I am going to shamelessly steal from the Oracle FY2012-10K the paragraph on what it does as a business.
We are the world’s largest provider of enterprise software and a leading provider of computer hardware products and services. Our software, hardware systems, and services businesses develop, manufacture, market, host and support database and middleware software, applications software, and hardware systems, with the latter consisting primarily of computer server and storage products.
Oracle generates copious amounts of cash. Even after acquiring a host of companies, it has much left over in cash flows.
The upper three rows shows the cash flow situation. Oracle has pretty low capital expenditure— which is not so surprising for a company with its business model. But still it is quite low compared to HP, Microsoft, IBM, Cisco and a host of other tech majors. In the last 10 years Oracle has generated $65.7 bn of FCF. See the table below.
|Cumulative Summary (2003-2012)||(in $ mn)|
|Free Cash Flow||+65,785|
|Increase in Debt||+13,361|
|Total cash raised||79,146|
|Total cash spent||-63,758|
Notice that the totals don’t match— which is to be expected because I did not take into account everything. For example the cash on hand has increased $22 bn in the same time period. Barring that, we see that Oracle has spent nearly 50% of the cash generated on acquisitions and only 26% on stock buybacks and dividends.
Let me say a few words about the share buybacks. Oracle has been jacking up its buyback plan and the most recent quarter the shares outstanding have come down by nearly 300 mn. On June 20, the company announced an addition of $12 bn to its already existing buyback plan and jacked up the dividend by 50%. There is a definite shift to returning value to the shareholders.
Given that most of the FCF goes into acquisitions, we want to see if they are being spent reasonably. Oracle’s acquisition strategy is succinctly described on their website as follows.
The tech industry has a history of chasing overpriced acquisitions and writing them off. A serial wrongdoer is HP, which wrote off Palm (~ $3.3bn, 2011), EDS (~ $9 bn, 2012), Autonomy (~ $8.8 bn, 2012). It is amazing still that even after so many write-offs the company still has $31 bn of goodwill on its balance sheet. Subtract this with $22.4 bn in equity and you get a negative value of -$8.6 bn.
Through our acquisition activities, Oracle seeks to strengthen its product offerings, accelerate innovation, meet customer demand more rapidly, and expand partner opportunities.
The argument goes that the tech sector runs on innovation and is quick to evolve and change. This creates opportunities for small companies to discover new technologies and steal customers away from the big ones. To risk extinction the big companies are “forced” to buy innovative companies with “promising” products. Acquisition in these cases are inherently risky because it is quite possible that the “promising” product may turn out to be not so promising after all. Sometimes the big company loses interest in the acquired company, the management feels slighted and leaves. This will result in shelving of the project. All of this ends up as “write-offs” and loss of shareholder value.
In an article published in New York Times in Feb 2008, Randall Stross gives a antidote to Microsoft’s acquisition strategy.
Let us see if it is true. One of the most recent acquisition of Oracle is Acme Packets for $2.1 bn. Acme makes hardware for the internet backbone - session border controller (SBC), multiservice gateway (MSG), and session routing proxies (SRP). The customers of Acme are ISPs and out of the largest 100 ISPs in the world, Acme counts 89 of them as its customers.
For an illustration of how Microsoft could select targets more judiciously, Mr. Cusumano, who is a professor at the Sloan School of Management at the Massachusetts Institute of Technology, pointed to the Oracle Corporation’s strategic acquisitions and its prudent use of capital to “roll up firms with similar products and customers to its own.” With impressive regularity — 13 strategic acquisitions in 2005, another 13 in 2006 and 11 in 2007 — Oracle has picked up key products and customers while avoiding an “oops” slip, venturing too far away from its core business, or paying too much. At no point along the way has it acted in a fit of desperation.
At the end of 2012, Acme has $358 mn cash on its balance sheet and no debt. This brings down the price paid to near $1.7 bn.
Acme will be characterized as a “growth” company. The revenue went from $116 mn in 2008 to $274 mn in 2012 at a compounded growth rate of 24%. In 2011, the company had an OCF of $55 mn. So, Oracle paid nearly 30 times 2011’s OCF and 6.2 times 2012’s revenue.
