Oracle Corporation is a large, liquid, stable, high quality technology company that has generated huge cash flows over long periods of time, generates very high long-run returns on capital and assets, with stable margins, and recently has been paying down debt and repurchasing stock. Despite this profile, the market has become overly bearish, and has bid the stock down to an attractive price at an 8.5% EBIT to EV yield.
The bear case paints a compelling story. There is fierce competition across Oracle’s markets, and it is only increasing. Firms hungry to take market share from the firm include not only traditional competition, consisting of big gorillas like SAP, IBM, and Microsoft, but also smaller, nimble, and dangerous new entrants such as Salesforce and NetSuite.
In this view, Oracle is an aging innovator with dim organic growth prospects. It is a classic legacy technology company, with a legacy business that is withering away steadily. Oracle’s core database business has slowed since the early years of its success, and today there are many database alternatives. Oracle was also slow to develop its Fusion suite, which hamstrung its ability to allow interoperability with software solutions and provide a broad-based solution to customers. It was also late to enter the booming cloud market, and is struggling to migrate its legacy business into the cloud, where it faces formidable competition from giants like Amazon and Google, who are building data centers rapidly, sending cloud prices plummeting. The hardware business is also under siege. Oracle got into the business with the Sun acquisition and hardware has been in steady decline ever since. Traditional hardware competitors like Dell and HP are repositioning to services, trying to muscle in on Oracle’s turf.
We believe the story around the bear case is just that: a story.
Before getting into the details of the business, we’ll provide a little background for those generalists who are not technology experts or don’t already know Oracle well.
The first thing to understand about Oracle is its roots as a database company. Back in the 70’s, Larry Ellison was among the first to recognize the many business applications for the database, and he founded Oracle to develop early products, which were SQL systems that could scale to accommodate growing amounts of data and users.
Over time Oracle innovated to maintain its database leadership, adding functionality, allowing more users to connect through networks, increasing speed/performance, integrating with new web technologies, adding hardware, and reducing storage and operating costs.
During this time, Oracle evolved towards a much broader focus as an information services and enterprise computing company. Today, Oracle’s stated value proposition is as a provider of integrated hardware and software solution that simplifies IT for businesses, and does so in an open source format that maximizes flexibility for the client. While that may sound a lot like just an Oracle commercial, there is much truth to it. Let’s dive into the business.
Oracle is first and foremost a software business, which is made up of two segments: 1) new software licenses and cloud subscriptions, and 2) license updates and ongoing support, which represents the majority of Oracle’s software revenues based on its installed base of approximately 400,000 customers. One basic dynamic to keep in mind is that Oracle’s new cloud subscriptions should offset declines in legacy software sales.
We will take these segments in turn, but first, we want to highlight the broader business framework in which they interrelate.
Oracle has been on the forefront of a technology trend in recent years towards Enterprise Computing. A decade ago perhaps, firms tended to purchase multiple specialized software applications for their business from different vendors, integrating them in patchwork fashion. In the next cycle of evolution, rather than continuing to purchase this wide range of one-off software packages for specific functions, firms began to use customized integrated software and technology packages, from Oracle and others, to manage the operations of entire companies. While these were unified underlying IT systems, they also had to be able to work with newer as well as pre-existing applications.
Consistent with this trend, Oracle developed from a pureplay database company, to a provider of a broader array of software, to a developer of middleware that allowed its database to integrate with Oracle’s and other vendor’s products, and then it made the leap into the cloud.
NEW SOFTWARE LICENSES AND CLOUD SUBSCRIPTIONS
Although new software is the smaller of the two segments, it is a bellwether for the company as it can indicate growth trends and future follow-on support and update revenues. Oracle’s new software licenses (non-cloud) are in connection with its 1) database product, 2) middleware products, and 3) software applications.
Databases, which are useful for storing large collections of data and sorting or searching them for specific information, are deployed across the business world today, in applications ranging from management of sales and customer information to airline flights, credit card information and inventory management. Oracle’s customers include essentially all the largest firms across virtually every substantial industry out there: airlines, automakers, banks, high tech companies, insurers, manufacturers, oil & gas, pharma, retailers and telcos.
Oracle’s core database offering has been aided by the trend towards Big Data; the ability of firms to create ever larger data sets has led to growth in software products for organizing and managing it. Increasingly, businesses have begun to mine unstructured data, such as blogs, social media and email, for business intelligence purposes.
