Oracle (NYSE:ORCL) is a legacy technology company that was founded way back in 1977. The company was known for its databases and the iconic programming language Java, which it acquired from Sun Microsystems in 2009. Since then Oracle has continued to innovate its business model and now has a huge opportunity to become a major player in the “hybrid cloud”. The cloud industry was valued at $545.8 billion in 2022 and is forecast to grow at a rapid 17.9% compounded annual growth rate reaching over $1.2 trillion by 2027. In this post, I’m going to break down Oracle’s business model, financials, and valuation, let’s dive in.
Evolving Business Model
Oracle has its business segmented into three main categories; Oracle Cloud Infrastructure, Cloud Applications, and its Hardware/legacy software. I will now break each segment down in turn.
Many large organizations are going through a “digital transformation” as they aim to migrate their onsite IT to the cloud. The “cloud” is basically just someone else’s data center (in this case Oracle) and offers organizations flexible computing options, with no management overhead. The three largest cloud providers are AWS, Microsoft (MSFT) Azure, and Google (GOOGL) (GOOG) cloud. However, Oracle has found a niche offering in cloud databases as a service and has a 2% market share of the overall market. Helping companies comply with data residency regulations is a key use case Oracle is poised to provide a solution for, as the company has 9 national security cloud regions globally. For example, the CEO of social media giant TikTok announced at a New York Times event that it will be using an Oracle cloud database to store U.S citizen data. This is a major deal as the company was criticized for potentially sending U.S. data to China. This partnership will involve Oracle engineers performing data reviews at “transparency centers”.
Oracle’s cloud service also looks to be better suited for those organizations operating with a hybrid cloud model. According to Oracle, the company offers the same billing model for on-premises as it does for the cloud, but AWS does not. Oracle also offers great solutions for Artificial Intelligence [AI] and machine learning models. This is a hot topic as enterprises aim to aggregate their “siloed” data and create AI models on top. Open AI recently released a free consumer AI model, called ChatGPT which went viral for its solutions helping everyday people. I believe we are now at a tipping point where AI will become part of our everyday life. The industry is forecast to grow at a 20.1% CAGR and be worth over $1.394 trillion by 2029.
Oracle Cloud Applications, include a variety of solutions from enterprise resource planning [ERP] software to supply chain management and even customer experience solutions. Oracle was classed as a “visionary” by Gartner in 2022, for both its cloud infrastructure and applications.
Hardware and Software
This is Oracle’s legacy segment which includes its on-premises applications and hardware such as servers and storage. In addition, to the legacy software solutions such as Java, MySQL databases etc.
Oracle reported strong financial results for the second quarter of fiscal year 2023. Revenue was $12.275 billion, which increased by a solid 18% year over year and was $200 million higher than management guidance. International revenue was impacted by a foreign exchange rate headwind, driven by a strong U.S dollar. Therefore on a constant currency basis, its revenue actually increased by a rapid 25% year over year. This growth rate is great for a “mature” company and is more aligned with a “growth” technology business. Approximately 1% of revenue was impacted by an exit from Russia.
$1.5 billion of Oracle’s revenue was driven by the huge $28 billion acquisition of Cerner, a digital healthcare service provider. Excluding this acquisition, revenue growth was 9% year over year organically. Cerner is aiming to “modernize” electronic health records [EHR] and provide a better patient experience, which is a huge market opportunity. Its database already is running on Oracle, and the acquisition is expected to accelerate the integration of new user experience. This will involve Oracle’s “hands-free” digital voice assistant which will enable medical professionals to interact easier with databases. I believe this will act as a great showcase for Oracle’s latest technology which could be used as case studies to spur business customer sales.
Breaking revenue down by segment, Cloud services, and license support drove the majority (70% of revenue), or $8.598 billion. This metric increased by 14% or a solid 20% year over year on a constant currency basis. This was driven by Oracle’s “2nd generation” cloud infrastructure platform. Its cloud services revenue increased by an outstanding 59% on a constant currency basis, with annualized revenue of $3.8 billion, excluding legacy hosting. Its autonomous database products also were widely popular and increased revenue by 50% year over year. Oracle’s MySQL HeatWave database is critically acclaimed. Traditional MySQL databases can be slow to run complex analytical queries and often need a separate database solution purely for reporting. However, Oracle’s “HeatWave” database reportedly “melts” the competition, such as Snowflake (SNOW). It does this by offering a single database for storage and real-time analytics. In addition, Machine learning and AI applications can be easily run inside a single database without the need for a separate solution. According to database industry analysts (cited by Oracle), its HeatWave is approximate “7 times faster” than Snowflake or Amazon Redshift. But even more amazingly this is at “2 to 5 times lower cost”.
