At the cost of repetition, the current crisis facing the world is that of an unprecedented magnitude. Most of us haven’t seen a disaster of this magnitude.
While the pandemic shows not much sign of abating soon and this author is by no means an authority on the disease, the only silver lining is the 75%+ recovery rates. Going beyond the numbers of the disease governments across the world have orchestrated an almost synchronised shut down of all forms of travel to enforce social distancing and to impede the spread of the virus.
The impact on the economy is yet to be ascertained with estimates of GDP fall ranging from 30-50%. Such extreme fall led to stimulus measures ranging from 1-10% of GDP to subsidise for the relatively weak economic output for at least 2020 and possibly into 2021.
In such a grim scenario, why do we like Oracle?
No one can call the bottom
For ages, some investment managers have been vouching about the virtues of sustained investments across the market rise and fall to benefit from dollar cost averaging.
Cost averaging means if one continues to deploy an even amount of capital (say, $1,000) to buy a stock over the rise and fall of the stock, the number of units purchased during the downturn would be higher than they would be in case of a surge. In the long term, assuming that the markets move up, the higher number of lower-cost units will lead to a sizeable return.
Appended is an illustration to explain the theoretical benefits of cost averaging.
Source: Author analysis
The returns will be negative if the stock price continues to fall. While we may have our reservations about the length of time one can follow the cost averaging in uncertain times, Oracle (ORCL) presents a rare opportunity to have a hedge against the current macroeconomic weakness and a potential to ride the upside.
Devil in the details
For the fiscal 1Q20, Oracle had claimed 3,700 trials and 2,000 customer trials. This was followed up by another addition of 2,000 customers in 2Q20 and has culminated into database revenue growth of 5% in 3Q20 (database revenue growth was 1% in 2Q20).
Source: Company filings, Author analysis
Without going into detailed customer wins, etc., the graph above does point towards a decided change in momentum in favor of Oracle’s cloud business. So much for the good news.
It’s not yet clear what the effect that the virus will have on our customers and suppliers and, as a result, what the impact will be on our business in Q4.
The subscription part of our business, cloud and product update, will continue to grow, and we expect minimal impact from the virus in the quarter, given that much of the subscription revenue is already contracted.
It will be based on the ever-growing portion of our revenue attributable to our faster-growing subscription business. You saw a bit of it in Q3, and it would have been even more obvious but for the early impact of the virus.
Source: 3Q20 Oracle Earnings Call
Oracle had come out with this commentary on Mar 12. Much of the lockdown measures and the ensuring impact started in the second half of March. Thus, it is likely that the company could see a contraction in new business growth in the near term.
Our bullishness on Oracle stems from the strength of conversions and ongoing transition projects that the company is in the process of executing. Ellison shouting about Gen 2’s cost advantage is a thing of the past, the conversion of trials and growth in trials is likely to create a new tail for Oracle over the next couple of quarters. Not only will these ‘proof of concepts’ inspires new logo growth for Oracle but also are likely to lead to cash flow growth.
It’s not that we just started working with them, we started working with them 18 months ago. And we’re taking their first division, it will be live this summer.
Source: 3Q20 Oracle Earnings Call
The key point to understand here is that the momentum had been building up over the last year or so. While some people may choose to defer the final deployment, it would not be in the interest of businesses to stall critical enterprise software beyond a quarter or two. The parts of the economy that are critical are still operational, with a portion of the working population moving to remote. People will need to transact, store data etc. Oracle had noted that Depository Trust & Clearing Corporation (OTC:DTCC) was migrating to Oracle’s public cloud using the autonomous database. Considering a vast majority of global trades go through DTCC, it is unlikely to be stalled. The same holds for many other mission-critical projects, which give us confidence that the momentum of the last few quarters is likely to lead to consistent business growth.
For more discussion on how Oracle’s technology stacks up against competition, please refer to our articles on the cloud:
Beyond the fundamental strength of the company, Oracle also appears to be arbitraging the cost of capital to maintain shareholder return while making merry of the easy money policy.
Cost of debt is lower than the cost of equity
As on Apr 12, Gurufocus estimated Oracle’s cost of equity to be a little above 6% with WACC around 5%. Compared to the sub 4% cost of new investment grade debt, it appears to be a smart move to benefit from the interest rate environment.
There have been comparisons with businesses where cash flows are dependent on asset-intensive companies (airlines, etc.). However, we see this comparison unfounded. While it may not be correct to assume that Oracle has only issued these bonds to benefit from the likes of Fed’s Secondary Market Corporate Credit Facility, we do note that Hathway Berkshire (a company with nearly $130 billion in cash) had issued $1.09 billion senior notes at 0% due in 2025, early this year.
Add to the $4 billion in quarterly free cash flow plus the $25-26 billion in cash; the total available cash comes out to around $50 billion. Is that excessive for a company doing $40 billion in revenue? Well, maybe. But to tide over the current situation, having a solid pile of cash is likely to be a good thing.
Assuming a hit to revenue growth from the current environment, we expect the company to witness a 2020 revenue number of $40 billion (+1.2% y/y). While the numbers in themselves are not stellar, the underlying growth momentum appears to be reasonably substantial.
At a 5% FCF yield, the P/FCF comes out to 20x. We expect 2021 revenue to see a 3.3% growth to reach $41.3 billion while FCF remaining flat at $14.3 billion. At our expected level of P/FCF, the market cap of Oracle works out to $287 billion or over 70% above current levels. (Please note there is no work done on buybacks etc., which will reduce the share count leading to a higher share price appreciation).
Given the expected continuation of share buybacks and the ensuing fall in the number of shares, dollar-cost averaging may lead to profits – assuming that the share price fall does prop up the share price.
Overall, we find Oracle to have a fundamentally strong business and some rather exciting shareholder reward programs that are likely to translate into strong returns.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.