By The Valuentum Team
Oracle (NYSE:ORCL) has an attractive business model that continues to drive a dependable recurring revenue stream. Recurring revenue as a percentage of total revenue has grown to 71% in fiscal 2015 from 65% in fiscal 2010, and its balance sheet health is nothing short of impressive (net cash position of nearly $12.3 billion as of the end of fiscal 2016). Free cash flow generation has been superb, averaging nearly $12.7 billion in fiscal 2015 and 2016.
Management has grown increasingly shareholder friendly as of late; dividends and share repurchases from fiscal 2013-2015 were three times that of fiscal 2010-2012. The firm's impressive free cash flow generation has been the basis for such growth and has averaged several times the firm's annual dividend obligations (averaging just under $2.4 billion in fiscal 2015 and 2016). Not all stories are clean, however, even if Oracle's Dividend Cushion cash-flow bridge is stronger than those of most.
Perhaps the biggest drawback to Oracle's dividend growth profile is its less-than appealing yield, which is ~1.5% at the time of this writing. Competing uses of capital have the potential to keep the firm from realizing its true dividend growth potential, particularly in the form of share repurchases; cash spent on share buybacks in fiscal 2015 and 2016 averaged nearly $9.3 billion compared to average annual cash dividend obligations of less than $2.4 billion over the same time period. Oracle's agreement to acquire NetSuite (NYSE:N) for $9.3 billion could impact its future dividend growth potential as well.
Nevertheless, we like the trend we have seen in Oracle's payout growth in recent years and expect it to continue for some time. This is in addition to the valuation opportunity we see as shares changing hands near the lower bound of our fair value range. Let's take a closer look at some of Oracle's investment highlights.
Oracle's Investment Considerations
• Oracle is shifting the complexity from IT, moving it out of the enterprise by engineering hardware and software to work together-in the cloud and in the data center. Its on-premise software, hardware systems, services, and cloud businesses account for ~72%, ~14%, ~9%, and ~5% of total revenues, respectively.
• Long-time CEO Larry Ellison has resigned the position. Former Hewlett-Packard CEO Mark Hurd and Safra Catz will be co-CEOs going forward. Ellison will take over the role as chairman, and we expect him to continue to impact the firm in a positive way.
• Oracle will continue to focus on growing its cloud business. The segment only accounted for ~8% of total revenue in fiscal 2016 but has been growing at an impressive rate since fiscal 2010. This growth has helped drive an increase in recurring revenue over the same time period. Competition remains fierce in the space.
• Oracle's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively. The company has a very attractive Economic Castle rating.
• Oracle has positioned itself nicely against Salesforce.com (NYSE:CRM). Oracle sold more than $2.2 billion of new SaaS and PaaS business in fiscal 2016, which would surpassed Salesforce.com's target. Competition will remain intense.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Oracle's 3-year historical return on invested capital (without goodwill) is 84.2%, which is above the estimate of its cost of capital of 9.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Oracle's free cash flow margin has averaged about 35.6% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Oracle, cash flow from operations decreased about 2% from levels registered two years ago, while capital expenditures expanded about 114% over the same time period.
We think Oracle is worth $48 per share with a fair value range of $38-$58.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 1.8% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 1%.
Our model reflects a 5-year projected average operating margin of 42.5%, which is above Oracle's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Oracle, we use a 9.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $48 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Oracle. We think the firm is attractive below $38 per share (the green line), but quite expensive above $58 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Oracle's fair value at this point in time to be about $48 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Oracle's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $63 per share in Year 3 represents our existing fair value per share of $48 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
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.