Company CEO Larry Ellison recently announced that Oracle (ORCL) will join the cloud battle. Along with President Mark Hurd, Ellison outlined a broad lineup of PaaS (platform as a service), SaaS (software as a service), and particularly social media offerings on June 6, 2012.
This decision is being made at a time when the high-margin traditional software business model is being greatly challenged by cloud computing offerings. I believe Oracle is very likely to succeed in this strategic move. If so, a higher portion of revenue from lower-margin cloud services should depress its operating margin in the long run.
However, with these predictions factored in, my DCF model still suggests a fair value of $40, implying a 30-percent-plus discount from its closing price of $27.16 on June 8, 2012.
Oracle has been very good at what it does
Oracle is one of the best software companies on the world. It is the second largest software company by market cap just after Microsoft. Its $24.53bn software revenue in 2011 ranks it the fourth among the global software industry. It is very efficient at turning sales into hard cash. Its operating margin has never dropped below 30 percent since 2002. Its free cash flow over sales hovered around 30% during the same time period. It is liquid and solvent, with $4.55bn cash in hand, a healthy current ratio of 3.23 and a moderate financial leverage of 1.73 as of latest quarter.
Transferable strengths will help Oracle win the cloud battle
Here are three reasons why Oracle has been able to fend off its competitors and maintain a high margin business. These competitive advantages are largely transferable in the cloud setting.
1. Oracle excels at database
Hosting data on virtual machines does not eliminate the need for solid database management software. To the opposite, cloud vendors have an even greater need for efficient, reliable and secure platform and database architecture in place to support multi-tenancy. Oracle's dominance in the database business will be heightened in the cloud.
Another strength for Oracle lies in managing big data. Big data refers to datasets that are too complex and large in volume to be handled by ordinary database tools. The rise of social media and the growth of consumer-driven technology business produce more big data that needs to be tracked and analyzed. Oracle's cloud social services are created to meet the growing demand on this field.
2. Sticky products with high switching costs will continue to help Oracle win deals from big corporations
Oracle's clients are mostly large corporations, who are generally more risk-averse and biased towards status quo than SMEs. Its integrated software, middleware and hardware engineering makes its products sticky. High switching cost also presents a hurdle to switch vendors.
Furthermore, the 2011 cloud computing trends survey report prepared by hosting.com states on Page 8 that large company respondents hope to maximize value derived from previous investments in infrastructure while choosing cloud vendors. Integration with existing architecture is quoted as a top deciding factor. This gives Oracle the edge over other cloud providers to win enterprise clients.
3. Oracle knows how to grow through acquisitions
Oracle has scored a long list of acquisitions since 2002 to expand its product lineup, vertically integrate and obtain leading position in each market segment. An article on WSJ last December sums it well here: "Oracle is able to "acquire companies with 10%-20% operating margins, strip out costs, and rapidly realize 40% operating margins for the acquisition targets."
Given Oracle's M&A track record, it is not entirely unrealistic to imagine an acquisition of salesforce.com (CRM), which has a market cap of $18.9 bn. To put this number in perspective, Oracle bought PeopleSoft for $10.3 bn in 2005 and Sun Microsystems for $7.4 bn.
Moving into the cloud will depress margin
Although Oracle is well positioned to compete in the cloud computing market, the departure from the traditional software model will erode Oracle's profit margins. This comes in two ways: a higher portion of Oracle's revenue will be from the lower-margin cloud business. The margin and growth of its non-cloud software business will also take a hit.
Firstly, cloud computing has lower margin than the traditional software business. Customers can get cloud services at a variable cost. However, it takes vendors fix cost to offer such services. While customers can be flexible in their usage, vendors need to install enough machines and bandwidths for the peak usage volume. This is also true for Oracle. The following table shows that Oracle's cloud services have a much lower margin than its software segments:
Oracle's Business Segments
Operating Margin (%)
New Software License
Software License Updates and Product Support
Note: Data is taken from Oracle's 2011 annual report.
Secondly, as an economic alternative to enterprise software that charges high up-front cost, SaaS will depress revenue growth and profit margins of Oracle's non-cloud software business. As this article rightly points out and explains in great details, meter-pricing of SaaS alternatives is particularly disruptive to Oracle's old model. Price-sensitive clients would prefer cloud offerings. Customers that stay with Oracle would demand more out of what they pay, being fully aware of the economics behind alternatives to Oracle's products. In the next decade, Oracle should see a downward trend on its margins.
DCF assumptions are set below
My model forecasts free cash flows for each of the next 10 years and calculates a terminal value in 2021. Segment revenue and margin data is taken from Oracle's 2011 and 2008 annual reports. Other data on the income and balance sheets is sourced from Morningstar.com.
1. Revenue growth and margins
An annual revenue growth of 10% for new licenses is a rather conservative estimate. The revenue multiplier of 1.79 reflects my observation that software license update revenue strongly correlates with the previous year's new license revenue. I also forecast cloud services revenue to grow at an annual rate of 30% for the next 10 years. I assume margins for both segments of software business to decrease by 2 percentage point per year.
New software license
Slightly below trailing 10-year average: 10%
Decrease from 48% to 30% over 10 years. 2% per year.
Software license updates and product support
1.79 times previous year new software license revenue
Decrease from 90% to 78% over 10 years. 2% per year.
Total hardware business
Stable at 38%
About 5-year average: 30%
5-year average: 19.59%.
5-year average: 8.11%
5-year average: 16.51%.
Annual revenue remains the same as 5-year average, $380.33 mn
5-year average: 28.72%.
2. Cash and non-cash expenses
- Product development, marketing and administrative expenses is estimated to be 18.03% of annual revenue, the trailing 5-year average.
- Acquisition and restructuring cost: $405.8 mn per year.
- Stock-based compensation: $343.2 mn per year.
- Non-operating income (expense): $153.2 mn year.
- Effective tax rate: three year average of 26.43%.
- Interest rate expense: 4.88% of sum of short-term and long-term debts. I assume that debts grow at 20% per year.
- Amortization: 22.66% of previous year's intangible assets. Annual intangible asset is reduced by current year amortization.
- Depreciation: 15.80% of previous year's net PP&E. Annual net PP&E is adjusted by depreciation and capital expenditure.
- Capital expenditure: Trailing 5-year average, 1.45% of annual revenue.
3. Discount rate and terminal value
I use WACC as the discount rate. The weights of equity and debts are calculated using three components on the balance sheet of the latest quarter: common stock, retained earnings and long-term debt. I set cost of debt to be the percentage of annual interest expense over debt. I assign 10% to be the cost of equity for Oracle. Refer to this article on my blog for more details on how I decide the cost of equity. This gives a WACC of 8.35%. After 2021, I estimate free cash flow to grow at a perpetual rate of 3%. This gives a terminal P/E of 19.3, in line with Oracle's 5-year average P/E of 20.
Conclude on fair values
The model suggests a fair value of $39.94. Oracle is currently trading around $27. This gives investors a $12 safety margin, which I think is sufficient to cushion the risk that my model assumptions fail to materialize.
Alternatively, let's suppose that new software revenue grows at 6% and cloud services grow at 15% per year between now and 2021 and hold all else unchanged, then the fair value is revised down to $29.30, closer to Oracle's market price. I don't think it is likely that Oracle, one of the largest and best managed software companies, grows its business at a CAGR of 6% for the next ten years. In other words, the actual intrinsic value should be much higher than $29.30. Therefore, it is a great opportunity to buy Oracle at the current price now, especially before its Q4 2012 earnings come out on June 21, 2012.