ORACLE CORP ORCL
April 03, 2012 - 2:55pm EST by
miser861
2012 2013
Price: 29.20 EPS $2.64 $3.10
Shares Out. (in M): 5,000 P/E 10.0x 7.5x
Market Cap (in $M): 143,000 P/FCF 10.0x 7.5x
Net Debt (in $M): -14,000 EBIT 16,000 20,000
TEV ($): 129,000 TEV/EBIT 8.0x 6.5x

Sign up for free guest access to view investment idea with a 45 days delay.

  • Software

Description

Oracle trades for less than 8x my estimate of the next 12 months’ levered free cash flow, net of cash.  EBITA has grown at a 20% annual rate the last five years.  EBITA grew 11% in FYE 5/31/09.  Management is shareholder conscious, and openly states that they will actively seek to prevent free cash flow per share from ever declining through buybacks, acquisitions and expense management.

 

The Business

72% of new software license revenue is database and middleware software.  Database software is used to collect, store and enable access to data across an enterprise.  For example, a retailer can use database software to collect sales and inventory data from stores and relay the data to headquarters.

 

28% of new software license revenue is application software.  Examples include supply chain management and CRM applications. 

 

One-time license fees are charged for new licenses.  Thereafter, recurring fees are charged for updates and product support. 

 

The hardware business was acquired when Oracle bought Sun Microsystems on 1/27/10.  Oracle paid $5.4 billion for Sun.  At the time Oracle stated that Sun would generate $1.5 billion of cash pre-tax in the first year and $2 billion in the second year.  Sun cash pre-tax was closer to $2.8 billion in the 5/31/11 fiscal year, and $1.8 billion in the first nine months of the 5/31/12 fiscal year.  The acquisition is viewed by some as a failure because many of the legacy Sun server products are likely in terminal decline.  I think management would say that they are intentionally exiting commodity hardware products.  At any rate, the $5.4 billion price was relatively immaterial, and Sun has likely earned back most of the cost after two years.

 

The hardware competency that came with Sun enabled Oracle to develop an integrated database/server and middleware/server product, Exadata and Exalogic, that will be doing $1 billion of run-rate revenue exiting the 5/31/12 quarter (growing 100%+ year over year).  According to management, Exadata and Exalogic have gross margins closer to the margins of the software business (software is bundled with the hardware) than the legacy hardware business.  Exadata and Exalogic are high-performance server products designed for users with intensive data processing needs like insurance companies, they do not compete with commodity servers. 

 

If you assume half of R&D is related to new license fees and half is related to product updates, and sales & marketing is the “cost of sales” of new license fees, here are the contributions to pre-G&A earnings:

Updates & Support       75%

New Software Licenses  12%

Hardware                       7%

Services                         6%

 

Competitive Threats

One fear is that cheaper “big data” database applications will destroy Oracle’s database business.  One example is Hadoop, an open-source database application.  Hadoop is used by Facebook and YouTube because it is better suited for unstructured data like user-generated posts and videos that don’t fit a predictable category like February revenue for store #753.  Also structured databases like Oracle aren’t adept at processing very large data sets.  My thinking about this threat is that it’s true that Oracle won’t participate in the big data market, Facebook will never use Oracle.  However, I think most companies don’t have the engineering expertise to run an open source application that Facebook does, and those companies will always want full-service support for their mission critical database software.  Oracle has a near 100% attachment rate for support services.  Also I’m not aware of any situation where open source has gained significant penetration in an enterprise setting.  I think enterprise customers prioritize reliable support, regular security patches, and application stability by a wide margin over cost.  Hadoop has also been around since at least 2008, so this isn’t a new threat.  It’s also worth remembering that Oracle’s customers have critical data stored in their databases, and the risks inherent in switching are high.

 

Gartner estimates Oracle’s database revenue market share at 48% and growing, more market share than the next five competitors combined, and 2.5x the next largest, IBM.

 

Management

In 1996 Larry Ellison formed a group to take over Apple and reinstate his friend Steve Jobs as CEO, but Jobs decided to sell NeXT to Apple instead:

Ellison: “If we don’t buy [Apple], how can we make any money?”

Jobs: “You don’t need any more money.”