Oracle still leads the database market, with an approximately 50% market share, and still generates most of its software license revenues from database licenses. Oracle’s flagship database product is its 12c, and the company’s current focus is on adding a so-called “In-Memory Option,” which, in theory, will provide truly real-time access and queries, with immediate results for users. This is a big deal since companies will be able to see, say, sales or inventory data at any given moment in time. The product will be fully compatible with independent vendor applications and should be available next month. This is essentially a product upgrade cycle for Oracle, and represents a significant catalyst as it could accelerate organic revenue growth to double digits from current single digit rates.
This is also valuable weapon in the company’s arsenal to keep legacy clients, and also a direct competitor to rival SAP’s HANA, which has had a multi-year head start, as well as IBM’s BLU Acceleration.
Middleware essentially handles a user’s requests, acting as the “glue” that connects operating systems with software applications, allowing integration of software with hardware. For example, middleware might allow a database to talk to a server, enabling a user to access database results via a web browser.
For Oracle, this gives rise to its Service-Oriented Architecture framework. Service-oriented architecture has been likened to “lego blocks” that enable modular software services to be plugged into the broader enterprise technology infrastructure (as discussed above, in “Enterprise Computing”). This promotes Oracle’s ability to provide open-source solutions, since it allows Oracle products to connect to software from other companies, such as IBM, Microsoft or SAP, or to customized software. This way, you might have older, legacy software packages that can be easily integrated into the core enterprise IT infrastructure.
Oracle’s core middleware product is Fusion, which includes a foundation for cloud applications, as well as business intelligence and process-management products and developer tools, and is based on Java technology.
SOFTWARE AND CLOUD
Oracle offers applications across a range of business functions, from resource planning, customer relationship management, and supply chain, to financial management, governance, risk, and human capital management.
A significant trend in technology today is the advent of the Software as a Service (SaaS) model. Concurrent with the growth of the cloud, the software industry has moved away from a traditional software installation/maintenance model, and towards SaaS, whereby software is accessed via the internet, as a service. The software resides on servers managed by the service provider, who maintains and updates the application.
Oracle undertook a massive development effort to upgrade its applications to enable them to run in the cloud. This allows the firm to offer its core database and middleware products through the internet browser. Crucially, these SaaS applications will provide the company with a way to drive organic growth for its cloud revenues. Recently, rumors have surfaced that Oracle is in talks to acquire Micros Systems for a reported $5 billion, which would be the company’s largest purchase since Sun Microsystems in 2010. Micros provides software for the hotel, hospitality and restaurant markets, and would beef up Oracle’s SaaS portfolio by providing it with penetration of the retail market and another source of recurring revenue.
As computing has evolved beyond the desktop and networked PCs, businesses have migrated to a cloud-based model employing remote servers located in data centers. Oracle’s success in databases, middleware and SaaS have positioned it for success in the cloud, with cloud revenues growing by 25% YoY in the most recent quarter. Many feel that Oracle’s prospects for future top-line growth depend on its success in moving into the cloud business. But a price war is currently raging. Competition is intense in across Oracle’s SaaS and cloud lines, with upstart competitors, such as Salesforce, NetSuite, and Workday gaining traction. Salesforce’s primary product is CRM software, and grew its cloud sales by 37% in the most recent quarter. They are also providing “platform-as-a-service,” which allows firms to create their own private cloud services, and it is a very low cost provider. Salesforce is also active in mobile, and recently partnered with Microsoft to deploy Salesforce’s CRM applications on Microsoft’s Windows and Windows Phone operating systems.
Oracle’s competition in the cloud also comes from large infrastructure companies, such as Amazon, which is building out data centers and leasing them to companies. Larry Ellison has said that Amazon is a new primary competitor. Other competitors include HP, Dell, Cisco, and VMware. Significantly, Google is also getting into the game, having created dozens of data centers, and dramatically reducing its rates for rental storage and computing power.
Hardware is primarily servers, storage, networking, virtualization tools, and the Solaris Operating System. These are deployed in data centers and are part of Oracle’s cloud offering.
