Before discussing the transaction du jour in the IT world, I have to offer a mea culpa to readers of these articles. I do write the articles with the goal of offering useful, profit making advice. Hopefully, that works a majority of the time. But yes, I am the guy who chose to write as recently as July 15 about the peculiar takeover speculation regarding NetSuite (NYSE:N) and Oracle (NYSE:ORCL).
I was dead wrong - obviously - and for that I tender my regrets. I thought then that it would be unlikely for a group of mature men and women to embark on a transaction of this size without some remote strategy of justification. Psychology, hubris, vanity - in a situation such as this, understanding motivations can easily transcend logic.
For those of you who didn't take advantage of the potential trade based on my analysis, my regrets. I do what I do using a certain methodology. It often works - but not always. This is one of those very prominent "not always." For those on the other side of the trade, congratulations.
Oracle has announced an agreement to pay $9.3 billion in cash to buy NetSuite. The consideration is one of the highest multiples of sales that has been seen for a company of this scale. NetSuite has never come close to making a GAAP profit and its sales growth at around 30% in its last reported quarter represented a nice improvement over the recent past.
The premium over the closing price before the announcement was 19%. But a far more appropriate gauge is the premium over the company's price on June 27 before the more emphatic rumors regarding a transaction started to surface. That premium is 63%, one of the more significant premiums seen in recent years for a transaction of this scale. Just as a comparison, the IGV has appreciated by 11% since June 27.
The press release says that the deal would only close if a majority of the N shares not held by Mr. Ellison and his family (about 60% of the total according to the most recent filing) votes for the deal. I will take a very, very long odds bet as to how that vote is going to go. The deal has been negotiated and approved by a committee of Oracle independent directors. Honestly, just reading the statement has provided me with new insight into the meaning of the word "independent."
The press release goes on to say that the deal will be accretive to Oracle's earnings in the first year after the deal's closure. Just for the record, N had non-GAAP earnings last quarter of $.08 or $6.6 million. That was a significant over-attainment and compared to non-GAAP earnings of $.02 in the year earlier period. The current estimates for N for 2016 are for EPS to double to $.45 and then to increase to $.71 in 2017. In dollars, given that NetSuite currently has 80 million shares outstanding, those estimates equate to income of $36 million and $57 million, respectively.
This is an era of zero interest rates - but that doesn't mean the cost of capital is actually zero for a private, profit making company. Given the consideration to be paid for NetSuite and the current forecast for earnings, the after tax cost of capital has to be something less than .6% for the deal to be accretive. I really am not inclined to comment further on that kind of analysis. Other observers with more sarcastic writing styles may find more to say on the subject.
Revenues are anticipated to increase by about 30% this year to $966 million and to rise 27% in 2017. There has been little in the way of material revisions to estimates for several months.
Before descending or drilling into the core of the argument, let's just try a 30,000-foot analysis. Oracle currently has an enterprise value of $156 billion. So the NetSuite acquisition, at $9.3 billion, represents 6% of the value of Oracle's enterprise value. In return for that 6%, NetSuite will be contributing 2.3% of the revenues of the combined enterprise and will be contributing about .5% of non-GAAP profits. Oracle had operating cash flow of $13.6 billion last year and NetSuite generated $68 million of operating cash flow in the first six months of this year. Almost all of NetSuite's cash flow is a product of stock based comp and more than 60% of the increase in cash flow is a product of stock based comp. So, NetSuite is contributing about 1% of the cash flow for the combined company again in return for 6% of the enterprise value.
What are the synergies?
Oracle has done its share of mergers through the years. A decade ago, the company's growth was all about buying companies of some scale and at decent premiums, eviscerating them and enjoying the earnings accretion as operating margins increased at prodigious rates. Even as the cloud paradigm started to grow, Oracle still followed a similar strategy of buying companies and cutting expenses although the motivation was as much about building a base of cloud revenues and maintaining its overall market share within enterprise software than it was about financial accretion.
Over the last decade, Oracle has acquired 93 companies that were listed in a Wiki compilation - and that was probably not exhaustive. Under the circumstances, I find it perhaps cognitively dissonant to criticize an Oracle merger. Much of the time, I marveled at the success that Oracle has enjoyed with its acquisition strategy. Even the most conspicuous failure on the list of Oracle's top 10 mergers, Sun, has probably generated enough cash flow to justify its purchase, at least from a financial perspective. After all this time, it still generates a significant level of maintenance revenues which have high margins.
