Oracle Could Leap On Cloud In 2013

May.16.12 | About: Oracle Corporation (ORCL)

Oracle (NASDAQ:ORCL) has been known for buying up smaller companies and integrating them nicely under its roof. During the last decade, Oracle acquired PeopleSoft (2005), Siebel Systems (2006), Hyperion (2007), BEA Systems (2008), and Sun Microsystems (2010). More recently, Oracle has acquired two cloud computing software companies, RightNow and Taleo. I believe that Oracle will benefit from these two acquisitions, and after the company integrates them, its earnings per share and stock should rise in 2013 due to increasing demand for cloud computing. Also, Oracle stock at current valuation levels provides a good entry point as it is undervalued compared to competitors. The company is a strong free cash-flow generator with above-average profit margins while its stock price has been lagging.

There are various opinions about cloud computing, but without doubt it is an industry that is here to stay and shape the future. Oracle recently acquired RightNow Technologies and Taleo to expand its offerings in this area. RightNow offers cloud-based customer experience management and had about $180 million in revenue in 2011. While the purchase price was steep at eight times sales, or $1.5 billion net of cash and debt, I think Oracle will be able to leverage the new technology. Oracle prides itself on having 100 of the Fortune 100 firms as clients. It will be easy for Oracle to offer to its existing clients cloud-based customer service solutions at a minimal incremental costs.

Similarly, Oracle bought Taleo for $1.9 billion net of cash and debt earlier in 2012. Taleo generated $309 million in revenues in 2011, so Oracle paid a better price at 6.2 times sales. In my opinion, this makes sense as customer service outsourcing is a lot more popular than human resource outsourcing. Also, customer service deals with external clients and is crucial for sales. Human resources, while also important, is viewed more as a cost center. I estimated that Taleo and RightNow will start contributing between $250 million to $275 million in revenue in the first fiscal quarter of 2013, starting June 1, 2012. Oracle, with its resources, should be able to increase an already remarkable growth these two formerly independent companies have experienced in the past (over 20% of revenue growth per year).

Companies are increasingly moving their IT operations to the cloud. Amazon (NASDAQ:AMZN), which is known for selling books and many other items, offers its own cloud service called Amazon Web Services. The division generated revenues of $1.2 billion and had a net income margin of about 10%. This is not bad for a business launched six years ago. Google (NASDAQ:GOOG), which is best known for its maps and search capabilities, is also catching up to the cloud craze. This is not a surprise, as cloud-based revenues are expected to grow from $3.7 billion in 2011 to $10.5 billion in 2014.

Similar to Oracle is another technology company, Hewlett-Packard (NYSE:HPQ), whose CEO recently left for Oracle. It is expanding into the cloud business through acquisitions. At the end of 2011, Hewlett-Packard bought a German-based print and cloud solutions company Hiflex. This follows the $10.2 billion acquisition of U.K.-based Autonomy for $10.3 billion, which was preceded by the acquisition of 3PAR for $2.4 billion. All this should allow Hewlett-Packard to enter the enterprise and cloud-computing business. In my opinion, Hewlett-Packard, which is known mostly as a consumer company, faces headwinds in growing its enterprise solutions business as Oracle, IBM (NYSE:IBM), Microsoft (NASDAQ:MSFT), and even Amazon have a large lead.

In terms of share valuation, Oracle stock is undervalued in my opinion on a stand-alone basis, as well as when compared to other technology companies. During the past 10 years Oracle has been trading at a P/E ratio of 20. Currently, its shares are trading at a trailing 12 months P/E ratio of 14 and a P/E ratio based on estimated fiscal 2012 earnings of 11. This compares favorably to IBM and Amazon, for example, which are trading at forward P/E ratios of 13 and 177, respectively. In terms of margins, Oracle has some of the best profitability in the industry with an earnings before interest, taxes, and depreciation (EBITD) margin of 44%. This compares favorably to IBM's EBITD margin of about 25%, Hewlett-Packard's 11%, and Amazon's 4%. Only Microsoft comes close to Oracle with an EBITD margin of 42%. However, Microsoft sales grew at a 6% rate compared to 8% growth for Oracle.

In addition to an undervalued stock and solid profit and growth capabilities, Oracle pays a quarterly dividend of $0.06 per share for an annual yield of 0.9%. Also, Oracle is repurchasing shares and has over $4 billion authorized to repurchase. The company generates significant free cash flow for a free cash flow yield of over 11%. Its financial position is solid and it should be able to continue paying its debt while returning cash to shareholders in the form of dividends and share buybacks.

I anticipate Oracle will continue rewarding shareholders. I believe the company will further improve its performance in the future from its expansion into cloud-computing. There are other areas in which Oracle offers potential upside. For example, it owns the Java programming language that is used in various mobile applications and operating systems. Oracle is suing Google for patent infringement related to the Android mobile operating system. A partial verdict has been reached, and while Oracle has won a small victory so far, Google has come out ahead in some aspects of the case. At current valuation levels, Oracle stock offers a good investment opportunity to participate in the ever-increasing dependence on information and software.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.