Technology always changes and always will. No one knows that more than Oracle (NASDAQ:ORCL). ORCL stock lets you buy into one of most famous software and technology companies to ever come out of Silicon Valley. It’s one of the largest enterprise software companies in the world and offers applications and database software in such areas as enterprise resource planning, human capital management, customer relationship management and supply chain management.
The historical business model was typically an expensive license arrangement with a five-year upgrade cycle and constant service and support. That business model provides a high-margin steady stream of revenues which is why Oracle was often called an ATM machine. The Oracle installation and service personnel infrastructure is the stuff of business legend.
What Changed for ORCL Stock
What changed? The answer is, of course, cloud computing. Although there are many definitions for what actually constitutes cloud computing, there is general agreement that it allows many companies to avoid or minimize large software and hardware infrastructure costs.
“The availability of high-capacity networks, low-cost computers, and storage devices as well as the widespread adoption of hardware virtualization, service-oriented architecture, and autonomic and utility computing has led to growth in cloud computing”
So in order to adapt to the new technology standard, Oracle simply added cloud to the end of its applications and created a subscription business model with quarterly updates. Human Capital Management Cloud, Supply Chain Management Cloud, Enterprise Resource Planning Cloud, etc.
This is a gross oversimplification of Oracle’s infrastructure products and applications, but the big picture financial implications are clear. ORCL’s legacy on-premise licensed software business is slowly declining and cloud applications are growing rapidly.
Oracle has stated it expects to increase capital expenditures over 200% in the fourth quarter of 2021 drive more cloud revenues and adoption. We can expect it to stay at elevated levels in the near-mid term.
Currently subscription revenue accounts for 72% of ORCL’s total revenues. This predictable, recurring revenue-stream may help create double-digit earnings per share increases if share buybacks continue.
Massive Share Buybacks Keep EPS Afloat
Over the past four fiscal years (including nine months of FY 2021), ORCL has bought back an astounding $72.5 billion of their own stock. There are only about 150 publicly traded company in the U.S. whose market capitalizations are bigger than that figure.
Almost all those purchases were made when the ORCL stock price was far lower than it is today. That’s actually not a bad capital allocation plan – borrow at 3% and use the money to buy back shares that subsequently increase by 50%. Not many publicly traded companies get the timing right and they end up buying back shares at all-time highs and high valuation multiples which destroys shareholder value.
Whether that $72.5 billion could have been used for accretive or growth oriented acquisitions is a discussion for another time. It’s even possible that if the levels of share buybacks remain high in the fourth quarter of this fiscal year, Oracle will have negative shareholders equity at year end (yes that’s possible).
Oracle Looks Fairly Valued
My cash EPS estimates for FY 2021 are approximately $3.94, which is well below consensus estimates of $4.42. That is primarily because analysts usually add back stock compensation to their net income calculation. As note previously, that makes no sense. as Warren Buffett once famously said:
“If compensation isn’t an expense, what is it? And, if real and recurring expenses don’t belong in the calculation of earnings, where in the world do they belong?”
That leaves a 2021 P/E of 20x for a low-to-mid-single-digit growing company, which is too high. Utilizing a discounted cash flow calculation which employs a generous long-term growth rate of 6%-8%, the company is fairly valued at its current all-time high. If ORCL continues to buy back shares at these levels, it will likely destroy shareholder value.
It’s amazing how similar the Oracle story is to the Cisco (NASDAQ:CSCO) story, despite being in different products and solutions. Both are old mature tech companies who survived two market crashes and the same amount of recessions. Both have about 2/3 of their business in secularly challenged product lines that are declining and about 1/3 in new fast-growing technologies and software applications. Both have massively overfunded balance sheets with billions in cash and investments. Both sport an above average market dividend yield. Both have flat revenue growth in recent years but are expected to grow from this point on.
Who knows which one will shed its “old tech” legacy perception first. But at these price levels, it doesn’t matter, because if Oracle the company wins this horse race, ORCL stock won’t follow its lead.
On the date of publication Tom Kerr did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Kerr, CFA is an experienced investment manager and business writer who has worked in the investment and securities business since 1994.