Ellison: “Well, I may not need the money, but why should some fund manager at Fidelity get the money?  Why should someone else get it?  Why shouldn’t it be us?”

 

Since 1993 Oracle has deployed 100% of its free cash flow into buybacks, acquisitions and dividends.  Over the last seven years Oracle has spent 75% of FCF on acquisitions and 20% on buybacks (net of option exercises) and 5% on dividends (first dividend was declared in March 2009).  For the last seven years Oracle has maintained net cash averaging 30% of EBITA.  The net cash position is 85% of EBITA today.  Oracle would have to spend 110% of free cash flow on acquisitions and/or buybacks to end FY2015 with 35% net cash/EBITDA.  Spending 110% of free cash flow would require about $60 billion of acquisitions and buybacks over the next three years.  It seems like an unmanageable amount of cash.  I think this bloated cash position is less likely to persist at Oracle than at other tech companies.  Oracle is a relatively active acquirer.  Larry Ellison is also exceedingly greedy, so I think he understands that building cash at negative real rates isn’t going to help him overtake his nemesis Bill Gates on the Forbes list.  I think he could overtake Carlos Slim if he can get the stock to $70 in a reasonable case.

 

For the record, I realize how stupid I sound talking about a cash/EBITA ratio.  I’d love to see Oracle achieve net leverage, it’s a very leverageable cash flow stream.  But we have to operate within the confines of reality.

 

Here’s my analysis of Oracle’s major acquisitions in recent years.  EV is market cap less net cash.  NTM revenue is the sell-side consensus estimate for the 12 months post-acquisition for the targets.  Free cash flow is my own fully-taxed pro forma estimate that assumes Oracle integrated the acquisitions at similar margins to Oracle, which I think is a safe assumption since these acquisitions represent about 35% of Oracle’s revenue today and margins have consistently risen in this period of time.  In Sun’s case management explicitly says that it is now running at pre-acquisition Oracle margins, despite being a hardware business.  Also all of these companies came with 60-80% gross margins, except Sun which came with 42% gross margins.  In every case except Sun the companies were growing revenue at 10-20%.

 

Target

Closed

EV

NTM Rev.

Rev. Mult.

FCF

FCF Mult.

Taleo

Pending

           1,807

              380

               4.8

              129

             14.0

RightNow

1/25/2012

           1,357

266

               5.1

                90

             15.0

Sun

1/27/2010

           5,363

7,092

               0.8

           2,138

               2.5

BEA Systems

4/29/2008

           6,376

           1,689

               3.8

              588

             10.8

Hyperion Solutions

2/28/2007

           2,618

891

               2.9

              287

               9.1

Siebel Systems

1/31/2006

           3,372

           1,382

               2.4

              415

               8.1

 

Total

         20,893

         11,700

               1.8

           3,647

               5.7

 

Ex-Sun

         15,530

           4,608

               3.4

           1,510

             10.3

 

So I think history shows that Oracle has made acquisitions at reasonable valuations.  Repurchasing stock at today’s valuations is also very sensible.

 

Model & Valuation

FYE 5/31

Worst

2015

2014

2013

2012

           

  Updates and Product Support

  17,257

   20,884

  19,337

  17,740

  16,128

  YOY

7%

8%

9%

10%

9%

  New Software Licenses

    7,831

   11,659

  10,999

  10,376

    9,789

  YOY

-20%

6%

6%

6%

6%

  Service Revenues

    4,029

     5,030

    4,931

    4,835

    4,740

  YOY

-15%

2%

2%

2%

2%

  Hardware Systems Products

    2,638

     2,747

    3,053

    3,392

    3,769

  YOY

-30%

-10%

-10%

-10%

-14%

  Hardware Systems Support

    2,306

     2,719

    2,666

    2,613

    2,562

  YOY

-10%

2%

2%

2%

0%

  Exadata/Exalogic (Incremental)

       500

     2,300

    1,500

       750

 

  Q4 2012 Acq'd Rev.

