Oracle Business Model
(During the analysis, I will consistently quote my previous post for some general processes and definitions to reduce words in this post. )
The business model is about how a company generates revenue and earns
profits, directly affecting three essential elements in finance and investment- how the
company raises capital, generates growth, and returns
to its stockholders. While Oracle is a technology company, I will try my best
to use language that people with no technology background can understand to
explain its business models.
Oracle designs, manufactures and sells software hardware and mainly offers enterprise application and data management services.
Enterprise application: Most organizations have different departments with
different responsibilities, types of data, and work styles. The Enterprise
application helps different people in the organization to work together to
improve productivity and efficiency. For example, medical companies conduct clinical
trials to test new medicines. They need to collect information about government
requirements for different phases and ensure the information is current.
Since there will be various requirements for different phases and different
types of medicines, they will need an enterprise application called contract
research organization (CRO) so that other departments in the company, such as
finance and human resources, can plan investment, hiring, and training accordingly
even if they know few about medical trials.
Data management: Collecting, keeping, and using data securely,
efficiently, and cost-effectively. For example, banks collect millions of
clients’ information. If companies don’t manage data well, they may encounter data
breaches like what happened to TD Bank recently. If they don’t collect them effectively,
the process can be costly. For example, some banks can only verify clients when
they are physically in the branch. They will lose growth opportunities and competitive advantage if they don't use data efficiently. For example, better
banks should be able to offer and propose products according to their
background, spending style, and life goals. In contrast, offering credit
card/Financing to a client with 100 dollars left in the account at the end of every
month wastes time and money. But many banks keep doing it.
After I understand Oracle’s business model, I think the growth rate of
Oracle will depend on the growth rate of the whole market of enterprise systems,
data management, and Oracle’s competitive advantage relative to peers. Since
competitive advantage can transfer to high-profit margin((revenue-cost)/revenue)
and increasing market share over time.
But while calculating Oracle’s growth rate in my next steps, I
found that this is NOT Oracle’s REAL business model.
Growth rate estimate
For a general guide for growth rate calculation,
please check the Fundamental Growth Rate Forecast in my previous post here.
From that guide, we can summarize that the growth rate
depends on:
1.
How
much capital the company reinvests into its company.
2.
How
well the company generates returns from invested capital.
Reinvestment rate
The following formula consists of all items to be
included in the reinvestment rate calculation.
You can easily understand Capex(Capital expenditure), and depreciation by your own research, and you can learn about NOWC from my
post here.
So, the main items I will explain in this post are R&D expense (Research and Development expense), and acquisition.
R&D expenses, Amortization R&D expenses (research and
development) are money the company spends today to generate growth for the
future. For example, Apple invests money to design new versions of iPhone and
Macbooks, Nvidia spends money to design more advanced chips for AI, and Facebook
(Meta) improves its algorithm to analyse its users better. When the company spends money (for
example, in 2022), it will expect a return after 3-10 years (based on different
industries) rather than gain growth instantly this year. Therefore, recording
them as operating expenses for the current year, as accountants do, will
underestimate the company's current earnings.
To resolve accountants'
inconsistency, we add back R&D to operating
income first then
spread the R&D expense into several years and calculate accumulative
amortization.
This process is called capitalization in Finance.
For example, if we estimate it takes
three years for the company to generate a return from its R&D, it spent $3000 million in R&D in
2022. We will record $1000 million amortization for 2023,2024, and 2025
separately. However, remember that if you have R&D in previous years, you
must also amortize. So, if there is $1800 million in R&D in 2021, you will
amortize $600 in 2022,2023,2024 separately.
Figure 1
Oracle R&D converter for 2014
Figure 2
Oracle R&D capitalization
Note. Capitalization process for Oracle 2014 R&D. Adapted from "New York University Stern School of Business R&D capitalized".
Figure 3 below shows the effects of the R&D
adjustment. You may find several items you may need help understanding now. I will cover
them later when calculating the ROIC (return on invested capital).
Figure 3
Effects on R&D Amortization
Acquisition. Acquisition
refers to the process in which an Acquirer company buys out another Target
company. According to multiple sources such as Harvard Business Review and
McKinsey, around 50-70% of M&A deal end up losing money for the acquirer
company. There are several reasons, but one of the main reasons is that M&A
deals are usually advised by investment banks such as JP Morgan, Goldman Sachs, and Morgan Stanley. They receive advising fees proportionately to the deal
size. In other words, acquisitions are like Under Armour asking Golden States how
much they think they should pay for Stephen Curry to wear their shoes, like
Taylor Swift fan (while I am not) asking a Facebook seller how much they believe
their concert tickets are worth like a high school graduate asks Ohio State
University campus tour guide how much tuition fee they think worth attending
the school. The answers are simple. They will want to give you as high a number
as possible as long as they can self-justify it. So, it is crucial to take
acquisitions into account in the valuation. In addition, if your company has a
habit of making acquisitions, you may need to estimate how much money
they will burn for future acquisitions.
