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Will Oracle hold its island and march higher? (Part II)

AInvestFriday, Mar 15, 2024 11:34 am ET
8min read

The Importance of Cloud and OCI 

Oracle's $ORCL(ORCL)Cloud and OCI Gen 2 infrastructure business showcased a significant outperformance in the quarter, achieving a 52% growth rate, which management anticipates will continue in a hypergrowth phase for the foreseeable future. This growth surpassed expectations by nearly 5%, a notable achievement given the performance of other cloud companies recently. Oracle's guidance for Q4 suggests a growth rate of 22-24%, indicating a potential deceleration but less severe than what investors might have feared. The robust quarter's performance, particularly in OCI with a 63% consumption rate, reinforces the narrative that Oracle's future is closely tied to its cloud offerings, especially the success of OCI Gen 2.

In Q3, Oracle saw a 13% year-over-year growth in infrastructure recurring revenue in constant currency, with OCI's consumption revenue surging by 63%. This period also marked a 49% growth in infrastructure cloud services revenue, or 52% excluding legacy hosting services, with cloud database services revenue increasing by 34% to an approximate $1.9bn annual run-rate. However, growth in Oracle's Fusion Cloud ERP and NetSuite Cloud ERP has decelerated slightly, though NetSuite's growth remains relatively stable. This trend may reflect broader market conditions affecting customer spending rather than being a challenge unique to Oracle, as similar patterns of deceleration have been observed among other major ERP software providers.

Oracle's Gen2 AI infrastructure is currently being used by major corporations such as Nvidia, McDonald's, Walmart, and Uber, with the company expanding its cloud data centers to keep up with the overwhelming demand. After integrating Cerner into its Gen2 Cloud infrastructure, Oracle is set to launch a new Ambulatory Clinic Cloud Application Suite, promising to modernize healthcare systems significantly.

The importance of Cloud services and Oracle Cloud Infrastructure (OCI) for Oracle is multifaceted, playing a critical role in the company's growth strategy, competitive positioning, and future prospects.

The shift towards cloud computing is a fundamental transformation in the IT industry. For Oracle, a leader in database and enterprise software, embracing cloud computing through services like OCI is essential for growth and maintaining relevance in a rapidly evolving market. Cloud services offer scalable, flexible, and cost-efficient computing resources to businesses, aligning with the growing demand for digital transformation.

Cloud services represent a shift from traditional upfront software license sales to a subscription-based model, offering recurring revenue streams. This model provides Oracle with more predictable revenue, improved cash flows, and the potential for higher lifetime customer value compared to one-time license sales.

OCI and Oracle's cloud applications (SaaS) allow the company to compete more effectively with cloud giants like Amazon Web Services (AWS), Microsoft Azure, and Google Cloud. By offering a comprehensive suite of cloud services, including IaaS, PaaS (Platform as a Service), and SaaS, Oracle aims to attract a wide range of customers, from small businesses to large enterprises.

OCI provides advanced cloud capabilities, including artificial intelligence (AI), machine learning, high-performance computing, and cutting-edge database technologies like Autonomous Database. These innovations are vital for Oracle to support its customers' most demanding workloads and to drive the adoption of new technologies.

By offering a robust and competitive cloud platform, Oracle can retain its existing customer base, encouraging them to migrate from on-premises solutions to Oracle's cloud. This migration helps deepen customer relationships and opens up opportunities for selling additional cloud services. ORCL spoke in-depth about the success it was having with customers migrations from Cerner to the new OCI platform.

Cloud infrastructure enables Oracle to expand its global footprint more efficiently. OCI's growing network of data centers around the world ensures that Oracle can meet local data residency requirements and provide low-latency services to customers globally.

OCI and Oracle's cloud services play a crucial role in building a vibrant ecosystem of developers, partners, and third-party software vendors. This ecosystem enriches Oracle's cloud offerings and makes OCI a more attractive platform for a wide range of applications and services.

Capex and Margins

Oracle's capital expenditure (CAPEX) in Q3 was slightly less than anticipated at $1.6 billion, compared to $1 billion in Q2, with management indicating a true quarterly figure of $2.1 billion due to timing discrepancies. This did raise some red flags as investors were concerned about the lower spend which may point to a delay in orders.

Despite this, Oracle is aiming for a significant increase in CAPEX for Q4 and projects a substantial $10 billion in CAPEX for FY25. Capex is likely to fall short for FY2s original $8 billion forecast, likely landing between $7.0 and $7.5 billion for the full year. However, investors have looked past this and are encouraged by the $10 billion outlook for next year. The investment reflects Oracle's focus on expanding its data center capacity, especially for larger facilities capable of supporting AI servers, which is expected to enhance overall gross margins as cloud regions become more utilized.

