Oracle Corp (ORCL, Financial) is the world's largest supplier of information management software and a leading provider of computer hardware products--including computer server, storage and networking products. It is also the world's second largest independent software company behind Microsoft Corp.
While Oracle's flagship product is the Oracle database, Oracle also develops and maintains software and hardware for enterprise Cloud Computing to help customers manage their businesses and reduce IT infrastructure management costs. With the full integration of Sun Microsystems and heavy strategic focus on software and cloud, hardware and business services, ORCL should hold a strong competitive advantage for many years to come in such activities as data warehousing, data transmission and data analysis.
ORCL is organized into 3 main segments. Sales of software and cloud products and services accounted for 76% of total company revenues in fiscal 2014. Sales of hardware systems accounted for 14% of company revenues. Sales of business services generated the remaining 10% of revenues. Sales to the America's accounted for 53% of revenues while sales to Europe, Middle East, Africa and Asia Pacific accounted for 47%.
Purchase considerations and cautionary notes
System integration, ease of operation, data security and system reliability are critical to the success of businesses within ORCL's product/service lines. While ORCL success is clearly visible within its software lines, hardware sales continue to underwhelm.
Anticipated synergies from the Sun acquisition have not yet taken hold as intensified competition from HP, International Business Machines (IBM, Financial), Intel (INTC, Financial) and SAP (SAP, Financial) have put downward pressure on sales. It is also unclear what traction has been built selling the highly anticipated Sun Exadata platform. This is a bundled software/hardware product that facilitates online data transaction processing for consumers in a comparatively fast and cheap way. While initial sales spurred hopes of a new growth driver in hardware, how these sales have contributed to new earnings is not particularly clear.
The extent to which ORCL's products/services have become integrated into clients' systems has created substantial switching costs for consumers and provides ORCL a strong competitive advantage. The company is also an enormous cash generator, with cash and equivalents growing to almost $39 billion in fiscal 2014. This is in addition to moderate share repurchase activities and small dividend payments.
That being said, we would like to see management intensify its share repurchase activity and boost dividends further. With so much cash on hand, sales and earnings per share could use the boost.
The benefits of the Sun acquisition and other recent acquisitions will take time to manifest. While management has historically proven itself, successfully generating returns on reinvested capital of about 19% per year, the firm's ability to continue to grow organically is in question. We would like to see the company boost activities in the IT service space and in business solutions consulting.
Free-cash flow to equity valuation (methodology)
A company’s fair value estimate can be calculated as the present value of expected future free cash-flows to equity. Free cash-flows to equity represent the amount of cash-flows available to common stockholders after all operating expenses, interest and principal payments to lenders have been paid and necessary investments in capital equipment and working capital have been made to maintain and grow operations.
Here we estimate fair value in 5 steps:
- we forecast the firm’s free-cash flows to equity for the next 10 years using econometric processes;
- we discount those cash-flows to the present;
- calculate a terminal value for the firm 10 years out based on a long-term expected growth rate and terminal discount rate and discount it to the present;
- add the discounted terminal value to the discounted value of free-cash flows to equity over the next 10 years; and
- divide the present value of all cash-flows by the diluted number of shares outstanding.
The table below presents our free cash-flow to equity projections. Model inputs and a valuation matrix are also presented.
