Oracle (ORCL), a leading software maker which is venturing into hardware, reported $8.18 billion in sales for the fiscal first-quarter. This represents a 2.3 percent decline, missing the Bloomberg average estimate of $8.42 billion.
Does this slight disappointment create a buying opportunity for investors, or is Oracle unattractive at current valuations? Oracle's price multiples and growth trajectory were compared to its peers. In addition, its past cash flows used to acquire other companies was compared to other business technology solutions companies.
Q1 Revenue Lower than Estimated
This marks the sixth straight quarter that Oracle's hardware sales have fallen, an especially critical trend as Oracle is attempting to expand into cloud-computing services. Many customers that often hail from sectors such as banking and air travel use Oracle's database to store vital, mission-critical information. Oracle is working to deliver more technology through Oracle Cloud, which can make it possible for professionals to develop applications and distribute them online.
Oracle has been thwarted by slow hardware sales despite its acquisitions. It acquired Taleo for $1.9 billion and RightNow Technologies for $1.5 billion. In 2010, it bought out Sun Microsystems for $7.4 billion in a bid to acquire computer hardware. Revenues for hardware fell to $779 million during the fiscal first quarter, a decline of 24 percent.
On the bright side, core profits minus some items matched projections at 53 cents per share. Net income in the first quarter rose to $2.03 billion or 41 cents per share for Oracle. This represents an 11 percent increase from 36 cents a share or $1.84 billion in the previous year. Even better, new license sales rose to $1.6 billion, or 5.1 percent. License shares are critical and are considered by Wall Street as an indicator of future support revenue.
Analysts remain hopeful for Oracle. They project 5 percent sales growth for the company in the fiscal second-quarter. They forecast a 2012 earnings per share at 61 cents.
Valuation
Oracle trades at the highest price-to-earnings ratio and price-to-sales ratio among peer companies that provide technology solutions to big business:
Ticker | Company | P/E | P/S | Past 5 Years EPS Growth | Next 5 Years EPS Growth | Past 5 Years Sales Growth |
Hewlett-Packard | NA | 0.27 | 8.85% | 3.40% | 6.78% | |
Dell | 5.86 | 0.28 | 10.63% | 4.53% | 1.57% | |
International Business Machines | 15.26 | 2.26 | 16.60% | 10.08% | 3.18% | |
Microsoft | 14.83 | 3.37 | 7.01% | 8.87% | 7.60% | |
ORCL | Oracle | 15.67 | 4.13 | 19.28% | 12.27% | 15.58% |
Oracle does also have the best growth trajectory, both based on historical trends and based on analyst estimates. All in all, there is no reason to think that the market is over-punishing Oracle for its short-term disappointment.
Acquisition Addictions
We must next consider each of these firms' cash flow behavior. Some of these firms are serial acquirers, and grow by spending huge piles of cash to buy other companies. Usually an acquisition benefits the company that is being bought more than the firm that buys it.
Jim Chanos famously characterized Hewlett-Packard as a short candidate. Chanos is concerned that Hewlett-Packard will go on a spending spree to acquire other companies in desperate attempts to acquire lost market share. Value investors can use this pattern of behavior to diagnose value traps.
There is an accounting issue that arises from acquisitions. Research and development spending is typically expensed immediately but is largely capitalized in an acquisition. Firms which engage in acquisitions can shield reported earnings from R&D expense. Companies that internally develop their brands and technology would be at a disadvantage vis-à-vis accounting rules, since their earnings would be lower after expensing research and development costs. Their assets would be understated because they do not include expensed intellectual property. Worse yet, cash payments for acquisitions are not usually deducted when computing free cash flows.
Value investors who don't pay attention to this would fall prey to inflated valuation multiples for serial acquirers. Companies which buy R&D instead of doing it in-house would have lower price-to-earnings ratios, lower price-to-book ratios, and lower price-to-free cash flow ratios.
Therefore, investors should pay careful attention to acquisition expenditures and free cash flow adjusted for acquisition payments. Net acquisition cash flows were subtracted from free cash flow below:
Free Cash Flow ($ Millions) | 2007 | 2008 | 2009 | 2010 | 2011 |
IBM | 11459 | 14641 | 17326 | 15364 | 15738 |
ORCL* | 7159 | 7726 | 8451 | 10764 | 13095 |
HPQ | 6575 | 11601 | 9684 | 7789 | 8100 |
DELL | 3118 | 1454 | 3539 | 3525 | 4852 |
MSFT | 15532 | 18430 | 15918 | 22096 | 24639 |
Acquisition Cash Flow, Net | 2007 | 2008 | 2009 | 2010 | 2011 |
IBM | -699 | -6242 | -793 | -5867 | -1797 |
ORCL | -7643 | -1159 | -5606 | -1847 | -4702 |
HPQ | -6793 | -11248 | -391 | -7977 | -10391 |
DELL | -2217 | -176 | -3613 | -376 | -2562 |
MSFT | -1150 | -8053 | -868 | -245 | -71 |
Adjusted Free Cash Flow | 2007 | 2008 | 2009 | 2010 | 2011 |
IBM | 10760 | 8399 | 16533 | 9497 | 13941 |
ORCL | -484 | 6567 | 2845 | 8917 | 8393 |
HPQ | -218 | 353 | 9293 | -188 | -2291 |
DELL | 901 | 1278 | -74 | 3149 | 2290 |
MSFT | 14382 | 10377 | 15050 | 21851 | 24568 |
*Oracle's financial year ends in May. Its year ending 2012-05 was listed as 2011, and the other fiscal years were also moved back 5 months for a better comparison.
These numbers for adjusted free cash flow after acquisitions highlight how IBM, and Microsoft are cash generating juggernauts. Hewlett-Packard has a history of sporadic cash inflows and outflows after taking into account acquisitions. Dell and Oracle are in between these two extremes. These spending behaviors from the past 5 fiscal years are summarized below:
5 Year History | Total Adjusted FCF ($ Millions) | % FCF Spent on Acquisitions |
IBM | 73,071 | 20.66% |
ORCL | 34,631 | 44.41% |
HPQ | 4,658 | 84.12% |
DELL | 9,834 | 54.25% |
MSFT | 110,796 | 10.75% |
Conclusion
Oracle is not undervalued despite its recent disappointment. Instead of buying Oracle, investors should first consider IBM or Microsoft as firms with better spending discipline. IBM in particular has growth and valuation multiples which are similar to Oracle, while spending less than half on acquisitions that Oracle does as a percentage of free cash flows. Microsoft spends even less, though it has a much lower growth trajectory.
Please read the article disclaimer.
Disclosure: I am long IBM.
