Oracle Is Misunderstood and Fully Mispriced

By: SumZero Staff | Published: October 04, 2013 | Be the First to Comment

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Ilan Costica

Oracle is a great company at a great price. As management continues to return their $14bn in free cash flow to shareholders in the coming years the stock should re-rate materially higher.

Thesis Key Points
•Critical technology for many of the world’s largestcompanies
•Very sticky biz / significant recurring profitability
•Long-term data growth tailwind
•Competitive advantages through vertical product integration
•$12bn buyback in place (~8% of S/O)
•Seasoned management and significant ownership
•Historical biz strength & growth even during the recession
•Near lowest valuation in a decade
•Dirt cheap relative valuation
•Favorable EPS optics in coming years

Upside / Downside
Where else can you buy a growing business with 100%+ ROIC, a fortress balance sheet, and trading at only 10x free cash flow (ex-cash)? As management continues to take their ~$14bn in annual FCF and return it to shareholders via buybacks and dividends the stock could easily be worth $55-80 with in the next few years (~60%-135% upside). Downside seems well protected given that Oracle’s valuation low in March 2009 was only ~9x EV/FCF (vs. ~10x currently).

Why does the Opportunity Exist?
•Claim: Decline in Hardware Segment
Reality--Management has also spelled out in the past quarters that Oracle is deliberately shrinking their hardware segment to remove their low margin server business and focus on their high-margin engineered systems hardware (where allthe hardware and software is designed to work together).

•Claim: Management doesn’t understand the cloud
Reality--Sun was acquired for about ~$5.5bn (net of cash) in 2010 and has already paid for itself generating nearly $9bn in aggregate operating profit. This claim also implies that Oracle has completely missed out on cloud opportunities when, in fact, Oracle started re-tooling their applications software for the cloud about a decade ago and their full application suite came out for SaaS last year.

•Claim: Oracle’s is losing their lunch money to cloud competition
Reality--Oracle has traditionally operated with an on-premise model. This was historically a very costly process for clients as it involved buying hardware and software that the company would keep on their premises (hence the name).
However, The economics of the SaaS model are actually very favorable for Oracle. The largest customer savings actually comes from reduced IT Labor / Services (i.e. not needing to spend any money on integration and product customization) while the total cost of the software (Oracle’s bread and butter) increases by ~80%. From Oracle’s perspective, a SaaS solution will have generated the same revenue as an on-premise solution within 3-4 years.
By 10 years from adoption, the SaaS client will have generated ~50-60% more revenue than a comparable on-premise client.

Valuation Variables
Oracle’s TTM free cash flow is $14bn+. If you make the following assumptions, there’s 100%+ upside over the next 5 years:
•No growth in FCF (despite their SaaS initiative discussed below)
•Any acquisitions they make are funded out of their $15bn of net cash but thiscontributes nothing to their growth
•Management maintains their current policies and nearly all free cash flow is returned to shareholders via buybacks and dividends
•In 5 years it’s valued at 15x FCF

Conclusion
Given that Oracle is a huge company there’s a lot more ground to cover and I could go on listing the perceived issues that are holding back the stock. There are definitely other competitive risks the company face s (e.g. AWS, Rimini Street), but there are also favorable growth initiatives I haven ’t mentioned (e.g. their IaasS offering or their new 12c Database, etc.). When you consider all of these variables, Oracle is well positioned and should continue to grow. Even if their results remain flat over the next five years the stock still has 100% upside potential given a realistic multiple and management’s focus on returning cash to shareholders.

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