Buy Oracle Now As Success In Cloud Computing Will Likely Support A Valuation Of $40

This decision is being made at a time when the high-margin traditional software business model is being greatly challenged by cloud computing offerings. I believe Oracle is very likely to succeed in this strategic move. If so, a higher portion of revenue from lower-margin cloud services should depress its operating margin eventually.

The best software companies on the world

Oracle is one of the best software companies on the world. It is the second largest software company by market cap just afterwards Microsoft. Its $24.53bn software revenue in 2011 ranks it the fourth among the global software industry. It is very efficient at turning sales into hard cash. Its operating margin has never dropped below 30 percent since 2002. Its free cash flow over sales hovered around 30% while the same time period. It is liquid and solvent, with $4.55bn cash in hand, a healthy current ratio of 3.23 and a moderate financial leverage of 1.73 as of latest quarter.

Here are three reasons why Oracle has been able to fend off its competitors and maintain a high margin business. These competitive advantages are largely transferable in the cloud setting.

The need for solid database management software

Hosting data on virtual machines does not eliminate the need for solid database management software. To the in contrast, cloud vendors have an even greater need for efficient, reliable and secure platform and database architecture in place to support multi-tenancy. Oracle's dominance in the database business will be heightened in the cloud.

Another strength for Oracle lies in managing big data. Big data refers to datasets that are too complex and large in volume to be handled by ordinary database tools. The rise of social media and the growth of consumer-driven research business produce more big data that needs to be tracked and analyzed. Oracle's cloud social services are created to meet the growing demand on this field.

Furthermore, the 2011 cloud computing trends survey report prepared by hosting.com states on Page 8 that large company respondents hope to maximize value derived from previous investments in infrastructure during choosing cloud vendors. Integration with existing architecture is quoted as a top deciding factor. This gives Oracle the edge over other cloud providers to win enterprise customers.

The cloud computing market

Although Oracle is then positioned to compete in the cloud computing market, the departure from the traditional software model will erode Oracle's profit margins. This comes in two ways: a higher portion of Oracle's revenue will be from the lower-margin cloud business. The margin and growth of its non-cloud software business will as well take a hit.

Firstly, cloud computing has lower margin than the traditional software business. Clients can get cloud services at a variable cost. But, it takes vendors fix cost to offer such service. During customers can be flexible in their usage, vendors need to install enough machines and bandwidths for the peak usage volume. This is as well true for Oracle. The following table shows that Oracle's cloud services have a much lower margin than its software segments:

Secondly, as an economic alternative to enterprise software that charges high up-front cost, SaaS will depress revenue growth and profit margins of Oracle's non-cloud software business. As this article rightly points out and explains in great details, meter-pricing of SaaS alternatives is particularly disruptive to Oracle's old model. Price-sensitive customers would prefer cloud offerings. Clients that stay with Oracle would demand more out of what they pay, being fully aware of the economics behind alternatives to Oracle's products. In the then and there decade, Oracle should see a downward trend on its margins.

My model forecasts free cash flows for each of the then and there 10 years and calculates a terminal value in 2021. Segment revenue and margin data is taken from Oracle's 2011 and 2008 annual reports. Other data on the income and balance sheets is sourced from Morningstar.com.

An annual revenue growth pf 10% for new licenses is a to put it more exactly conservative estimate. The revenue multiplier of 1.79 reflects my observation that software license update revenue strongly correlates with the previous year's new license revenue. I as well forecast cloud services revenue to grow at an annual rate of 30% for the at once 10 years. I assume margins for both segments of software business to decrease by 2 percentage point per year.

Alternatively, let's suppose that new software revenue grows at 6% and cloud services grow at 15% per year between now and 2021 and hold all else unchanged, at the time the fair value is revised down to $29.30, closer to Oracle's market price. I don't think it is likely that Oracle, one of the largest and best managed software companies, grows its business at a CAGR of 6% for the then and there ten years. That is, the actual intrinsic value should be much higher than $29.30. In short, it is a great possibility to buy Oracle at the current price now, especially previously its Q4 2012 revenues come out on June 21, 2012.