Oracle is a money machine that prints $1.2 billion in free cash flow per month. Oracle has an extremely valuable “razor and blades” business model, which is being substantially undervalued in its current share price. Investors are presently paying fair value for Oracle’s largest segment, “Software License Updates & Product Support,” -- a business that is so profitable we see it as a currency printing press -- and getting its other five segments for free.
We believe Oracle can sustain 6%-11% non-GAAP EPS growth over the long-term. The company’s EPS growth is poised to accelerate from 1% this fiscal year, hurt by a strong USD and large investments in R&D, to 7% and 9% in FYs 2016 and 2017, respectively. 2016 and 2017 growth could jump to the double-digits if the USD corrects. We project Oracle’s forward P/E multiple to expand from its current 15.2x, net of surplus cash, to a 10% premium to the market (or 18.6x), resulting in 44% total return potential to our 24-month price target of $63. We estimate downside risk at $37, or 12x FY 2016 non-GAAP EPS, plus net surplus cash, for 16% downside. With an almost 3:1 reward-to-risk ratio, Oracle shares meet Warren Buffett’s criteria of an investment whose odds are heavily stacked in one’s favor.
Key Investment Points:
1. An extremely profitable “razor and blades” business model
Since its beginnings in 1955 when the first software company was founded -- Computer Usage Company, in New York City -- the software industry has been a growth industry. Market growth accelerated in the mid-1970s with the rise of the personal computer, which brought desktop computing to the office and then to the home. Software stocks attracted growth investor who focused on license revenue growth. The support contracts (also called “maintenance contracts”) software companies sold, giving customers access to upgrades and technical support, largely went ignored by investors as they made up a small percent of revenues.
Fast-forward to today and we have the phenomenon of the mature software company, practically an orphan in the stock market. Such stocks don’t have a natural shareholder base as their growth days are long behind them and many value investors, taking their cue from Warren Buffett, dismiss technology as impossible to predict and analyze. In addition, the old way of analyzing software stocks (i.e., license revenue growth) doesn’t apply to mature companies, as the recurring revenue stream of support contracts often makes up the majority of profits. While mature software companies are seen as dinosaurs by tech investors and often trade at below-market valuations, they can have far more predictable business models than younger, faster-growing software companies.
At first glance, Oracle appears to be a complex company with six different divisions. However, within the complexity, we see a “razor and blades” business model where the “razors” -- one-time sales of new software licenses and hardware -- almost always bring along a support contract (the “blades”), and add to the ultra-high-margin, recurring revenue stream of support revenues. While some analysts still focus on new software license and hardware sales at Oracle, the vast majority of the company’s earnings comes from support contracts, which have very high renewal rates and annual inflation-correlated price increases.
2. Oracle’s “Printing Press”
In this section we focus on Oracle’s largest segment, “Software License Updates and Product Support” (a.k.a., Software Support) which made up 47.6% of revenues in FY 2014 (ending May 2014) and 72.6% of earnings.
In its last 10-K, the company states that “substantially all” customers who buy a software license purchase a support contract (which typically has a 1-year term), and “substantially all” customers renew their support contracts annually. SAP, Oracle’s closest competitor, echoed this dynamic on its Q4:14 earnings call by stating that its support contracts exhibit a 99% attach rate (the percent of software license customers who purchase a support contract) and a 97% renewal rate.
Oracle prices its support contracts at 22% of the license fee. Therefore, Oracle doesn’t need to grow software license sales (the “razors”) in order to grow the printing press of software support revenues. In fact, if license sales are just flat, support revenues will grow nicely, as the added support contracts more than offset minimal customer attrition. Underscoring this point, co-CEO Mark Hurd, at Oracle’s last Financial Analyst Meeting, stated that new software license sales could fall as much as 13% and support revenues would still grow.
3. Investors are paying fair value for the “printing press” and getting the rest of Oracle for free
In attempting to value Oracle’s Software Support segment, we acknowledge that it’s a theoretical exercise, for two reasons: 1) While third-party software maintenance companies do exist, and offer substantially lower prices than purchasing this service from Oracle, a stand-alone software update and product support business is unrealistic as one would need the source code to upgrade the software, as well as a large investment in R&D. 2) While this segment has the highest margins in the company, it’s margins are inflated as Oracle doesn’t ascribe any Sales & Marketing expense to it. Oracle loads the “New Software License and Cloud Subscriptions” segment with all software Sales & Marketing expense, which is fair, as selling a support contract is as simple as asking customers if they’d like one. But if we think of software support as a stand-alone business for valuation purposes, no business could grow without Sales & Marketing.