       646

        646

       646

       646

 

  Total Revenues

  35,207

   45,985

  43,132

  40,352

  36,987

  YOY

-3.0%

6.6%

6.9%

9.1%

3.8%

           

  Updates and Product Support

     

  GP

  15,962

   19,474

  17,983

  16,454

  14,918

  GPM

92.5%

93.3%

93.0%

92.8%

92.5%

  Cost of Services

         

  GP

       846

     1,056

    1,036

    1,015

       995

  GPM

21.0%

21.0%

21.0%

21.0%

21.0%

  Hardware Systems Products

         

  GP

    1,174

     1,511

    1,679

    1,798

    1,941

  GPM

44.5%

55.0%

55.0%

53.0%

51.5%

  Hardware Systems Support

         

  GP

    1,280

     1,686

    1,653

    1,568

    1,473

  GPM

55.5%

62.0%

62.0%

60.0%

57.5%

  Exadata/logic GP

       275

     1,380

       900

       450

 

   Exadata/logic GPM

55.0%

60.0%

60.0%

60.0%

 

   Total Hardware GPM

50.1%

58.9%

58.6%

56.5%

46.6%

   Acq'd GP

       512

        524

       521

       515

 

   Total GP

  27,880

   37,290

  34,770

  32,177

  29,116

   Total GPM

79.2%

81.1%

80.6%

79.7%

78.7%

 YOY

2.1%

7.2%

8.1%

10.5%

7.0%

  Sales and Marketing

  (7,000)

   (8,507)

  (8,066)

  (7,667)

  (7,139)

  % of Rev.

19.9%

18.5%

18.7%

19.0%

19.3%

  G&A

  (1,100)

   (1,380)

  (1,294)

  (1,211)

  (1,110)

  % of Rev.

3.1%

3.0%

3.0%

3.0%

3.0%

  R&D

  (4,225)

   (5,518)

  (5,176)

  (4,842)

  (4,438)

  % of Rev.

12.0%

12.0%

12.0%

12.0%

12.0%

         

21%

  EBITA

  15,555

   21,885

  20,235

  18,457

  16,430

  EBITA %

44.2%

47.6%

46.9%

45.7%

44.4%

 YOY

1.6%

8.2%

9.6%

12.3%

8.4%

  Amortization of Intangibles

  (2,414)

   (2,036)

  (2,166)

  (2,304)

  (2,400)

  Interest Expense

      (789)

       (760)

      (760)

      (760)

      (789)

  EBT

  12,352

   19,090

  17,310

  15,393

  13,241

  Taxes

    3,088

     4,772

    4,327

    3,848

    3,310

  Net Inc.

    9,264

   14,317

  12,982

  11,545

    9,931

  Amort.

    2,414

     2,036

    2,166

    2,304

    2,400

  Goodwill Tax Shelter

       397

        397

       397

       397

       397

  Free Cash Flow

  12,075

   16,750

  15,545

  14,246

  12,728

           

In this scenario that I believe to be a reasonable base case, Oracle could do $2.85/share in FCF in the next 12 months.  And we’re paying $23.50 net of gross cash (for which this model gives no credit via interest income).  So we pay 8.2x NTM free cash flow, even without any acquisitions or buybacks.  If Oracle spent $15 billion on acquisitions next year, that could add another $.30/share in earnings power, putting us closer to 7.5x free cash flow.  Doing $15 billion of buybacks would reduce the shares outstanding by 10%, adding $.28/share. 

 

Without doing any acquisitions or buybacks Oracle could do $3.35/share in 2015.  I think that could easily justify a $60 stock in two years if we add in the $12/share of cash they’ll have at the end of FY2014.  Let’s pretend that Oracle spends $50 billion on acquisitions at 10x pro forma FCF.  That would add another $1/share in free cash flow.  Then I think you’d get closer to a $70 stock.

 

In the downside scenario, even if new license fees, service revenues, and hardware revenues are down 15-20% as I believe they were organically during the worst quarter in FY2009 (they were down much less for the full year organically), I believe that pre-G&A earnings will grow 1% if update & support revenue grows mid-single digits organically as they did in FY2009.  Additionally I think Exadata/Exalogic revenues will grow no matter what in 2013 – it’s a matter of do they grow 50% or 100% I think.  Management would also likely accelerate the rate of buybacks as they did during FY2009, providing further support for EPS.  So even in the downside scenario I think FCF will grow.  So if we go into a recession of 2009 severity and Oracle does $2.50/share and we give that 8x and add $6/share in cash the stock could go to $26, 10% downside.

