Open Letter To Larry Ellison: How To Boost Oracle's Value By $65 Billion

Management at Oracle can boost the market value of the stock by $24 to $65 billion by simply focusing on return on invested capital as opposed to earnings growth. It's very simple. I'm going to outline it in a few slides as well. The takeaway: Oracle should put less of an emphasis on growth through acquisitions And focus more on incremental shifts to maximize long-term free cash flow and return on invested capital. Don't focus on GAAP earnings, focus on real cash flows. And management can boost the value of the stock by $25 to $65 billion simply by aligning the firm's strategy and performance compensation With real cash flows, or what we call return on invested capital. This is what you got to pay management based on. As we've talked about in the past, you pay management based on non-GAAP earnings, they'll focus on non-GAAP earnings. You pay management based on creating shareholder value, they'll create shareholder value. The basis of our argument predicated on the ideas that A, real cash flows matter, and superior profitability is ultimately rewarded by the market. These are not just kind of crazy ideas. They're based on statistical analysis and what we believe to be also a very intuitive relationship. This is a regression analysis included in our letter to Mr. Ellison. And it shows that return on invested capital explains 92% of the changes in the valuation of Oracle and its peers. Valuation as expressed by price-to-book. More specifically, enterprise value divided by invested capital, a much fancier, more sophisticated price-to-book. You'll see in the letter to Mr. Ellison that all the details behind the regression analysis and our logic are provided. For example, in the appendix, Appendix B, there's more detail on the regression analysis. Here's a definition of enterprise value to invested capital. Or enterprise value. Here's the definition to invested capital. Enterprise value definition in the education section of our site. Invested capital definition also near the education section of our site. We're not the first people to use this regression framework. It's most notably in McKinsey's Valuation Handbook, right? One of the most popular books around valuation. Bennett Stewart used it in Quest for Value. Michael Mobison, really what they call the EVA maven, the first guy to do this on Wall Street. He wrote about this first in 1996 in an article titled Plus Ça Change, Plus Ça Paraît, French for the more things change, the more they stay the same. He also wrote about it more recently in ROIC Patterns and Shareholder Returns, right? And so our regression analysis is not just on the peer group, it's on the S&P 500, and there, there's a 59% Explanation by return on invested capital of enterprise value to invested capital. Now enterprise value invested capital effectively shows how much value the market places on the capital put into the business. We find this very intuitive. It only makes sense that the market will award the most value per capital invested in it in the market To the companies that generate the most cash flow or value per capital invested in them, right? If you got 2 companies, they both have $10 of capital and one generates a 50% return. So they've got $5 on $10 of capital and the other company generates a 20% return. So they got $20 on $10 of capital. Which one should be valued higher? Which one deserves more value? Which one at the end of the day will provide the cash flows to sustain its value better? Obviously the one that has a 50% return on capital. And just as I said in my webinar on how to navigate a dangerous market, if you want to see more webinars, just check out our YouTube channel or the education section of our site. What I said is at the end of the day, all you got in a bad market when there's blood in the streets, all you got is cash flows. It's the only life raft on a sinking ship. It's the only way to be safe. So measuring cash flow is really important. And as you all know, we focus on that very, very well. We make that our specialty. It's our goal in life to measure cash flow better than anybody in the world. And then we also have an additional regression analysis that shows return on invested capital explains 67% of the changes in evaluation for large-cap tech stocks. Right. We've done tons of these regressions over the years, but the key takeaway is that If management focuses on return on invested capital instead of growing earnings, they're going to go from a discount valuation, right? Because they're below the line, it's a discounted valuation. If they just go to the line or maintain a 23% return on invested capital right here, sustain current level of profitability, it's worth $42 as opposed to $36, or 16% gain or $25 billion increase in market value. These are other scenarios that if management follows our advice, similar to the way they would follow the advice of any consulting firm. Strategic consultants come in and they say, you should do X and Y. We're saying, that's a great thing, but if you can wrap that advice or link that advice directly to improvements in market value, well, then your value proposition is stronger. Specifically, we show we have targeted proposals that could result An improvement in return on capital from 24%, 26%, 27%. And here are the resulting impacts on the market value of the company based on this regression analysis. If they move return on capital this way and they get to trade