I recently posted an article on SeekingAlpha (Oracle’s Sun Acquisition is Paying Off in Spades) that drew from the data about operational leverage that I posted previously on this blog. The SeekingAlpha posting received several good questions, and I wanted to post those questions and my answers here.
In a nutshell, the questions are:
- Oracle seems like its obfuscating its financial picture. How do you know that it is making good acquisitions in light of the continuing shrinking in the hardware business?
- Your operational leverage argument may not be causal, but coincidental. How do you know the software update segment wouldn’t have done better without the Sun acquisition.
I have been following ORCL for some time now and my unease stems from the following:
- ORCL stopped breaking out its database and middleware business from its applications business and now reports everything under “cloud revenues.” Now you do not know how each business is doing. Maybe all lines are doing well – maybe not.
- Too much goodwill ($40 billion) sitting on balance sheet.
- The hardware business is yet to find its bottom. Even for Q2, Safra has guided to minimal to negative growth for the hardware segment. If the business keeps shrinking, I think they will have to write down the Sun acquisition in the same way that HPQ had to write down the Autonomy acquisition.
Thanks for the thought-provoking questions–much appreciated. I’ll address each one-by-one.
Oracle financials are confusing
I know how you feel. I get frustrated with companies too when they change reporting categories seemingly to obfuscate performance of a certain segment or business. CSCO has driven me crazy with this tactic and I think ORCL is guilty to a lesser extent.
The one thing I would say is that for something as large and complex as a modern multinational, there is simply no way to get all the detail one would like and I’m not sure that having all the data would do a great bit of good in terms of tightening up the valuation.
My goal is to be 80% right rather than 100% wrong–get the direction basically right and try to find clues (like the op leverage) to either deny or confirm my educated guesses.
As an analyst, I believe that I and other analysts get caught in a behavioral trap where we can never have enough data without realizing that the marginal impact of what they are trying to figure out is very small to the valuation overall. I do think that sometimes we simply cannot know everything but think that my valuation assumptions have pretty good .
I know a lot of people are concerned when they see goodwill in a statement of accounts, however, it is best to keep in mind that goodwill is only an accounting convention and that its link to economic reality is tenuous.
Goodwill simply is the amount paid for an asset above the book value of that asset. There are a lot of issues with book value in the first place, but keep in mind that most of the companies ORCL acquired in the mid-2000s were software companies and that software companies have a higher proportion of ‘assets’ that are not reflected on a balance sheet then say, a widget manufacturer (e.g., IP of present products and those in development, worker know-how and experience, etc.).
Because the intangibles were not listed on the balance sheets of the acquired companies, their book value was understated. This understatement leads to a good bit of the goodwill on Oracle’s balance sheet now.
The best way I have found to think about acquisitions and whether they are creating or destroying value is to look at a chart like this one:
|IOI Estimate of Oracle’s Marginal Growth in Economic Profits
Source: Company Statements, IOI Analysis
The most important thing is whether or not the acquisition of another firm is adding or destroying value for the shareholders; the easiest way to think about value creation or destruction is to look at how much wealth the firm is creating versus some benchmark (like nominal GDP growth). ORCL has done, according to this measure, an excellent job of creating value for its shareholders and that is what the second chart expresses.
The Hardware Business Hasn’t Found Bottom Yet
Right–I agree that the hardware business has not found a bottom yet and its revenues may continue to shrink.
That said, ORCL’s primary business is software and its cash cow is selling subscriptions to updates. My point related to operational leverage is simply that the acquisition of Sun seems to be generating steadily increasing margins for the most important of ORCL’s divisions, and that no matter what happens shorter term with the small proportion of sales and profits stemming from the hardware business, it is the improvement to the software update business that is really important for ORCL shareholders.
A write-down would be appropriate if the company could not show its auditors solid proof that the Sun acquisition was not impaired. Considering the sales increases in “engineered systems” and the profitability increase in its most important division, I don’t think this would be a hard case for the management to make to the auditors.
Thanks again for your excellent questions,