Oracle
Acquisitions
I first collected
information from the 10k annual report about acquisitions, and I got the Total reinvestment based on
financial statements. (Not include the “Acquisition calculated and
disclosed” column).
Figure 4
Oracle Reinvestment
Then, I
calculated the reinvestment rate by dividing last year's operating income by
the total reinvestment next year.
Then I multiplied the reinvestment
rate by ROC (return on capital), which I will cover later, I got the following
growth rate.
Figure 5
Oracle ROC.
(Will
explain process later)
Figure 6
Fundamental
Growth rate
Figure 7
Operating
income growth rate
If you check Figure 4,5,6,7, you
will find that while Oracle’s ROC (return on capital) is comparatively stable,
the growth rate goes up and down dramatically. So, Oracle’s growth rate mainly
depends on its reinvestment rate.
More
interestingly, you can tell that the reinvestment rate and growth rate will jump whenever the company has a significant acquisition. And they are flat
whenever the company has few acquisitions.
Note: You
will find that the growth rate I calculated and the operating income growth
rate are mismatched for years 2017 and 2018. These are purely due to the way accountants record data at different times. Please check this Link for more
information.
*** From this information,
I can make the judgment that Oracle is a company that mainly grows with
acquisitions regardless of how it will or may advertise its technology or
strategies. My further research shows that Oracle has about 127
acquisitions since 2004 and didn’t disclose over 70. I first contacted
Oracle investor relations, showed them that I am an Oracle stockholder, and
requested them to disclose the cost of those acquisitions with the expectation that
they would NOT tell me. Oracle has never replied to my email while I
have been valuing each undisclosed acquisition. I will not cover the
valuation process, but in this link,
I give three examples of how to value a private business when you don’t have
enough information or know little about the company.
After estimating all
undisclosed-cost M&A, I calculated adjusted reinvestment with the Acquisition calculated and disclosed
column in Figure 4 and got the adjusted reinvestment rate.
Figure 8
Action
Now, valuing
Oracle stocks is distilled into an estimate of how much money the company will
invest in acquisition in the future and how much return it will generate from
acquisition for how long. In other words, I will set times in which:
1. -Oracle spends similar amounts of
money on acquisition and gets similar or higher returns.
2. - Oracle’s return on acquisitions
starts to decrease, but it still spends similar amounts of money.
3. - Oracle’s management team finally realizes
that they cannot generate the same return as before and decides to decrease
investment in acquisitions.
The second
step is necessary because, just like when people are aging, the management team's first reaction when their return starts to decrease is to refuse the
fact. Then, they will keep doing the same things and expect different results.
But until a point at a time, they will have to admit and scale back the
investment.
I will explain how we quantify that
process when we forecast future reinvestment in the Future cash flow
calculation, but now let us do the second part of the growth rate calculation.
Return on
Capital
Part 1
Invested Capital
We calculate how much the company
invested in its capital to calculate the return on capital later. The invested
capital includes the following:
Interest-bear debt
While accountants reported various
liabilities, the company only spent money on interest-bear debt. Many so-called
liabilities are only for accountants' convenience while do not cost the
company's capital.
For example, the account payable
occurs when the company has received raw materials or services from suppliers
but has yet to pay the supplier. We will not include them since the company
does not bear any interest for them. We will consider these raw materials as
the cost of goods sold when calculating operating income.
Accountants also reported
"Other" current liabilities and "Other "non-current
liabilities, the word that they always favor but always get other people
confused about. After reading through the 10k, I found that page 80 mentioned
that those are operating leases. An operating lease is a contract for a company
to use an asset but not own it. For example, if the company leases a building
for manufacturing. So, even if the accountants do not categorize them as
debt, we still need to take it into account.
Shareholder equity less cash
These are capital invested either by
the company owner or its stockholders. We subtract the equity from cash since
the cash is on balance rather than invested in the project.
We observe Oracle's 10k and find
that the company has had negative equity for 2022. Some companies, especially young
ones, have negative equity because they lose money. For those companies, you
will need to estimate when they can turn to positive earnings. But that's not
the case with Oracle. Some companies have positive earnings, but the
accountant equity number is negative since they purchase more stock than their
earnings.