on the line, that has a certain implied enterprise value invested capital, which implies a certain stock price. If you want to see our math behind that, go to the appendix, Appendix A. Click here for the original spreadsheets with all the calculations. Here they are for you to see. Click them, download them. You can see regression scenario details, right? These are, these are some of the details in the model. This is what you saw in Figure 1. This is later in the report, Figure 5, but a lot of this has been Well, it's in the appendix as well. SG&A sensitivity, right? You know, these are the gain of the current market value. If we change this from -4% to -5%, you'll see a change. All right, if we go -10%, it's a $39 billion increase over market value. Just, you know, for every 1 percentage point increase in SG&A, we can tell you exactly How much incremental market value that implies. We can do that for any element of the business. Importantly, that's a big part of the beauty of return on invested capital, right? And we show this here as well. At the end of the day, we care about free cash flow, right? And there's 3 ways to grow free cash flow: increase revenue growth, increase ROIC, or expand your growth appreciation period. We explain this all in our discounted cash flow model. This all goes back to first principles. The value of an asset is the present value of future cash flows. For a bond, that's easy. You get coupon payments, you got your risk or interest rates, and you have a maturity date. So you can easily model it out because you know exactly what your coupon payments are, you know how long you're going to get them, and you know what interest rates are. That's why bond prices are exact every day. Now, the same idea goes for stocks, except none of these cash flows are contractual, but they still exist implicitly. We just quantify them. Simple as that. We've got models. We've been doing this for years. We're the best in the business. That's why some of the top hedge funds and wealth managers in the world pay us as much as they do for access to our system. And when you look at the enterprise value of the business, you break it down into current operations value, non-operating assets, and the future operations value. This is a negative value. That's why you see Oracle trading below the trend line. And when you break down future operations value, that's free cash flow growth. And that's these 3 things: increase ROIC, extend the gap, and increase revenue growth. Increasing ROIC is the most important. If you can drive ROIC, then the market will believe you have a longer growth appreciation period. That's the number of years you can grow your profits. That's analogous to the maturity date of a bond. Or you can increase revenue growth. But increasing revenue growth only matters if you increase— if your returns are above the cost of capital. And really, you know, when you're breaking down increasing an ROIC, the cool thing is that you can break it down into as many discrete parts of the business as possible. First, you can look at the income statement or the NOPAT margin, right? The profit margin. You can look at operating costs, taxes. On the invested capital or the balance sheet side, you look at working capital, fixed assets, and break those down further. The point is we provide targeted proposals as to how exactly management can improve its return on invested capital, just like any consultant would. And the key takeaway is the regressions aren't the only thing that tell you that return on invested capital matters. They say that return on invested capital matters for that— this point in time. Well, if we look over time for Oracle, we can see since the tech bubble, when you plot enterprise value divided by invested capital against ROIC, look. I mean, it's like, it's like white on rice. I mean, it's a perfect, really very high correlation over time. Guess what is not correlated? Gap earnings. What's the deal here? As we said in the beginning of our thesis, Oracle should put less of an emphasis on growth through acquisitions or growing earnings per share and focus more on ROIC. Less of an emphasis on EPS and focus more on free cash flow and ROIC. Now, how do they make sure we get— they get credit in the marketplace? You know, and I'm getting a few questions here. How do we know the market's going to care? Well, the regression analysis shows you it does care. And I would submit that the intuitive nature, the fact that the more cash flow you make, the more market— the more market— the market will like you. There may be times when the market, again, is inefficient, but over the medium and long term— let me put it another way. Is it a bad thing if they make more cash flow as opposed to earnings? No. All right, whoever answers that next gets another free question and potentially a free month's worth of access to the system. But the key takeaway also is that if you want to ensure the market rewards the focus on ROIC, you got to do 4 things. Number one, leadership. It's got to start at the top. That's why this open letter is to Larry Ellison. If the boss doesn't back the plan, it's hard to believe that everyone else will, and you got to have everybody else. It's also going to be tied to capital budgeting. Every capital allocation decision needs to pass through the net present value test, which means whether or not ROIC is greater than the weighted average cost of capital, or expected cash flows are high enough to cover all costs. You