The Oracle of Delphi and its ambiguous Voices.
Oracle (NYSE:ORCL) is one of the oldest software companies in continuous operation. I didn't know until recently that it was an outgrowth of a CIA-funded project that one of its founders, Larry Ellison, had worked on in the mid-1970s. I had always thought that the name had come from the Greek Oracle at Delphi who would give answers to questions posed by Kings, Princes, heroes and beautiful women in a way that was difficult to decipher. Like many people of a certain age, I was obliged to study Greek Civilization and Literature in order to graduate college. And now, half a century later, I follow a company that would have given the priestesses who manned the shrine a good run for their money when it comes to making up more or less ambiguous commentary that needs to be carefully parsed in order to understand its true meaning.
But Oracle the corporation, as opposed to Oracle the shrine, has outdone the priestesses of classical antiquity. Taking a leaf from its long-ago parentage, the company has often embarked on disinformation campaigns that would do the CIA proud. The apple, as the saying goes, doesn't fall far from the tree. (No pun intended). A couple of weeks ago, I wrote a series of articles about the cloud offerings of the major competitors in the space. The theme was that this was a once in a lifetime or at least generation trend with clear winners Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT). There is a clear potential loser as well and that would be Oracle.
The database, the cloud and some other inconvenient facts of life.
Oracle remains a database company. After many years of extending and tweaking the company's product offerings, and becoming the No. 2 software company in the world, the company's financial health is still a function of its success in remaining the de facto standard as king of the database world. Indeed, the maintenance revenue that Oracle derives from its installed database software is by far the largest profit contributor to the company. It is far more interesting and of comfort to shareholders to talk about cloud bookings and how strong they are, but doing so is more or less the same as throwing sand in the eyes of shareholders.
Why might I say something so harsh? Simple really, Oracle derives 52% of its revenues from maintenance. Those revenues have operating margins of 94%. The cloud accounts for 8% of revenues and has gross margins (gross not operating) of 48%. I really do think that at scale, cloud gross margins will be higher than today, but still lower than the operating margins reaped by "selling" maintenance contracts. To the extent that Oracle is replacing a revenue stream with 94% margins with one that has margins of 75% - hopefully. Needless to say, that is not the best of trades.
For some years until quite recently, Oracle liked to brag about its prowess in the database marketplace. After all, the company was proud that it had essentially knocked off IBM's DB2 product that it had over time destroyed its independent competitors such as Informix and Sybase and most recently had more or less - perhaps less, repelled the assault on its primacy in the database market that had been launched by Microsoft starting in 2005. There are very few if any of the Fortune 500 who do not have some Oracle database installed somewhere in their organization.
So what has the cloud to do with the stream of maintenance revenues?
Oracle today is thought by Gartner to have a market share of 34% in the database world although IDC says it has a 46% share. That is not all that surprising when the next largest competitor is IBM that has been a share donor in that area for much of my adult life. I think that IDC tracks dollars rather than seats and thus, it probably has the most reliable statistics. IBM is said by IDC to have a 24% share and Microsoft, whose products are far less expensive per seat, has a 7% share. That being said, Microsoft is the clear leader in the Windows DB market with a 38% share, actually now surpassing Oracle.
Oracle started to sell its own apps about 10 years after it started to sell RDB. The effort has been, from the vantage point of 20-plus years on, moderately successful. It has made tons of in the applications space, some good, some bad and most very accretive to earnings. On the other hand, it really was never quite able to threaten the primacy of SAP (NYSE:SAP) in the space. At the end of the day, it turned out that lots of Oracle's large application deals had a very heavy consulting content and for some years there were thoughts that consulting revenues, which are far less profitable than software revenues, would become very significant in the mix. Search as one might, you will not even see the caption of consulting revenues on any current Oracle earnings presentation. I suspect that consulting revenues are now bundled in with all of the other services revenues that Oracle reports - but I can't know. But as Oracle calls the caption "software license updates and product support" I will take the company at its word. I imagine most, but certainly not all of the 52% of revenues coming from updates and support, actually comes from the stream of database maintenance revenues. These revenues account for more than all of Oracle's operating profits. (Maintenance revenues do not have sales and marketing costs, they are for the most part, automatically renewed, they do not have R&D costs and they have minimal G&A costs). Without the golden stream of maintenance revenues, there's no stable, highly profitable and usually predictable Oracle.
Into that very comfortable world, at least for Oracle, have come three very loud explosions that threaten that golden stream with some measure of evisceration. One of these trends is called Open Source. This is not the place to discuss open source in any detail but the fact is that workloads that used to go, almost without thinking, to proprietary databases such as Oracle, are now considered to be suitable for migration to open source. Another important trend of note is the migration to what is called NoSQL. As the name implies, NoSQL solutions are not relational databases. One finds them mainly used by vendors of high-end data warehouse and analytic solutions. Do not think that these two trends aren't threats to Oracle. Open source is already up to 25% of database usage for which users paid the grand sum of $562 million. If someone wanted to put a stake in Oracle, it would come most certainly by the company having to charge that kind of price to maintain its installed base in the database market.