Oracle also reported Application subscription revenue of $4.1 billion, which increased by 35% on a constant currency basis. If we include support, but exclude Cerner, this metric was $3.3 billion, up 9% on an FX-neutral basis.
Its “strategic back office” SaaS applications, also continued to grow strong and reported annualized revenue of $5.9 billion, up 26% on a constant currency basis. Its Fusion Enterprise Resource Planning [ERP] solution increased by 28% year over year. Its NetSuite ERP, increased by 29% year over year. According to Gartner reviews, SAP and IFS lead the ERP software industry with 4.4 stars out of 5. However, Oracle’s fusion cloud ERP is not far behind with 4.3 stars out of 5, in its customer reviews.
Oracles Hardware products continued to grow steadily with $850 million in revenue reported, up 11% year over year or 16% on a constant currency basis. This is a positive sign as one would assume Oracle’s cloud business would effectively “cannibalize” its legacy hardware. However, I believe the trend toward hybrid cloud is keeping this part of the business steady.
Profitability and Expenses
Oracle has a super high gross margin of 79% for its cloud services and license support business. Oracle also reported an improvement in its infrastructure as a service [IaaS] gross margin, as the business benefits from greater data center capacity. The company reported a vast improvement in operating income which increased from negative $824 million last year, to positive $3.071 billion in the respective quarter this year. This was mainly due to acquisition-related costs of ~$4.67 billion reported in the equivalent quarter last year. However, Oracle has reported a minor operating leverage improvement on its Sales and Marketing [S&M] spend. In Q2, FY23, S&M spending was $2.2 billion, or 18% of revenue, which was a 1% improvement over the same quarter last year. Research and Development expenses were $2.158 billion, which made up 18% of revenue, up 1% year over year. Overall I don’t deem this to be a bad sign, as technology companies must continually improve and innovate in order to stay ahead.
Moving forward Oracle is forecasting its CapEx spend will be approximately $2.4 billion per quarter, over the next few quarters, which is aligned with the current quarter. Oracle has 40 public cloud regions globally and another 9 currently under construction as it expands its cloud footprint. Management also expects organic growth on its cloud business to be over 30% on an FX-neutral basis for the fiscal year 2023, which is a strong positive.
Oracle has $7.4 billion in cash and short-term investments on its balance sheet. However, the company does have a humongous amount of total debt equating to over $90 billion. A positive is the majority of this ($81.2 billion) is long-term debt and thus manageable.
In order to value Oracle, I have plugged the latest financials into my discounted cash flow valuation model. I have forecasted 15% revenue growth for next year, which is based upon a slightly lower growth rate than the prior quarter, due to the macroeconomic environment. However, in years 2 to 5, I have forecast an improvement in growth rate to 20% per year. I forecast this to be driven by improvements in economic conditions and the increased adoption of the Oracles platform for data residency use cases.
To increase the accuracy of the valuation, I have capitalized R&D expenses which has lifted net income. In addition, I have forecasted a pre-tax operating margin of 35% over the next 8 years. I expect this to be driven by economies of scale improvements, as Oracle scales the number of data centers it has.
Given these factors, I get a fair value of $144.86 per share, the stock is trading at $80 per share at the time of writing and thus is 45% undervalued.
As an extra datapoint, Oracle trades at a price to sales ratio = 4.67, which is 7.88% cheaper than its 5 year average. For comparison, I have compared Oracle to a variety of cloud application and database providers. We can see Oracle trades at a low to mid-range valuation. For example, cloud database provider MongoDB (MDB) trades at a more expensive valuation, with a PS ratio =10.39.
Recession/Longer sales cycles
Many analysts are forecasting a recession in 2023, due to the high inflation and rising interest rate environment. Therefore I would expect longer sales cycles as companies delay large infrastructure spending and possible cloud migrations. In addition, Oracle’s high debt could be vulnerable to interest rate hikes, which is risk as that will likely result in higher debt servicing costs.
Oracle is a legacy technology company that has continued to innovate its business model successfully. Oracle is now gaining solid traction with its niche cloud database solutions and I believe the company has a strong opportunity in the data residency space. Its stock is undervalued intrinsically and relative to historic multiples and thus it could be a great long term investment.