When your goods are not selling well, can you blame your sales people? You can if you are an Oracle. However, some analysts believe that the real problem is that cheaper cloud solutions are eating into the turf of more expensive enterprise software segments, the traditional stronghold of Oracle. Last quarter, Oracle (NYSE:ORCL) recorded revenues that missed estimates in key areas of its business, causing an unexpected drop in the stock price. The company had been going steady at a price between $34 and $37 for most of the last year before its disappointing earnings results caused it to dip quickly to as low as $31. Its hardware, software licenses and subscription services all recorded negative surprises. Given that these products make up a significant portion of Oracle’s revenues, analysts and investors could be increasingly concerned on Oracle’s future as a leading technology company.
So are Oracle’s products losing relevance? Are competitors quickly getting ahead? Or is Oracle’s future as a top technology company safe given its status as the creator of some of the important software programs used around the globe today? Lou Simpson, last year, bought a stake in Oracle, believing the company has value in its future:
- Oracle’s current P/E of 15.05 and a forward P/E of 10.67 the next year looks cheap. The company’s cheap price has been achieved through its de-facto status as a leading company in database technology, decreasing integration costs, and growing sales through the successful utilization of its database applications and engineering systems.
- Oracle reports exceptional profitability numbers with a profit margin of 28.46% and operating margin of 38.54%, a result of the company’s double digit revenue growth in software and database applications. The upward trend in margin numbers is expected to continue next year, as the expected improvement reflects the mix shift away from hardware and software to software and service products.
- An ROA of 11.63% and ROE of 24.29% are among many factors that illustrate a strong, healthy balance sheet and strong cash flow metrics for Oracle, creating the opportunity for the company to engage in acquisitions to strengthen its position in software technology.
Oracle is a leading provider of enterprise technology solutions, offering an optimized and fully integrated stack of business hardware and software systems across a wide variety of industries across the world. The company’s dominance in database technology has made it the platform of choice for developers building software applications. Oracle’s proposed enterprise value is roughly 4.5 times the 2014 sales estimate and 17.6 times the 2014 EBITDA estimate, which is roughly in line with technology companies carrying similar margin and growth characteristics. Oracle’s two biggest competitors are IBM (NYSE:IBM), a diversified technology provider, and SAP (NYSE:SAP), an applications developer. Oracle currently sells at $32.33, with the company carrying an attractive P/E of 15.05. As reflected in its “forward P/E” of 11.03, Oracle is valued cheaper compared to its closest tech peers. And Oracle’s P/E ratio is reflected in its diversified product portfolio and emphasis on lowering costs.
Despite negative developments over below-expectation earnings in key segments of its product portfolio, Oracle is still in good shape, as it couldn’t have achieved its 11.03 forward P/E without a low-cost business structure. By purchasing many solutions from one vendor, Oracle decreases the level of integration costs, a clear difference between IBM and Oracle's strategies for serving the customer. This eliminates performance bottlenecks in running business analytics, reading and writing data, and general processor performance. Also, by integrating hardware and software technology, customers can quickly launch appliances without the need for expensive implementation costs when various apps are not pre-integrated. Oracle’s engineered systems products continue to rapidly acquire new customers, seemingly validating the integrated hardware and software strategy Oracle has pursued. The company’s diversification of technology products shores up its defenses against changing economic conditions since customers can easily use Oracle’s services at a low price.
Software Revenue Growth and Increasing Profitability
Even in the face of economic uncertainty and missed revenue estimates in hardware and services, Oracle posted double-digit revenue growth in new licenses for database, middleware and software applications, boosting its operating income by 12% from the previous year. The rapid growth in sales demonstrates the solid value proposition of Oracle's engineered software systems. In particular, software licenses and product support was the most profitable segment of the company's operations, having accounted for about 70% of Oracle’s total revenue. These revenue items provide strong evidence of Oracle's wide economic moat.
Oracle, as a result of its economic moat, has increased profit margins to 28% and operating margins to 38%, both measures better than IBM and SAP. Oracle’s margin numbers were reported even in a phase of heavy investment in sales and marketing for vertical application sales. The improvement in profit and operating margins reflect the mix shift away from lower-margin hardware offerings to higher-margin software and service products. Oracle has been growing faster than the overall market and is expected to continue that trend. According to technology research firm Gartner, both the database and apps server markets are expected to grow at a 7% compounded annual growth rate in the next few years. Furthermore, Oracle expects to continue prudently focusing on profitability in the future.
