Both IBM (IBM) and Oracle (ORCL) have attracted famous guru investors: Everybody knows about Warren Buffett's multibillion investment in IBM, however his former stock picker Lou Simpson, who is now running his own fund, prefers Oracle. On IBM's side we also find Ben Grahams former assistant, the value investor legend Irving Kahn and Prem Watsa, while Oracle has attracted Seth Klarman, Donald Yacktman and Steven Romick.
Both companies trade at about 12 times expected FCF/share for 2013 and have lagged in this year's rally, yet Oracle has done better in the last few months, advancing (at the time of writing) to a decent 9% gain YTD, while IBM is down 6% YTD.
The two are of course very different companies, but in at least some ways seem to be morphing into similar structures. While Oracle had always been a software and IBM a hardware company, over the past decade or so Oracle has moved, through the Sun acquisition, a bit into hardware and IBM quite a lot into software. Both companies offer IT consulting services, with IBM being clearly the leader in this field.
% of net sales | Oracle | IBM |
Software | 73.4% | 24.4% |
Hardware | 14.4% | 16.9% |
IT services | 11.8% | 56.3% |
Financing | 1.9% |
Both companies generate enormous free cash flows and have used it in a similar manner over the past 5 years:
Use of cash | Oracle | IBM |
Buybacks (average annual reduction of average dil. shares outstanding) | 1.4% | 4.4% |
DPS (CAGR) | 24.5% | 14.8% |
Total op. cash flow ($ billions) | 56 | 101 (excl. financing receivables) |
- increase | 14.6% | 4.6% |
Total free cash flow ($ billions) | 53.5 | 80.5 (excl. financing receivables) |
- increase | 15.2% | 6.2% |
Dividends (total $ billions spent) | 5.2 | 16 |
- as a % of total OCF | 9.3% | 15.8% |
Buybacks (total $ billions spent) | 23 | 60 |
- as a % of total OCF | 41% | 59.4% |
Acquisitions (total $ billions spent) | 21 | 18.9 |
- as a % of total OCF | 37.5% | 18.7% |
FCF / share | 19.6% | 11.1% |
We can spot a few major differences here:
Oracle spends 41% of its operating cash flow on buybacks, yet shares outstanding shrink only very slowly. This is clearly because of heavy share issuance through stock options. IBM reduces its shares outstanding at a much faster rate.
Oracle has increased free cash flow and dividends far stronger than IBM over the past five years.
The question is: Will this outperformance continue? And: Are there other factors to take into account that make one or the other company a safer or better investment?
Looking at analysts forecasts, Oracle's capital expenditures should rise strongly over the next few years, reducing FCF growth significantly. Thus, while analysts project IBM to grow FCF/share by almost 40% from now to 2015, Oracle's FCF/share is projected to grow only 10% in the same timeframe.
This might be related to Oracle's expanding hardware business. Larry Ellison has clearly indicated that he wants to take a run at IBM's mainframe and Unix server businesses. This may seem surprising to all those who announce the "death of the mainframe" (again and again…), yet we have to consider that in spite of accounting for only about 4% of IBM's revenue these days, the mainframe is a vital asset to Big Blue - mainly because of all the business that is connected to it.
When all the mainframe-related software, services and storage are included, mainframe technology delivers about 25% of I.B.M.'s revenue and more than 40% of its profits, estimates A. M. Sacconaghi, an analyst at Sanford C. Bernstein. (Source )
As I have shown in another article, the main reason for IBM's reduced revenues over the past few years lies in reduced corporate investments and strategic divestitures by the company itself. Seeing Oracle's strong investment in the hardware sector, we can identify yet another sign for a bright future of mainframe computing. Probably Larry Ellison foresees higher capital expenditures into hardware and technology and wants to profit from it, taking a bite from IBM's traditional business.
But will he succeed?
This question is very hard to answer. In my opinion the fundamental difference between the two businesses is their approach to IT complexity and how it is conveyed, which in the end depends on the different strengths of their respective brands. Let me explain this further.
Oracle - Cloud
When you look for Oracle's cloud offer on the company website, you'll find the following page:
(click to enlarge)
There is not much text and Oracle's key message is "Now you can offload IT management and focus on growing your business." This is quite a promise and probably no reader will believe this is really possible. So what does Oracle try to achieve by stating it? It outlines its own philosophy in a very convincing way: Oracle wants to simplify IT complexity. If you are fed up with (or afraid of) always having system integrators and IT consultants around, give Oracle a try. That's the message.
If you scroll down, you will find a link to a whitepaper written by Oracle itself that confirms this message:
(click to enlarge)
This whitepaper however also reveals the rather basic nature of Oracle's cloud offering.