So my disposition is to imagine that Oracle would have developed some thoughtful strategy to justify the acquisition of NetSuite, which will be its second largest merger and surely the one that will have the most governance issues. (It is pretty hard to avoid governance issues - and in this day and age that probably means lawsuits, if the control shareholder is on both sides of the transaction. The parties involved in the merger have done what they could to avoid the pitfalls of being tarred with the conflict of interest brush - but that is not a subject about which I might opine with confidence and outside consultants have written that the deal is going to pass muster from a governance standpoint.)
But try as I can, the logic of the transaction simply doesn't add up in terms of a strategy designed to maximize value for Oracle shareholders. Oracle can afford the destruction of shareholder values involved in this kind of transaction. If NetSuite never earned any return, Oracle's future would not be materially worsened.
Oracle's worst merger, arguably the takeover of Sun, has probably destroyed shareholder value in terms of the current valuation of Oracle shares but hasn't drastically hobbled the company's operating results when viewed from a 30,000-foot level. But it is my assertion that this merger is destructive of shareholder values at Oracle and is "anti-strategic." And it will create operating issues for Oracle going forward that are most likely underappreciated by many investors.
Many observers and journalists have speculated about synergies. Needless to say, there would have to be some fantastic level of synergies in order to come close to justifying some logical rationale for the acquisition but without my sarcastic pen in hand, I will at least try to recapitulate some of the arguments I have read before puncturing those balloons.
Justifications that I have read include reuniting Mr. Ellison with Zach Nelson who was a leading player in Oracle marketing in its salad days back in the 1990s. Mark Hurd, Oracle CEO, explained that Oracle would accelerate the pace of innovation and expand the global reach of NetSuite. One analyst claimed that NetSuite will benefit from Oracle's global sales operations. It is also said that Oracle stands to gain engineering experience in the cloud through the acquisition.
I imagine that many analysts will try to find some justification for the acquisition simply to avoid having to deal with the obvious - that the merger has more to do with some personal aspirations of Mr. Ellison than it has to do with the maximization of shareholder value for the rest of Oracle's shareholders.
I will take the "justifications" in turn. I really have no direct or personal knowledge of Zach Nelson. Mr. Nelson has an impressive track record of accomplishment and he has had a reasonable record as the CEO of NetSuite. It is true that sometimes technology companies make acquisitions in order to acquire executive talent. Symantec (NASDAQ:SYMC) recently bought Blue Coat and one of the justifications was the desire to find a CEO for Symantec who might have bring some much-needed expertise to revivify what has been a forlorn vendor. But I would have a hard time in equating Oracle's situation to that of Symantec. I would have a harder time yet in thinking that a single individual, not in a CEO role, might have a significant impact in terms of dealing with the issues that confront Oracle.
I really am perplexed by Mr. Hurd's comments. Why buy a vendor at some extraordinary multiple if indeed it needs Oracle to help accelerate its pace of innovation? Many people, myself included on occasion, say things without trying to reflect on context or tonality. Are there development projects that NetSuite has wanted to fund but which have been deferred for financial considerations? How would a user like to hear that his software company wasn't delivering the best products it could because of lack of resources?
The most charitable explanation I can find for that assertion is that Mr. Hurd is being more than a bit economical with the truth. And I wonder why Oracle's CTO, Mr. Ellison, didn't chime in with some explanation at least in broad terms of what a product road map might be? Mr. Hurd also commented that the set of NetSuite applications would remain independent from those of Oracle "forever." How that is going to produce the cost synergies that are necessary to make this deal accretive I leave to the imagination of readers.
Then there are the assertions that NetSuite will benefit from Oracle's global sales presence. That sounds pretty good and I suppose if one doesn't dig a bit more it might be taken as a reasonable justification - although how the numbers might add up to justify the purchase price is beyond my poor imagination. It is true that NetSuite has been seen as a specialist in selling ERP to the SMB market. That is why it was not thought to be a direct competitor with Oracle and why it was not thought to be a conflict for Mr. Ellison to have a control interest in a company that from a product perspective might be considered a direct Oracle competitor.
But perhaps we ought to turn our attention to Mr. Nelson's comments during the Q1-2016 conference call. Mr. Nelson closed his prepared commentary with the following comment: "Whether you are a fast growing star-up driving an industry of a Fortune 100 company we re-imagined your global operations (and) NetSuite has become the go-to platform for business transformation." CFO Ron Gill said "25% of NetSuite's revenue came from outside of the US and that EMEA continues to be for us... a strong quarter... we are opening offices on continents and with data center investments."
