Oracle (NYSE:ORCL) is one of the most tempting cash-rich plays in the market right now. The company has an undoubtedly cheap valuation, but is it a long-term value trap in the way that Dell or Hewlett-Packard (NYSE:HPQ) have been over the last five years? Moreover, is its current low-single-digit growth rate signaling the endgame of its relevance as a growth company?
It's the cash-flow, stupid
Investing is supposed to be easy. Take a stock like Oracle, which just generated $14.1 billion in free cash flow over the last four quarters--representing more than 10% of its enterprise value. In other words, if you hold the stock for 10 years, even with no growth, the company will have generated enough cash to buy you another Oracle for free. Furthermore, it can return that cash flow to shareholders by increasing its dividend, buying back stock, or increasing earnings through acquisitions. Sound good?
And that's assuming no growth, when the reality is that Oracle's forecast revenue growth rates for the next few years are pretty close to nominal GDP growth.
Why this isn't a no-brainer
Superficially, this isn't a hard choice to make, but the market seems to be making some harsh conclusions about Oracle:
- The market does not reward tech companies if they cannot generate growth, and you can stay waiting ages for "good value" to be realized
- Corporations are favoring cloud-based software, and Oracle's traditional on-license, on-premise software will lose sales to providers of software as a service, or SaaS, like Salesforce.com (NYSE:CRM). It looks set for a structural decline just like Hewlett-Packard was.
The first concern is an existential one, and older investors would do well to remember how the mentality of the market changed after the dot-com bubble burst. During the bubble, traditional valuations didn't matter, but after the burst suddenly everyone remembered value. It doesn't matter if Oracle makes database solutions or chicken tikka sandwiches; if it can return 10% of its valuation in cash every year then it is good value.
The second is more problematic. It's easy to look at Salesforce's near 30% growth rates, and conclude that Oracle is being left behind in the shift to the cloud, but the fact is that Oracle does have growing SaaS sales. The problem is that they are not enough to counter slow growth in its traditional software sales. In addition, the increasing use of SaaS solutions is reducing customers' need to buy hardware, and negatively impacting Oracle's aim of selling hardware and software systems to them. Indeed, Oracle's hardware system revenues (around 14% of total sales) have declined for the last two years.
Hardware revenues are forecast to drop next quarter. Even worse, Oracle predicted that its new software license- and cloud-subscription revenue growth (20% of revenues, and the key to growth) would be -4%-6% in the next quarter. Game over?
It would be a mistake to jump to a negative conclusion. First, Oracle is up against a very strong comparison from last year's second quarter for new license and cloud subscription sales.
In fact, the second quarter was so strong last year that there appears to have been a pull-forward effect on the third quarter.
Second, Hewlett-Packard's problems were that its core profit centers of printers, notebooks and desktops were in decline. Its challenge was to restructure in the face of a systematic decline in end demand. In comparison, Oracle's customers still want software; it's just that more of them want it from the cloud. The company has the cash pile and cash-flow generation to make significant acquisitions of cloud based companies (such as its purchases of Taleo and RightNow), and it's hard not to see it doing some more in future.
Third, there is an element of geographical effect here. New software license and cloud software subscriptions grew 7% in constant currency for the first quarter, but they were up 14% in the Americas. This indicates that it's not necessarily a structural issue.
Where next for Oracle?
The market looks like it's pricing in some severe problems for Oracle in the future, but if things don't turn out as bad as many fear, then the stock has significant upside potential. The company needs to stabilize its hardware revenues while demonstrating willingness to invest in cloud-based solutions. It could also do with a quarter or two of beating the mid-point of its software sales guidance. These are not necessarily high hurdles to overcome, and the reward of owning the stock could be significant. Moreover, even if Oracle's growth does graduate into a "GDP+" type of range, the stock still represents good value.