Catalyst

 
    sort by    

    Description

    Oracle trades for less than 8x my estimate of the next 12 months’ levered free cash flow, net of cash.  EBITA has grown at a 20% annual rate the last five years.  EBITA grew 11% in FYE 5/31/09.  Management is shareholder conscious, and openly states that they will actively seek to prevent free cash flow per share from ever declining through buybacks, acquisitions and expense management.

     

    The Business

    72% of new software license revenue is database and middleware software.  Database software is used to collect, store and enable access to data across an enterprise.  For example, a retailer can use database software to collect sales and inventory data from stores and relay the data to headquarters.

     

    28% of new software license revenue is application software.  Examples include supply chain management and CRM applications. 

     

    One-time license fees are charged for new licenses.  Thereafter, recurring fees are charged for updates and product support. 

     

    The hardware business was acquired when Oracle bought Sun Microsystems on 1/27/10.  Oracle paid $5.4 billion for Sun.  At the time Oracle stated that Sun would generate $1.5 billion of cash pre-tax in the first year and $2 billion in the second year.  Sun cash pre-tax was closer to $2.8 billion in the 5/31/11 fiscal year, and $1.8 billion in the first nine months of the 5/31/12 fiscal year.  The acquisition is viewed by some as a failure because many of the legacy Sun server products are likely in terminal decline.  I think management would say that they are intentionally exiting commodity hardware products.  At any rate, the $5.4 billion price was relatively immaterial, and Sun has likely earned back most of the cost after two years.

     

    The hardware competency that came with Sun enabled Oracle to develop an integrated database/server and middleware/server product, Exadata and Exalogic, that will be doing $1 billion of run-rate revenue exiting the 5/31/12 quarter (growing 100%+ year over year).  According to management, Exadata and Exalogic have gross margins closer to the margins of the software business (software is bundled with the hardware) than the legacy hardware business.  Exadata and Exalogic are high-performance server products designed for users with intensive data processing needs like insurance companies, they do not compete with commodity servers. 

     

    If you assume half of R&D is related to new license fees and half is related to product updates, and sales & marketing is the “cost of sales” of new license fees, here are the contributions to pre-G&A earnings:

    Updates & Support       75%

    New Software Licenses  12%

    Hardware                       7%

    Services                         6%

     

    Competitive Threats

    One fear is that cheaper “big data” database applications will destroy Oracle’s database business.  One example is Hadoop, an open-source database application.  Hadoop is used by Facebook and YouTube because it is better suited for unstructured data like user-generated posts and videos that don’t fit a predictable category like February revenue for store #753.  Also structured databases like Oracle aren’t adept at processing very large data sets.  My thinking about this threat is that it’s true that Oracle won’t participate in the big data market, Facebook will never use Oracle.  However, I think most companies don’t have the engineering expertise to run an open source application that Facebook does, and those companies will always want full-service support for their mission critical database software.  Oracle has a near 100% attachment rate for support services.  Also I’m not aware of any situation where open source has gained significant penetration in an enterprise setting.  I think enterprise customers prioritize reliable support, regular security patches, and application stability by a wide margin over cost.  Hadoop has also been around since at least 2008, so this isn’t a new threat.  It’s also worth remembering that Oracle’s customers have critical data stored in their databases, and the risks inherent in switching are high.

     

    Gartner estimates Oracle’s database revenue market share at 48% and growing, more market share than the next five competitors combined, and 2.5x the next largest, IBM.

     

    Management

    In 1996 Larry Ellison formed a group to take over Apple and reinstate his friend Steve Jobs as CEO, but Jobs decided to sell NeXT to Apple instead:

    Ellison: “If we don’t buy [Apple], how can we make any money?”

    Jobs: “You don’t need any more money.”

    Ellison: “Well, I may not need the money, but why should some fund manager at Fidelity get the money?  Why should someone else get it?  Why shouldn’t it be us?”