IBM - Cloud
If you had looked on IBM's website, you would have found this page:
(click to enlarge)
Unlike Oracle, IBM explicitly talks about "managing" increasing IT complexity. Not about "offloading" IT management, but about enhancing its performance. Not about getting rid of IT to focus on the real business, but about considering IT as a part of the business and a chance to grow it. The key words here are "simplify", "enhance performance", "predictive analytics" and "cost savings".
Below the bullet points IBM links to a 15 page long EMA whitepaper that analyzes the marketplace for private cloud technologies from a customer perspective and includes the following graph:
(click to enlarge)
This independent report confirms the key message: IBM delivers more value than anyone. It might be complex to get there, but you can trust IBM's consultants.
Oracle - Supply chain management
Now let's move to a spot where Oracle, having a long history as a database solutions provider, should look better. This is the page promoting Oracle's inventory optimization tools:
(click to enlarge)
Wow - that's a lot of text. Probably you did not read it all, and the same applies almost certainly to many visitors of Oracle's website. It not only looks complex, it also sounds so. Overall it seems like the description on the back of a business software box you could find in almost any computer shop. Hence, quite surprisingly after the first example, Oracle's message is not consistently one of complexity reduction. Or maybe yes, but only in the sense that customers buy a complex "out of the box" solution that in some way will do the job for them. (As the final paragraph seems to imply.)
IBM - Supply chain management
On the contrary, IBM shows a rather short and structured text:
(click to enlarge)
The key message is again the same: cost savings through smart complexity management. There is even a precise percentage indication. From a marketing point of view, the clear winner here is IBM. Its message is consistent, clear and easy to understand.
Conclusions
1) My own experience in the software sector has taught me that new products often start with the ambition to reduce the complexity of the existing (aka competing) ones. However, as these products mature, they get complex themselves, breaking the initial promise. If we read the two examples above through this lens, it becomes clear why Oracle, being a suitor in the cloud competition, bases its marketing on the reduction of complexity and why IBM, being one of the leaders, must convey a different message. What is most interesting, though, is how IBM transforms its necessity into virtue, incorporating the complexity issue into the marketing message and morphing it into the promise of competitive advantages.
The same does not apply to Oracle, when it comes to a field that should be its forte like supply chain management. Dealing with its more mature product, Oracle itself falls victim to its complexity, at least as far as the marketing message is concerned.
I know how difficult it is to convey through simple words a succinct impression of how a software application does its job. It is really tough. But here comes brand power into play. While Oracle needs to convince customers of its application's capabilities (with sentences like "You can also define different service levels at various levels as every product, sales channel, and customer does not need to have the same service level."), IBM can focus on what it adds to the process. This is basically only because of brand power. Nobody doubts about IBM's capabilities (although one might be right to do so!), thus the focus shifts to the added value - which is also far easier to convey. A company with a stronger brand often can successfully sell even less valuable products at a higher price.
2) Besides all relevant financial metrics, which certainly deserve to be analyzed accurately on their own, the philosophical differences outlined in the second part of this article should make it easier for you, as a potential investor, to decide between the two: Oracle thinks the market wants a Business Suite which is perfectly integrated out of the box, even if it does not fit 100% into a specific business environment. IBM thinks the market should profit from complexity, consider custom integration as an opportunity and delivers, partly through the sheer power of its brand, the promise of perfect adaptation to continuously evolving needs.
If you believe that a business promising a strong reduction of IT complexity will win the game, you should choose Oracle. On the contrary, if you think that businesses will need to think about IT complexity not as something to just get rid of, but as a chance to achieve competitive advantages, IBM should be your favorite.
In the real world, there will be obviously a place for both of them. And both stocks are currently good value, especially when compared to the broad market average.
3) Will Oracle outperform IBM in the years to come? And how certain is this? In my opinion, there are a few good arguments for the contrary:
a) Software makes up most of Oracle's revenues and only a smaller part of IBM's. As both companies have been growing strongly their software business in the past few years, Oracle has obviously harvested more net income on a relative basis. However, software is becoming a more important part of IBM's portfolio and a less important part or Oracle's.
b) On the other hand, hardware and all businesses flowing from it for IBM, will provide a strong boost to Big Blue once corporate capital expenditures pick up again - and probably a much stronger boost to IBM's income compared to Oracle's.
c) IBM, thanks to its strong brand and deep roots in global IT infrastructures, is certainly the safer choice. If Oracle manages to gain share in the hardware sector, it might surprise on the upside much more than IBM, but, as Ellison has a history of overpromising, you'd have to watch his business more closely. All in all, it is no surprise that Buffett, having a huge amount of capital to invest (it took him several months to buy the stake), chose the more reliable company, while other value investors that can close their positions far more quickly, preferred Oracle.
(This article wouldn't have been possible without a very thoughtful discussion initiated by Seeking Alpha user fatbaboon and the many ideas he contributed to it. Thank you!)
Disclosure: I am long IBM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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