Earlier this month, Oracle made a series of product announcements of some significance.
These announcements at the least allow Oracle to compete for new database workloads that had increasingly been migrating to both Microsoft and Amazon solutions.
The company also finally entered the emerging market for both Blockchain and for Container based development.
The company’s valuation is predicated on a continuation of low growth trends and reflects negligible operating margin expansion.
I think the advent of product announcements at Oracle OpenWorld will be a catalyst that will change the company’s organic growth trajectory which is not yet an expectation embedded in the share price.
Oracle’s Broadside in the database wars!
Last week, Oracle (ORCL) held its annual customer event, OpenWorld. Most of the time, OpenWorld passes quietly and offers little in the way of news for those hoping to gain an insight into Oracle’s next chapter. Last year’s OpenWorld featured company founder and CTO Larry Ellison throwing down a challenge to the company’s competitors in the data base world. Nowadays, Oracle’s most threatening competitors in the database space include Amazon (AMZN) and Microsoft (MSFT) that offer web-based solutions that are far cheaper than the products that Oracle has sold for many years. This year, Oracle formally announced what it calls its 18c database. I would rarely choose to write an article commenting on just another database from Oracle. It is after all what it does. I think, however, that this product is both innovative and has the potential to change the market dynamics for the company in a visible fashion.
I believe that fixing Oracle’s database problem is one of the keys to unlock both higher growth for this company, and concomitantly, for multiple expansion. One can argue about whether or not the new technology and other announced Oracle innovations are really market leading or represent catch-up. My own opinions on that subject are totally unimportant. I have linked here to a skeptical but still generally supportive article written on the subject. But these new product offerings are most likely to staunch market share losses that have plagued the company’s financial results for several years.
Oracle has been losing market share for years now to both Amazon and particularly Microsoft in the database space (Oracle actually claimed that this is not the case, and without specific data, it is impossible for observers to validate the point. It claimed during its financial analyst presentation that its database revenues have grown at 5% year, faster than the market growth of 4%. Oracle management, in addition to promoting elastic databases, often promotes an elastic version of the truth and I imagine that is the case at this point).
The loss of market share has been one reason for the company’s lack of meaningful growth over the past several years. It seems possible at the least that the company’s days of donating share in the database market are ending. That alone is significant news in considering Oracle as an investment. If Oracle is to return to growth status, at least in the mid-high single digits, then one prerequisite will be to achieve rapid growth in IaaS. This is the company’s shot to accomplish that goal.
In considering Oracle shares, its success in database is of paramount importance. It is and is likely to remain the business that generates most of Oracle’s profitability and operating cash flow through renewals of maintenance contracts. And for some years, it is a business segment that has not apparently grown for the company – I take the company’s claim of 5% revenue growth as a bit of polite fiction (Oracle used to report database revenues and the metric was closely followed). It ceased providing this glimpse into its business segment over time as first it re-labeled database revenues as part of a technology category so that it could include more rapidly growing middleware sales. Eventually, as the growth of the cloud became the subject of investor interest, the split between technology and apps was dropped in favor of today’s financial reporting that focuses on growth of different web business segments. The components of Oracle’s business on which this article is focused are called PaaS and IaaS which had revenues last quarter of $400 million, up 27% in constant currency. Last quarter, this category was only 4% of total revenue but it is already 16% of product revenues and I believe the new product will change these percentages meaningfully in a few quarters starting by the end of the current fiscal year.
Oracle announced what it describes as the world’s first autonomous database cloud. It is a product release and this is Oracle and so hyperbole is to be expected. Specifics of the new product include an extraordinary level of availability (99.995% which is less than 30 minutes/year). While the guarantee is real enough, users have to be in an all-Oracle environment that includes database options to afford themselves of the guarantee.
The technology is based on adaptive performance tuning which is based on machine learning. In turn, this technology can be used to enhance security while applications continue to run. Further, the product is described as self-scaling which essentially means that it allows for resizing of compute and storage. This in turn is said to consume less storage than competitors and will also allow for a significant degree of automation by taking over functions typically assigned to data base administrators.
