This post relates to two IOI Tear Sheets we published about Oracle ORCL:

There are three parts to this post:
  1. Investment performance update
  2. Oracle’s Delphic Announcement
  3. Tweaks to Oracle’s fair value estimate
Investment Performance Update
Long Diagonal
The IOI Tear Sheet specified selling ORCL puts struck at $30 and expiring on September 21 (this Friday) and buying ORCL calls struck at $37 and expiring on January 17, 2015. Readers who did this have better returns than do I, because when I ordered on 26 June using a new trade entry system, I inadvertently sold the August 2013 puts, so received less premium. Also, rather than trading these two positions as a spread, I traded them separately, so ended up paying $10 too much in commissions and fees.

I received $89.27 per contract sold and paid $158.75 for each contract bought for a total cash outlay of $69.48. The put expired worthless for a realized gain of $89.27. The call LEAPS has an unrealized gain of $220. If I were to realize this gain now, I would net a profit of $51.25 on the position. The total realized value of this entire position would be roughly $140.52 on an investment of $69.48, which equates to a period return of 202%.

In contrast, the S&P 500 closed on 6/26 at 1,603.26 and closed today at 1,722.34 for a period return of 7%.

Levered Long
The IOI Tear Sheet specified buying In-the-Money (ITM) calls struck at $20 and expiring on January 17, 2015, and overlaying that on a purchase of 100 shares for each contract purchased. On 1 July, I paid a total of $1,070.75 (inclusive of fees) for 1 call option contract and $3,020.49 (inclusive of fees) for the shares. This represented a total cash outlay of $4,091.24. On August 2, I received $12 in dividends, which reduced my effective cost to $4,079.24. The call LEAPS has an unrealized gain of $324.25 and the shares, an unrealized gain of $368.51. If I were to realize these gains now, I would realize a profit of roughly $682.76 on an investment of $4,079.24, which equates to a period return of 17%.

In contrast, the S&P 500 closed on 7/1 at 1,614.96 and closed today at 1,722.34 for a period return of 7%.

Were both strategies to be liquidated today, we would realize a gain of 20% versus the S&P 500’s 7%. Over this time period, Oracle has risen from an average price of $30.02 (closing prices for 6/26 and 7/1) to today’s closing price of $33.89, which implies a period return of 13% (somewhat less if fees are included). This implies our combined position has had an upside leverage factor of around 1.5. This leverage factor is a little less than I would like it to be (roughly 1.8 or so), but maybe the market will give me the chance to correct that error in the next couple of months.

Oracle’s Delphic Announcement
In addition to announcing that Larry Ellison was too busy at the Americas Cup races to host the quarterly earnings call, Oracle released its 1Q2014 numbers and guided for 2Q2014 after hours on September 18. You can find the press release and transcript on Oracle’s Investor Relations page. You can also find a lot of nonsense written by the chimpanzees on crack that care about things like “pro-forma EPS.” The chimps were excited to see that non-GAAP EPS beat sell-side analysts’ earnings projections by a few cents per share, but then started hooting and banging their cages when the company guided 2Q2014 earnings and revenue to the lower end of Street expectations.

When I think about how much brain power, technological sophistication, and monetary resources are expended trying to figure out the next 90 days’ worth of business results, I shake my head. Even if one assumes that the statistically volatile quarterly earnings are meaningful from a long-term perspective, forecasting them with perfect exactitude would only contribute to being right on around 2% of the total valuation or less.

After all was said and done, and–in true Delphic fashion–market participants read whatever they wanted into the firm’s quarterly results and guidance, Oracle closed today at about where it did after yesterday’s big run up, which was in turn fueled by another ladle full of Ben’s Magic Punch.

When I looked at the quarterly results and went back to check Oracles FY 2013 annual report (which had not been published when I first analyzed the company), I saw a fair amount of good and a bit of bad, but nothing that makes me think the operational projections I made for the company at the end of June are materially wrong.

The first mark in the “good” column is a big one. Namely, in the 2013 annual report, there is evidence that the operational leverage in the vitally important Software Updates segment has continued to increase over the last year. This means that operational leverage in this segment has now increased every year since the acquisition of Sun Microsystems. I don’t much care for Larry Ellison’s public persona, but when he says that the acquisition of Sun was a huge plus for the company, looking at the following chart makes me think he is right.

Estimated Operating Leverage in Oracle’s Software Update Segment
Source: Company statements, IOI Analysis

What this chart means is that for every extra dollar of revenue coming into the Software Update segment, the segment’s profits are increasing by an even larger amount. In 2011, this segment generated $1.05 of profit for every dollar of revenues. In 2012, that increased to $1.17 of profit for every additional revenue dollar and in 2013, it jumped again to $1.24. Oracle is paring down Sun’s line of servers, and the revenue decreases caused by this bother some analysts. However, in place of the pared down product lines, Oracle is selling “engineered systems,” high-spec pieces of hardware engineered to work very quickly and efficiently with Oracle’s database software. As I mentioned in the Oracle Valuation Notes published in June, Software Updates are the key to Oracle’s business model and profitability. The chart above is evidence that the acquisition of Sun and move to an engineered systems product line is creating a lot of value to that key segment.

Another mark in the ‘good’ column was that in 1Q2014, Economic Profits according to the IOI definition were about 500 basis points better than they were in the same quarter of FY 2013. Of course, we should not make the mistake of extrapolating this margin expansion indefinitely into the future, since there are a lot of immaterial transactions and pure randomness that can affect the number. That said, the fact that the number looks like it will probably average out with other quarters to generate an annual EP margin rough
ly in line with our best-case estimates makes me think that our best-case profitability projections cannot be rejected as unreasonable.

In the bad column was the fact that operational leverage in the Services segment turned slightly negative in FY2013. For every extra dollar of revenues, Oracle only generated $0.94 worth of extra profits. One year does not a trend make and considering that Software Updates made up 71% of Oracles operating profit versus only 4% for the Services segment, I am not worried if operational leverage slips a bit here.

In general, the 1Q2014 earnings announcement and a full analysis of the FY2013 numbers showed us nothing that would make us think our projections for Oracle are materially wrong.

Tweaks to Oracle’s Fair Value Estimate
I went on and on about how much shareholder value Cisco CSCO destroyed by using its cash to soak up stock compensation-based dilution, but all the while, I had been understating the degree to which Oracle was doing the same thing. Making a correction to these assumptions, our fair value estimate decreased by around 15%.

My usual rule is that if anyone claims they can predict a stock’s intrinsic value to within 10%, they are either deluded or are lying. Fifteen percent is just barely outside of that liars’ zone, but crucially, the reduction brings our weighted average fair value estimate down to the $37 mark at which we have purchased LEAPS calls.

In terms of investment strategy, this means I will probably be more likely to realize profits on the remaining leg of the Long Diagonal opportunistically before expiration. Even if the stock price only approaches the $37 mark, as long as it does so fairly quickly, we will be able to realize a handsome profit simply due to the increase in the option’s time value. Those of you who are in this position as well might consider a similar strategy, and no one should be surprised if I do close the call LEAPS early.