Buy Oracle At A Discount

| About: Oracle Corporation (ORCL)

Oracle (ORCL) is the world's largest enterprise software company and a leading provider of computer hardware products and services. Its main competitors in this space are International Business Machines (IBM) and Hewlett-Packard (HPQ). Oracle has three main businesses:

1) Software Business: Represented 68% of total revenue in 2011. Includes database software, Fusion Middleware software, Business Intelligence, Data Integration, and many other offerings.

2) Hardware Systems Business: Represented 12% of total revenue in 2011. This division is a result of Oracle's acquisition of Sun in January 2010. Consits of SPARC servers running the Oracle Solaris operating system as well as x86 servers. Also includes storage products, such as tape storage systems.

3) Services Business: Represented 19% of total revenue in 2011. Includes consulting, cloud services, and training to customers, partners, and employees to accelerate adoption.

Along with spending $4.5 billion in R&D in 2011, Oracle has been actively acquiring companies such as Art Technology Group, Phase Forward, Sun Microsystems, and many others. This should allow Oracle to continue to offer new products and grow well into the future.

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Oracle's stock hasn't done much overall in the last year, trading as low as $24.72 and as high as $36.50. It currently trades for $29.56. Let's take a look at Oracle's financials:

(In Million $) 2007 2008 2009 2010 2011
Revenue $17,996 $22,430 $23,252 $26,820 $35,622
Operating Cash Flow $5,520 $7,402 $8,255 $8,681 $11,214
Capital Expenditure $-319 $-243 $-529 $-230 $-450
Free Cash Flow $5,201 $7,159 $7,726 $8,451 $10,764

Revenue has been growing quickly, doubling from 2007-2011, while free cash flow has done the same. Free cash flow was over 30% of revenue in 2011, which shows that Oracle is a cash machine.

Owner Earnings

Owner Earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines Owner Earnings as follows:

These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges... less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.

I'll calculate Owner earnings by taking the 5-year average capital expenditure and subtracting that from the operating cash flow. I'll also subtract stock-based compensation from the operating cash flow since it has a dilutive effect on the company but is routinely included in the cash flow figure. I'll also add interest payments adjusted for taxes since interest is tax deductible.

(In Million $) 2007 2008 2009 2010 2011
Operating Cash Flow $5,520 $7,402 $8,255 $8,681 $11,214
Interest Payments $343 $394 $630 $754 $808
Stock-based Comp. $0 $369 $355 $436 $510
Avg Capital Expenditure $-355 $-355 $-355 $-355 $-355
Owner Earnings $5,410 $6,956 $7,995 $8,451 $10,955

Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the Owner Earnings figures to determine Oracle's Cash Return on Invested Capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the Owner Earnings divided by the total invested capital. This is a better measure than ROIC because ROIC relies on earnings, which is a poor measure of profitability.

(In Million $) 2007 2008 2009 2010 2011
Owner Earnings $5,410 $6,956 $7,995 $8,451 $10,955
Invested Capital $34,572 $47,268 $47,416 $61,578 $73,535
CROIC 15.65% 14.72% 16.86% 13.73% 14.9%

Oracle's CROIC has been fairly consistent over the past 5 years, with a CROIC of 14.9% in 2011. This means that given, say, $1 million in invested capital (retained earnings for example) the company will generate $149,000 on that investment. Oracle is clearly efficient in creating cash, with a high CROIC and high historical owner earnings growth. Here's the balance sheet:

Cash and Cash Equivalents $29,742
Investments $0
Debt $14,777
Pension Obligations $0
Minority Interest $393
Net Cash (Debt) $14,572
Diluted Float 5,123
Cash/Share $2.84

Oracle has a almost $15 billion in debt and debt-like obligations, with nearly $30 billion in cash and investments. This results in $2.84 net cash per share. Interest expense was 7.4% of owner earnings in 2011, which is perfectly sustainable. Oracle's balance sheet is strong, with plenty of cash to fuel future acquisitions.


I use a discounted cash flow analysis to determine the fair value of a company. I use a 15% discount rate, and you can read about my view on discount rates here. The average analyst estimate for 5-year earnings growth is 11.8%, while the CROIC is 14.9%. I will use an initial owner earnings growth rate of 11% and let that growth rate decay over 20 years to a perpetual rate of 3%, as shown in the growth rate table below.

Year 1 2 3 4 5 6 7 8 9 10
% 11% 10.6% 10.2% 9.8% 9.4% 9% 8.6% 8.2% 7.8% 7.4%
Year 11 12 13 14 15 16 17 18 19 20
% 7% 6.6% 6.2% 5.8% 5.4% 5% 4.6% 4.2% 3.8% 3.4%

Using these parameters I put the fair value of Oracle at $32.43 per share. The current market price is about a 10% discount to this fair value. Buy targets for various margins of safety are listed below.

Margin of Safety Buy Target
10% $29.18
15% $27.56
20% $25.94
25% $24.32


Oracle is an efficient company that is very good at generating cash. It is currently trading at a discount to fair value, but I would look for larger margin of safety before committing capital. It was trading under $26 at the beginning of the year, so it's not unreasonable to think we could see those prices again. Oracle is a great company, and if bought at a great price it could be a very good investment.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ORCL over the next 72 hours.

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