Of course, the trend that is the highest visibility and which concerns most investors is the migration of standard workloads to the cloud. Why should that be a problem for Oracle?
Until now, the company did not face real challenges in its installed base. Applications had long lives and the databases that they ran on were considered part of the furniture. Renewals came automatically and since maintenance revenues are based on the total number of seats installed, the golden stream of revenues grew every year. License sales could and did miss regularly or they were above expectations but underneath it all was the constant coursing of the golden stream.
For the first time in a generation, that stream may be under threat. I think it is beyond dispute that standard workloads are migrating to the cloud. I have commented in other articles why that is so but it is happening and will continue to happen at an accelerated pace. When users migrate standard workloads to the cloud they have a choice they must make regarding which database is to be used to support their shiny new cloud-based application. Most of these users are, just because of Oracle's market leadership, already Oracle customers. And many of the migrating users will continue to remain Oracle customers. Oracle claims from every rooftop it can find that migrating to the cloud with an Oracle database is the easiest process and that Oracle users are drinking the Kool-Aid.
But users have two new and very strategic alternatives to choose from besides Oracle. For the first time that I can ever remember, Oracle is no longer considered by the most widely respected industry analysis company, Gartner, as having the leading database solution. That position now goes to Microsoft. Gartner says that MSFT has a "cloud first" strategy that has placed it ahead of competitors in their Magic Quadrant.
And then there is AWS nipping at Oracle's heels in the MQ rankings. What Amazon sells is a bit more complicated to be sure but it has offerings that allow users to keep Oracle in those use cases that seems appropriate on a platform managed by Amazon RDS. But users can also elect to go with Amazon's own DB which it calls Aurora. On the other hand, those users who want NoSQL offerings will pick DynamoDB as the key value based management platform when migrating workloads to AWS.
One serious challenge that Oracle faces is flexibility. Most users perceive that Oracle's pricing is draconian and its audits… well lots of users have been known to cheat here and there in order to achieve their budgets and lots of sales people aid and abet those kinds of things. In addition to the pricing, the inflexible "Ts&Cs" there is the subject of vendor lock-in. Oracle has loads of other things they want to sell users and if users choose the Oracle cloud and then want an in-memory database, their choice is Oracle Exadata and nothing else. No rewards for guessing what that means to the prices paid by users.
I don't want to represent that all of Oracle's maintenance stream is going away tomorrow or next year or even in the next five years. But it is going to fall and fall significantly over that time frame. Yes, it is being replaced by cloud services and the cost of a seat in the cloud is greater than the cost of an Oracle maintenance renewal - mostly. (That being said, when Oracle determines that a deal is strategic, Oracle's pricing is scarcely to be believed.)
What is hard to ignore is that over the next five years, most of Oracle's remaining on-prem software license revenues will disappear and that there will be significant degradation in the golden stream of Oracle support revenues. I have seen it written on this site that Oracle is a high-quality company with well assured cash flows and a flawless balance sheet. All of that has certainly been true in the past. But the new threats that Oracle faces and particularly the threat to the financial basis for Oracle's metrics are now under attack as ever before.
Oracle lovers contend that the company is through the worst part of its cloud transition and, to the extent that transition simply meant replacing on-prem license revenues with cloud services revenues, I would agree at least to the extent that there is really some decent light at the end of the transition tunnel. But I think that the threat lies elsewhere and has really not been appreciated by many observers and investors to this point.
I make no claim to call Oracle's Q4 which will end on May 31. The company will enjoy some tailwinds from currency changes to this point. The IT spending environment is benign and after the turmoil of the last several quarters, Oracle's guidance may have been conservative. Stay tuned. But don't look to an Oracle earnings conference call to hear that it is becoming challenging to maintain support levels and the course for that revenue stream over the next few years is down. It will happen soon enough and put paid to some of the rosy sentiment that has leaked back into the valuation of the company's shares.
Some Closing Thoughts:
Investors may not realize the extent to which Oracle relies on maintenance revenues for both its top line and more important its very high level of operating margins. By one calculation, Oracle's support operating margins constitute more than 100% of the company's operating profit.
The cloud revolution is going to mean different things to different vendors. In the case of Oracle, one serious issue is going to be that its users will have to revisit their choice of database when they move historic workloads to the cloud.
Oracle today faces two competitors that have technology that is equal to or superior to what the company offers on its own proprietary databases. Oracle also has a commanding market share in the installed base of database seats. It is hard to escape the conclusion that these competitors, Microsoft and Amazon, will not poach a significant component of the Oracle DB market share, especially given their advantages in both pricing and in the flexibility of their contracts as well as their position as either having superior technology or equivalent technology in the Gartner ratings.
This company has had a long and basically well deserved reputation as enjoying a secure and highly profitable business model. As the support of that business model comes under attack, it is difficult not to conclude that the company's stability and profitability will start to erode in time. The risks at Oracle are far greater, I believe than many of its owners and other stakeholders really appreciate at this point.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.