With that said, what would a global business with +90% gross margins, very sticky recurring revenues as virtually all customers renew, annual inflation-correlated price increases, consistent high-single-digit FCF growth, quarterly sequential growth 90% of the time, and practically no capital requirements, be worth in the stock market? If it were a stand alone public company and used its FCF to buyback stock, it could deliver consistent low-double-digit EPS growth. Clearly, such a business is superior to the S&P 500 aggregate and would deserve a premium multiple.
The S&P 500 currently trades at 16.9x 2015 earnings estimates (slightly above its 16x median multiple since WW II – in other words, the market has spent half the time trading above 16x and half the time trading below it). While businesses with comparable characteristics presently trade at +20x P/E’s, for conservatism, and to acknowledge points 1) and 2) above, we value Oracle’s Software Support segment at 20x earnings.
4. Oracle’s specialty is running printing presses (a.k.a., support businesses)
Almost five years after the Sun Microsystems acquisition, experts continue to debate whether the deal was a good one. From a strategic point of view, Oracle gained control of Java, the world’s most popular programming language, keeping it out of the hands of competitors. But critics point to shrinking hardware revenues, which have declined every year since the deal closed.
5. One of the world’s most valuable brands
In its Best Global Brands 2014 survey, Interbrand -- the world’s largest brand consultancy -- named Oracle the 16th most valuable brand in the world. What’s most remarkable about Oracle’s ranking is that the company is an enterprise software and hardware business (it sells technology to large companies and governments), while Interbrand’s Top 100 is dominated by household names. Oracle, founded 37 years ago, ranked ahead of such powerful consumer brands as American Express, Nike, Facebook, Budweiser, Pepsi, Gillette, Kellogg’s, Colgate, Ford, Ebay, J.P. Morgan, Citi and Goldman Sachs.
6. Sustainable competitive advantages
With technology stocks, one must respect Warren Buffett’s view that one can’t have a high degree of certainty about what the business will look like in a few years. In fact, the fate of the world’s first software company, Computer Usage Company (mentioned above), was bankruptcy. But Oracle has certain sustainable competitive advantages that give us confidence the company will not only survive, but thrive in the future.
Oracle’s products are often mission-critical to the operations of its 400,000 customers, which include some of the largest companies and governments in the world. Like Apple Inc. (the consumer version of Oracle, in our view), Oracle has an ecosystem in which all of its products integrate flawlessly, saving customers time, money and headaches. As one customer put it at Oracle’s 2013 Financial Analyst Day, there’s a “peace price” one pays for Oracle’s integrated ecosystem. This “peace price” becomes more valuable when one considers that, outside of Oracle’s ecosystem, a customer would have to perform cumbersome and expensive integration every time it buys incremental software. In addition, Oracle’s products make companies more efficient and reduce overall costs. In many cases, a customer pays more to Oracle to add incremental software, and its overall costs decline.
As the same customer stated, Oracle is “a blessing and a curse. The blessing is you save money. The curse is you’re locked in [to Oracle].”
Nothing verifies the strength of a company’s moat like its margins. In FY 2014, Oracle had a company-wide gross margin of 81.1%, a non-GAAP EBITA (before stock-based compensation) margin of 47.3% [this is the margin management focuses on and for which it has a long-term target of 50%], and a non-GAAP net margin of 34.5%. Oracle has the highest margins of any enterprise software provider.
7. “At the leading edge, but not the bleeding edge of technology.” – Larry Ellison
Oracle’s business model is surprisingly low-risk. In addition to 80% (and growing over time) of its earnings coming from the recurring revenue businesses of software support, hardware support and cloud software, Oracle’s massive size gives it a large competitive advantage with respect to staying at the forefront of technology.
8. Passionate and incentivized management
If there’s one thing that strikes us whenever we hear Chairman Larry Ellison and co-CEOs Mark Hurd and Safra Catz speak on earnings calls and at Financial Analyst Meetings, it’s their passion for Oracle and their desire to win. One can’t understand Oracle’s culture without first understanding its founder, Larry Ellison. We’d encourage readers of this report to watch the 25-minute Bloomberg documentary: Larry Ellison: Billionaire Samurai Warrior of Silicon Valley (available on YouTube).
