Few tech companies operate in more attractive segments than Oracle (ORCL 2.05%). From retail to big data, Oracle is famous for providing best-in-class functionality. The company has been the leader in database software for more than three decades, and it was never afraid of big acquisitions and investments to support its organic growth.
Unlike IBM (IBM 2.20%), which is struggling with a sharp decline in hardware sales, Oracle is a software-focused company with an attractive portfolio of cloud products. And unlike most cloud companies, such as Workday (WDAY 2.90%), Oracle is trading at a dirt-cheap valuation. Why is Oracle undervalued? Is this tech giant protected against fierce competition from cloud companies?
Source: Oracle Investor Relations
Oracle is cheap
At $33 dollars per share, Oracle is a great company at an even greater price. As portfolio manager Daniel Osowsky from Osowsky Capital notes, the company's free cash flow for the trailing 12 months represents more than $14 billion dollars.
Even if we assume cash flow won't improve, the company is trading at only 10 times free cash flow. Oracle has attractive exposure to the cloud arena. It's committed to return most of its free cash flow to investors in dividends and buybacks. It acquires promising start-ups frequently, and it is reducing its exposure to the problematic hardware business. The company has plenty of upside potential. If Oracle were to be valued at 15 times free cash flow, investors would benefit enormously from a $55 billion increase in market value.
Explaining current market pessimism
Although Oracle is in the middle of a promising transition to a cloud-based, software-focused subscription business model, the stock has underperformed in the past three quarters.
Transitions tend to be regarded as difficult processes with a lot of uncertainty involved. However, because Oracle sells crucial technology to several corporations around the world, downside risks are limited. The new Oracle will be in a better position to attract customers in the cloud sphere, but will also retain most of its core competency -- database specialization, cross-selling, etc.
Oracle isn't IBM
Some bearish investors may also be putting Oracle and IBM in the same basket, as both corporations are currently in transition. However, there are fundamental differences between these two companies that also need to be considered.
First, Oracle is less exposed to the low-margin hardware business, and more exposed to software. Second, Oracle is particularly interested in strengthening its telecommunications business unit. This is a promising space, as companies are increasing their telecommunications capital expenditures. Third, there are important differences in execution. As Morningstar analyst Rick Summer notes, unlike IBM, Oracle's strategy is aimed at getting clients to purchase as many solutions as possible from the company. This is a win-win situation, as customers benefit from a decrease in the level of integration costs, while Oracle enjoys more sales.
These differences explain well why Oracle is experiencing better top-line performance than Big Blue.
Source: YCharts
It's all about competitive advantages
Investors may also be worried about Oracle's ability to deal with cloud competitors. Companies like Workday, which delivers human resource and financial software based on the cloud, are challenging Oracle's traditional solutions.
Workday's easy-to-use software, attractive graphical user interface, and low pricing are attracting a lot of attention among new customers, who use Workday instead of Oracle's Taleo solutions. Oracle bought human resources software company Taleo last year to remain competitive.
However, despite Workday's amazing recent revenue growth, Oracle has enough competitive advantages to recapture market share. For example, Oracle has a rich portfolio of loyal clients. If Oracle's loyal clients decide to move to the cloud, they will probably be reluctant to change vendors or leave Oracle, because doing so would mean high transaction and training costs.
Final Foolish takeaway
Oracle is a great business at a great price. Investors tend to focus on the short-term challenges: fierce competition in the cloud arena, hardware exposure, and an uncertain transition. However, long term, the company has value. With a secure cash flow due to dominance in the database space, a rich portfolio of loyal clients, increasing cloud exposure, and active share repurchases, the company has plenty of upside potential.
