Within the world of investing exists a dichotomy that has often befuddled and confused us. On the one hand, we have investors that are interested in becoming owners of some of the most profitable and rapidly growing businesses on the planet. And, on the other hand, we have the trader mentality where the sole focus is on the erratic nature of short-term stock price movement. But what is most confusing of all is how even though the interests of these two groups are the polar opposites of each other, the irony of all ironies is that they need each other. The businesses need the traders to provide the liquidity and capital they need to function. While the traders need the businesses in order to have something with which to trade upon.
But the main point proposed from the above diatribe is how these polar opposites functioning together can create anomalies that can be exploited. We believe that one such anomaly that currently exists is how the market is currently undervaluing the technology sector. This sector contains some of our fastest growing and most powerful companies with records of profitable growth that is unequaled in the annals of business history. But even more importantly, the odds are extremely high that the technology sector sits at the forefront of the next leg of what might be the greatest transformation in the history of business. Yet somehow, Mr. Market, the short-term trader is currently seeing fit to price our best technology companies at some of the lowest valuations ever.
Voss Capital is long Nintendo, Avid and Extreme Networks despite “Software bubble”
Voss Capital's Voss Value Fund was up 19.91% for the third quarter, while the firm's Voss Value Offshore Fund was up 19.88%. Both funds are now in the green for this year after erasing the damage that was done in March. Year to date, the Voss Value Fund is up 2.41%, while the Voss Value Read More
If you examine most of our greatest technology names, you discover that as a sector they are trading at below market valuations. Yet, as a sector, they have produced the strongest historical growth and are expected to produce some of the strongest future growth as well. Today we find Microsoft (MSFT) trading at a PE ratio of 11, Oracle (ORCL) at a PE ratio of 12.9, and Hewlett-Packard (HPQ ) can be bought at a PE of only 7. Even the mighty Apple (AAPL) computer only trades at a PE ratio of 15. These appear to be extremely low valuations when you consider both the importance and the promise of the technology sector’s contribution to our future.
The Possibility of Abundance: Abundance — The Future Is Better Than You Think.
There is a new book soon to be published that we had the privilege to be on the advance list of purchasers. With all the pessimism and fear of the future so prevalent today, we highly encourage every investor to get a copy of this important work. We believe you will find that it is not Pollyanna but full of facts and logical hypotheses supporting the case for optimism. The book is titled Abundance — The Future Is Better Than You Think.
The book is written by Peter H. Diamandis and Steven Kotler, who are both renowned visionaries.
“Dr. Peter H. Diamandis, is Singularity University Cofounder and X PRIZE Foundation Chairman. The X PRIZE Foundation, leads the world in designing and launching large incentive prizes to drive radical breakthroughs for the benefit of humanity. Best known for the $10 million Ansari X PRIZE for private spaceflight and the $10 million Progressive Automotive X PRIZE for 100 mile-per-gallon equivalent cars, the Foundation is now launching prizes in Exploration, Life Sciences, Energy, and Education.
Steven Kotler, is a science journalist. His articles have appeared in over 60 publications, including: New York Times Magazine, Wired, Discover, Popular Science, Outside, GQ, and National Geographic. He writes “The Playing Field,” a blog about the science of sport and culture for PsychologyToday.com.E. Steven Kotler is also the co-founder and director of research at the Flow Genome Project, an international organization devoted to putting flow state research on a hard science footing.”
What follows are a few excerpts from part one of their book – Perspective:
“technology is a resource- liberating mechanism. It can make the once scarce the now abundant.”
“Of course, the make more pies approach is nothing new, but there are a few key differences this time around. These differences will comprise the bulk of this book, but the short version is that for the first time in history, our capabilities have begun to catch up to our ambitions. Humanity is now entering a period of radical transformation in which technology has the potential to significantly raise the basic standards of living for every man, woman, and child on the planet. Within a generation, we will be able to provide goods and services, once reserved for the wealthy few, to any and all who need them. Or desire them. Abundance for all is actually within our grasp.”
