Oracle's Bets in Telecom Are Underappreciated

We believe  Oracle's (ORCL) recent acquisitions of Acme Packet and Tekelec are largely underappreciated, and the company's investments in vertically focused applications provide opportunities for revenue growth while reinforcing the wide-moat database business and narrow-moat applications businesses. Our favorable assessment of Oracle's acquisition strategy is critical to our wide Morningstar Economic Moat Rating and our optimistic view of management's capital allocation.

Oracle is one of the widest-moat enterprise software firms we cover. We continue to have a fundamentally positive long-term view of the shares and see approximately 20% upside from the current share price to our $38 fair value estimate. Our view is supported by the firm's global advantages, prudent acquisition strategy, solid free cash flow generation, midteens returns on invested capital, and well-established dividend policy.

Evolution of Oracle's M&A Strategy, $45 Billion Later
We believe Oracle's buy-versus-build approach has generally been prudent, and the company has smartly acquired assets that protect its wide economic moat. Oracle has spent approximately $45 billion over the past decade on more than 85 acquisitions, allocating capital to generate revenue growth, enter new markets, and defend its turf. The enterprise software market has continued to evolve, as new applications, new architectures, and cloud computing have increased the complexity for vendors and their customers' IT environments. As customer requirements change, Oracle cannot successfully build every product, so acquisitions often fill in holes.

We see three key initiatives in Oracle's acquisition strategy: acquiring key horizontally focused applications with lucrative maintenance streams to lessen risk of integration, attaching key middleware and analytics technologies as platforms for the core database business, and deepening penetration into key industries purchasing vertically focused software companies. Not all acquisitions fall into these three categories (most notably, the Sun deal in 2010), but we believe this evolution provides important context for current and potential Oracle investors.

With respect to horizontally focused deals, the acquisitions of PeopleSoft (2005) and Siebel Systems (2006) provided Oracle with core enterprise resource planning and customer relationship management customers that the company continues to support. Admittedly, the investment community is more enthusiastic about cloud application offerings, as lofty valuations for Salesforce.com (CRM) and Workday (WDAY) demonstrate, but we believe Oracle would be weaker today had it not completed these two acquisitions nearly a decade ago. Furthermore, management has recognized the company has lagged in delivering cloud applications and responded by acquiring Taleo and RightNow.

In terms of protecting Oracle's wide moat, the key purchases of BEA Systems (2008) and Hyperion (2007) are the most notable. Acquisitions of this ilk have changed the software landscape, in our view, because this middleware provides key services and supports business analytics that are integrated into a company's workflow. Often, these processes are difficult to replace, reinforcing customer switching costs. The integration into Oracle's database products increases these switching costs even more. Technology and sales integration have allowed Oracle to become the largest provider of applications servers, in our opinion. This software giant has also snapped up companies complementary to its core database business, including technologies supporting in-memory and open-source databases.

Meaningful Opportunity in Communications Sector
In our view, fiscal 2013 marks Oracle's most significant acquisition activity in the communications sector. Although the company counts 11 deals in the media and communications sector over the past seven years, Acme Packet and Tekelec are easily the largest, totaling a combined $3 billion. These two additions strengthen Oracle's position in this sector in two ways: by broadening the firm's industry-specific product portfolio and positioning the company to capture the blending of mobile operators' IT and networking environments.

Before these acquisitions, Oracle generated nearly $1 billion in revenue selling databases, middleware, service delivery platforms, CRM and related business support systems, and operational support systems products to service providers. This $47 billion market is highly fragmented, with major players also bundling in hardware and professional services. By contrast, the bulk of Oracle's revenue generated from the service provider segment is license and maintenance fees.

Generally, most service providers have segmented their investments along two categories: IT investments, such as billing or other customer-facing systems that help generate and support revenue, and network investments that help manage and control costs while ensuring the network is up and available. On the network side of the business, Oracle has been largely shut out, for both business reasons and technology reasons.

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However, as operators roll out 4G networks, we anticipate several trends to provide opportunities for Oracle, particularly with new assets from Tekelec and Acme Packet. We expect the convergence of IT environments and networks to become a necessity, as carriers need to control network quality at the device level while supporting a wider variety of business models. Service providers need their networks to become more flexible, and we expect some hardware functions to become more reliant on software functionality, much in the way that network functions virtualization is being explored in the data center world. As the integration between the network and IT systems (for example, billing and customer care) becomes a necessity, we believe Oracle is well positioned. As a software-dominated company, Oracle will not have to cannibalize any significant telecom hardware business to benefit from potential technology shifts.

Evolving business models in the face of upgraded network deployments hold significant technology challenges, in our view, and the potential requirements of integration are significant. Service providers are taking a much more holistic view regarding their goals for customer experience and their desire to create networks that support high performance, personalization, and third-party services. For mobile operators that are focused on optimizing customer experience management, new deployments are integrating solutions across the BSS and OSS landscape.

As operators look to increase integration between IT and network assets, Tekelec and Acme Packet contribute three key assets to Oracle: policy management, signaling products, and subscriber data management. Of the three functions, Tekelec's leading policy management solutions have been the first to become more heavily integrated into the IT side of the house. While policy management and enforcement have previously protected access to the network according to predefined business rules, service providers are now using policy managers to define new business relationships. For example, a carrier may want to prioritize traffic for a premium-priced offering, such as streaming a live event or a subscription to a sports video package. Other BSS companies, like Amdocs (DOX), have also acquired their way into the policy management market. We expect policy management to disappear as a stand-alone product as operators push new business models. In particular, the variety of applications accessed and volume of bits are exploding. Just within real-time entertainment traffic, there could be dozens of separate business models that a policy engine would need to enforce. Oracle's Tekelec is the largest policy management vendor, according to our data, and the industry is growing. According to Stratecast, policy management is a $2.7 billion industry today that should grow to nearly $4 billion in 2017, an 8% compound annual growth rate.

The proliferation of applications and devices will also create a tsunami of signaling traffic, which, if not managed properly, can ultimately bring down a network. This signaling traffic in 4G networks is projected to grow at a 170% CAGR through 2016, according to Tekelec, an even faster rate than mobile data growth (101% CAGR). This messaging overhead is even more complex as subscribers and devices move across 4G, 3G, and 2G networks. Oracle is now the largest vendor of diameter-signaling products (resulting from products of Tekelec and Acme Packet), and because service providers require integration with legacy signaling products such as those sold by Tekelec, the firm is positioned well to deliver core functionality that bridges network and IT investments.

Shares Are Undervalued
We forecast average annual internal revenue growth in the mid- to high single digits during the next five years as Oracle gains share of enterprise IT spending in on-premise data centers, followed by a steady decline in growth through the latter half of the decade as subscription-based cloud solutions become a larger portion of the revenue mix. Operating margins should remain stable through this period, excluding the effects of recent acquisitions, as benefits from a larger proportion of high-margin software support revenue will be offset by higher selling and marketing expenses as the company faces competition from cloud-based software providers.

We believe the market is assuming that Oracle's core markets are being disrupted, contradicting our wide moat rating, and we view the shares as fundamentally undervalued. In our view, Oracle's M&A strategy has served to protect the company's wide moat while providing for potential upside to our growth forecast.