Many were surprised when sales in Oracle’s hardware business increased by 8% in the most recent quarter. Success has been driven by engineered systems, including Exadata, as well as SPARC and Solaris technologies from its Sun acquisition.
Over time, firms have begun separating software applications from hardware, allowing the creation of “virtual” systems that leverage available space and computing power. Oracle has leveraged R&D in virtualization, to enhance its offering.
Oracle’s hardware products are tightly integrated with its core software and database offerings, thus generating networking effects, since the value of its core products is enhanced by complementary hardware products and services.
Oracle derives multiple advantages based on its scale. Oracle’s sheer size and market breadth give it a huge range of products to sell, across the technology stack. These systems are interoperable, and make for a fertile environment for cross-selling. Oracle can bundle products for the enterprise, as fully integrated suite, or make modular offerings, where pieces can be custom-tailored to the client. It has among the largest developer pools in the world, and a huge trove of Intellectual Property. Its scale also allows the company to make big acquisitions that would be unavailable to smaller competitors. Oracle has invested approximately $50bn in the past 10 years in acquiring companies.
The company also discourages competition is through substantial economies of scale. The company has a $190 billion market capitalization, and it makes heavy, regular R&D expenditures that allow product differentiation, or illuminate ways to provide products more cheaply. Its scale and existing infrastructure can also make new products more directly competitive versus those of other vendors; its extensive existing support function can be leveraged for new products, lowering the all-in cost it charges to customers. This cost advantages versus competitors makes it difficult for them to enter the market and compete on price.
Oracle has a highly recognizable brand, which ranked #18 in Interbrand’s Best Global Brands for 2013. The company’s brand is highly recognizable, discouraging would-be competitors from entering various segments of the market to compete against a household name. If you are a business looking for an IT upgrade, you will not be fired for choosing Oracle.
A key aspect of Oracle’s highly integrated offering is the high switching costs it promotes. If a customer relies on Oracle for a broad range of its technology, from software through hardware, it becomes more difficult, expensive, and time consuming for customers to adopt an alternative. The customer becomes in a sense captive. Indeed, the majority of its software revenues are predicated on the generation of recurring licensing and service revenues.
We believe Oracle’s scale, brand and switching costs contribute to its strong franchise. One indicator of this franchise value is the strong returns on assets and on capital it has earned over long time frames. The company generated an impressive TTM 13.6% return on assets, and over the past 8 years has averaged 12.6%. When we compare this long term ROA average with the universe of large-cap securities (>$2.0bn), we find this places Oracle in the 90th percentile. Oracle’s returns on capital are also strong over the long run. Over the past 8 years, Oracle has generated an average ROC of 16.5%. This puts it in the 86th percentile for large-caps.
FREE CASH FLOW
Oracle is a strong generator of free cash flow, which is another indication Oracle possesses a franchise. When we sum the free cash flows from the past 8 years, we find the total is 95% of its total assets, placing it in the 94th percentile for our large-cap universe. Not many businesses generate sufficient free cash flow over a mere 8 years to entirely replace their asset base.
Another sign of a franchise is the stability of margins over time. Oracle has maintained high margins within a narrow range over a long time frame. Below are gross margins for Oracle over the past 8 years:
The stability of Oracle’s margins suggests it has pricing power within its markets.
Oracle exhibits many signs of being a financially strong company. It generated positive earnings and free cash flow over the past year, and free cash flow has exceeded net income, indicating the company is not using accruals, which is an accounting red flag. In fact, the company’s free cash flow has exceeded net income in each of the past 8 years. The company also paid down debt over the past year, and has been a net repurchase of equity, both of which benefit equity owners. Returns of assets increased in the past year, as has free cash flow, when scaled by assets. Margins also increase in the past year. Together, these metrics suggest that the company has strong financial and operational momentum.
In sum, Oracle is a cheap, high quality mega-cap business, benefitting from stable margins, multiple economies of scale, and a well-known brand. It has successfully penetrated the enterprise computing market, and is an industry leader. The company’s core database product is still world class, and the firm appears to be successfully adapting to changes in technology by successfully transitioning from its legacy software business to middleware, SaaS, and cloud offerings that are integrated with its strong hardware platform. It also seems to be effective in using acquisitions to fuel its growth, as with Sun Microsystems, and now (perhaps), Micros Systems.
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.
The 10K is coming out tomorrow...should be interesting.