at 16.5x past earnings but only 11.8x forward earnings. Adobe trades at a respective 20.1x and 12.5x past and forward earnings versus 11.6x and 10.6x for Microsoft. Assuming a multiple of 16.5x and a conservative 2013 EPS of $2.52, the rough intrinsic value of Oracle's stock is $41.58.
Consensus estimates for Microsoft's EPS forecast are that it will hit $2.99 in 2013. Assuming a multiple of 13x and a conservative 2013 EPS of $2.90, the rough intrinsic value of the stock is $37.70. The company delivered impressive recent performance despite a challenging PC market. Demand held up strong, and a record holiday season was record - largely driven by Xbox 360. I believe that the firm is led by top management that has a secured a strong foothold in the emerging cloud business. With its leading brand, Microsoft is also a safe defensive play.
Adobe, on the other hand, is riskier than both Microsoft and Oracle. It is 56% more volatile than the broader market and does not offer any dividend yield. At elevated multiples, the firm requires meaningful growth to justify its valuation, let alone to create value. While I am optimistic about the firm's future, I believe it faces intense competition beyond what the market acknowledges. If it can make it out of the full recovery with greater than expected market share, it will be well positioned to significantly outperform the overall stock market.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.