In 2008, Oracle acquired BEA Systems, an enterprise software products maker for $8.5 bn. BEA had $1.5 bn in revenue and $200 mn in profits. Oracle paid 5.6 times sales and 42.5 times earnings.
It is clear that most of the valuation which Oracle pays for, is expected to be realized in the future.
Oracle has a reputation of cutting costs. It acquires companies at seemingly high valuations and then aggressively cuts costs to return them to profitability. Oracle acquired its major competitor Sun Microsystems in 2010. With one clean swoop Oracle controlled MySQL, Java, and Sun’s server systems. Oracle paid $5.6 bn (net of cash and debt) for the company. Sun had $11.4 bn in revenue and was a loss making entity at the time. This explains why Oracle was able to acquire it for 0.5 times sales.
A good way to see this is the net margin and revenue of the company over the years. Even after gobbling up $40 bn worth of companies - the net margins have stayed near the 25% mark. So, it can be argued that Oracle’s strategy has worked in this sense. Although without finding out which part of the revenue is organic -- it is difficult to pass a judgement.
In my opinion, Oracle has paid fair prices for its acquisitions. Let us look at the facts. Oracle has paid $40.5 bn on acquisition in the last 10 years. In the meantime, its sales have gone from $9.5bn to $37.1bn— an increase of $27.6bn. At current P/S of 4.6 for Oracle, $40.5bn is worth only $8.8 bn in sales. In other words, it was better to acquired than buy Oracle stock - assuming that at least most of the $27.1bn sales increase was due to acquisitions.
The executive pay is something else. The table below shows what the management was paid during the last 3 years.
Larry Ellison owns 23.35% of the company stock.
Apart from the pay, which in my opinion is greedy of the management -- they have performed quite well. They have managed the balance sheet quite conservatively and have shown phenomenal return on invested capital. As a byproduct, the interest cover is nearly 17.
The company has nearly $13 bn of excess cash (cash & equivalents - LT debt - ST Debt) on its balance sheet.
Risks: The acquisitions pose the risk of write-offs. The company’s intangible assets over the last ten year period is shown below.
From the figures above, it may be said that the company has either started paying closer to book value for its acquisitions, or it has managed to keep its cash on the balance sheet -- increasing the tangible book value. As opposed to HP, which still has negative TBV, Oracle has some tangibility. But this is still quite small compared to the EV of nearly $142 bn ($142 bn market cap @ $ 30/share - $8 bn of net cash). The large amount of goodwill (intangibles) open Oracle for the risk of write-offs in the future.
Oracle’s margins are quite high. The table below shows all the margins and the tax rate it has paid for the last 10 years. The figures show that Oracle has a pretty wide moat.
Compare these figures with one of Apple (AAPL). The net margin and the tax rate figures in the last few years are almost the same. It also means that Apple has been playing catch-up with Oracle on the margin numbers.
The fear of margin squeeze has sent the price of Apple stock from $705 to $420. I am not saying that Oracle sees a foreseeable margin squeeze but competition will lead to lower margins for all involved. At the moment it seems that Oracle is the “top dog” and can demand higher profitability. The risk of margins going down is more than the chance of them going up— at this point.
Oracle has also managed to cut down its tax bill. Probably because it is a more international company now then it was before. The tax rate has gone down from 32.64% to 23%. An increase in tax-rate to 30% will lead the net margin to 24.4%.
Valuation: The company has a great history of free cash flow. As we saw earlier, most of it has been used to acquire new companies. Unfortunately, Oracle cannot really stop acquiring unless it wants to get obsolete. The recent example was the binge of acquisition it needed to do to compete with the cloud computing entrants. So, the acquisitions are really a part of the cap-ex. Having said that, I still think that Oracle has managed to do acquisitions in a balanced sort of way at fair prices. A 10 times FCF is a good price to pay. That puts the share price at $26 a share.
Additional disclosure: No positions yet. Will buy if the shares drop to around $26.