The announcements also include some specific products such as what is described as an Autonomous Data Warehouse Cloud which is basically a data management platform. The data warehouse solution set brings user benefits including simplicity, performance and elasticity in building out data warehouses.
In addition to the database announcements, Oracle has also announced what is called a Container Native Application Development platform and it has also announced the company’s Blockchain Cloud Service. It seems likely that these announcements will have a positive impact on the growth of Oracle’s Platform as a Service (PaaS) offering which has shown relatively modest growth when compared to the other elements of Oracle’s cloud revenues.
The area of this announcement focused on by many observers has been pricing. Oracle’s Larry Ellison has made a claim that the company would guarantee as part of an enterprise contract that its new database service would cost less than half the price of running the same workloads on the Amazon data warehousing offering, Redshift, or on other AWS workloads. One thing to note is that the pricing Oracle announced, while probably valid in terms of the database itself, does not include the cost of what are known of as database options. These include multitenancy, Oracle RACs (real application clusters) and what is called Active Data Guard. Users have to buy all three of these options in order to get the up-time guarantee – the price performance and the actual seat cost of the new offerings are not quite as remarkable as the raw numbers might suggest.
Amazon responded that some of the Oracle claims were “wild claims and lots of bluster.” I am not going to attempt to evaluate all of what Mr. Ellison had to say. He has been notorious for many years for his unsubstantiated claims. This particular thrust against Amazon, and by extension against Microsoft as well, almost certainly included unsubstantiated and inaccurate claims. That really is not the point.
As an investor, I am not all that much concerned about Oracle’s specific product performance claims or about whether or not Amazon has “elastic” data warehouses or about the reliability of its database. This is just part of a marketing strategy that Oracle has used many times over the years with greater of lesser success. In fact, I doubt that AWS users care about Oracle’s claims.
What should be of interest to investors is that Oracle, coming from a position of not really having answers to potential database customers considering switching to database offerings from both Amazon and Microsoft, is at least positioned with a competitive offering in the database space. It may or may not be radically better. It may be catch-up. But from the point of view of expectations and modeling future growth, it is significantly better than what came before, and that is the key point
The issue of maintenance vs. cloud revenue growth
One of the principle investment risks that has bedeviled some analysts and even some investors who have followed Oracle for a long time relates to the company’s reliance on maintenance revenue. Last quarter, software maintenance revenues were 54% of the total having grown 1% in constant currency year over year. But more important to the financial model is that the company had a margin of no less than 95% on those revenues and that metric actually climbed marginally. Overall, maintenance revenues represented 166% of operating income in the quarter. In the prior year, maintenance operating profit was 171% of total operating income. Maintenance operating profits actually rose by 4% year on year.
Most of the maintenance revenue that serves as the base for the Oracle financial model comes from database customers. We do not know precisely how much of maintenance revenue is from database, but based on historical data from the time that Oracle did report revenues from database and applications, the ratio is probably something in excess of 70%. It may indeed be higher than that based on the longevity of the applications that run on Oracle on-prem databases. Management continues to maintain that maintenance revenue will continue its slow growth despite the headwinds that are blowing from user migration to the cloud and now a cloud-only database that certainly offers significantly superior price/performance when compared to older offerings in the product space. I have found over the years that Oracle’s management typically will fulfill these kinds of claims regardless of how dubious I might be as to how this kind of result might evolve.
One of the issues for investors is whether Oracle will be able to grow EPS by double digits. There are several levers to make that happen as I discuss below. A key lever, if not the key lever, I believe is whether maintenance revenues can continue to grow at some level. Some growth in maintenance revenues is more or less a minimum requirement for Oracle’s long-term financial model.
