Description

Investment thesis

Strong recurring, deeply entrenched, high ROIC, FCF business with variable cost structure and aggressive management. Dominant player with number one or two position in each of its core segments. Buy best in class consolidator, priced for no growth, trading at historical lows with meaningful upside from a re-rating which should be realized as earnings profile proves its resilience and new license revenue growth reaccelerates.

Oracle (ORCL) description

Oracle is the largest enterprise software company globally. The company develops, manufactures, markets, distributes and services database and middleware software as well as applications software. The company's fiscal year ends May 31. In FY 2008, 51% of revenues were from the Americas, 35% from EMEA and 14% from Asia. Founder and CEO Larry Ellison owns 23% of the company.

Oracle is organized into two businesses segments: Software and Services.

Software (80% of sales)

Oracle is the market leader in the database segment with approximately 50% share. IBM is its closest competitor with approximately 20% share. Oracle and IBM are also the dominant players in the middleware business where they have similar scale. In the enterprise applications market, Oracle is the second largest player (12% share) after SAP (21% share). 

Database and middleware account for 52% of total revenues and Application accounts for 28% of total revenues.Database software provides the foundation for every information system; once installed, customers depend on databases to store, access, and secure all sorts of critical information for business operations. Applications software includes a wide collection of integrated applications designed to support and streamline business activities across the organization.

Software revenues are comprised of a) New license sales and b) License upgrades and product support. New license sales are generally one time and for the perpetual use of the software. License upgrades and product support are priced as a percentage - 22% on average - of the new software license fee. License upgrades and product support are effectively recurring maintenance contracts and have very high margins. In contrast, new license revenues have significant sales and marketing costs and are thus low margin. New licenses sales can be thought of as the upfront investment associated with acquiring the proverbial toll road - maintenance - business. However, at scale, the costs associated with new licenses are sufficiently variable that they can be effectively managed such that non-maintenance revenues offset all operating costs.

License upgrades and product support (maintenance) revenues are renewed on an annual basis and have a renewal rate of greater than 95%. Once customers have invested in a particular system it is very difficult and costly for them to change vendors - high switching costs. And, customers of a given vendor are effectively required to renew the maintenance contracts because the risks of losing ongoing vendor support (e.g. access to virus patches, updated versions...) are too risky to the enterprise.

Services (20% of sales)

Services is predominantly a consulting business, in which, Oracle assists its customers in the deployment of the company's products. Services have low but positive margins that together with new license sales help cover operating costs. Like new license sales, the costs here (people) are primarily variable at scale.

Financials

Below we cut the historical financials employing the above framework.

Valuation

As of 2.20.09, with a share price of $16.56, ORCL trades at 7.4x LTM maintenance revenue of $11,474.

Employing the assumptions on the right, we calculate that a conservative terminal valuation multiple for the maintenance business is close to 8.0x.

The growth rate of 2.5% is an estimation of the inflationary annual step up rate.

Further, we assume that new license revenues offset the annual anticipated churn of 5%. For context, at a maintenance revenue fee schedule equal to 22% of new license sales, ORCL would require annual new license sales of $2.6bn or ~70% less than Oracle's LTM sales of $7,623.

At the current stock price, investors have a call option on growth with minimal downside risk. For instance, we assume new license growth rates of -5% in FY '09 and -2% in FY '10 as well as annual churn of 5% (note: Application software currently accounts for approx 30% of new license sales. We assume application declines by 18% and 7% including growth from completed acquisitions in FY '09 and FY '10. For the same periods we assume data and middleware grow at 0-2% - see risks below). This results in a FY '10 maintenance revenue of $12.5bn which implies an IRR of 23% at the 7.875x terminal multiple - see math at right. This excludes the effect of a re-rating as the market looks out to a reacceleration in new licensing growth as well as the ability for ORCL to make accretive acquisitions at low valuations over the next several quarters.

Note: Over the last several years, Oracle management has executed well with its acquisition strategy by creating revenue synergies, expanding margins and diversifying into newer markets with a more defensive and better growth profile. Further, the company's acquisition strategy has transformed it into a one stop vendor for many of its customers due to the completeness of its technology stack which facilitates cross selling and allows customers to simplify support / wring costs from their IT environment. As a result, Oracle should be a share gainer in this environment.

Alternatively, consider that ORCL is currently trading at 8.0X LTM EBIT and 11.4x CY 2009 consensus EPS estimates. We believe that a company with this kind of predictability and growth profile should at a minimum trade at a 15.0x fwd P/E.  Current consensus CY 2010 EPS estimates is $1.66. This estimate appears to assume some share repurchases and / or deleveraging; thus, we assume no yield. Using this approach (i.e.15.0x 1.66), at the end of the year, ORCL should trade at $24.9 or 50% above the current price.

Of note: Oracle has been a meaningful buyer of its stock below $20. During the last two quarters it purchased $2.3bn. The company has approximately $7.5bn left in its authorization.

Risks

Currently we anticipate organic declines in new software license sales of ~25% for applications and flat to minimal growth in database and middleware. CTOs appear to view many ORCL applications as "nice to have" as opposed to "must have"; however, database and middleware is viewed as more mission critical since storage needs  continue to double in size every of couple years. Moreover, customers view enhanced database and middleware software as an avenue to quick cost savings via more efficient data usage. Our assumptions result in a total FY 09 decline of approximately 5% in new license sales. A material delta to our new license sales projections or churn rates materially in excess of 5% would meaningfully alter our expectations for growth in maintenance revenue. For FY '09 and '10 we did not budget price inflation on the maintenance stream.

The appreciation of the dollar against foreign currencies adversely affects results. Oracle has not historically engaged in material hedging activity and approx 50% of its revenues are foreign based.

Upcoming events

Q3 FY09 Earnings ~March 25, 09

Catalyst

Over the course of CY 2009, earnings results should prove the sustainability and predictability of Oracle's cash flow profile

Investors will eventually look forward to a period in which new license revenue growth reaccelerates 

The highly probable acquisition of size at a compelling price over the next 16 months