With the 5% fall in Oracle’s (ORCL) share price after reporting first quarter 2017 results, we took a break from our valuation of Gilead (GILD) to see what Ellison et al had to say. While reviewing Oracle’s quarterly numbers, we also took the opportunity to look at our last three years’ worth of valuation assumptions for the firm and analyze Oracle’s FY 2016 numbers which were published in June.
We are reviewing our valuation of the firm now, and will published an updated opinion to our members shortly.
We do see some added uncertainties to our Oracle valuation and those uncertainties as well as our analysis of Oracle’s FY 2016 results are discussed in our next article.
Quarterly Results
A post-Brexit currency headwind held back Oracle’s quarterly revenue growth, and strong Cloud sales in the U.S. boosted the tax rate a bit, which in turn caused earnings per share to come in a bit weaker than the Street expected.
Oracle’s On Premise revenues were flat, but overall the software business grew in the mid single digit percentages – a bit faster than our best-case revenue growth estimate. Profitability on an Owners’ Cash Profits (OCP) basis was outstanding, but so much so that we know it will return towards the mid-30% range over the next three quarters. Oracle’s first quarter is usually a slow one for the firm, so it is hard to meaningfully extrapolate conclusions from just this one quarter’s results.
Long story short, we saw nothing in this announcement to cause us concern regarding Oracle’s business prospects or strategy.
Long-Run Forecast Review
One of the cornerstones of the IOI valuation methodology is to review prior forecasts, understand where those forecasts were correct or not, and apply this learning in creating our next round of forecasts. This focus on observation and hypothesis testing is the reason why we like to say that we add a scientific element to our valuation methodology.
We have done two valuations of Oracle over the past three years – one in 2013, the other in 2015 – and we present our review of both here.
2013 Forecasts
We published an IOI Tear Sheet on Oracle in June of 2013 and an update a few months later. This is what our valuation looked like at that time.
Figure 1. Source: Company Statements, IOI Analysis
Checking our profitability (OCP) and Free Cash Flow to Owners (FCFO) forecasts from that valuation, we find that our accuracy was fairly good, though with some reservations on the OCP side.
Figure 2. Soure: Company Statements, IOI Analysis
The green extension shows actual OCP over the intervening three fiscal years. While still within our original projected range, we see that 2016’s value was getting perilously close to the worst-case value. We discuss 2016 results more below.
In contrast, actual FCFO – the cash flow on which we base our valuation – ended up being very close to our best-case forecast.
Figure 3. Source Company Statements, IOI Analysis
FCFO can swing a great year from year to year as the company makes acquisitions or other investments, so we find it helpful to look at FCFO projections on an aggregate level.
Figure 4. Source: Company Statements, IOI Analysis
Clearly, actual FCFO has been well within and closer to our best-case scenario, implying a valuation at the higher end of our 2013 forecast.
2015 Forecasts
In the fall of 2015, Oracle’s stock price was dragged down by the China-influenced macro weakness, so we refreshed our valuation to see if there may be an opportunity to increase our position size or increase our leverage on the position using In-the-Money call options. We originally took the latter route on the strength of this valuation:
Figure 5. Source: CBOE, IOI Analysis
With a stock price in the mid- to upper-$30 range and a likely valuation in the mid-$40s, we increased our leverage in this position to roughly 1.8. / -1.5 (using the IOI convention explained in The Framework Investing) using ITM LEAPS.
Because Oracle’s profits had been so resilient even in the face of revenue headwinds, we tightened our best- and worst-case OCP margin assumptions. In hindsight, this may have been too hasty of a decision as shown below.
Figure 6. Source: Company Statements, IOI Analysis
As you can see, Oracle’s actual 2016 OCP came in just under our worst-case forecast. However, due to relatively low acquisition activity and lowered compensation-related stock issuance, actual FCFO was much higher than our best-case forecast.
Figure 7. Source: Company Statements, IOI Analysis
Since FCFO is the metric on which we base our valuations and because had significantly overshot our expectations, we left our levered position open. After the 1Q 2017 earnings results, this does not look like a very smart move, but we have no need to look smart in the short run as long as we are correct about value in the long run and our investment is properly structured to take advantage of that.
Our next article goes in depth into the 2016 annual results and looks at several sources of operational uncertainty that have developed at the firm.