Looking at Oracle’s Growth Levers
Oracle has a couple of potential growth levers beyond improving its performance in the IaaS/PaaS spaces that are likely to be of significance going forward. The largest single opportunity for Oracle is cloud migration. At this point, new license software licenses have fallen to a relatively modest $966 million/quarter. Last quarter that result represented a revenue decline of about a 7% constant currency rate. Even at this point, the relatively modest organic growth rate of SaaS revenues which reached only 18% last quarter is starting to overcome the drag from the loss of on-prem revenues (I have adjusted for the NetSuite (NYSE:N) revenues in calculating organic growth. That is a very modest number to be sure and one which suggests substantial room for improvement
Oracle at its analyst day talked about the opportunity it described in cloud migration. Is the opportunity some significant multiple of the current run rate of revenues in applications? Can it be pulled off without sacrificing maintenance revenues?
A well-known brokerage recently conducted a cloud ERP survey. I am not sure as to the validity of user surveys that are frequently undertaken in the IT space. They are better than guessing. On the other hand, they are often very flawed because of the sample size or the self-selecting nature of the sample or because of the questions that are asked. But this recent survey spoke to the opportunities that Oracle has in cloud ERP. The survey suggested that 45% of respondents thought that Oracle had the “best” financial management software on the market.
Somehow, so far, surveys such as this have not translated directly into revenue dollars for Oracle which suggest some significant upside potential to revenue growth. While not often talked about, simply looking at numbers, Oracle is not achieving the kind of sales results in SaaS that might be expected based on this and other surveys as well as its broad range of SaaS products.
I believe that the opportunities that Oracle has to develop more business in the cloud-based ERP space actually are conjoined with its new data base offering. Over the years, ERP has become a very neglected stepchild of both the analyst community and of investors. Some analysts nowadays, as those in the report linked here, and the authors have included an extraordinarily expansive definition of ERP which was never intended. Most of the attention has been given to the many other newer and “sexier” part of the applications market such as CRM, HCM and most recently optimization technologies that are more horizontal in their appeal.
But users still have to manage their inventories, control and collect their receivables, optimize the level of their payables and plan their production and do all of the other basic processes that are involved with running enterprises. It is not the most exciting market to consider and it is a market in which there are countervailing trends between the decline of on-premise sales and the growth of the cloud. Oracle has been evaluated as the leader in this space for many, many years and that was still the case when the latest edition of the Gartner Magic Quadrant report that was published at the end of June. It is said to beat out Workday (WDAY) significantly, although Workday’s growth in ERP is several times that of Oracle. It is considered by Gartner to be far ahead of Microsoft Dynamics, although again, certainly not in terms of percentage revenue growth.
This latest report continues to rate SAP (NYSE:SAP) as a niche player, slightly behind the rating for a vendor called Epicor. That alone gives pause to any reader I think. In this case, the issue that Gartner has flubbed is in what it is evaluating. SAP very successfully sells S/4HANA Cloud which is designed to compete against Oracle for large ERP customers. Evaluating SAP’s Business ByDesign and comparing it against the products that Oracle sells is really like trying to compare a VW Jetta with a Cadillac Escalade.
But regardless of that, Oracle does have a top-rated product in the space. It should be achieving better sales results than has been the case. Oracle is focused on capturing a disproportionate share of users who are migrating ERP to the cloud. It has the product strength to secure that result. Now, with its new database, which might often be sold in conjunction with a cloud ERP decision, it has another tool with which to achieve a significant advantage in the market.
Putting it all together and trying to value the sum of the parts
Most investors buying Oracle these days are doing so for reasons other than consensus recommendations or consensus estimates. Over the next 12 months, the consensus growth estimates for this company are all of 4%, and so far as that goes, the growth rate is shown as declining, some going through fiscal 2019. The company currently has a market capitalization of $206 billion. It has a net cash balance of about $14 billion, leaving an enterprise value of $192 billion. The published First Call consensus revenue forecast for the next 12 months is just a little bit greater than $40 billion, so that yields an EV/S of about 4.75X. Oracle has always been expensive on an EV/S basis because of its high profitability. That said, it is no great bargain at current level…unless, as I believe the case, the assumption of 4% growth proves to be too conservative and the company can achieve growth of between 7% and 9% by the middle of next year based on a faster cadence of growth in the SaaS and IaaS and PaaS business segments.