Ellison is one man who was born to win, and for whom being number two is no different than losing. Only after watching the documentary will one understand that when Ellison states Oracle is #1 in virtually all of its software categories except for applications software (where it is #2 to SAP) because he didn’t see applications coming, this fact is like a thorn in his side.
9. EPS growth is poised to accelerate
Oracle’s revenue growth slowed in the last two fiscal years, largely driven by Software Support sales (48% of total revenues) decelerating from the low-double-digits to the mid-single-digits, as shown in Table 3. Declining revenues in Hardware Systems Products (8% of revenues) and Services (10% of revenues), further cut revenue growth in the last two years. Software License revenues (25% of total revenues) were down 5% in FY 2013, flat in FY 2014 and down 3% in H1:15, while cloud revenues grew well into the double-digits but made up only 4% of revenues.
The company is clearly in a transition, as its traditional on-premise business matures and cloud revenues accelerate off of a small base. Cloud revenues have actually grown at increasing rates each quarter as the business has gotten bigger. Positive customer references and a growing portfolio of cloud products should keep this trend in place.
10. Oracle is levered to a falling U.S. Dollar
With 56% of its revenues generated outside the U.S., Oracle has been disproportionately hurt by the recent sharp rise in the USD. The DXY Dollar Index is up 19% in the last six months, an unprecedented rise. Oracle’s Q2:15 (November 2014) revenue growth of 7% in constant currencies was cut to 3% on a reported basis due to the strong USD. Since Q2:15 was the first quarter to include the Micros acquisition, and Micros added 4% to Oracle’s revenues, the strong USD essentially wiped out the Micros deal. The dollar kept rising after Oracle closed its books on Q2, and recently went parabolic up to a high of 95 on the DXY.
Investors are concerned about slowing growth overseas and are viewing the U.S. as the global economy’s only growth engine, as Q3:14 GDP growth came in at 5%. While we aren’t macroeconomists, we sense a possible crowded trade where any positive surprises in non-U.S. GDP growth and/or weaker than expected U.S. GDP growth could reverse the direction of the USD rapidly.
While we haven’t modeled it into our projections, Oracle could benefit strongly from a declining USD. Before the recent rise in the USD, our EPS growth projections for Oracle were 6.8%, 10.7% and 11.2% in fiscal years 2015, 2016 and 2017, respectively.
11. Sustainable EPS growth of 6% - 11%
The assumptions in our model are fairly simple. Excluding the impact of FX, we’ve incorporated the Micros acquisition as of Q2:15, and from then on we’ve assumed Software Support revenues grow at 5%-6% annually, cloud revenues grow by 35% and everything else flat-lines. New Software Licenses (25% of revenues), Hardware Systems Products (8% of revenues), Hardware Systems Support (6% of revenues), and Services (10% of revenues) all remain flat going forward except for the impact of Micros and FX.
Therefore, on a constant currency basis, 49% of Oracle’s revenues are not growing, but the 51% that are growing come with far higher margins. On an earnings basis, 25% of Oracle’s profits are flat-lining while 75% are growing, and the growing portion will approach 80% in two years.
12. 44% total return potential over the next 24-months
When we look out two years, we believe investors will have seen FY 2015 as the bottom in Oracle’s growth, with the company climbing out of the growth hole in FYs 2016 and 2017. By January 2017, we estimate investors will be anticipating non-GAAP EPS of $3.36 (and possibly higher if the USD declines) in FY 2017, for growth of 8.8%, following growth of 6.7% in 2016 and 0.7% in 2015. We believe Oracle’s current below-market multiple of 15.2x FY 2015, net of $0.25 in net surplus cash, will expand as the company’s EPS growth accelerates.
We’ve valued Oracle using three methods: sum-of-the-parts, EV/EBITDA and common sense.
13. What management can do to improve Oracle’s multiple
While Oracle has long ago become a mature software company, one aspect of the company remains stuck in the past: how it gives guidance. Management provides guidance each quarter for only the following quarter. This is the old model under which young software companies, whose earnings were heavily dependent on difficult-to-predict new license sales (and customers typically delayed making purchases until the 11th hour of the quarter to try and get the best deal, knowing the software provider needed to make its quarter), gave guidance one quarter out.
