Oracle Earnings Preview- Near-term uncertainty as cloud transition impacts growth

Oracle Corporation (ORCL) is set to release its Q3 (Feb) results, which will provide insights into the company's performance and growth potential. Investors are keen to analyze various indicators, including EPS, revenue, and operating margin, to evaluate ORCL's investment value. However, recent quarters have seen ORCL facing challenges due to the transition of its Cerner unit to the cloud, impacting growth rates and revenue recognition.

Oracle has a track record of reporting EPS upside and beating expectations in the past five quarters. However, the previous quarter saw a marginal EPS beat and a revenue miss, which disappointed market expectations. The shift from license purchases to cloud subscriptions has resulted in near-term headwinds for Cerner's growth rates, as cloud subscriptions are recognized ratably. Despite the challenges, Oracle's non-GAAP operating margin has been growing, driven by expansion in cloud data centers and improved profitability in the cloud segment.

Street expectations are for the company to report non-GAAP EPS is $1.38, while non-GAAP revenue consensus is $13.29 billion. It is important to note that ORCL typically provides EPS and revenue guidance for the next quarter on the call.

Oracle has reported EPS upside in each of its past five quarters, but the Q2 EPS upside was quite small. More concerning was the revenue miss, which was barely below expectations. Over the past two quarters, Oracle shares have gapped lower following earnings. The stock has been generally trading sideways since mid-June 2023, unable to generate a sustainable move to the upside.

Recent quarters have been affected by Oracle's transition of the Cerner unit to the cloud. This process has resulted in near-term headwinds to Cerner's growth rates as customers move from license purchases to cloud subscriptions. Management has emphasized the huge and unprecedented growth in Cloud Infrastructure demand, and Oracle is in the process of expanding 66 existing cloud data centers and building 100 new ones. The only limiting factor is the ability to get data centers handed over and filled up quickly.

In Q2, including Cerner, non-GAAP operating margin grew to 43% from 41% a year ago and 41% in Q1. As Oracle continues to benefit from economies of scale in the cloud and drives Cerner profitability to Oracle standards, it expects to expand operating margin.

Investors should expect near-term uncertainty at ORCL in F"3Q, as quarterly reseller surveys indicate mixed results with marginally improving trends. While investor expectations are relatively muted, OCI momentum may not be sufficient to hit the steep ramp implied in the 2H/Q4.

Oracle management acknowledges the increasing demand for Cloud Infrastructure and is expanding its existing data centers while constructing new facilities. However, the pace of transitioning customers to the cloud remains a limiting factor in revenue recognition. Oracle estimated a significant revenue potential in Q2 alone if capacity had been available. This highlights the significance of resolving capacity issues to fully capitalize on Cloud Infrastructure demand.

Investors remain cautious near-term given capacity issues (sovereign cloud vs. GPU/GenAI) and weaker profitability in GenAI limiting EPS growth. There are terminal value questions with OCI growth largely lower quality IaaS revenue, with the profitable database business yet to modernize. 

Investors are also cautious around the steep QoQ ramp for Cloud and capex following a slow start in 1H. Analysts expect 3Q OCI to decelerate further (~49%y/y cc) as the ramp in revenue (AI + sovereign cloud) may remain sluggish. SaaS should sustain mid-teens growth, but upside remains capped on weaker HCM outlook across peers, resulting in total cloud ex-CERN of ~26%y/y cc which would be at the lower end of guidance. License should recover as it laps easier comps, but there are still expected headwinds from Cerner integration. Total revenue should be relatively in line despite ~50 bps of incremental FX headwinds.

Citigroup noted that it"s reseller survey points to mixed results compared to the previous quarter, although a marginal improvement is observed. The momentum of Oracle Cloud Infrastructure (OCI) may not inflect sufficiently to meet the steep ramp implied in the second half of the year. Concerns about capacity issues, weaker profitability in the GenAI segment, and the need for modernization in the profitable database business also influence analysts' perspectives.

Key Performance Indicators and Expectations: 

- Total Cloud Revenue (ex-Cerner): Guidance is for 26-28% growth y-o-y, analyst expectations of 26%.

- laaS (OCI + Cloud@Cust.) consensus is for 49% growth y-o-y.

- SaaS (Fusion, NetSuite, Cerner) Consensus is for 15% growth y-o-y.

- Cloud Services & License Support: Consensus is for 12% growth y-o-y.

- Cloud License & On-prem License: Consensus is for (6%) growth y-o-y.

- Total Revenue (non-GAAP): Guidance is for 6-8% growth y-o-y. Typically, Oracle comes in 7 bps above street expectations for total revenue. 

- Organic growth guidance is for 8-10%.

- Gross Profit: Consensus Guidance is for flat margins of 72.9%.

- EPS (non-GAAP): Guidance is for 11-14% growth y-o-y, which is below analyst expectations of 13%. Typically, Oracle comes in 29 bps above street expectations for EPS.

Oracle Corporation faces near-term uncertainty as it navigates the cloud transition and its impact on growth rates and revenue recognition. While Oracle has been improving its non-GAAP operating margin through the expansion of cloud data centers, challenges surrounding capacity issues persist. Investor caution is warranted due to recent stock performance trends and the variability of EPS upside quarter-to-quarter. Analysts highlight concerns about cloud growth, weaker profitability in GenAI, and the need for modernization in the database business. As Oracle reports its Q3 results, market participants will be closely monitoring the company's performance and guidance for insights into its investment potential.