     

    Since 1993 Oracle has deployed 100% of its free cash flow into buybacks, acquisitions and dividends.  Over the last seven years Oracle has spent 75% of FCF on acquisitions and 20% on buybacks (net of option exercises) and 5% on dividends (first dividend was declared in March 2009).  For the last seven years Oracle has maintained net cash averaging 30% of EBITA.  The net cash position is 85% of EBITA today.  Oracle would have to spend 110% of free cash flow on acquisitions and/or buybacks to end FY2015 with 35% net cash/EBITDA.  Spending 110% of free cash flow would require about $60 billion of acquisitions and buybacks over the next three years.  It seems like an unmanageable amount of cash.  I think this bloated cash position is less likely to persist at Oracle than at other tech companies.  Oracle is a relatively active acquirer.  Larry Ellison is also exceedingly greedy, so I think he understands that building cash at negative real rates isn’t going to help him overtake his nemesis Bill Gates on the Forbes list.  I think he could overtake Carlos Slim if he can get the stock to $70 in a reasonable case.

     

    For the record, I realize how stupid I sound talking about a cash/EBITA ratio.  I’d love to see Oracle achieve net leverage, it’s a very leverageable cash flow stream.  But we have to operate within the confines of reality.

     

    Here’s my analysis of Oracle’s major acquisitions in recent years.  EV is market cap less net cash.  NTM revenue is the sell-side consensus estimate for the 12 months post-acquisition for the targets.  Free cash flow is my own fully-taxed pro forma estimate that assumes Oracle integrated the acquisitions at similar margins to Oracle, which I think is a safe assumption since these acquisitions represent about 35% of Oracle’s revenue today and margins have consistently risen in this period of time.  In Sun’s case management explicitly says that it is now running at pre-acquisition Oracle margins, despite being a hardware business.  Also all of these companies came with 60-80% gross margins, except Sun which came with 42% gross margins.  In every case except Sun the companies were growing revenue at 10-20%.

     

    Target

    Closed

    EV

    NTM Rev.

    Rev. Mult.

    FCF

    FCF Mult.

    Taleo

    Pending

               1,807

                  380

                   4.8

                  129

                 14.0

    RightNow

    1/25/2012

               1,357

    266

                   5.1

                    90

                 15.0

    Sun

    1/27/2010

               5,363

    7,092

                   0.8

               2,138

                   2.5

    BEA Systems

    4/29/2008

               6,376

               1,689

                   3.8

                  588

                 10.8

    Hyperion Solutions

    2/28/2007

               2,618

    891

                   2.9

                  287

                   9.1

    Siebel Systems

    1/31/2006

               3,372

               1,382

                   2.4

                  415

                   8.1

     

    Total

             20,893

             11,700

                   1.8

               3,647

                   5.7

     

    Ex-Sun

             15,530

               4,608

                   3.4

               1,510

                 10.3

     

    So I think history shows that Oracle has made acquisitions at reasonable valuations.  Repurchasing stock at today’s valuations is also very sensible.

     

    Model & Valuation

    FYE 5/31

    Worst

    2015

    2014

    2013

    2012

               

      Updates and Product Support

      17,257

       20,884

      19,337

      17,740

      16,128

      YOY

    7%

    8%

    9%

    10%

    9%

      New Software Licenses

        7,831

       11,659

      10,999

      10,376

        9,789

      YOY

    -20%

    6%

    6%

    6%

    6%

      Service Revenues

        4,029

         5,030

        4,931

        4,835

        4,740

      YOY

    -15%

    2%

    2%

    2%

    2%

      Hardware Systems Products

        2,638

         2,747

        3,053

        3,392

        3,769

      YOY

    -30%

    -10%

    -10%

    -10%

    -14%

      Hardware Systems Support

        2,306

         2,719

        2,666

        2,613

        2,562

      YOY

    -10%

    2%

    2%

    2%

    0%

      Exadata/Exalogic (Incremental)

           500

         2,300

        1,500

           750

     

      Q4 2012 Acq'd Rev.

