In addition to announcing that Larry Ellison was too busy at the Americas Cup races to host the quarterly earnings call, Oracle (ORCL +2.40%) released its first quarter numbers and guided for the second quarter after hours on Sept. 18. You can find the press release and transcript on Oracle's Investor Relations page.
You can also find a lot of nonsense floating around the blogosphere and popping up in sell-side research about how a few cents' worth of "pro forma EPS" that the firm announced this quarter or forecast for the next has profound implications one way or another on its future.
When I think about how much brain power, technological sophistication, and monetary resources are expended trying to figure out the next 90 days' worth of business results, I shake my head. Even if one assumes that the statistically volatile quarterly earnings are meaningful from a long-term perspective, forecasting them with perfect exactitude would only contribute to being right on around 2% of the total valuation or less.
Analyzing the company's quarterly report, there was not a great deal of ground-breaking information in it. Revenues were flat due to the shrinking hardware business acquired from Sun Micro in 2010, but this was anticipated by the market and, at the end of trading the day after the announcement, Oracle's share price had hardly budged.
While the quarterly announcement did not provide much information that was material to the company's valuation, it did provide a good opportunity to review Oracle's most recent annual report (published in August). In contrast to the quarterly report, the annual report did yield some encouraging information that is material to the company's valuation. Namely, a thorough analysis of the numbers hints at the success of Oracle's 2010 acquisition of Sun Micro and should remove some concern in investors' minds about the firm's growth trajectory.
How can lower revenue growth be good?
Critics of the Sun acquisition focus on revenue declines in the hardware segment caused by Oracle's paring down of Sun's legacy product line. Oracle is replacing these legacy products with a new line of "engineered systems," high-spec pieces of hardware engineered to work very quickly and efficiently with Oracle's database software. Engineered systems' revenue growth is brisk, but volumes are still relatively small, so tend to get drowned out by the shrinking legacy business.
However, Oracle's 2013 annual report shows evidence that the move to engineered systems has caused operational leverage in Oracle's vitally important software updates segment to increase for the third year in a row. A graph of estimated operational leverage over the last ten years shows this trend very clearly.
Source: Company statements, Erik Kobayashi-Solomon analysis
* Please see Explanatory Note
What this chart shows is that for every extra dollar of revenue coming into the software update segment, the segment's profits are increasing by an even larger amount. In 2011, this segment generated an extra $1.05 of profit for every extra dollar of revenues. In 2012, that increased to $1.17 of additional profit for every additional revenue dollar and in 2013, it jumped again to $1.24.
Oracle's software updates segment is the key to Oracle's business model and profitability, and the chart above is evidence that the acquisition of Sun and move to an engineered systems product line is creating a lot of value in that key segment and for Oracle owners.
Considering that hardware is a small part of Oracle's overall business and that its most important business--software updates--has shown strongly improving profitability, it is easy to see why Ellison has called the Sun acquisition the best acquisition he has ever made.
In a phrase: Lower revenue growth is OK if the firm is able to increase profits faster than revenues are falling. Oracle is doing this very thing.
How are competitors doing?
Some investors say that Oracle--a traditional seller of licensed software--has a business model that is ill-equipped to compete against "Software as a Service" vendors such as Salesforce.com (CRM 1.48%). Unlike Oracle's model, Salesforce.com does not sell software to its customers, but basically rents out it out to them and provides storage for customers' data in the Cloud. Salesforce.com's business has grown very quickly since it started marketing its product in 2000, especially among small to mid-sized customers. Oracle's maintains a strong foothold among the largest firms.
Oracle critics are wont to say that Oracle's business model built on selling software is outdated, and that SaaS vendors' rapid growth is proof of the SaaS model's superiority. Indeed, Salesforce.com is growing much faster, whether one looks at revenues or profits. However, no matter how fast Salesforce.com is growing, even the most strident Oracle critic must admit that the absolute level of profits generated on behalf of shareholders is much larger in the case of Oracle.
Some hard numbers make this discrepancy clear. In the last fiscal year, Oracle generated roughly $13.7 billion worth of wealth on behalf of its shareholders; in comparison, Salesforce.com generated roughly $514 million, using the same measure. This difference implies that Salesforce.com will have to grow profits at a compound annualized rate of 25% for nearly fifteen years before it generates as much wealth for its shareholders as Oracle did last year.
Despite this, the amount the market is paying for Oracle per dollar of generated wealth is much lower than what the market is paying for Salesforce.com. Oracle's market capitalization is just over $151 billion--11 times the amount of wealth generated last year. In contrast, Salesforce.com's market capitalization is $31.5 billion--more than 61 times the wealth it created for its shareholders last year.
If Salesforce.com can keep up the rapid growth for a long time, the premium on its shares may be worth it. However, it is hard to imagine a case in which Oracle--a differentiated market leader with compelling network effect advantages--deserves so low a valuation.
* Explanatory Note
FY2010 has been redacted from the graph for reasons of clarity. This was the year that Oracle acquired Sun, and timing of the acquisition created a misleading data artifact. The nominal value of operational leverage in FY10 was -80%, but this number has little economic meaning due to the acquisition.