Figure 9
Oracle statement of stockholders'
equity 2020-2022
The column "Total Oracle Corporation Stockholders' (Deficit) Equity" shows that the
company has a similar amount of stock dividend, compensation, and repurchase. So, the generous stock repurchases should
not be the reason for Oracle's negative equity.
Then, I find that reported net
income in 2022 decreases by almost 50% compared to 2021 and 2020.
Figure 10
**From the company's income statement, we can find that the
sudden drop in net income is due to the 4.7 billion dollars in "acquisition-related
and other" costs.
Reading through the 10k, I found on
p106 10k that the 4.7 billion is the company's litigation cost after
losing a legal complaint to Hewlett Packard Enterprise Company (HP). The
cost is a one-time cost, and we should not punish the company's
long-term growth with that.
Therefore, we will add that to
the total equity for 2022. We will also add back this to operating income when
calculating the company's profit margins.
R&D
(research and development expense)
R&D is obviously the long-term investment that I have explained above.
With this
information, we can get the Adjusted Capital Value in Figure 3.
But we still
have one important item to include…
Operating
Leases
You can
check the general definition of operating leases in my previous post here by
searching the term in the center.
Usually, accountants will record
operating lease expenses as one of the operating expenses in the income statement
to reduce tax. But I didn’t find such an item on Oracle's income statement. I
thought Oracle accountants may have more common sense and ethics and record them
as liabilities only. However, the following text on page 77 of the Oracle 2023
annual report shows that the accountants just mingle the leasing expense with the
operating expenses.
While I need to include operating
lease liabilities in the invested capital anyway, these accountant actions make
us add back operating leasing expense to the operating income (EBIT) when
calculating reinvestment profit margin so that growth rate.
In addition, while the accountants said that
the other short-term operating lease liabilities are included in the “Other
Current Liabilities,” and the long-term operating lease liabilities are
included in the “Non-Current Liabilities” in the consolidated balance sheet,
those numbers are accounting book value rather than market. So, we must
calculate the present value of future lease liabilities yearly. For
example, I need to check all future operating lease liabilities on the Oracle
2019 annual report, discount them with Oracle’s cost of debt in 2019, and
add the result to the invested capital for 2019. And I did the process for
every year from 2014-2023 to calculate each year's invested capital.
You can find the calculation guide in my previous post here by searching “Market Value of Leases Calculation” and " Cost of Debt Calculation. You can check here to learn about how I calculated the cost of debt for Oracle and the present value of lease liabilities. Figure 11 shows adjusted invested capital for 2023, including:
Interest-bear
debt
Equity
R&D
Operating
Leases
Figure
11
You can
download the format to calculate ROC from NYU stern school from here.
Part 2
Operating
Income
-Add back
non-repeated/one-time large expenses.
-Adjust the R&D expenses based
on the process in the R&D
expense and Amortization, as
I explained above.
I added back
operating lease expense since I have explained here that
operating leases are debt. We will include that in the invested capital and the company’s total debt, while subtracting after we calculate the company’s free cash
flow.
As a result,
I calculated the adjusted EBIT(Operating income) in Figure 12.
Figure 12
Figure 13 shows the ROC based on accountants' reported operating
income without adjusting leasing and R&D expenses, while Figure 14 shows the ROC based on adjusted operating income.
Figure 13
Figure 14
Conclusion:
Return on capital and reinvestment are the essence of
the company's growth rate, and that’s fundamentally why the company grows and
why we, equity investors, may have capital gains through stock price increases
or dividends.
I attached Figures 7 and
8 again to compare with Figure 14 to show that Oracle’s growth is
mainly driven by its acquisitions. So, estimating Oracle’s growth requires us
to forecast the size of the company’s future acquisitions and return on its
acquisition.
I will explain how I will estimate it in my next post.
A little more…
Some companies can scale up their growth. For example, a company may generate 10% ROC last year but 12%, 15%, 18%, and 20% for the next five years. If you find the company you value has such performance, you can use the next ROC/Last year's ROC -1 to calculate the Efficient Growth Rate. In other words, even if your company spends similar reinvestment, it may still have higher growth rates over time. But you also need to estimate when they cannot sustain that efficient growth rate.
I don’t think we should
use the efficient growth rate for Oracle. As you can see below, the efficient
growth rate is unstable and mainly driven by acquisition. In addition, Oracle’s reinvestment rate is also unstable and operated by the size of the acquisition. We must estimate an average growth acquisition size and reinvestment rate rather than last year’s number. The company just acquired Center
for USD 28 billion, making the 2023 reinvestment over 200%. Using that reinvestment
rate will explode your growth rate and give an over-optimistic number.
So, how do we value the
company’s future growth rate while it relies on M&A to grow? Please check
my next post here.
Figure 15
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