Oracle: Behold The Power Of Low Expectations

| About: Oracle Corporation (ORCL)

Summary

Oracle's beat on top and bottom lines was driven by a stronger-than-expected performance from its cloud and hardware segments.

Though operating margins were pressured due to product mix, the company drove stable EPS on share buybacks.

With shares up +5% in after-hours trading Wednesday, the stock trades at a modest discount to my fair value estimate.

I remain a buyer on weakness.

Oracle (NYSE:ORCL) reported Q2 earnings Wednesday that largely topped analyst expectations on the top and bottom lines, after hardware revenues and margins came in higher than anticipated.

The long-term story for high switching costs continues to support the company's economic moat, as evidenced by growing revenues and stable margins in its License Updates and Support segment. The move to the cloud continues apace, and Oracle continues to drive revenue growth through recurring subscriptions to its cloud services, though lower margins and lower switching costs weigh on the company's overall profitability.

The company may be making headway as well in its attempts to overhaul its hardware segment through engineered solutions, but the long-term story remains to be told. I believe the shares are modestly undervalued relative to a fair value estimate of $48, though I view them with some caution despite the generally good results, as the long-term story poses challenges for the company. That said, I can't imagine Oracle's business eroding that quickly. So, on the balance, I remain cautiously optimistic.

Operating Results

Last Quarter 1 Year Ago Change Year to Year Change Year to Date
Consolidated Revenues $9,598,000,000 $9,275,000,000 3.5% 3.1%
Gross Margin 80.2% 81.5% -125 BPS -68 BPS
Operating Margin 36.9% 36.8% +14 BPS -149 BPS
Net Margin 26.1% 27.5% -146 BPS -113 BPS
Earnings per Share $0.56 $0.56 0.1% 1.2%


With analysts having largely predicted a decline in revenues, Oracle's relatively flat performance represents a solid beat on the top line. Though gross margins were pressured due to product mix, operating margins improved somewhat (though are still down for the year), with decreased Sales and Marketing and Acquisition costs. With operating income stable, a higher tax rate continues to pressure net margins, coming in at about 300 basis points higher year-to-year.

Segment 2014-11 2013-11 Revenue Growth Gross Margin 2014 Gross Margin 2013 Basis Point Change
New Software Licenses 2045 2121 -3.58% 85.5% 86.6% -104 BPS
Cloud SaaS and PaaS 361 259 39.38% 54.3% 59.8% -555 BPS
Cloud IaaS 155 97 59.79% 43.9% 21.6% 2222 BPS
Software License Updates and Product Support 4768 4516 5.58% 93.8% 93.7% 10 BPS
Software and Cloud Revenues 7329 6993 4.80% 66.6% 66.5% 13 BPS


Breaking down performance by segment, the long-term move to the cloud is obvious. Revenues for cloud services jumped by an aggregate 45% year-to-year, with margins improving for cloud services by an aggregate 170 basis points. This stands in stark contrast to the flat-to-declining margins in virtually all other segments, including hardware.

Segment 2014-11 2013-11 Revenue Growth Gross Margin 2014 Gross Margin 2013 Basis Point Change
Hardware Systems Products 717 714 0.42% 0.485355649 0.483193277 22 BPS
Hardware Systems Support 617 609 1.31% 0.646677472 0.648604269 -19 BPS
Hardware Systems Revenues 1334 1323 0.83% 0.559970015 0.559334845 6 BPS


For the hardware segments at least, a flat comp was better than the -10% comp many analysts had been expecting, and margins remained robust. On the bottom line, though net margins fell. Oracle's EPS of $0.56 came in flat year-to-year on the back of over $2 billion worth of share buybacks.

Last Quarter 1 Year Ago Change Year to Year
Book Value Per Share $10.07 $9.47 6.4%
Net Current Asset Value per Share $0.25 $0.56 -55.6%
Tangible Book Value per Share $2.24 $1.73 29.40%
Current Ratio 4.34 3.38 28.6%


The balance sheet remains robust, driven by a large gain in short-term investments and some debt restructuring. The company continues to have a large amount of cash on hand, and continued bolt-on acquisitions seem to be a likelihood. That said, goodwill is piling up a bit on the overall balance sheet. Even with the goodwill, though, Oracle remains in fine financial shape.

*Numbers from Oracle's Investor Relations website

Assessment And Outlook

Oracle's performance this quarter was largely in line with my investment thesis, which was that the company would be able to transition, albeit slowly, to cloud-based platforms that seem to be all the rage with the kids these days. The company's legacy products' switching costs appear intact, as it seems Oracle's transition toward software-based solutions isn't having too much of a negative effect on its installed user base. That said, the impact on operating margins has been notable and, in general, Oracle's economic efficiency over the years can be seen in the slow but nigh inexorable decline in working capital turns.

Source: self-produced. 10-y financial data from Morningstar.

That may have something to do with the company's battleship-slow pivot toward software solutions, so I would hope to see improvement in time. But as much as these most recent results are encouraging, I'm not sure it's guaranteed. That said, the company's fortress balance sheet, extremely high switching costs associated with its legacy products, shoring up of its weaker segments and rapid expansion into the cloud suggest that it may yet exceed the market's low expectations.

Valuation

I value ORCL at about $49 per diluted share. I average the results of a historical valuation model ($50) and a discounted cash flow model ($48) to arrive at my result. For my discounted cash flow model, I assume low-single digit (2-3%) revenue growth for this year and mid-single digit revenue growth thereafter (around 7% or so), as the company's cloud offerings gain traction. I model revenue declines in the back half of the decade outlook to account for the increasing proportion of cloud products. Countering this, however, I envision a general compression of operating margins (by about 100 basis points), as competition heats up and the high margins offered by legacy products recedes.

The model forecasts 2015 EPS of $3.00 and 2015 EPS of $3.37. I assume a 9.5% weighted average cost of capital to discount cash flows. For my historical valuation model, I apply historical price-to-earnings, price-to-book and price-to sales ratios of 18.5x, 4.2x and 4.76x to forward estimates. My overall fair value estimate of $49 implies a 5-year forward PEG of 1.18, EV/EBITDA ratio of 12.97 and forward PE ratio of 16.7 times.

Quantitative Analysis And Conclusion

Free Cash Flow Yield 7.67% Historical PE 18.49
Calculated FCF Growth -0.36% Historical PB 4.21
FCF Total Return 7.30% Historical PS 4.76
Expected Earnings Growth 3.63% 5-Year Forward PEG 1.18
Dividend Yield 1.18% FPE 16.67
Anticipated EPS Total Return 4.81% Fair EV/EBITDA 12.97
Median ROIC/WACC 1.91 Current EV/EBITDA 10.73
Morningstar Moat Wide Cost of Equity | Cost of Capital 11.32% | 9.52%


I always feel like I should have bought more Oracle after a dip, and now is no exception. The long-term story remains intact, though risks remain. I am happy to hold my shares for the moment, and with shares up about 5% after hours, will probably continue to add on any weakness.

Disclosure: The author is long ORCL.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: General Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. The author is not a professional financial adviser. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions.

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