Turnkey Research Note: Oracle Corp. (NMS:ORCL)
In an increasingly wired world, databases reach into almost every aspect of daily life, from personal uses such as cell phone address books and electronic calendars, to business purposes such as software that can track customer accounts or manage inventory. The sheer ubiquity of these discrete collections of data that provide us with the ability to manage the universe of information that surrounds us suggests that database technology could be a fertile area in which to operate a profitable software business. And sure enough, within the S&P 500 there is one component firm that has come to be defined by the database: Oracle Corporation (ORCL). At Turnkey Analyst, we created a company report for ORCL, in order to assess this database juggernaut, and make a judgment as to whether now is a good time to buy the stock and place a bet on the continued growth of the database in the highly wired world we inhabit.
Although ORCL was originally a pureplay database company, it has become much more than that, and is today the world’s largest enterprise software company. ORCL develops, manufactures and markets database, middleware and application software, hardware systems, and storage products. The company’s systems are engineered to work together or independently, within standard IT configurations or in the cloud. The company was founded in 1977, employs over 100,000 people, and is based in Redwood City, CA, in the heart of Silicon Valley.
Reviewing our Turnkey Fundamental Factors, we see that ORCL has a Quality Measures score of 82.0%, and a Pricing Measures score of 58.1%, which combine for our overall Turnkey score of 70.0%. It would appear that ORCL is a very high quality company, trading at a cheaper than average price. Let’s review the various inputs that make up these component scores, and see what we can learn.
Turnkey’s Financial Health measures consist of a Profitability score and a Stability score, which provide insight into two critical dimensions of a company’s financial position. ORCL’s scores a perfect 100% on Turnkey’s Profitability score. Cash flow from operations, and net income were both strongly positive, at $11.2 billion and $8.5 billion, respectively. Consistent with these strong profits and cash flow, return on assets was a healthy 11.6%, while return on capital was also solid at 14.1%. Normalized (8 yr average) earnings are also substantial at $7.8 billion. It would appear the company is very profitable, and has been so, on average, for a number of years.
ORCL also scores 83% on Turnkey’s Stability score, reflecting its overall financial strength. The Altman Z score, which predicts the probability of bankruptcy, is well north of our threshold benchmark score of 3.0, indicating a low risk of financial distress. On Piotroski’s F-Score, another accounting-based fundamental tool that evaluates a company’s financial health, the company scores 7.0 out of 9.0, placing it in the 93rd percentile of our screening universe (> $250mm market capitalization). Liquidity seems adequate, with a current ratio of 2.8, safely above the 2.0 threshold where would have concerns, and with a quick ratio of 2.7, also comfortably above our 1.0 threshold for this metric. While the EBIT/interest expense coverage ratio is high, and seems safe at almost 15X, total debt/capital does exceed 50%, indicating the company has slightly more debt statistically than we are comfortable with. This would be our only area of concern with respect to ORCL’s financial health, although generally the risk of financial distress or bankruptcy otherwise appears low.
ORCL scores 77% on our Improvement metric, based on numerous positive recent financial developments. TTM revenues increased by $8.8 billion versus the prior year, while TTM net income also increased, by $2.4 billion versus the prior year. Return on assets and capital also both increased, suggesting the firm is creating more value through its investments. Total debt/capital decreased versus the prior year, which is also a positive trend, as it reduces the risk of financial distress. The quick ratio also increased rather dramatically, indicating enhanced liquidity. Asset turnover also increased, which may mean the company is using its assets more efficiently. Account receivable turnover declined slightly, although the change was minimal. The only area that may be worthy of closer scrutiny by a human analyst is the company’s gross margin, which declined. In a software business, we would want to know what drove the decline in margins, and the company’s general margin outlook going forward. We will come back to this issue.
The practice of revenue recognition on an accrual basis within the software industry raises a host of complex financial questions, and can sometimes lead to restatements and associated reductions in market capitalization. We therefore want to assess ORCL’s accruals. ORCL scores 49% on our Earning Quality measure, which assesses the statistical likelihood of poor stock performance based on observed rates of non-cash accruals. Net operating assets / total assets of 7.3%, and operating accruals / assets of -3.6% are both approximately average for our screening universe. Operating accruals / net income was -31.2%, which places the company in the 46th percentile. It would seem that ORCL’s earnings are of neither especially high, nor low quality. Next, we turn to a discussion of ORCL’s economic moat.
There is a very high index of change in the technology industry, and so economic moats in software tend to be difficult to maintain. Nevertheless, ORCL would seem to have some advantages that make life hard for competitors and might be difficult to reproduce. Before getting into the numbers underlying our economic moat scores, we will take a moment to review some observations on the sustainability of, and recent changes to, ORCL’s business model.
