Oracle's Final Offer

Database king Oracle (Nasdaq: ORCL  ) has made what it says is its final offer of $24 cash per share for business software maker PeopleSoft (Nasdaq: PSFT  ) . Oracle says the bid will expire at midnight on Nov. 19 unless the board agrees to a deal or more than 50% of PeopleSoft stockholders agree to tender their shares.

The latter scenario is the most interesting. If shareholders effectively vote to hand over their ownership to Oracle, but the board rebuffs this latest advance, then Oracle CEO Larry Ellison has promised to go back to the courts to force PeopleSoft to agree to a deal.

With so much back and forth since June 2003, when Oracle first said it wanted PeopleSoft, it might seem as though this latest offer is yet another meaningless attempt by Ellison to paint PeopleSoft as an alcoholic one binge away from death. Certainly, his recent court testimony didn't flatter the business software maker. But is it fair to paint Ellison as a warrior seeking only a kill? I don't think so.

Of course, we aren't privy to Ellison's private conversations, and we know only what we've been told by Oracle's management team. But we can judge whether Ellison's statement that he's offering to buy PeopleSoft at a "substantial premium" is correct. All we need to do is a little valuation work.

Show me the money
How should we value the stock? For the more volatile tech stocks, I prefer an approach that fellow Fool Rich Smith profiled here, called enterprise value-to-free cash flow-to-growth, or EV/FCF/G. Although it's a screening metric most commonly used for Hidden Gems, it can apply to any stock in which you have an interest.

Let's start by looking at the financials, including the last three years' worth of statements plus the results from the trailing 12 months, beginning with enterprise value:

Metric TTM 2003 2002 2001
Shares Outstanding 370 344 320 324
Share Price $22.93 $22.79 $18.30 $40.20
Total Debt $0 $0 $0 $57
Cash & Equivalents $1,628 $1,401 $1,908 $1,633
Enterprise Value $6,856 $6,439 $3,948 $11,449
All numbers in millions except for per share figures. Share price calculated as of the last trading day of the fiscal year. The trailing 12-month share price was as of 11/1/04 closing price.

Next, let's tackle free cash flow. If you've followed my coverage of this story, you won't be surprised if I tend to favor structural free cash flow, which usually takes into account expensing of stock options:

Metric TTM 2003 2002 2001
Sales $2,674 $2,267 $1,949 $2,119
GAAP Net Income $76 $85 $183 $192
Net Options Expense $122 $161 $192 $125
Net Depreciation, Amortization $230 $176 $101 $103
Capital Expenditures $162 $250 $93 $92
Structural FCF $22 ($150) ($1) $78
EV-to-FCF 312 n/a n/a 147
All numbers in millions; sales is for reference only and is not factored into structural free cash flow. Net options expense includes a $20 million estimate for the recently completed third quarter.

Finally, let's take a look at the company's historic sales and income growth rates and then compare them with what the Street expects.

Start those calculators
Revenue for the trailing 12 months is up 26% from 2001, no doubt helped by last year's acquisition of JD Edwards. Unfortunately, there's been zero income growth, and a massive depreciation credit helped turn cash flow positive over the past four quarters. Negative income growth doesn't give us much to work with in calculating EV/FCF/G, so we'll have to fake it, relying totally on company and Street estimates.

In its most recent quarter, PeopleSoft grew license revenue by 24% while net income doubled. I think it's safe to assume that won't continue. But if PeopleSoft is really gearing up, then 12% long-term earnings growth isn't totally out of the question.

With me so far? Good, because now we can do the math to see where PeopleSoft stacks up. Our EV-to-FCF calculation for the last 12 months is a whopping 312 (6856 / 22 = 312). That means the market prices PeopleSoft at 312 times its cash flow.

Now let's do the ratio. Ideally, an undervalued company will trade for no more than one and a half to two times its estimated growth. Uh-oh. Dividing 312 by 12 equals 26. Again, that's a massive premium. Going by the fair value assumption, PeopleSoft's shares ought to command an enterprise value of no more than $528 million, or a measly $1.43 per share. How did I arrive at that? Take the cash flow number and multiply it by the ratio times the growth rate (2 x 12 = 24; 24 x 22 = 528).

The Foolish bottom line
Let's be honest: PeopleSoft is easily worth more than $1.43 per share. Moreover, PeopleSoft could add anywhere from $0.10 to $0.20 in per-share earnings to Oracle's results in 2005 and beyond. That kind of growth can't be easily repeated organically. So there's no question Oracle should pay a premium to become OracleSoft.

This exercise, however, reveals the pressure on PeopleSoft's business by way of options and declining net income. Plus, Oracle will have to spend to integrate the two firms, and to meet its commitment to innovate in bringing to market PeopleSoft 9. Is $24 a share a premium? You bet your assets it is.

Sorry, folks, but if Larry Ellison is somehow out to get PeopleSoft through his repeated bids for the company, it is potentially the dumbest bluff in corporate history. PeopleSoft's board needs to first take a hard look in the mirror and at its financial statements, and then ink the deal before Ellison decides he can do better.

For related Foolishness:

  • Recently Europe gave the OK to OracleSoft.
  • It was Ellison's testimony about the durability of PeopleSoft's business that came across to me as a smart and sleazy stock striptease.
  • PeopleSoft's prevarication about the reasons for its increasing sales shouldn't distract investors.

Not to worry if all this math has you confused. Leave the work to us. Get great stock and mutual fund ideas to juice your portfolio returns by giving any of our investing newsletters a try. A risk-free 30-day trial is yours for the asking.

Fool contributor TimBeyers owns shares of Oracle. You can view his Fool profile and stock holdings here. The Motley Fool is investors writing for investors.


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