This certainly doesn't sound like a company that needs help with its global reach and it certainly sounds like a company that is chasing the same kind of customers that are the mainstay of Oracle's business. Here is another answer from Mr. Nelson during the conference call" "Just generally our philosophy on the enterprise marketplace, a true enterprise marketplace, we've established our approach about three years ago where we wanted to make sure that we kept all the DNA that we have in the mid-market. It's very hard to build an organization that can sell complex... and implement complex applications... so as we move to the enterprise I didn't want to lose that DNA and we set out building really a separate organization both in the sales and services and go-to market strategy... to do it differently."
It is really hard reading the unscripted commentary from just three months ago to believe that this acquisition will not have a significant negative impact on NetSuite. How can NetSuite sell to the enterprise with a radically different product than that being offered by Oracle and not run into competitive situations? It can't! And as a merged entity that new organization about which Mr. Nelson recently enthused will either be dismantled or be subsumed within Oracle. In neither case will that be a situation that might lead to any kind of positive accretion for the merged enterprise.
The March to Moscow
Perhaps that is unkind. Larry Ellison is no Napoleon. Our politicians seem to enjoy calling each other names. But this transaction does smack of overreach more or less for the sake of overreach. No, there will be no decimation of the Grande Armee or the destruction of the 6th Army before Stalingrad, but overreach will have consequences although given Oracle's size, it can well afford them.
Oracle CEO Safra Catz has said that the first fiscal year the transaction should be consummated. Since Oracle is not issuing shares and since NetSuite has positive non-GAAP earnings, I suppose it must be true at some level that there will be some accretion. Not very much accretion, just looking at the consensus numbers as I did above. NetSuite might add $57 million to Oracle's expected earnings. Oracle is supposed to earn about $12 billion in calendar 2017 - so the addition of $57 million one way or the other is inconsequential.
Last month, Oracle sold $14 billion of debt presumably to help pave the way for the merger. The debt is divided into multiple tranches but basically the interest rates were set as an addition to US Treasury securities. Currently, Oracle's long-term debt has a yield of about 3.6% on overage. Oracle's GAAP tax rate in the year to 5/31/16 was 28.5%. So, the after-tax cost of the debt that was necessary to pay for the merger is around $240 million a year.
Most professional analysts would use a different calculation relating to the weighted average cost of capital for Oracle. Without attempting to review that in detail, the WACC would be higher than 3.6%. It should be remembered that the earnings being forecast by the consensus for N represent an increase of more than 55% from this year's levels. In any event, simply looking at the transaction as it stands would result in Oracle being $183 million under water in the first year after the consummation of the transaction.
So how might the forecast accretion occur? In the short run, the only feasible way it could happen would be for Oracle to slash costs at NetSuite. Just how it might slash operating costs by something like 25% in a year is not even worth contemplating. But slashing costs would almost certainly impact growth. If Oracle wants to accelerate the pace of innovation at NetSuite, the way to do so is really not to eviscerate the research and development budget.
How about sales and marketing? The company spends half of its revenues on sales and marketing, on a GAAP basis, which is not particularly out of line for SaaS companies. I'm not blessed with the kind of imagination that understands just how chopping sales people might lead to greater sales, and even more so in the short run. Are Oracle sales people going to be trained to sell N solutions to N prospects? Is Oracle going to take over N channel sales? Is Oracle going to develop a significant tranche of revenue in overseas geographies that has been ignored by NetSuite? Is Oracle going to use the set of NetSuite solutions to sell to its current customers? If none of these strategies seems likely to you, well where is the accretion?
How about G&A? It was 10% of revenues on a GAAP basis last quarter and it declined noticeably from the same quarter the prior year. Oracle spends 3% of revenues on G&A so there are obviously cost synergies to be had. If Oracle could bring N's G&A expense ratio to its level, then that would save $85 million pre-tax or some $61 million after-tax. That still leaves the transaction $120 million under water. Is it possible that Ms. Catz misspoke and might want to reconsider her commentary about accretion? I will leave that question for a discussion over cocktails.
I have read the guess of one commentator to the effect that N has 30,000 customers that will now be ripe potential customers for Oracle. That might not be a traditional way of finding accretion - but it is a way. The problem for that line of thought is that most NetSuite customers chose to do business with the company because they wanted to buy an integrated solution that is far easier to install and maintain than typical software offerings that involve taking a bit from column "A" and a bit more from column "B" and so forth.
The company's integrated product is called OneWorld and it accounted for over 50% of new business. Just read a couple of lines of Mr. Nelson on that particular subject, "many of you of course are familiar with our OneWorld product which has been a key driver of our market expansion... in selling to larger companies." And again, "I also think that data points to the fact that our strategy of building an ERP system that is architected with the whole business in mind... has resulted in a much more function and modern approach to running a business."