Despite what you may think of Larry Ellison, ORCL has a recognizable brand that people trust and that contributes to the success of the company by discouraging competitors in certain segments of the market. If you are an IT director selecting a new database technology, it is going to be easy for you to choose the industry standard: ORCL. Another way the company discourages competition is through economies of scale. The company has an almost $150 billion market capitalization, and it makes heavy, regular R&D expenditures that might, for example, differentiate ORLC’s products from those of its competitors, or illuminate ways to provide products more cheaply. Its scale and existing infrastructure can also make new products more competitive; for instance ORCL has an extensive existing support function that it can leverage 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.
Although ORCL was founded as a database company, over the years it has migrated into various additional technology areas, including business software applications, and middleware. Then, in 2010, the company got into the storage and server hardware business with the acquisition of Sun Microsystems. This was a game changer for the company as it allowed ORCL to provide a soup-to-nuts, integrated offering, from software applications, databases, and middleware all the way through operating systems, and server and storage hardware, allowing it to compete directly with IBM and Hewlett-Packard, which have been traditionally more focused on hardware. This combining of hardware and software arguably contributes to ORCL’s economic moat in several respects.
These new hardware products are all tightly integrated with ORCL’s core software and database offerings, thus generating networking effects, as the value of ORCL’s core products is enhanced by these additional complementary hardware products and services. The new hardware products also generate cross selling opportunities. Pre-existing database customers might purchase Exadata, an ORCL Database Machine. Middleware clients might purchase Exalogic, a bundled ORCL product consisting of network, operating system, software, and storage.
Perhaps the most powerful aspect of this highly integrated offering is the high switching costs it promotes. ORCL claims it can deliver integrated products more cheaply than if customers custom-build their solutions by performing the integration themselves. Regardless of whether this is true in a given situation, to the extent that a customer relies on ORCL for a broad range of its technology, from software through hardware, it becomes more difficult, expensive, and time consuming for customers to throw it out and adopt an alternative. The customer becomes in a sense captive. Indeed, ORCL’s model is predicated on the generation of recurring licensing and service revenues. Something on the order of 80% of ORCL’s operating income is recurring. And keep in mind software tends to have strong margins, since once it’s been created there are no variable costs associated with its use.
What is particularly impressive is that ORCL has been able to maintain quite high, near software-like margins even as they have integrated hardware products – which typically have substantially lower margins – into their revenue stream. The question is: are these margins eroding or are they sustainable? Will the customer buy into the idea that ORCL’s integrated approach makes the most sense? We don’t think the answer is obvious, although we are not technology experts. You could, for example, make a decent case that the cloud could pressure this integrated approach over the next few years. And as we saw in the Recent Operating Improvements section, these margins may already be getting pressured, and whether they can be maintained is key question for the company going forward.
Regardless, the numbers suggest ORCL’s economic moat is strong, with an Economic Moat score of 87%, among the highest we have reviewed. The company has not lost money in any of the past 8 years. Normalized (8 yr average) cash from operations – capex / assets is 68%, placing ORCL in the 88th percentile of our universe. Normalized returns on assets and capital are very strong, consistent with the existence of a wide economic moat. Normalized (8 yr average) return on assets was 13%, while normalized return on capital was 17%; both were good for the 93rd percentile of our universe. Margin strength is where the company really stands out with a value of 81%, good for the 97th percentile. Still, given the recent changes to ORCL’s business model, do these numbers accurately represent the company’s current economic moat? It is difficult to say conclusively one way or the other.
Our Valuation metric reads 58%, which is above average, although not paricularly compelling. TTM cash flow yields offer the best values we can see. TTM EBIT/TEV and TTM FCF/TEV yield 9.3% and 8.4% respectively, which places the company near the breakpoint for the top quartile of our universe for both. Normalized cash flow yields were a bit weaker, with a normalized (8 yr average) EBIT/TEV yield of 5.4%, and a normalized (8 yr average) FCF/TEV yield of 6.3% placing the company in the 55th and 67th percentiles respectively. Normalized (8 yr average) net income/market cap yield of 3.4% is actually below average for our universe. Book to market is also quite low at 27%, which is in the bottom third of our universe.
In conclusion, what can say about ORCL? The company looks financially healthy, and is profitable and stable, with a low risk of financial distress. ORCL is also showing many signs of improvement over the past year, although margins have declined. The company is not showing any obvious signs that it is manipulating earnings with accruals, which is a good sign in the software business. The company has many wide moat characteristics, and is showing very strong economic moat metrics consistent with these. Given the company’s recent entry into the market for hardware, however, perhaps a key question is whether the firm can maintain its traditional margin strength and high returns, even as it increases its reliance on the more commoditized, and lower return hardware business for its profits. Can ORCL sell its fully-integrated technology product and generate software-like returns? Do you believe what Larry Ellison is arguing? In light of the fact that margins have declined over the past year, at the very least the jury is still out on this question.
On balance, while statistically you are buying a very high quality business with financial features indicating it has a very wide moat, there have been recent changes to its business model that may call into question elements of that moat, including potential effects on margins and returns. And while the price is better than average, in our view, it is not so good as to merit the risk a new shareholder bears that the firm may struggle to maintain its traditional returns and margins. We recommend that you hold the stock, but we are not buyers at today’s prices.