With almost 80% of earnings -- and growing by 200 bps a year -- coming from recurring revenue sources, we believe Oracle needs to purchase an update and support contract on the antiquated way it communicates with the Street. We would strongly encourage management to provide conservative annual guidance and drop next-quarter guidance all together. If management had given annual guidance for FY 2015, it could have spent less time explaining why it missed Q1:15 expectations and simply reiterated that it remained comfortable with its annual EPS guidance.
We believe a switch to annual guidance would make a big difference in shifting the investment community toward seeing Oracle as a fairly predictable business on an annual basis, whose predictability will only improve over time. It will also contribute towards Oracle achieving the premium multiple it deserves.
14. An unlevered balance sheet
Table 14 illustrates Oracle’s $1.1 billion in net surplus cash, or $0.25 per share. We calculate net surplus cash by taxing Oracle’s foreign cash to repatriate it to the U.S. (Oracle disclosed in its latest 10-K that its implied repatriation tax rate is 30.8%), adding that after-tax amount to its U.S. cash, and deducting total debt.
Once again, we see a remnant of the company’s past: A very conservative balance sheet. For a young software company where volatile license sales make up the vast majority of revenues, a large net cash position is imperative. But for a mature software company with 80% of earnings (and growing) coming from recurring revenue sources, Oracle’s balance sheet reflects the company it was many years ago, and isn’t optimized for the behemoth it is today.
Over the last two years, activist shareholders such as Carl Icahn and Greenlight Capital worked with Apple Inc. (AAPL) management to move the company off of its “depression-like” balance sheet (i.e., a huge net cash position, which was very necessary when Apple was a smaller and higher-risk company) towards issuing debt to buyback stock (appropriate for the more predictable, established company Apple is today). We believe a similar “catch up” is needed at Oracle.
15. Warren Buffett probably wouldn’t buy Oracle, but Lou Simpson did
Lou Simpson managed Geico’s (part of Berkshire Hathaway) equity portfolio for many years up until his retirement in 2010. His holdings, which were blended with Buffett’s purchases in Berkshire’s 13Fs, often confused the media, who believed Buffett made the buys. In those days, the way to tell the difference was to keep in mind that Simpson was managing less money and would put hundreds of millions into a stock, while Buffett would put billions into a stock.
Simpson, like Buffett, isn’t one for diversification. If he finds a great idea, he goes in big. As of his last 13F (September 30, 2014), he owned just 12 stocks. His holdings, and their weighting in his portfolio, were:
Berkshire Hathaway 12.0%
Wells Fargo 11.5%
Oracle Corporation 10.2%
United Parcel Service 9.9%
Valeant Pharmaceuticals 9.2%
U.S. Bancorp 8.3%
Charles Schwab 7.6%
Brookfield Asset Mgmt. 7.0%
Liberty Global plc 6.7%
Crown Holdings 6.7%
Moody’s Corp. 5.5%
1. Falling IT spending, a global recession and/or a strong U.S. dollar
2. R&D expenses continue to eat into margins
3. Good earnings quality within technology, less so outside the industry
4. Like all U.S. multinationals, repatriation taxes reduce surplus FCF.
5. $39 billion in “trapped” overseas cash, representing 20% of the market cap
6. A value trap
Net of net surplus cash, Oracle trades at 15.2x our FY 2015 (May 2015), 14.2x our FY 2016 and 13.1x our FY 2017 non-GAAP EPS estimates, respectively. We expect non-GAAP EPS growth to accelerate from 0.7% in FY 2015 (impacted by a strong USD and a peak R&D/Revenue ratio), to 6.7% in 2016 and 8.8% in 2017. A decline in the USD could boost 2016 and 2017 growth into the double-digits.
In addition, we estimate the percent of total revenues coming from cloud subscriptions to rise from 4.1% in 2014 to 8.4% in 2017. Oracle will exit FY 2017 with a $4 billion in revenue cloud business, up from $2.1 billion today. Our 24-month price target of $63 reflects 18.6x (a 10% premium to the market) our FY 2017 estimate of $3.36, plus net surplus cash, offering a total return of 44%, including two years of dividends. We estimate downside risk at $37, or 12x our FY 2016 estimate of $3.08, for 16% downside.
With 44% total return potential over the next 24-months and 16% downside risk, Oracle shares offer an almost 3:1 reward-to-risk ratio. We therefore initiate coverage with a BUY rating.