With an operating margin of 44% in the quarter, 2 percentage points higher than in the same period last year, Oracle is committed to further improving margins, demonstrating the company's strategic investment in infrastructure to meet the surging demand for its cloud services.

A Deeper Dive into RPOs

Oracle's Remaining Performance Obligations (RPO) demonstrated a robust growth, with a total RPO balance exceeding $80 billion, marking a 29% increase in constant currency (excluding Cerner). This significant growth in RPO, with approximately 43% expected to be recognized as revenue within the next 12 months, underscores the solid financial foundation Oracle has built as it transitions more deeply into cloud services. Management's emphasis on the hypergrowth phase of the Gen2 Cloud Infrastructure business, which saw a 53% increase in Q3, further highlights the strength and potential of Oracle's cloud offerings. However, it's important to recognize that Oracle's RPO, being a leading indicator of future revenue, only accounts for contracted usage and does not include many government contracts or usage above contracted minimums at enterprise customers, indicating a conservative yet promising outlook.

Despite the optimism surrounding Oracle's RPO figures, there appears to be a limited correlation between RPO growth and subsequent revenue growth. Over the past seven quarters, Oracle's organic RPO and cRPO growth rates have varied from low-double-digits to the high-20s, which contrasts with the company's sub-10% and decelerating total revenue growth. This discrepancy suggests that while RPO is a valuable metric for assessing future revenue potential, especially in the context of a company in cloud transition, the direct impact on near-term revenue growth may not be as strong as initially anticipated. Factors such as business line contributions to backlog, shifts in revenue mix from license to subscription models, and the transition from on-prem hardware to cloud subscriptions could influence the flow-through of backlog to revenue, complicating the relationship between RPO growth and immediate financial outcomes.

Oracle's projection that 43% of its RPO will translate to revenue over the next year, suggesting approximately $34-35 billion or around 15% year-over-year growth in cRPO, reflects a significant demand for large contracts, particularly for the advantages offered by OCI. The forthcoming joint announcements with NVIDIA, a major OCI customer, underscore the strategic importance of such partnerships and Oracle's cloud capabilities. This collaboration not only highlights OCI's appeal to leading tech companies but also positions Oracle advantageously amid a competitive landscape where rivals are developing technologies that could challenge NVIDIA's products. This strategic alignment with NVIDIA not only showcases OCI's strengths but also hints at Oracle's potential to capitalize on its cloud infrastructure's unique offerings in a rapidly evolving tech ecosystem.

The Cerner Drag

This quarter, Cerner negatively impacted Oracle's revenue growth, contributing to a growth rate of 7% including Cerner and 9% excluding it. Despite management's assurances that this trend will cease after this year, the effectiveness of their strategy remains to be seen. Cerner's performance has lagged behind Oracle's broader business due to the shift from a license-based to a subscription-based model, and spending freezes at the Department of Veterans Affairs have further exacerbated this issue. However, there is optimism that these challenges may diminish over the year and that the impact of the business model transition will lessen in the medium term.

Thoughts on the Outlook

CEO Safra Catz has outlined Oracle's financial outlook for Q4 of FY24 and provided insights into FY24 and FY25, affirming the company's dedication to its long-term objectives for FY26, which may even be considered conservative by current standards. The forecast suggests minimal impact from foreign exchange rates, projecting a total revenue growth of 4%-6% for Q4, including Cerner, and 6%-8% excluding Cerner. Cloud revenue, excluding Cerner, is anticipated to increase by 22%-24% as Oracle ramps up capacity, particularly highlighting a surge in GPU growth. Despite a challenging comparison due to last year's lower tax rate of 9.2%, non-GAAP EPS is expected to range from -2% to 0%, with a non-GAAP tax rate assumed at 19%. The company expects an acceleration in revenue growth rates into FY25 as supply constraints ease, with Cerner predicted to return to growth next year.

However, Oracle's guidance for Q4 revenue growth at approximately 5% year-over-year falls short of the consensus expectations of about 6.5%. This guidance, coupled with comments on revenue trajectory, may lead to a revision of Q1 revenue estimates downward, marking a continued discrepancy in the conversion of current RPO to revenue. This ongoing gap between revenue growth and cRPO growth underscores forecasting challenges within Oracle's model compared to the more direct relationship seen in the broader software industry between backlog growth, CapEx spending, deferred revenue growth, and future revenue. The difficulty may stem from contract variability and data center expansion limitations, raising questions about the future alignment of bookings growth with investor expectations.

