This Company Is The Definition Of Technological Moat
Federico is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In this article, I will explain why I like Oracle (NASDAQ: ORCL) and describe its main growth drivers and the reasons why I think Oracle is a solid investment in the technology industry.
The secular cloud trend will benefit Oracle
Oracle is expected to benefit from higher corporate spending on Software-as-a-Service (SaaS) and cloudbased services on a long term. Revenue from the global SaaS segment will grow by 18% to $14.5B in 2012, according to Gartner. The market research firm projects that revenue will reach $22.1 billion by 2015. This strong growth is driven by continuing adoption of cloud-based services by Enterprises. Oracle is committed to innovate in this high growth area witnessed by the development of Oracle Cloud, a top cloud system. Oracle’s cloud system enables enterprises to shift data and applications between the public cloud and their private cloud, a service not offered by other cloud-computing providers. I believe that this technological edge will drive huge market share that has been reflected in the last earnings report. On top of that, Oracle´s SaaS bookings are near a record $1.0 billion with a number of major customer wins in recent times. In addition, Oracle’s new products, like Oracle Cloud, Fusion Applications and Cloud CRM are promising to boost organic growth in the coming years. The introduction of Oracle Cloud is anticipated to provide significant competition to Salesforce.com moving forward. Also, the cloud services offering opened a new source of recurring revenue through subscriptions that is expected to drive profitability in the coming years too.
Oracle is the true leader in the huge database market and other segments
Research firm IDC projects that the company commands 45% of the overall database market, followed distantly by IBM and Microsoft, both with 21% market share. Oracle's free cash flow as a percentage of revenue has remained fairly steady, averaging about 31% since fiscal 2005. The company's database and middleware products serve as the technological infrastructure for numerous business applications used by hundreds of thousands of customers. Customers typically stick with their installed database and middleware platforms for a long time, providing Oracle high-margin recurring revenue from annual support contracts. This is the definition of Oracle´s moat. The company also expanded its leadership in the database market to the enterprise software industry. Building on the ubiquitous launch of their database systems, the company spent almost $36 billion since 2005 acquiring and integrating dozens of enterprise software providers such as BEA, PeopleSoft, and Siebel. The important aspects behind Oracle’s highly profitable operations come from its software license updates and product support revenues.
Oracle also has successfully invested on its strong competitive position to enter new enterprise software markets. I see Oracle's application software venture as a narrow-moat franchise protected by high switching costs. Oracle's application software is mainly used by large enterprises to manage a variety of business processes, including business resource planning, supply chain management, and customer relationship management or CRM’s. Applications such as ERP and SCM tend to have half-lives of more than a decade because of the high burden of user-retraining costs as well as the inherent risks in switching mission-critical software, which is why Oracle’s services are for a long-term haul and protected.
The company also enjoys a strong position in the software business and relational database management system industry. Enterprise resource planning (ERP) is projected to be the largest enterprise application market, with total revenues of $24.9 billion in 2012, according to market research firm Gartner.Other than Exadata and Exalogic, Oracle is also anticipated to achieve strong growth from SPARC Supercluster, Exalytics and Big Data Appliance for a long term.
Hardware protects Oracle´s software motal
Oracle's hardware venture has been a drag on overall financial results, however, it is a key factor of the company's competitive advantage over private cloud competitors like IBM, Hewlett-Packard and SAP. With Oracle's ownership of the whole IT stack, which includes SPARC processors, operating system, database, middleware, and application software, it enabled the company to pursue an engineered systems strategy that its rivals are not fit to even copy. Engineered systems like Exadata, Exalogic, and Exalytics are preintegrated hardware and software appliances that customers can use quickly, minimizing the need for expensive consultants or IT personnel to integrate and customize hardware and software that are purchased from different vendors. These integration and customization services often exceed the cost of the software itself, making Oracle's value proposition important to customers while putting pricing pressure on rivals.
Oracle is fairly valued
In the table below, I compare Oracle to other companies in the industry. I think that Oracle shares are fairly valued. For example, IBM (NYSE: IBM) trades at 15.35x earnings, Microsoft(NASDAQ: MSFT) at 14.8x and Oracle at 15.76x, a multiple that it is reasonable considering these companies growth rates. Also, Microsoft trades at 3.76x book, a multiple similar to Oracle´s 3.53x. I think these big cap technological giants looks fairly valued at this time. Oracle, IBM and Microsoft have an excellent combination of strong free cash flow generation and low financial leverage. I think that Oracle can trade at a P/E multiple similar to SAP´s if the company shows the market that its SaaS segment is gaining traction. If not, I think that it will keep trading as a single digit growth technology giant.
I am positive on Oracle´s last earnings results
From the last earnings report, I was very encouraged to see that Oracle’s engineered systems, which comprises of Exadata, Exalogic, Exalytics, SPARC SuperCluster and the Oracle Big Data Appliance product group grew 100% year over year in the reported quarter. Fourth-quarter bookings of $274 million also were a strong result. Oracle Cloud Software-as-a-Service business also continued to grow at a huge rate in the quarter, in fact, its operating income increased 4.4% to $5.31 billion driven by cost efficiencies. NonGAAP operating margin went up 140 bps year over year to 48.6% due to the higher-margin software venture. The company's balance sheet is very solid. Net debt is around $1B, a small sum for a company this size. Yet it is not hoarding cash but rather reinvesting it into the company with large R&D ($4.5B) and Capex ($650MM). The company's cash flow situation is solid, as it has had cash flow growth each of the past 3 years, and 2 out of 3 periods had FCF growth of over 20%. FCF yield currently sits around 8.8% It has announced a $10B stock repurchase plan and pays a dividend of almost 1%. There is still plenty of money to reinvest in the business.
My fair value estimate is $41 per share, which implies a forward fiscal 2012 price/earnings of 17.5 times, an enterprise value/EBITDA of 12.8 times, and free cash flow yield of 8.3%.
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federicoflom has no positions in the stocks mentioned above. The Motley Fool owns shares of International Business Machines, Microsoft, and Oracle and has the following options: short JAN 2013 $150.00 calls on Salesforce.com and long JAN 2013 $150.00 puts on Salesforce.com. Motley Fool newsletter services recommend Salesforce.com. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
