This Software Behemoth Is Priced for a Meltdown

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The best investment opportunity is one in which a great business is selling for a low price. That opportunity currently exists in the form of Oracle(NYSE: ORCL). Oracle has become a reliable cash cow that regularly churns out more cash than it reports in Generally Accepted Accounting Practices (GAAP) earnings. Even though its cash flows are predictable, the stock is currently priced so low that shareholders will probably earn at least a 10% annual return over a multi-year holding period.

Best in the world

Oracle is the world's number one enterprise software provider. Its acquisitiveness has kept competitors at bay while allowing the company to expand its product offering. The acquisitions of PeopleSoft and Siebel enabled Oracle to enter application software, which the company has used to further its entrenchment in customers' businesses.

Customers have come to rely on Oracle for mission-critical databases and applications. Not only are these products highly integrated into the day-to-day business of Oracle customers, they are also crucial to the success of the customers' business. Customers are often unwilling to switch to a different provider simply due to price differences because the risk of downtime or integration problems is too high.

As a result of these enormous (and growing) switching costs, Oracle's cash flows are secure for the foreseeable future.

In addition, Larry Ellison has shown himself to be a prudent capital allocator. The founder and CEO owns 23% of the common stock and has made many shrewd acquisitions, even if they appeared overvalued at the time. The company has repurchased $11 billion in stock in recent years and continues to pay a strong dividend. In addition, it carries ample cash on the balance sheet for acquisitions and continued repurchases.

Competition

The only way for Oracle's free cash flow to decline is if competition starts to eat away at its market share. Although most of the risk comes from start-ups and smaller software firms in general, the company can easily acquire those companies and count the acquisition as a cost of protecting its moat.

Oracle's real competition comes from bigger players like SAP (NYSE: SAP) and IBM (NYSE: IBM).

SAP is a threat to Oracle because of its market position in cloud computing. Although Larry Ellison would say that cloud computing is just a new name for what Oracle already does, SAP's cloud computing segment represents a significant threat to his business.

SAP's large installed base of enterprise customers gives the company the same benefit from significant switching costs that Oracle enjoys, and affords it time to build out its cloud services.

SAP's cloud offering includes HANA -- a high-speed database and analytics tool that is the company's key growth driver. HANA is the key differentiator between SAP and Oracle's offering, but Ellison thinks it is over hyped. The Oracle founder says SAP's boasts about the rapid adoption of HANA are simply false; he says none of his customers are leaving Oracle for HANA. Meanwhile, Ellison claims that Oracle's cloud offering is currently on a $1 billion run-rate, which is bigger than SAP's cloud business.

In any case, Oracle has been acquiring companies in the cloud space and its installed base is unlikely to be wooed away by SAP. Therefore, most of the competition will take place at the margin. Each incremental customer will be more difficult to acquire, but Oracle's current cash flows remain safe from SAP.

Meanwhile, Oracle maintains a steady advantage over IBM in that it provides a whole range of solutions -- database software, application software, and hardware -- compared to a more narrow range provided by IBM.

Oracle's acquisition of Sun Microsystems placed it in direct competition with IBM's servers. Oracle's newest servers are faster than IBM's and are less expensive. However, IBM's servers tend to be more reliable and have a reputation for strong security -- an important component in the value proposition.

IBM's mainframes continue to sell well in the financial services industry, but the proliferation of cloud computing is lessening the demand for IBM's expensive systems. Like Oracle, IBM faces competition from players in the cloud space like SAP and Workday. In fact, the proliferation of lower-priced cloud technology hurts the bottom line of IBM and Oracle alike; both would rather sell customers on their higher-priced integrated solutions. But IBM's strong relationships and current integration into customers' businesses will enable the company to retain much of its current customer base, while new customers will increasingly look to SAP and Oracle, which can provide a broader range of SAAS.

Investment case

On the surface, Oracle trades at 14 times trailing earnings. However, after backing out $3 in net cash, the company trades at just 10 times free cash flow. A 10% free cash flow yield -- for a company that is almost certain to grow cash flows over the next five years -- is a bargain. For Oracle to trade this low, it is an opportunity too good to pass up.


Ted Cooper has no position in any stocks mentioned. The Motley Fool owns shares of International Business Machines. and Oracle.. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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