Oracle: Seeing Cash

This week's Foolish Duel features a bare-knuckles brawl over the prospects for database maker Oracle. Fool contributor Tim Beyers says the firm is still in fighting shape, but W.D. Crotty disagrees. What's your opinion? Vote after checking out both sides.

I admit it. Larry Ellison, CEO of database software maker Oracle (Nasdaq: ORCL  ) is an easy target, and I've taken some measure of joy in lampooning him before. After all, this is the guy who ordered private dicks to sift through Microsoft's (Nasdaq: MSFT  ) garbage.

But Ellison is nothing if not a survivor, and his influence -- for good and for ill -- has spread far and wide, well beyond the reaches of Silicon Valley. Indeed, can you name an executive, or a company, responsible for more capital growth than Ellison? I can't. Think about it: Tom Siebel of Siebel Systems, Marc Benioff of Salesforce.com, Gary Bloom of strugglingVeritas, and, of course, rival Craig Conway of PeopleSoft (Nasdaq: PSFT  ) are all Ellison protégés. And those four, while the best known at the moment, are but the tip of the proverbial iceberg.

No one has yet found a way to knock Ellison off his pedestal, and I contend that it will be some time before anyone does. Now, fellow Fool W.D. Crotty will try and convince you that Oracle is an overvalued, aging dog that isn't worth your time because of anemic growth in sales and net income. He's right, of course. But that argument misses the big picture. There's a much better way to value Oracle's business.

Show me the money
I can boil down the argument for Oracle to one word, folks: Cash. Moolah. Bread. Jack. Bucks. Scratch. Yeah, I know that's six words, but you get my point, right?

For the 2004 fiscal year, which ended in May, Oracle had roughly $8.6 billion in cash and short-term investments. And structural free cash flow has grown by more than 40% since 2002, or 12% annually, to $3.1 billion for the trailing 12 months. No wonder the firm's liquid assets -- cash and short-term securities -- are up 45% since 2001. Like rival Microsoft, Oracle is the corporate equivalent of an ATM.

And think about this: At its current rate of cash production, Oracle delivered roughly $0.59 per diluted share in structural free cash flow last fiscal year, well above its total net income of $0.50 per stub. Not bad, eh?

But, wait! There's more
It gets really interesting when you compare Oracle's cash flow to shareholders' equity, for a measure that Fool Rex Moore eloquently titled cash return on equity, or CROE. You can learn a whole lot more about cash and the importance of return on equity by reading this commentary about Hidden Gems investing. For now, think of ROE and CROE as ways to measure the performance of management in allocating the earnings and cash it retains for growing the business. Let's take a look at how Oracle does, comparing traditional ROE and CROE for the past three years. First, here's the core data we'll need to make the calculations:

Measurement 2004 2003 2002
Avg. shareholders' equity $7.158 billion $6.219 billion $6.198 billion
Structural free cash flow $3.092 billion $2.329 billion $2.198 billion
Net income $2.681 billion $2.307 billion $2.224 billion


Now what does all that add up to? Have a peek:

Year

Return
on equity

Cash return
on equity

Cash +/-
on ROE

2004 37% 43% + 6%
2003 37% 37% + 0%
2002 36% 35% - 1%


Sorry, folks but this just doesn't look like a firm in decline. Oracle's ROE and CROE are both on the rise and cash growth is accelerating. Those are excellent signs for an admittedly old company.

So, is that it? Not quite, bucko. Measurements are only good when done in context, so let's stack Oracle up against its largest competitors using ROE. Since all we want is a snapshot, we probably don't need three years of data, so I've pulled the key information for the trailing 12 months from Yahoo! Finance. Bear in mind that the cash flow numbers are Yahoo!'s estimates, and do not mirror the calculations presented above:

Company ROE Free cash flow Enterprise value FCF-to-EV
IBM (NYSE: IBM  ) 29.16% $11.88 billion $156.34 billion 13.16
Microsoft 11.79% $14.83 billion $237.68 billion 16.03

Oracle

37.84% $2.99 billion $45.93 billion 15.36


Seems to me the database king does pretty well, especially in ROE. The picture gets even better when you consider peers in the infrastructure and applications software markets:

Company ROE Free cash flow Enterprise value FCF-to-EV
BEA Systems (Nasdaq: BEAS  ) 13.14% $238.55 million $1.87 billion 7.84
PeopleSoft 1.62% $283.38 million $4.63 billion 16.34
SAP (NYSE: SAP  ) 32.16% $1.55 billion* $43.26 billion 27.91
Siebel 1.07% $238.17 million $1.70 billion 7.14
* Based on most recently published cash flow statement, from the close of fiscal 2003

But, what about PeopleSoft?
Well, what about it? Yeah, the proposed deal has created a circus, but the combination would add substantial revenue growth and a large stable of customers paying high-margin annual maintenance fees that could grow by at least 10% annually. At that rate, a combined "OracleSoft" would generate nearly $8 billion in maintenance fees alone within three years. For fiscal 2004, Oracle reported just more than $10 billion in sales.

It's also important to note that Oracle's $7.7 billion bid for PeopleSoft really wouldn't cost $7.7 billion, but rather $6.12 billion. Oracle would inherit the $1.58 billion PeopleSoft has in the bank upon acquisition.

Sure, there's reason to be concerned about integrating a massive company like PeopleSoft, but what would you do if you were Ellison and you knew it was getting harder to sell new software? You might pay out a dividend, of course. But then again you might look at the valuations from the table above and conclude the cheapest way to get growth is to buy it. I mean, really, BEA -- the other heavy in infrastructure software besides IBM, Microsoft, and Oracle -- trading for three times net cash? An Oracle bid for the firm seems all but inevitable, unless IBM or Sun Microsystems (Nasdaq: SUNW  ) beats Ellison to it.

Old, troubled, and cheap
Compared to its most famous peers -- IBM, Microsoft, PeopleSoft, and SAP -- Oracle trades at a discount on a cash flow basis. Its 15.36 free cash flow-to-enterprise value price tag is also just a few tenths higher than the 14.83 average ratio of all of its peers. Some might call that fairly valued, but I just can't.

At the risk of sounding like a broken record, go back to the cash flow story. Structural free cash flow growth has averaged 12% annually over the past three years and appears to be accelerating. Were it to continue growing at, say, 13%, then $4.4 billion in free cash flow appears achievable by 2007. Factor in that 14.83 multiple and you've got an enterprise value of $65.25 billion, a better than 40% gain in three years. And that's not including acquisitions.

Old? Troubled? Ridiculed? Yeah, sure, you can call Oracle any of those things. But, while you're at it, you just might want to include cheap.

Fool contributorTim Beyersstill thinks he's undervalued on a cash flow basis. Tim owns no interest in any companies mentioned, and you can view his Fool profilehere. The Motley Fool has adisclosure policy.


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