“In this modern age of cynicism, many of us bridle in the face of such proclamation, but elements of this transformation are already underway. Over the past 20 years, wireless technologies and the Internet have become ubiquitous, affordable, and available to almost everyone. Africa has skipped the technological generation, by-passing the land lines that stripe our Western skies for the wireless way. Mobile phone penetration is growing exponentially, from 2% in 2000, to 28% in 2009, to an expected 70% in 2013. Already folks with no education and little to eat have gained access to cellular connectivity unheard of just 30 years ago. Right now a Masai warrior with a cell phone has better mobile phone capabilities than the present United States did 25 years ago. And if he’s on a smart phone with access to Google, then he has better access to information the president did just 15 years ago. By the end of 2013, the vast majority of humanity will be caught in the same World Wide Web of instantaneous, low-cost communications and information. In other words, we are now living in a world of information and communication abundance.
Oracle: A Paragon of Consistent Above-average Growth
Oracle (ORCL) is a world leader in the database software industry, and after acquiring Sun in 2010, is now the world leader in complete, open, integrated hardware and software systems. According to their website:
“With more than 380,000 customers—including 100 of the Fortune 100—and with deployments across a wide variety of industries in more than 145 countries around the globe, Oracle offers an optimized and fully integrated stack of business hardware and software systems that helps organizations overcome complexity and unleash innovation.”
The following graph plots Oracle’s earnings-per-share growth since 1998, which averaged 20.8% per annum. Notice that the company initiated its first dividend in calendar year 2008 as depicted by the light blue shaded area on the graph.
Although Oracle (ORCL) is a leader in software innovation with a strong commitment to R&D, the company has primarily achieved its growth through acquisitions. Since calendar year 2005, the company has spent approximately $36 billion acquiring and integrating over 80 acquisitions.
At Oracle’s current price of approximately $28 per share, it is a $140 billion market cap technology titan. We would estimate fair value at approximately $49 per share (see earnings and price correlating graph below), which would give Oracle a market cap of over $246 billion. Consequently, we believe that Oracle, at its current valuation, represents an opportunity to build a position at a price that is almost 50% below its intrinsic value. The orange line with white triangles represents a PEG ratio fair valuation of 20.8. Therefore, the reader should note that any time the stock price is touching the orange line, it is trading at a PE ratio of 20.8.
But more importantly notice how the stock price has tracked the orange earnings line over time. With the exception of the irrationally exuberant period spanning 1999 to 2001, it is clear that the market has generally capitalized Oracle shares in line with its earnings growth. And, perhaps even more importantly, it is clear that every time the stock price falls below the orange earnings line, as it now does, it quickly comes back to value. Consequently, we believe the below graph paints a clear picture that based on historically normal valuation, Oracle is currently undervalued.
When we calculate performance associated with the above graph, we discover that Oracle has significantly outperformed the S&P 500 even considering the 50% undervalued case we made above. Moreover, the 15.3% capital appreciation (closing annualized ROR) correlates to earnings growth adjusted by low valuation.
With our next graph we overlay free cash flow (the orange shaded area marked with an F) in addition to price and earnings. Here we’re provided a clear picture of Oracle’s solid financial condition which supports their ability to continue making future acquisitions to support future growth.
On February 9, 2012 Oracle announced it is acquiring Taleo for $1.9 billion or $46 a share. The Taleo acquisition follows their recent acquisition of RightNow Technologies., a leading provider of cloud-based customer service. RightNow’s Customer Service Cloud helps organizations deliver exceptional customer experiences across call centers, the web and social networks. We believe that both of these acquisitions indicate that Oracle is not willing to rest on its laurels and past successes, and continues to assess the future of technology.
Our next earnings and price correlated graph calculates Oracle’s earnings growth since 2003. This is offered to illustrate remarkable consistency of Oracle’s growth. Our first graph covered the 15-year period (14-years plus the year were currently in) which averaged earnings growth of 20.8%. When calculating the shorter time frame since calendar year 2003, we discover that Oracle’s earnings growth of 20.2% is virtually identical to the longer time period.In order to continue with our analysis of Oracle’s growth, we shorten our time frame even further from 2008, the year of the great recession, to current. Here we continue to discover the remarkable consistency of Oracle’s operating results. Once again we find that since 2008 Oracle has continued to grow earnings in excess of 20% per annum. Therefore, with each example we provided continuing evidence that Oracle is currently undervalued. Each time it has been undervalued in the past we see the stock price rather quickly moves back to the orange earnings justified valuation line.