Table 1: Free Cash Flow to Equity Estimation
 | Historical Year End | Projected Year End | |||||||||||
 | May12 | May13 | May14 | May15 | May16 | May17 | May18 | May19 | May20 | May21 | May22 | May23 | May24 |
Total Revenue | 37121 | 37180 | 38275 | 39615 | 41001 | 42436 | 43921 | 45459 | 47050 | 48696 | 50401 | 52165 | 53991 |
-COGS | 7858 | 7379 | 7236 | 7902 | 8859 | 9169 | 9490 | 9822 | 10166 | 10521 | 10890 | 11271 | 11665 |
Gross Profit | 29263 | 29801 | 31039 | 31713 | 32142 | 33267 | 34432 | 35637 | 36884 | 38175 | 39511 | 40894 | 42325 |
Margin % | 79% | 80% | 81% | 80% | 78% | 78% | 78% | 78% | 78% | 78% | 78% | 78% | 78% |
-Operating Expense | 15557 | 15117 | 16280 | 17379 | 17648 | 18265 | 18905 | 19566 | 20251 | 20960 | 21694 | 22453 | 23239 |
EBIT | 13706 | 14684 | 14759 | 14334 | 14495 | 15002 | 15527 | 16071 | 16633 | 17215 | 17818 | 18441 | 19087 |
Income Before Tax | 12962 | 13898 | 13704 | 13660 | 13798 | 14281 | 14780 | 15298 | 15833 | 16387 | 16961 | 17555 | 18169 |
Net Inc./Starting Line | 9981 | 10925 | 10955 | 9562 | 9658 | 9997 | 10346 | 10708 | 11083 | 11471 | 11873 | 12288 | 12718 |
 |  |  |  |  |  |  |  |  |  |  |  |  |  |
 | Free Cash Flow to Equity | ||||||||||||
+Dep & Amort | 2916 | 2931 | 2908 | 2840 | 2879 | 2980 | 3084 | 3192 | 3304 | 3419 | 3539 | 3663 | 3791 |
% of revenue | 8% | 8% | 8% | 7% | 7% | 7% | 7% | 7% | 7% | 7% | 7% | 7% | 7% |
+Deferred taxes | 9 | -117 | -248 | -594 | -615 | -637 | -659 | -682 | -706 | -730 | -756 | -782 | -810 |
% of revenue | 0% | 0% | -1% | -2% | -2% | -2% | -2% | -2% | -2% | -2% | -2% | -2% | -2% |
+Other non-cash | 295 | -1368 | 97 | -6099 | -1208 | 13095 | 79 | 37 | 27 | 24 | 13 | 18 | 8 |
% of revenue | 1% | -4% | 0% | -15% | -3% | 31% | 0% | 0% | 0% | 0% | 0% | 0% | 0% |
-WC investments | -83 | -712 | -162 | -594 | -615 | -637 | -659 | -682 | -706 | -730 | -756 | -782 | -810 |
% of revenue | 0% | -2% | 0% | -2% | -2% | -2% | -2% | -2% | -2% | -2% | -2% | -2% | -2% |
-Cap expenditures | -648 | -650 | -580 | -617 | -635 | -658 | -681 | -704 | -729 | -755 | -781 | -808 | -837 |
% of revenue | -2% | -2% | -2% | -2% | -2% | -2% | -2% | -2% | -2% | -2% | -2% | -2% | -2% |
+Net borrowings | 295 | 2024 | 5566 | 396 | 410 | 424 | 439 | 455 | 470 | 487 | 504 | 522 | 540 |
% of revenue | 1% | 5% | 15% | 1% | 1% | 1% | 1% | 1% | 1% | 1% | 1% | 1% | 1% |
 |  |  |  |  |  |  |  |  |  |  |  |  |  |
FCF-to-Equity | 13390 | 15598 | 19907 | 11390 | 11492 | 11894 | 12311 | 12742 | 13187 | 13649 | 14127 | 14621 | 15133 |
Table 2: Model Inputs
Model Inputs & Results | Â |
Long-term growth rate | 3% |
Terminal discount rate | 9% |
Terminal value ($M) | $259,781 |
Discounted terminal value ($M) | $109,734 |
Discounted FCFE (t1-t10) ($M) | $ 87,769 |
Cash ($M) | $ 38,819 |
Diluted weighted average shares (M) | 4,604 |
Fair value | $51.33 |
Market price | $38.58 |
Margin-of-safety (%) | 33% |
Table 3: Valuation Matrix
Valuation Matrix | Terminal Discount Rate | |||
8% | 9% | 10% | ||
Terminal Growth Rate | 2% | 53.38 | 47.73 | 43.65 |
3% | 58.86 | 51.33 | 46.14 | |
4% | 67.08 | 56.37 | 49.46 | |
5% | 80.78 | 63.94 | 54.11 |
Free-cash flow to equity valuation (assessment)
ORCL’s per share earnings in 2014 were $2.38. Historical earnings per share grew at an annual rate of approximately 18% per year since 2005. ORCL’s sales per share in 2014 were $8.31. We project that sales will grow at a rate of about 3.5% per year between 2015 and 2024. We expect stable gross margins with some margin compression on the bottom line. Interest expenses will remain stable. Capital expenditures will remain at recent historical levels in the amount of approximately 2% of sales. Our fair value estimate of ORCL equals $51.33. Trading at $38.09, this implies a margin-of-safety of 35%. The question that remains for investors is: is a 35% margin-of-safety sufficient to qualify for investment given the risks inherent in this business.