oracle of redwood city

Oracle Corporation is the world's largest provider of enterprise software and a leading provider of computer hardware products and services as per its filing with the SEC. The company is organized into three businesses - software (new licences, and licence updates and product support), hardware systems (products and support) and services (consulting, managed cloud services and education services). A large portion of revenue (about 70%) is contributed by software, followed by hardware (17%) and services (13%). In short, this is a hi-tech company.

Being a technology company, it is subject to several risks, primary being technological obsolescence and competition. The 10-K filed by the company lists a number of risk factors. These are sort of caveats on company being unsuccessful.

Given the background how has the company performed?

In March 2008 it had a market cap of $100 b and now it is selling at $150 b; about 8% annual return over 5-year period is not bad, especially under difficult economic conditions.

May 2012

That's the story from the market. But how has the business performed? Revenue for the year ended 31 May 2012 was $37 b which has grown 13% annually over 4-year period and 16%+ over 3-year period. Not bad at all considering the state of the global economic conditions.

Key aspect of this growth, however, has been acquisitions. The company realized that only software services from its original portfolio was not enough; therefore it has been acquiring other companies; recent acquirees include: Taleo Corporation ($2 b); RightNow Technologies ($1.5 b) and Art Technology Group ($1 b).  Standout acquisitions include Sun Microsystems ($7.3 b) in 2010 and BEA Systems ($8.6 b) in 2008. Total goodwill on acquisition stands at $25 b as of May 2012. The economic value of this goodwill remains to be tested over the next few years, though. If the acquired businesses do not generate adequate cash flows the goodwill will turn out to be just water.

The company has about $14 b of operating income and about $10 b of net income, both of which have grown over 15% over the last four years. Debt ratio has been respectable at about 29% on average. Almost half of total assets is cash ($ 30b). With operating assets of $30 b, after-tax return on capital (over 30% average) and return on equity (25% average) have been extraordinary. Average free cash flows to equity have been more than $5 b over the past 3-4 years.

This sounds one heck of a business. Can this continue? Recent quarters also have not been bad (analysts are not happy though since software segment has not been good enough).

Hardware...at this time?

Why did the company buy Sun Microsystems which is into hardware business? It is $7 b and the world is not so much gaga over hardware these days. Remember all growth is not value.

Use of cash

The company has also been using its cash for stock buy-backs, a signal from management that its stock is under-priced. It bought back $5 b worth of stock in 2012; and $5 b again in the last 2 quarters ended Nov 2012. The question is: is the stock cheap? Say the truth.

Valuation

At $150 billion the company is selling at about 11 times pretax operating income and about 15 times 2012 earnings. Trailing-12-month multiple is also similar. It appears on a reasonable valuation level if you see it from the historical standpoint. This means if you buy the stock today and expect the company to replicate its past performance in the next 5-10 years, you should be able to get about 10-20% annual returns. That's cool!

But wait.

What if the company does not do as well in the future? What if its growth slows down? What if it does not find good acquisitions? What if it overpays for future acquisitions? What if its past acquisitions fail to generate adequate cash flows? What if it fails to catch up with changes in the latest technology? What if the margins come down (they are hard to maintain in the long run)? The average annual capex (before netting off depreciation and amortization) has been $4.5 b. Similar amount is spent for research development activities as well. The company will have to spend similar or more in the future and these reinvestments will have to translate into growth - which will have to translate into cash flows which will have to translate into increase in value of the business - which will translate into higher stock price. Bingo! you have created value for the business.

Estimating technology business cash flows....is that possible?
I am not tech savvy; I don't even understand what Oracle does in the first place. That new boy in town...Cloud Computing...the name itself is scary....That didn't stop me; when I tried more realistic assumptions of free cash flows, growth (period) rate, terminal growth rate and discount rate (representing cost of capital or cost of equity as the case may be), I found the current price of stock at $31 to be expensive.

Who knows what's in store? Hardware days are gone; expensive software is being undone; cloud computing has arrived. Revenue pressures; margin pressures ahead.

But then you may have different set of assumptions. Management may have different assumptions.

How deep is ......let's explore!