Valuation

P/E (adjusted): This is the price to earnings ratio, adjusted for certain factors, starting at 22.3x in 2023 and showing a declining trend each year to 16.6x by 2026. The average P/E ratio over these years is 19.5x, indicating a general decrease in valuation relative to earnings over time.

EV/Sales: The enterprise value to sales ratio starts at 8.0x in 2023 and decreases steadily each year to 6.4x by 2026. The average EV/Sales ratio is 7.2x. This shows that the company's valuation in relation to its sales is also decreasing.

EV/EBITDA (adjusted): The enterprise value to EBITDA ratio, similarly adjusted, begins at 17.1x in 2023 and decreases each year to 12.6x by 2026, with an average of 14.7x. This suggests that the company's valuation in terms of its earnings before interest, taxes, depreciation, and amortization is on a downward trend.

Other metrics like equity free cash flow yield, dividend yield, net debt/EBITDA, and total debt/capital also show slight fluctuations over the years.

These metrics collectively suggest that Oracle is expected to become less expensive in terms of these valuation multiples over the period from 2023 to 2026, which might indicate a forecast of increased earnings or a decrease in the companys market valuation.The bottom line, if ORCL can grow into its RPO, then it is not terribly expensive at these levels.

Technicals

Daily Chart:

On Oracle's daily chart, the critical level to watch is the island low at $124.60; a break below this could raise concerns among investors. Following its recent earnings announcement, Oracle experienced a significant uptrend, moving away from the previously consolidated range of $110-115, which resulted in the convergence of its 20-, 50-, and 200-day moving averages—a bullish indicator. Additionally, the Relative Strength Index (RSI) is robust at 68, indicating strong momentum without venturing into the overbought territory, suggesting that there is still room for upward movement without immediate reversal pressures.

Monthly Chart:

Oracle's monthly chart presents an attractive outlook for long-term investors, featuring a promising flag pattern that has been forming since November 2022. The recent upward movement following last week's earnings announcement suggests a potential breakout, signaling a positive trend for the stock. Additionally, the risk for investors is well-defined, with the $100 psychological level serving as a strong support area that Oracle has consistently maintained, offering a clear delineation of risk for those looking to capitalize on Oracle's long-term growth potential.

Conclusion

Oracle's recent quarter showcased notable achievements with a significant beat in cloud performance and margin improvement, setting an optimistic tone for the upcoming quarter, FY25, and reaffirming goals for FY26.

The company is positioned for strong growth into Q4 and FY25, driven by the stability in Strategic Back Office growth, increased OCI capacity to meet the soaring demand, and robust demand for AI technologies, albeit with conservative expectations. The potential for database growth and contributions from Cerner beginning in FY25 underpin bullish investor sentiment.

Oracle's resilient revenue stream, characterized by its sticky, recurring nature and lower viability risk, positions it favorably. This is supported by a mix shift towards faster-growing business segments, a substantial portion of renewable revenue adding resilience, and continued operating expense discipline.

Despite the significant CapEx investments for cloud infrastructure expansion potentially impacting free cash flow in the short term, these are viewed as necessary trade-offs for future revenue growth. While there are potential downside risks from weaker than expected OCI demand and competitive pressures on its core database license business, Oracle's strategic investments and focus on cloud infrastructure are designed to navigate these challenges and capitalize on the growing demand for cloud services. Oracle's transition to the cloud, coupled with strategic investments to expand capacity and meet customer needs, underscores its evolution and potential for sustained growth despite some operational growing pains.

Oracle's daily chart highlights a critical support level at the island low of $124.60, with a break below this point potentially causing investor concern. The stock has shown a significant uptrend after its recent earnings, moving beyond the $110-115 consolidation range and showing a convergence of its 20-, 50-, and 200-day moving averages, indicating bullish momentum. The Relative Strength Index (RSI) stands strong at 68, suggesting the stock has momentum for further gains without being overbought. On the monthly chart, Oracle exhibits a promising flag pattern since November 2022, with the post-earnings movement hinting at a potential breakout and the $100 mark providing a well-defined risk level, making it an appealing prospect for long-term investors.

Considering Oracle's robust project backlog, favorable technical configuration, and reasonable valuation metrics, we perceive ORCL to be an attractive investment prospect. Nevertheless, investors should monitor certain elements with diligence. The sustainability of the recent price 'island' and the effectiveness of the conversion of Remaining Performance Obligations (RPO) into actual revenue are pivotal to this assessment. Moreover, the company's broader strategic shift warrants attention, as it constitutes a significant variable that could impact the validity of our positive outlook.


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