got to be tied to compensation. If it's not what you get paid for, then what do you care? You can give lip service all you want. And you gotta communicate this. You gotta be able to go to sophisticated institutional investors and explain to them, hey, this is what we're doing, this is why. As I showed in Appendix C, we're, you know, you can go through all the elements of the business to explain how you were looking to lower costs, increase revenues, improve your competitive advantage period, all in the name of— Profit. Improving return on capital, improving cash flow, and therefore deserving of a premium valuation. So the targeted proposals, right, they have to be among these 3 kind of bylines: increase ROIC, extend the growth appreciation period, also known as the competitive advantage period, or increase revenue growth, right? And I start with increasing ROIC because this, by the way, is the most important. Right. And this analysis can also apply to each business line or division within a firm. And as we show in Appendix C, we recommend that management show investors how they can link the most discrete elements of the business back to free cash flow growth. The more specific, the better. Same is true with any consultants bringing a proposal to a company. Be as specific as you can about where these things happen because it just gives them more credibility. We basically go through, you know, look, we're outsiders. We're not consultants. We don't, you know, I don't pretend to be an expert Certainly not more of an expert than Mr. Ellison or Mr. Katz or Mr. Hurd are in their business, but these are going to give you some basic guidelines, right? You know, we've seen Oracle grow from— I'm sorry, SG&A grow from 21.2% to 23.5% of revenue. Get that down. All right, R&D spending is 14%, right, when peers are around 11%. Capital turnover has gone way down because you've been throwing a lot of capital in the business and not generating a commensurate amount of revenue. Right. Increasing revenue growth? Look, there's a million ways to do that. I don't pretend to be smart enough to make it that easy. I will say one potential great strategy for enhancing revenue growth— leverage a framework like the one we present in this proposal. When you go to your clients, you show them how the Oracle software and services can lower costs in SG&A, help them sell more into existing customers, tie that back to changes in return on capital and changes in free cash flow, and how that will improve the valuation of their business. And you can even then propose that you get paid based on getting a share of that incremental market cap. And I'll show later, if consultants were to have brought the same proposal we provide here, if they get just 1% of 1%, 1/100th of 1%, it's a pretty big payday even if you have the sustained current level of ROIC scenario. And just sustained current level of ROIC means All you gotta do is convince the market that return on invested capital is not gonna continue to decline. Extending your growth appreciation period. Look, you know, that's about communication first and foremost, 'cause you gotta convince the market of that. And the best way to convince the market that you're gonna have a long growth appreciation period, in my opinion, the best way to do that is to actually start increasing your return on invested capital and show you're focused on it and show that your money is where your mouth is and you're getting paid for that. If that's what you're focused on and you can convince the market that's the case because you're getting paid for it, well, you're much more likely to deserve a long competitive advantage period or growth appreciation period because it's clear that's what you focus on. And then quantifying the size of the prize, right? Each scenario here. In this scenario, bringing SG&A as a percent of revenue down from 23.5% to 21.5% increases the market value by $37 billion. As they go to $45.43 a share. As I mentioned before, in the model, for every 100 basis points of decrease in SG&A expenses, you get an additional $1.5 billion in market value. This is another way to look at it. Again, you can look at that in the model we provide. Oracle currently spends 15.1% on R&D in the last 12 months. They get down to closer to the peers at 12.6%. That's an additional— that's a $53 billion increase in market cap or $49 a share implied. If we assume that there's an improvement in Salesforce productivity and they can deliver an extra 5% to revenue while keeping the costs above and importantly not adding in invested capital, right? So this is more revenue without more capital. That means capital turns would improve from 0.81 to 0.85, or ROIC goes from 26% to 27%. And you combine that with all the cost savings, you get an implied price of $52 a share, or incremental $66 billion in market cap. Again, all these scenarios are detailed here in this model, so you can change them, play with them, Question my math, check my math, check my models, do as you wish. New Constructs is always super transparent. This is just another example of that. Now back to the gain share. If we take— if we as consultants were to take just 1/100th of 1%, it's a $2 million payday for helping management craft the message that convinces the market return on invested capital is not going to go down. It's going to stay the same. $3.7 million payday if we get it to go from— get the ROIC from 23% to 24%. If we go from 24% to 26%, $5.3 million. And if we get