Honestly, if that is so, then what is Oracle supposed to sell these customers? Or are Oracle sales people going to try to sell N solutions to their own prospects in competition with N? Oh well, I will let Mark Hurd and Zach Nelson worry about the conflicts. Surely they have an answer that just hasn't been revealed to us at this point.
I think the odds of accretion, as that term is used in generally accepted financial circles, is close to zero. I think the opportunities for conflict and mis-execution are enormous. I think that the challenges to present a consolidated and credible marketing message is just about insurmountable. And I think the idea of Oracle either increasing the funding for N development or using the N technology as a foundation for a different Oracle solution is risible. No accretion here as far as my poor eyes can see.
So why has Oracle committed to spending $9.3 billion?
First of all, I never forget that Oracle as an organization has many highly intelligent and capable people. It is the second largest software company in the world behind Microsoft (NASDAQ:MSFT) and depending on exactly how things are defined, it may have the most revenues in enterprise software. It did not get to that position by making bad choices all of the time. But at the end of the day, Oracle is run by one man and two acolytes and collegiality is not a well-known hallmark remarked about by Oracle veterans.
And so, the simplest answer to why Oracle has made the choice it has made comes down to vanity and machismo. Doubtless there are readers and analysts who disagree with that assertion or will think me prejudiced and cranky for making the bad call. But the fact remains, if a component observer or analyst can't measure accretion and actually calculates the opposite and if the possible synergies are a long, long stretch, then in the case of Oracle, one is simply left with a conclusion that the transaction was driven by ego, and dysfunctional ego at that.
By now, most readers are likely aware of Larry Ellison's aspiration to see Oracle as the first company to cross the $10 billion mark in SaaS revenues. The math of that statement, as I tried to demonstrate in prior articles, is more than a bit questionable. It seems almost beyond question, absent some amazingly sizeable acquisition that Salesforce.com (NYSE:CRM) will cross the $10 billion revenue line in 2017 ahead of Oracle. How that will either help or hurt Oracle's business is a tendentious question but the math is the math.
Cloud revenues last quarter were $859 million. If they were to double in this fiscal year, which seems more than a bit unlikely, they would still not reach $10 billion ahead of CRM. But buying N is going to allow this management to speak about hyper growth in the cloud - and that is an accomplishment for which it seems willing to pay - with shareholder dollars. It will allow the management to talk about their customer count in the cloud growing faster than anyone else. It will allow them to talk about competitive takeaways from their rivals. (Without discussing the matter in detail, N does have a CRM product and it has called out its market share gains and growth that are about the same as those of Salesforce).
Can I prove my assertion here? Of course not. Is it an excuse for my bad call? No, the call cost readers the money it did if they followed it. Whether or not the call was logical is not material - the call was wrong.
But sometimes explanations have value. The issue for me is that if Oracle and Larry Ellison were willing to make this decision in order to obtain some bragging rights, what else might they do and do so for similar reasons that do not put the interests of current Oracle shareholders in first place. Oracle might scour the firmament to find more cloud vendors to buy and perhaps the share price reaction of some companies in the space reflects that aspiration?
If that is really a potential, then it bodes ill for Oracle shareholders. Most of the available companies just do not "fit" in some strategic sense, most of them have business models that are not attuned to those of current Oracle shareholders and most of them will be a distraction in the context of trying to absorb NetSuite. Buying NetSuite doesn't make the best financial or strategic sense in my opinion but despite its size, the impact on Oracle's earnings is probably no more than 1%. Not good, but hardly a tragedy in and of itself. The decision making process that led to this merger - well that is something else again.
- Oracle has announced the acquisition of fellow ERP vendor NetSuite for $9.3 billion, its second largest merger ever.
- At more than 9X the consensus revenue forecast for the current year, the valuation is one of the largest seen for an acquisition of this scale within the author's memory.
- The product overlap between N and Oracle is far more significant than is generally understood and is likely to lead to some severe conflicts as the merger takes shape operationally.
- The financial justification for the merger is sorely lacking and the merger is more likely to lead to earnings declines, not increases.
- The strategic synergies that some have proclaimed undergird the logic for this merger are more than a bit far-fetched.
- Almost all of Oracle's prior mergers, especially those of size, had straightforward cost and marketing synergies that were readily explicable.
- Although there are some issues of governance, they are probably not sufficient to keep this merger from fruition.
- The decision-making process that seems to have animated this merger seems to be dysfunction and not in the interest of Oracle shareholders, in the opinion of this writer.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.