This interview originally appeared on the Inside Value website in January 2007.
In Part 1, we learned a little bit about Oak Value Capital managers David Carr and Larry Coats. Now we get to learn a bit about their portfolio.
David Meier: Let's jump into the portfolio. I see eBay
DC: In 1999, we wrote a white paper about tech investing saying that many of these companies have business models that we thought very well might have legs and defensible moats, but we quarreled a great deal with the multiples and the prices. We expected that at some point in time, those companies might actually give us opportunities where we might see an intersection of value and the margin of safety. I think that has happened along the way.
We have been followers of technology and understanding technology for a lot of years. In our portfolio, some holdings are Equifax
Oracle and eBay are ones that at the right time and the right price met our parameters. In both cases, they have reoccurring revenue streams, very strong cash flows, very high returns on equity, and extremely strong moats and franchises. They also leverage network effects, where as you layer on additional business, you get extremely high and extremely beneficial margins as well as the ability to layer a business on around the world. We have done all the work. You see a lot more value-net people in a number of the names in those arenas nowadays.
In the case of Oracle, when you look at a business that has been able to drive returns on invested capital as high as it has, generate tremendous free cash flow, and especially generate a reoccurring revenue base through the maintenance side of the business, we think [CEO Lawrence] Ellison is onto something. We think they have a good idea of understanding what is it that customers are most concerned about when they are buying software.
[Oracle has] gotten a lot of grief for the acquisitions Ellison made. But he quickly went in and took the huge benefit of the major support operations and made the current customer base of the acquired companies very comfortable with the fact that they would be serviced, they wouldn't be cut off, they wouldn't be stranded, and they would have clear paths to upgrading to future products when and if they desired. Combine that with a huge amount of free cash flow and a willingness to return that free cash flow back to shareholders through share repurchases, we found it quite an attractive company when we made the purchase, which was some time ago now, in price.
LC: Oracle is an interesting case if you look at the way we value businesses. We are running discounted cash flow models looking out five years and then obviously placing some terminal multiple on the fifth-year cash that business generates.
If you look at the predictability of the business today looking out five years compared to the predictability five years ago looking till today, the biggest difference is the component of the revenue stream represented by ongoing revenues, the ability to drive annual maintenance and service fees as opposed to the dependency on upfront licenses, and that transition over the last five years while they have continued to grow the install base on the core database side. These are what gave us the ability to understand and value the business and what has given us the opportunity to say we have a higher degree of confidence in our valuation equation.
When you combine that with, as David indicated, the fact that we bought the stock around $13, it was trading at basically somewhere between 13 and 14 times forward earnings on a cash basis, and we believe that was a pretty attractive valuation. The stock has been certainly a good solid performer for us in here, as it has demonstrated the merits of the business model as reflected in the transition of the revenue stream that it gets from the service that it provides to customers.
So for some reason, at the time everybody in the value community was focused on other names, some of which David commented on, and just seemed to be completely overlooking a business that had very attractive economics and in our opinion, much more predictability than it was being given credit for.
And importantly for us, the business had an approximate 43% EBITDA margin, 31% free cash flow margin, and 26%-plus return on equity. And all those numbers appeared to be moving in the right direction, and every incremental piece of growth was making those numbers stronger and creating more free cash flow. The moat around the business is in its ability to provide service, so every incremental customer has a very high incremental margin, which helps spread the cost of the support and service contracts over a larger customer base and helps provide additional capital to put into place the software migration to the future platforms.
DC: Most people who proclaim to be "value investors" will look at Oracle and eBay and say, "Hey, those are good businesses. Those are businesses that really have some pretty attractive economics. They have high returns on capital. But because they are such great businesses, they will never be attractively priced enough for me to be able to buy them."
We believe that you should spend time identifying good businesses and great businesses, understanding those businesses and knowing what they are worth so when the market gives you, as Buffett refers to it, that high, hanging curve ball, your responsibility is just to swing the bat and watch it glide wherever it might go. It at least makes it into the outfield, but the key is to be prepared, and that preparation has to be based on understanding of the business models. I guess that is a common theme you are probably getting by now.
In Part 3, we'll dig deeper into the portfolio to learn more about how David and Larry think about investments.
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Retail editor and Inside Value team member David Meier does not own shares in any of the companies mentioned. He's ranked 7,979 out of 30,725 rated investors in CAPS. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.