How Low Can Oracle Go? Seven Could Be Its Unlucky Number
thestreet.com
By Joe Bousquin
09/10/2001 09:08 AM EDT
Seven might be the magic number for Oracle (ORCL:Nasdaq) .
For much of the summer, the question on the minds of Oracle investors has been how low the company's shares can go. As shares descended past the high teens in July down to the mid and low teens in August, there were prognostications at each step -- including from TheStreet.com -- which figured the stock just couldn't go any lower.
What's even scarier now is that the stock could go even lower by as much as a third. The magic number? Somewhere around seven bucks, according to investors and a roughshod analysis by TheStreet.com.
Applications Business Trouble
Now, before you scribble off an email ranting about how the author of this article is short the stock -- he is not -- you should consider what has been driving the stock down in the first place. Much of Oracle's trouble has come from disappointing sales of its business software, known as applications. Applications are important for the company because the market for them is projected to have much higher growth than its more mature database business.
After posting somewhat respectable growth of 66% during the quarter that ended November 2000, Oracle's application sales have foundered. They grew by just 25% in the company's fiscal third quarter last year, ended in February, before declining 24% during the company's fiscal fourth quarter, ended in May. (Just looking at U.S. sales, Oracle's largest market, applications sales were down a staggering 40% during the May period.) Now, as the company gets ready to report results for its fiscal first quarter this Thursday, investors are scared to death the company will turn in even more disastrous results in that area.
"That's predominantly what investors have been basing their decisions on," says Brent Thill, an analyst with Credit Suisse First Boston, who rates the company a buy. "The applications piece has been a manic depressant. It's been all over the map with zero consistency. The upside of Oracle's stock has always been tied to the applications sector working."
Finding the Magic Number
The problem, at this point, is that the applications sector isn't working for Oracle. In fact, the decline in Oracle shares has been so drastic -- down 68% from its January highs -- you could make the argument that the market assumes the company's applications business is heading to zero. At least, it's an idea that analysts have been toying with lately. Working under that assumption, TheStreet.com ran the numbers on what investors might be willing to pay for Oracle as a database business alone. And we came up with the number seven.
We derived that number by assuming 10% annual growth in the company's database business. That growth rate is generous, considering the company's total database sales, including consulting and tools, grew by just 7% in fiscal 2001. But again, this is Oracle and fiscal 2001 was rough, so we're willing to be generous.
Growth, of course, is what investors pay for. Traditionally, they've been willing to pay a price-to-earnings ratio that's in line with a company's growth. This kind of valuation ratio, between a company's growth and its price-to-earnings, is known as a PEG ratio, or price-to-earnings growth. If investors pay 10 times earnings for a company with a 10% growth rate, the stock has a PEG ratio of 1.
Generally, stocks with a PEG ratio of less than one are considered less inexpensive, while those with a PEG ratio of greater than one are considered more expensive. Again, because Oracle is Oracle and investors have shown a willingness in the past to pay more than 30 times its earnings, we'll give the company a generous PEG ratio of between 2 to 2.5 -- it's trading in the middle of that range at present. In other words, we've assumed investors will pay 20 to 25 times Oracle's earnings, even if it grows at only 10% a year.
In 2001, Oracle's total database business amounted to just under $8 billion in revenue. If it grows by 10% in fiscal 2002, it would add up to $8.8 billion. We then multiplied that by the company's overall operating margin of 34.8% in 2001, because Oracle doesn't break out net income separately for its database and applications business, and came up with $3.1 billion in net income before taxes. Of course, the actual margins on Oracle's database business could be higher or lower than that, depending on the profitability of the firm's application business.
Accounting for "other income" and taking out taxes, we end up with $2.16 billion in net income. Dividing that by an approximated share count of 5.9 billion, that works out to 36 cents in earnings per share for Oracle's database business in fiscal 2002.
At the low end of the range, or 20 times those earnings, that works out to about seven bucks, or $7.20 per share.
Reality Test
Of course, the preceding argument assumes a lot. After all, in fiscal 2001, Oracle's applications business amounted to nearly $2.9 billion of its total revenue. Realistically, that revenue is not going to disappear in fiscal 2002, even if investors are treating Oracle's stock as if it might.
"I don't think that's rational," says Bill Schaff, portfolio manager of the $50 million Berger Information Technology Fund. "The applications business is here to stay, whether you like it or not, and it will grow again. Maybe Oracle will lose its superiority complex about it in the meantime, which couldn't hurt, but it will grow again."
Fine. So we asked Schaff, who owns Oracle shares, his best guess for how low Oracle's shares could go.
"I think it could possibly go down as low as seven," Schaff said. "That's when you're using a discounted cash flow analysis."
Many analysts and investors like to look at a company's discounted cash flow, rather than earnings or revenues projections, because of a familiar saw on Wall Street: Cash doesn't lie. While companies can play games -- quite legally -- with their earnings and revenue numbers, they can't do the same with the cash on their balance sheets or how much cash they generate.
In his worst-case scenario, Schaff assumed Oracle can generate cash flows equal to 20% of its total assets presently -- it generated 19.7% in fiscal 2001 -- and faded that return by 1% per year over time to account for the business maturing. That means 10 years from now, Oracle would generate cash flows equal to 10% of its assets.
He then calculated what that amount of cash would be in today's dollars, applied historical valuations to it using a range of assumptions for best- and worst-case scenarios, and ended up at his low-ball figure of seven bucks.
"What you're really trying to get is a bracket of valuation. In a worst-case scenario, you're looking at $7. In the best case, you're looking at $21."
Of course, not everyone makes investment decisions based on discounted cash flow analysis. Lately, a lot of people on Wall Street have been looking back to where stocks traded before the Internet bubble engulfed the stock market and blew valuations to the moon.
Oracle, of course, was not immune to that bubble, and took part in it gleefully. From June 1999 until its peak in September 2000, the stock rose more than 630%. Its split-adjusted price just before it started that meteoric rise?
Seven. |
