Oracle: Undervalued With Growing Cloud Sales Set To Drive Repricing

| About: Oracle Corporation (ORCL)

Summary

During FY17 SaaS, IaaS and PaaS sales should offset declining new software license sales.

Share repurchases should drive EPS growth.

Oracle is currently trading at a pessimistic valuation.

No company is immune from the impact of competition as we have seen play out with Oracle Corporation (NASDAQ:ORCL) over the past few fiscal years. The transition to the cloud has spawned multiple competitors to Oracle across the tech landscape and has slowed growth and depressed profitability. The decline in new software license sales has not been offset by growing cloud sales.

To be more specific, Oracle's users are switching from traditional on-premise computing to cloud computing (SaaS, PaaS, and IaaS) in an attempt to cut costs as traditional on-premise computing requires significant infrastructure and the maintenance of the infrastructure. In other words, companies are shifting some of the costs of application and data storage as well as compute costs to vendors such as Oracle.

While the shift is occurring from traditional on-premise software applications to cloud-based applications, companies are evaluating alternatives to traditional vendors such as Oracle. Some former Oracle users have switched to other vendors and consequently Oracle's revenues growth has stalled, but with the market transitioning to cloud computing, Oracle's total addressable market has expanded to include more mid-market enterprises and consequently has enabled Oracle to expand sales.

With that stated, FY17 is forecasted to be the year that sales of SaaS, PaaS and IaaS solutions more than offset declining new software licenses sales. Consequently, the growth in software revenues is expected to more than offset the declines of hardware and service revenues leading to sales growth of almost 2.5% in CC. However, margins are expected to continue to contract, albeit at a slower pace, but share repurchases should more than offset the decline in net income leading to EPS growth of just under 2%.

With cloud sales starting to offset declines in new software licenses and sales of hardware and services stabilizing, I expect shares of Oracle to rise about 33% over the next two fiscal years to $54.59, the base case valuation. The key risks to this forecast are steeper than expected declines in sales of new software licenses, hardware and/or services. Additionally, weaker than expected sales of SaaS, IaaS, and PaaS sales could lead me to revise my forecast downward.

Recent News

  • BMO Capital Markets upgraded shares of Oracle to outperform from market perform and raised its price target to $47 per share. The upgrade increases the demand for shares of Oracle.
  • Oracle priced a $14B debt offering with maturities ranging from five years to 30 years. Oracle's 30-year debt offering was priced at a 150 basis-point premium to the current US 30-year treasury bond's coupon of 2.5%. The spread on the five-year offering is 77 basis points.
  • Oracle partnered with Mellanox (NASDAQ:MLNX) on high-speed cloud networking standards in a move aimed at improving the quality of cloud offerings.

Stabilizing Performance & Undervalued Shares

FY 2017 is forecasted to be the year that growth from total cloud revenues offsets declines of new software licenses, but profitability is expected to continue to deteriorate as investments in the cloud and declining hardware sales weigh on the consolidated results. Additionally, increased financial leverage should lead to increased share price volatility.

Oracle Income Statement

FY2015 FY2016 FY2017E
Revenues
SaaS & PaaS 1485 2207 3752
IaaS 608 647 712
Total Cloud Revenues 2093 2853 4464
New software licenses 8535 7276 6476
License updates & product support 18847 18861 19200
Total On-premise Revenues 27382 26137 25676
Total Software Revenues 29475 28990 30139
Hardware products 2825 2471 2372
Hardware support 2380 2197 2153
Total Hardware Revenues 5205 4668 4525
Total Services Revenues 3546 3389 3287
Total Revenues 38226 37047 37952
Operating Income 13871 12604 12524
Net Income 9938 8901 8729
Shares Basic 4404 4221 4052
Shares Diluted 4503 4305 4133
Basic EPS $2.26 $2.11 $2.15
Diluted EPS $2.21 $2.07 $2.11
RPS $8.49 $8.61 $9.37

Forecasted results courtesy of Bottom Up Investing

The revenue forecast of 2.4% revenue growth assumes constant currency during FY17. The key downside risks to the revenue forecast are hardware revenue and new software licenses revenue. On the upside, stronger than expected total cloud revenues growth and stabilization of hardware revenues would likely lead to better than expected results.

In terms of profitability, I expect the deterioration of profitability to slow as margins expand in the cloud business and management implements tighter cost controls. I'm looking for an operating margin of 33% and a net income margin of 23% with operating income coming in at $12.5B and net income coming in at $8.7B. On the bright side, a 4% reduction in shares outstanding is expected to lead to an increase of 2% in EPS or FY17 EPS of $2.16.

Equity investors should be aware of the substantial increase in the use of financial leverage. With the addition of the $14B of debt that was recently priced, Oracle's financial leverage ratio could increase to over 2.50, which is up from 1.78 at the end of FY12. It's a wise decision to decrease the weighted average cost of capital for the firm during this period of historically low interest rates by issuing debt.

Consequently, the returns to equity investors will be amplified both on the downside and on the upside. In other words, the standard deviation of returns increased from 20.6% in 2012 to 21.6% in 2016 with a peak of 23.1% during 2013. The debt usage challenges come into play when the notes and bonds need to be either refinanced or extinguished. Will management decide to pay down debt rather than repurchase shares or will management decide to pay down debt using cash?

Valuation

ROE 2017E 18%
BVPS 2017E $11.49
Optimistic value $68.96
Base case value $54.59
Pessimistic value $40.23
F P/E 25.34
F P/S 5.83
F P/BV 4.75

Currently, Oracle is trading at the pessimistic value for its common equity shares. This is indicative of a company that isn't growing and is also experiencing deteriorating profitability. At the same time, there is significant upside potential as the transition to the cloud matures and profitability improves while deteriorating hardware sales stabilize. The growth in total cloud revenues should more than offset the decline in new software licenses driven partly by an increased total addressable market, mid-market enterprises.

While the base-case valuation with the associated multiplier values may be a bit pricey for FY17, I think Oracle could reach the base-case valuation in FY18. Simply stated, based on the current share price, investors could expect a 33% return in about 18 months, excluding dividends. The ex ante Sharpe ratio is 0.77.

The shares are valued based on forecasted fundamentals with the base case valuation assuming a long-term sustainable return on equity of 15%, which is 300 basis points lower than the forecasted 2017 ROE. The pessimistic value assumes a long-term sustainable ROE of 12.5%. All three valuations assume a sustainable nominal growth rate of 5.5%.

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.