Oracle has been a highly profitable company for many years. As mentioned, much of that is a function of the very profitable maintenance revenue that the company has generated. But as Oracle management has forecast, over time, cloud revenues are likely to achieve operating margins of at least 80%. Last quarter cloud operating margins were just 61%. Oracle spends a relatively high 17% of revenue on research and development and a relatively low 22% of revenues on sales and marketing on a GAAP basis. I do not suppose these metrics will change much as long as the company founder and control shareholder remains CTO. But the fact is that the spend metrics are of an unusual balance for a company of this scale and at some point should be expected to lead to greater sales productivity and to an improving competitive position.
On a GAAP basis, last quarter was a rare instance in which Oracle’s operating margins did not improve year on year. The consensus EPS estimates as appear on First Call essentially calling for negligible margin improvement for the fiscal year as a whole. Overall, current EPS estimates are for $2.94, up just 7% from the prior year while revenue growth by the same consensus measures is forecast to be 5%.
I think it is highly likely that Oracle will achieve some meaningful margin improvement from cloud revenues. The company is also likely to see some further expansion of services margins which are just 18%. I find it surprising, indeed, that the current consensus forecasts call for such muted margin improvement.
The 12-month forward P/E for Oracle is likely thought to be around 16X. Again, that is not a great bargain if indeed top line growth for the company is but 4% with limited improvement in margins. I think that the scenario that would produce such results is far gloomier than the outlook that has qualitatively been portrayed by Oracle management and hopefully in this article. Were I to be creating a model, I would use more optimistic assumptions than those that seem to animate most brokerage house models.
Oracle for years has generated a substantial level of cash flow, and as more of its business shifts to the cloud, cash flow generation will probably show an accelerating growth trend. Cash flow generation, in fact, has been one of the main supports of Oracle’s valuation. Overall, last quarter, about 27% of the company’s CFFO came from increases in deferred revenue. Last quarter, the company’s trailing 4 quarter CFFO was flat year on year at $12.6 billion. That is a free cash flow yield of 6.5%. That yield is consistent with a view of Oracle as a slow growth enterprise with nothing very exceptional on the horizon. If Oracle does seize the opportunity of its many potentials and succeeds in accelerating its growth while improving margins, then such a yield is a huge bargain.
Oracle as an investment is something that will not be for everyone. Many investors simply do not want to deal with mega-cap names that inherently will never achieve hyper-growth status. And many investors, such as this writer, are not enamored with the company’s penchant for hype and bluster. It further needs saying that just as Oracle’s maintenance revenue is the foundation for its financial performance, it is also a boat anchor. That part of Oracle’s revenue base will certainly not grow by much more than low single digits.
But putting it all together, I think that the advent of Oracle’s set of new product introductions is at least enough to restart the company’s growth engine in a visible fashion. For mega-caps, moving the revenue growth needle from 4% to 7%-9% counts as a huge win. And mega cap investors crave the consistency of margin gains that Oracle should be poised to achieve.
Oracle shares do pay a dividend, and the dividend has been rising. I suspect the dividend increase trend to continue. That doesn’t make Oracle a great yield name with a yield of 1.56%. But it is certainly possible that the company will accelerate capital returns both through accelerated share buybacks and dividend hikes as free cash flow starts to increase.
Oracle as a company will continue to attract a fair amount of attention from its flamboyant CEO. And the company’s culture has its less than desirable facets. It is probably not the most pleasant place to work. Sometimes its claims are so grossly exaggerated as to invoke opprobrium. But it has significantly improved its competitive positioning by its string of announcements. I think it will be able to build another leg onto its recent share price performance.