Strong Cash Position for Acquisitions
Oracle’s balance sheet has always been one of the company’s great strengths. The company currently has nearly $43.8 billion in total stockholders’ equity, $16.1 billion in cash, $17.3 billion in marketable securities, and nearly $20 billion in both long and short-term notes payable and borrowings. The business, as a result, has become a cash cow. In the past 10 years, while its operating cash flow increased from $3 billion in 2003 to $13.7 billion in 2012, its free cash flow rose from $2.7 billion to more than $13 billion in the same period.
As an active acquisition program is a fundamental component of Oracle’s overall strategy, most of the company’s cash was being used for acquisitions designed to expand its business and maintain the company’s long-term standing in software technology. The acquisitions are also an effort to penetrate the market for existing customers, an important factor supporting Oracle’s focus on satisfying customer demand. According to a report from Morningstar, management has been disciplined in its capital allocation decisions and has avoided overpaying for acquisitions most of the time. The company, most recently, has been actively acquiring smaller niche providers, focusing on areas like telecom and software services, an area Oracle is already involved but still behind in.
Of Oracle’s recent signature acquisitions were Tekelec and Acme Packet, both networking technology vendors serving the telecom industry. Another major acquisition was Sun, which is said to place Oracle as a datacenter company providing a complete integrated stack of hardware and software. Oracle is expected to gain incremental revenue and cost synergies from these acquisitions, resulting in higher EPS potential longer term.
Analysts believe Oracle can generate more than $12 billion in annual free cash flow in the next year, enabling it to service the $15 billion in debt used in acquisitions like these designed to expand its business.
Integrating Acquisitions Could Bring Further Disappointments
As Oracle has recently completed a number of acquisitions, its integration risk has been heightened. Business-model transition is the hardest thing to get right and Oracle has ample opportunity to fail in its efforts to adapt and integrate its products. Given Oracle’s lack of experience in telecom services, Tekelec and Acme are viewed as high-risk acquisitions that could threaten Oracle’s future growth. The company’s debt-equity ratio is most likely reflected on these acquisitions along with numerous others that Oracle pursued during 2012. Oracle also acquired networking hardware company Acme Packet and several software service companies, including RightNow for $1.5 billion in January, Taleo for $1.9 billion in April, and Eloqua for about $900 million in December.
And Oracle made further valiant attempts to get involved with cloud computing, another technology service that competitors have gotten ahead in. Cloud computing represents a real threat to Oracle's applications businesses because of the fact that many of the company’s legacy applications do not support cloud computing. Generally, companies are extremely sensitive to the cost and risk of switching out their database technology. During the next couple of years, the power of Oracle's switching costs will truly be put to the test as the company attempts to sell products that slowly migrate customers from legacy to cloud solutions.
Decline in Hardware Sales Affecting Return on Invested Capital (ROIC)
Despite recent sales growth in software products, Oracle’s numbers have been dampened by the hardware segment's declining revenues. The company recently reported greater-than-expected declines in its hardware business, exposing a slight blemish on Oracle’s revenue numbers and reducing its ROIC to 16.7%, now the lowest among competitors in its industry. The underperformance in new hardware sales was below Oracle’s forecast for the past year. Not being well-oriented in hardware could eventually catch up to Oracle. As competitors are in the process of developing hardware products to strengthen their portfolio, Oracle is lagging behind and trying to revive its hardware business. Oracle may find it challenging to earn its cost of capital in the hardware business, as hardware companies are notoriously low-ROIC companies. Currently, in terms of return on invested capital, Oracle’s 16.7% ROIC is lower than SAP’s 19.3% IBM’s 31.4%, mainly due to the hardware business.
What the Bulls Say about Oracle
The key question is: Can Oracle win the new war in cloud computing? If yes, at how margin erosion? Some analysts think Oracle, after a significant drop, represents a good investment opportunity for investors due to its low valuation, strong balance sheet, and superb cash flow growth. Clearly, the revenue mix tilting toward software continues to benefit the company. Although Oracle is contending with database competition from IBM and apps competition from SAP, Merill Lynch’s research report argues that Oracle is well-positioned with its deep software stack, strong sales execution, and vertical apps focus.
Disclosure: Brian Zen has positions in Oracle and IBM.