A careful examination of the above historical graphs will reveal that they do include forecasts for this fiscal year ending May 31, 2012 and a forecast for fiscal year ending May 31, 2013. Perhaps, the forecast of only 10% growth in fiscal 2013 might partially explain Oracle’s current historically low valuation. Furthermore, the consensus of 24 analysts reporting to Capital IQ forecast Oracle’s 5-year average earnings growth rate to be 13% per annum. However, this is less than the 14.4% estimated growth by 19 analysts reporting to Zacks. Consequently, we are comfortable estimating a range of future growth of 12% to 17%.
Additionally, the reader should consider that there is at least a possibility of pessimism built into analysts’ current thinking. Although Oracle’s last quarterly earnings report was solid, it nevertheless disappointed analysts by missing by approximately 3 cents a share. However, if you study the annual rates of change of earnings growth at the bottom of the above historical earnings and price correlated graphs (orange shaded area), you’ll see that this is not the first time that Oracle had a soft quarter. The reaction in their stock price acted like Oracle was going out of business, and not that they still produced a very profitable quarter.
Thesis for Oracle’s Continued Growth
There are several reasons why we believe that Oracle is capable of continuing to grow its business at above-average rates far into the foreseeable future. We believe that corporate spending on software and services will continue to be in demand. Furthermore, we believe that Oracle is poised to offer many innovative products that are not currently factored into anybody’s expectations.
Also, the company’s financial condition remains excellent with a solid cash position and the continuing ability to generate free cash flow. Since we cannot know what acquisitions might be on the horizon, we have to rely on their track record as a guide. And as we have illustrated in this article, their track record is superb. More importantly, so is the track record of their management team. Management does not let any grass grow underneath them, and continues to innovate. We for one don’t feel it’s wise to bet against them.
The future for technology is certainly an unknown. However, one thing that prospective investors should realize is that technology does not grow in a linear fashion. Instead, both the history and we believe the future of technology experiences exponential growth. No other industry understands or participates in the power of compounding more than technology has, and we believe will continue to do. However, based on what we already know about technology, it is clear that the developing world will be, and already is, participating in the technology revolution.
For example, according to the book Abundance — The Future Is Better Than You Think, referenced above, the information/communication revolution that is now underway is rapidly spreading across the planet:
“Over the next eight years, 3 billion new individuals will be coming online, joining the global conversation, and contributing to the global economy. Their ideas -ideas we’ve never had access to-will result in new discoveries products and inventions that will benefit us all.”
Although it’s hard to imagine what those ideas will mean, and how much growth they will provide, we believe it’s a safe bet that Oracle Corp. will be an active participant.
Summary and Conclusions
We believe that Oracle Corp., as we mentioned in our opening remarks, is just one of many technology titans that we believe the market is mispricing. Furthermore, we believe part of that stems from the general level of pessimism that has created the so-called flight to safety out of equities. Pessimism thrives on uncertainty; and one of the main attributes of technology is uncertainty. Any time a long-term investor takes a position in a technology company (business), they must do it with the realization that it’s more likely than not, that any future profits they are expecting will come from products and/or services that don’t even exist today.
Investing in technology is never without risk. However, the above-average growth and above-average returns that technology stocks have traditionally generated support the taking of the extra risk. During more normal and benign market environments, technology stocks usually command above-average price earnings ratios, which add even more to the risk of investing in them. However, as we previously indicated, many of our best technology stocks are trading at historically low valuations today. Not only are today’s valuations lower than the norm for technology stocks, in many cases they are below the valuations of the average company as measured by the S&P 500. Therefore, we believe that investors seeking maximum capital appreciation at reasonable levels of risk might do well to take a hard look at not only Oracle, but the technology sector in general.
Disclosure: Long ORCL, HPQ, AAPL, MSFT at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.