We recently hosted our quarterly client conference call. You can read a full transcript here. Below is an excerpt from the call discussing our investment in Oracle (ORCL).

Excerpt (Sean Stannard-Stockton speaking):

Oracle went public back in 1986, the day before Microsoft went public. During the quarter century leading up to 2012, these two companies generated very similar total returns for investors of approximately 6000%, making them both major blue chip companies.

But since 2012, Microsoft has almost tripled again (much better than the market overall) while Oracle has generated a total return of 40% or about half of the appreciation of the S&P 500 during that time.

We believe that rather than facing a permanently weaker future, Oracle is simply a couple of years behind Microsoft on fully transitioning to the reality of cloud computing and we believe that the market is only just starting to appreciate the degree to which this successful transition should lead to a much higher stock price for Oracle.

But before we delve into this transition, some background on Oracle. The company was founded by Larry Ellison. While Ellison is notorious in some circles, he is also unequivocally one of the great geniuses of the technology industry. While his best friend Steve Jobs owned less than 1% of Apple at his death, today Larry Ellison owns 27% of Oracle, ranking him as the largest individual holder of a company with a market capitalization of over $100 billion. Only Warren Buffett’s 18% ownership of Berkshire Hathaway and Jeff Bezos’s 16% stake in Amazon comes close. As an aside, many of the companies in our portfolio are managed by owners with large personal stakes in the business. L Brands’ Les Wexner for instance, owns 16% of the company.

The Oracle offering is complicated and the breadth of what they do is beyond the scope of this call. But at its heart, Oracle offers two platforms, a database that acts as the infrastructure for a myriad of critical corporate software applications, and a software suite known as Enterprise Resource Planning that allows companies to manage their business across planning, purchasing, inventory, sales, marketing, finance and human resources. For global companies coordinating employees, resources and activities around the world, ERP software is a must.
100% of the Fortune 500 use some of Oracle’s offerings, and their database, which powers not only Oracle’s ERP software, but much of the software offered by their direct ERP competitor SAP, is THE market leader. Their software is so important to other companies that it is one of the few technology implementation projects that is enough of a needle mover to be discussed on quarterly earnings conference calls.

The cost of switching ERP systems is massive, creating huge “switching costs”, an important competitive advantage that makes Oracle’s customer relationships very sticky. It isn’t just the cost of paying for new software, to switch ERP systems a company needs to spend vast resources retraining employees, rebuilding internal processes and changing how they work, while still operating their business. Remember, this software is used across entire organizations to coordinate activity in most business groups. Implementing a new ERP system takes years to complete and the cost is high enough that companies often measure their ROI on time periods of a decade or more.

But like all industries, the huge profits that Oracle earns have drawn competition. Remember, Oracle went public in 1986, but it was founded 40 years ago in 1977. Technology changes fast and over the past 15 years one of the most important changes to impact Oracle has been the shift from on-premise computing to cloud computing. Both Workday and Salesforce are cloud-based technology companies founded by ex-Oracle employees who have sought to use a modern cloud-based operating structure to compete against Oracle’s historically on-premise technology structure.

But Oracle hasn’t been sitting still. And those huge switching costs have afforded them strong competitive protection while they spent years rebuilding their software from the ground up to become a cloud first technology business and preparing themselves to eliminate the relatively short-term technology advantage that cloud-based competitors have had against them.

So let’s pause and go back to my earlier comparison to Microsoft. After seeing its share price go nowhere for a decade between 2002 and 2012, Microsoft got religion on transforming their software into a cloud first offering and the stock spent the next five years in a continuous rally that has led the stock to almost triple.

Beginning a year ago, Oracle’s cloud-based sales began to accelerate quickly. And on their earnings call in December, with their technology transformation to a cloud first business complete, their co-CEO Mark Hurd announced that they had actually stopped compensating their salespeople in their applications business for selling on-premise software.

We’ve seen with Microsoft, as well as other software businesses, that companies that successfully make the transition to the cloud are often well rewarded by investors. We believe that as this transition takes hold, the headwinds to revenue growth that have plagued the company in recent years will abate and profit margins will move materially higher, a pattern that is common to companies transitioning to cloud-based business models. The results from their most recent quarter announced in March support this thesis and we think the company and the stock have a bright future.

You can read the full transcript here.

Clients of Ensemble Capital own shares of L Brands (LB), and Oracle (ORCL).

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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