           646

            646

           646

           646

     

      Total Revenues

      35,207

       45,985

      43,132

      40,352

      36,987

      YOY

    -3.0%

    6.6%

    6.9%

    9.1%

    3.8%

               

      Updates and Product Support

         

      GP

      15,962

       19,474

      17,983

      16,454

      14,918

      GPM

    92.5%

    93.3%

    93.0%

    92.8%

    92.5%

      Cost of Services

             

      GP

           846

         1,056

        1,036

        1,015

           995

      GPM

    21.0%

    21.0%

    21.0%

    21.0%

    21.0%

      Hardware Systems Products

             

      GP

        1,174

         1,511

        1,679

        1,798

        1,941

      GPM

    44.5%

    55.0%

    55.0%

    53.0%

    51.5%

      Hardware Systems Support

             

      GP

        1,280

         1,686

        1,653

        1,568

        1,473

      GPM

    55.5%

    62.0%

    62.0%

    60.0%

    57.5%

      Exadata/logic GP

           275

         1,380

           900

           450

     

       Exadata/logic GPM

    55.0%

    60.0%

    60.0%

    60.0%

     

       Total Hardware GPM

    50.1%

    58.9%

    58.6%

    56.5%

    46.6%

       Acq'd GP

           512

            524

           521

           515

     

       Total GP

      27,880

       37,290

      34,770

      32,177

      29,116

       Total GPM

    79.2%

    81.1%

    80.6%

    79.7%

    78.7%

     YOY

    2.1%

    7.2%

    8.1%

    10.5%

    7.0%

      Sales and Marketing

      (7,000)

       (8,507)

      (8,066)

      (7,667)

      (7,139)

      % of Rev.

    19.9%

    18.5%

    18.7%

    19.0%

    19.3%

      G&A

      (1,100)

       (1,380)

      (1,294)

      (1,211)

      (1,110)

      % of Rev.

    3.1%

    3.0%

    3.0%

    3.0%

    3.0%

      R&D

      (4,225)

       (5,518)

      (5,176)

      (4,842)

      (4,438)

      % of Rev.

    12.0%

    12.0%

    12.0%

    12.0%

    12.0%

             

    21%

      EBITA

      15,555

       21,885

      20,235

      18,457

      16,430

      EBITA %

    44.2%

    47.6%

    46.9%

    45.7%

    44.4%

     YOY

    1.6%

    8.2%

    9.6%

    12.3%

    8.4%

      Amortization of Intangibles

      (2,414)

       (2,036)

      (2,166)

      (2,304)

      (2,400)

      Interest Expense

          (789)

           (760)

          (760)

          (760)

          (789)

      EBT

      12,352

       19,090

      17,310

      15,393

      13,241

      Taxes

        3,088

         4,772

        4,327

        3,848

        3,310

      Net Inc.

        9,264

       14,317

      12,982

      11,545

        9,931

      Amort.

        2,414

         2,036

        2,166

        2,304

        2,400

      Goodwill Tax Shelter

           397

            397

           397

           397

           397

      Free Cash Flow

      12,075

       16,750

      15,545

      14,246

      12,728

               

    In this scenario that I believe to be a reasonable base case, Oracle could do $2.85/share in FCF in the next 12 months.  And we’re paying $23.50 net of gross cash (for which this model gives no credit via interest income).  So we pay 8.2x NTM free cash flow, even without any acquisitions or buybacks.  If Oracle spent $15 billion on acquisitions next year, that could add another $.30/share in earnings power, putting us closer to 7.5x free cash flow.  Doing $15 billion of buybacks would reduce the shares outstanding by 10%, adding $.28/share. 

     

    Without doing any acquisitions or buybacks Oracle could do $3.35/share in 2015.  I think that could easily justify a $60 stock in two years if we add in the $12/share of cash they’ll have at the end of FY2014.  Let’s pretend that Oracle spends $50 billion on acquisitions at 10x pro forma FCF.  That would add another $1/share in free cash flow.  Then I think you’d get closer to a $70 stock.

     

    In the downside scenario, even if new license fees, service revenues, and hardware revenues are down 15-20% as I believe they were organically during the worst quarter in FY2009 (they were down much less for the full year organically), I believe that pre-G&A earnings will grow 1% if update & support revenue grows mid-single digits organically as they did in FY2009.  Additionally I think Exadata/Exalogic revenues will grow no matter what in 2013 – it’s a matter of do they grow 50% or 100% I think.  Management would also likely accelerate the rate of buybacks as they did during FY2009, providing further support for EPS.  So even in the downside scenario I think FCF will grow.  So if we go into a recession of 2009 severity and Oracle does $2.50/share and we give that 8x and add $6/share in cash the stock could go to $26, 10% downside.

    Catalyst

     
      Back to top