to 27%, $6.6 million. That's just 1/100th of 1% of the market value increase. That's a pretty good deal. Now, when we look at the feasibility of this, We think this is a no-brainer for Oracle. They have a really high return on invested capital business in the past. Look at this chart. Right? Oracle is among the top here for returns on invested capital over time. Not a lot here in terms of invested capital versus peers, right? And the great thing about this analysis is it's showing you where Oracle stands versus peers in terms of return on capital, the drivers of return on capital, Which include invested capital turnover, NOPAT margins. Look, right? Oracle's among the top. They're the best at running the business, but all these acquisitions have increased capital too much. That's the key takeaway here. That's why earnings per share can look good even though returns on capital don't look good, because earnings per share overlook the balance sheet too much. Revenue growth, all kind of a mixed bag, really. When we look at kind of how Oracle stands up against its peers, It's got the best margin of the group, right? Its capital returns are not so great. It's the second-best return on capital. So why does it trade at a discount to the overall group? The answer to that is that the market thinks that returns on capital are going to continue to decline. The company's been a serial acquirer for several years. It deployed a lot of capital to buy up a lot of smaller companies to build scale. But this acquisition-heavy strategy is not working. There's not— we don't think there's many companies around anymore that they can actually buy anyway and move the needle. History shows that takeovers destroy more value for larger acquiring companies in general. The company's current executive compensation structure continues to incentivize acquisitions. Bonuses are tied to revenue growth and cash provided by operating activities, which does not take into account the cost of building out or cost of acquisitions. So Oracle should put less of an emphasis on growth through acquisition and focus on ROIC. It might not be the most exciting strategy. I think it's exciting. Cramer might not think it's exciting. Investors will think it's exciting, and that's what matters. And figures 4 and 5 show that that focus is It's well worthwhile. Let's not forget what Google did last summer. $65 billion day. They didn't change their business operations that much. They changed the way they communicated what their business did. They changed the way they explained to the marketplace how each of those different business lines were accountable for the capital given them. There was accountability there. That's the key. It was a communication issue. It was a reorientation issue. The way Google had already run its business, but when they explained to the marketplace that they cared about return on capital, they cared about accountability by business line, it worked. We think it can work for Oracle too. All right, a couple questions before we're done here. Why isn't the market focused— what about price-to-earnings, price-to-sales, and price-to-book? That's a great question. In our article, The ROIC: The Paradigm for Linking Corporate Performance to Valuation, We show exactly why price-to-earnings and enterprise value to EBITDA don't work. And go to this article and you can see the issues with accounting book value, return on equity. If you go to general market comments, you'll see a lot of these articles in place. Why Cheryl? Why? There's a lot of good stuff here as well. Problem with using accounting book value, ROE. Why PE ratios are not a good measure of value. You know, the regression analysis on the PE side just doesn't work. It's that easy, right? The key takeaway is we've got a lot of resources here for you to understand why we do this. And this white paper on the paradigm for linking corporate performance to valuation really speaks to all of that. And really, you know, NuContra is bringing a paradigm shift here. We're bringing scale to calculating ROIC. Just like we wrote about in If ROIC Is So Great, Why Doesn't Everybody Use It? You know, it's because it's difficult to do. And we've used— we've leveraged technology and a lot of expertise. To apply return on invested capital with scale. Return on invested capital models with scale. That's what we mean. One more question. Would a company with a low ROIC benefit in the same way as Oracle? Yeah. Anytime you're moving your return on invested capital out this direction, It's a win for investors. If you honestly, and before you even do it, as long as you communicate and can convince the market and sophisticated investors, as long as you can convince them that's what you really focus on, then they're going to reward you for it immediately. I mean, they're going to want, you know, that's what they're going to want to hear. And the markets are forward-looking. So, if they believe it's going to happen, they'll reward you for it even before it happens. Now, if you mislead them and don't actually do it, they'll crush you. But if you meet the expectations of the stock price, you're just fine. All right, thanks very much for your time today. Remember, if you ever have any questions or you want more information, feel free to give us a call or email us, and we'd be happy to share more with you about how new constructs Brings transparency to the marketplace and helps provide a better link between corporate performance and valuation.