Here we go. Oracle (Nasdaq: ORCL) sells off. Anybody reading the press reports knows it must be because no one is buying software.
Balderdash.
There may, indeed, be slowing in global tech markets. Certainly, fears of a recession are holding U.S. consumers and investors hostage. But when Oracle's core business -- represented by new database license revenue -- is up both sequentially (4.5%) and year over year (20.5%), it's crazy to let loose with hysterical predictions of a tech downturn.
Once again, the business
Let's get back to basics, shall we? There are two primary elements to Oracle's business:
- New sales of database and other software for managing business functions.
- Subscriptions and support sales of said software.
Most often, customers buy Oracle's database and a license to receive continual support. Upgrades cost more, but once the database is installed, rarely do customers feel compelled to switch. Even as Microsoft (Nasdaq: MSFT), IBM (NYSE: IBM), and Teradata (NYSE: TDC) play hardball and open-source alternatives such as MySQL, now a subsidiary of Sun Microsystems (Nasdaq: JAVA), emerge, Oracle can continue to grow as it has.
And growth really was the theme this quarter. Third-quarter revenue, though coming in lighter than analysts expected, was up 21% to $5.35 billion. Per-share earnings rose 30% on a GAAP basis and 23% after accounting for stock-based compensation, amortization of intangibles, acquisition expenses, and other charges.
Free cash flow also continued to blossom:
|
Metrics |
TTM* |
FY 2007 |
FY 2006 |
FY 2005 |
|---|---|---|---|---|
|
Cash from operations |
$7,322 |
$5,520 |
$4,541 |
$3,552 |
|
Capital expenditures |
($331) |
($319) |
($236) |
($188) |
|
Free cash flow |
$6,991 |
$5,201 |
$4,305 |
$3,364 |
*TTM = trailing 12 months.
Wow. Since the dawn of fiscal 2005, free cash flow has improved by more than 25% a year.
If there's a legitimate complaint to be had with Oracle's reported results, it's that licenses for new applications software -- think of the Siebel customer service software or the PeopleSoft suite for human resources -- grew just 7%.
Seven freaking percent.
That's not much for a firm whose professed strategy is to buy growth. At least one investor I heard from yesterday via email sees the slowdown as evidence of Oracle's "M&A beast" needing to be fed.
Enter the BEA-st
It soon will be, thanks to an $8.5 billion feast called BEA Systems (Nasdaq: BEAS). The maker of middleware -- so named for its ability to connect systems not originally designed to talk to each other -- claims it has more than 15,000 customers, many of whom use Oracle's database.
No doubt that's a powerful draw for CEO Larry Ellison. But selling additional software to these clients won't be easy -- especially if the tough economic environment persists. Still, it'd be a lot harder to be on the outside looking in.
And let's not forget that Oracle's acquisition strategy is aimed at boosting its high-margin maintenance and support revenue and, thereby, free cash flow. You've seen the numbers. You know it's working.
The only way it could go wrong -- really wrong -- is if the database king were to take on too much debt. Fortunately, that doesn't appear to be the case, even if you factor in the BEA deal.
Do the math with me. Oracle had just north of $10.5 billion in cash and investments as of Feb. 29, vs. just $6.6 billion in debt. Most of those notes aren't due before 2009, at the earliest, which means the entire $8.5 billion can be taken from existing capital. Oracle's ample free cash flow, meanwhile, should be more than enough to fund its debt repayments.
Oh, and did I mention that BEA had more than $1.3 billion in net cash and investments on its books as of Jan. 31? That's $1.3 billion that will soon be in Oracle's bank account.
Maybe not a screaming buy, but ...
Finally, let's talk valuation. I understand that Oracle isn't exactly a screaming buy at $19.50 a share with a market cap nearing $100 billion. But if we agree that Oracle's ability to produce excess cash flow is what makes it great, then we should also agree to value the stock based on a reasonable multiple to free cash flow (FCF).
What's reasonable? I could make an argument for 30 based on the growth figures you saw earlier. Trouble is, looking backward doesn't help us much in looking forward.
However, we do know that Oracle is aiming for 20% earnings growth on an ongoing basis. FCF has grown at least that fast historically and, if Ellison is right, will continue to. So, let's say 20 is a fair multiple.
Back to the calculator. Oracle has produced $1.34 in free cash flow per share over the trailing 12 months. Multiplying that by 20 equals $26.80, or what I'd call fair value. Even with yesterday's "miss."
An Oracle sell-off? Great! Profiting from panic is what we Fools do best.
