When The Investment Waters Get Cloudy

In 2011, I noticed Google (GOOG) at $250 per share. It was actually $500 at the time, but has had a stock split since then. I thought the stock was cheap. There was innuendo on many Google stock message boards indicating that a change in the ownership structure was being deliberated internally and would affect the voting rights of shareholders. I did nothing.

Sure enough, shortly thereafter, Google announced that it would be doing an unusual 2-for-1 stock split. Not only was the stock splitting, but a change in ownership structure was attached to the terms of the deal. Google was creating separate class GOOG and GOOGL shares so that the founders Larry Page and Sergey Brin could retain 55% voting power over the company even as their actual ownership of the overall company dwindled to a portion of that.

I am not pleased with voting arrangement that do not correspond to actual economic ownership of a company, and so I passed. Since then, Google has grown its profits from $14.88 per share in 2011 to an estimated $22.80 per share this year. The price of the stock is $560, over doubled the price compared to the time it got my attention. I remain unsure whether that was the right hill to die on.

I similar situation presents itself to me when I study the current circumstances at Oracle. I was never comfortable with Larry Ellison’s stewardship of the company, even though he made shareholders fantastically rich. The share count never spiraled out of control because the company used cash from its coffers to repurchase stock in order to cover up things like paying Larry Ellison $67 million in stock awards in a single year. The high compensation ensured that the stock repurchase was never nearly as effective as it should have been. This compensation has enabled Ellison to gobble up over 26% of the company’s stock.

Now, here is where things get tricky for me: There is a very strong argument that shares of Oracle are currently undervalued. That’s the nature of the current market–if you want a deal, you have to look to banks, oil stocks, and tech firms for the most part.

Oracle has three factors that make it look attractive:

One, the stock currently trades at 13.9x earnings. For a company that usually trades in the 15x earnings to 18x earnings band, that merits a hard look. There just aren’t many moderately undervalued large-cap companies out there right now.

Two, the P/E ratio actually understates the case because Oracle is one of those companies deeply affected by the strength of the U.S. dollar in the past two years. It only makes 44% of its profits in the United States. That means earnings are “off” by about $0.30 if you prefer constant-currency analysis to make your decisions under the theory that it is a more accurate indicator of purchasing power. By that metric, Oracle would be making $3.17 per share rather than $2.87 per share.

If you use that as your base for calculation the P/E ratio, then it would seem that Oracle is trading around 12.6x profits on a normalized basis. As a reference point, it traded at 13x earnings during The Great Recession. That’s why Oracle has worked its way onto my research list even though I could think of possibly 150 other businesses that would be preferable to own for the long haul.

Three, the cash hoard at the company has become large It is sitting on $43 billion in cash. Granted, it has substantially offset by $30 billion in debt, but the interest rate on the debt is 2.8%. It’s still a $13 billion surplus, or a little over 7% of the overall market cap.

It is very good at delivering revenue growth and then converting that into strong earnings per share gains. Over the past ten years, Oracle has grown revenues by 16% annually and grown profits per share by 20.0% annually.The stock has compounded at 13% annually since then, which is actually somewhat of a miracle considering that Oracle was trading at 28x earnings in 2004 and is now trading at 13x earnings on a normalized basis. The valuation has cratered during this measuring period, and the stock has still performed well compared to the 7.8% returns of the S&P 500 over that time frame because the earnings growth has been so strong.

Even over the short term, Oracle has still done well. Over the past five years, revenues have grown at 14% annually and earnings per share have grown at 16% annually. It’s very difficult to find companies growing revenues at a double-digit rate and trading at a low P/E ratio, and Oracle appears to be one of those exceptions.

It really has showered wealth upon its owners. Since Oracle’s IPO on March 12, 1986, the server and storage firm has compounded at 25% annually. That kind of compounding for almost thirty years leads to staggering results. If you invested $100,000 in the 1986 Oracle IPO, you would own your town by now. You’d have $68,000,000 in Oracle stock, which would have been able to happen almost entirely tax deferred because Oracle did not begin paying a dividend until 2009. You’d be collecting $1 million per year in dividends, or roughly 10x your initial investment, which is absurd given Oracle has a low dividend yield and only pays out 20% of its profits as dividends.

That’s the conundrum. On one hand, Oracle has been very loose with share dilution and executive compensation. Most people are aware of the statistic that the ratio of CEO to average worker pay has climbed from 40 to 500. Does anyone really want to own Exhibit A for why that has happened?

On the other hand, this kind of dilution has been factored into the stock, and the returns have still been outstanding. Oracle has clearly been better than many companies with tighter executive compensation practices. When you have strong revenue growth that converts into strong earnings per share growth, you can suffer a lot of abuse and still do well, and that’s what Oracle’s history shows.

This is why it is important to have that set of first principles. Are there things that, if you encounter them, you will treat as prima facie evidence of cultural rot and cross it off your list? Or do you simply look for the best long-term returns period, and if it comes with baggage, it shall be regarded as a toll booth to be paid on your journey to where you want to go? Those are the thoughts going through my mind as I analyze Oracle.

Originally posted 2015-08-19 22:20:08.

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