Is Oracle's Cloud Strategy Destroying Shareholder Value?

| About: Oracle Corporation (ORCL)

Summary

Oracle continues to transition from a seller of on-premise licenses to a cloud subscription company.

The company's cloud strategy seems to involve lots of acquisitions.

But is this cloud strategy creating or destroying shareholder value?

When Oracle (NYSE: ORCL) sold $14 billion in bonds in June, investors feared that the company was preparing to make a large and potentially controversial acquisition. Those fears were confirmed when the company announced that it was looking to acquire NetSuite (NYSE:N) in a huge $9.3 billion deal (19% premium), continuing the company's long-standing trigger-happy acquisition strategy.

The NetSuite merger stood out simply because of its size, not necessarily because shareholders questioned its merits, or lack thereof. Oracle stock has badly underperformed the broader market over the past five years as the company's gradual transition from a seller of perpetual licenses to a cloud subscription player put revenues under pressure. ORCL stock is up a mere 25.7% over the past five years compared to an 86.4% gain by the S&P 500.

Oracle (Green line) vs. S&P 500 five-year returns

Source: CNN Money

Oracle's paltry gain looks even worse when compared to Microsoft's (NASDAQ: MSFT), another old-line tech company that has also been moving to the cloud. MSFT stock has tucked on gains of 120% over the past five years, or about four times as much as ORCL stock.

Oracle (Green line) vs. Microsoft 5-Year share returns

This year was shaping up to become an annus mirabilis for ORCL investors, before the NetSuite deal ruined the party. ORCL stock had an YTD gain of 12% by mid-2016, just before reports of the NetSuite merger hit news feeds. The merger seems to have reversed some of those gains, and now ORCL has YTD gains of just 6%, indicative of negative shareholder sentiment regarding the deal.

Oracle's cloud strategy

I will not discuss the NetSuite merger at length since other SA contributors have already done that. Nevertheless, the fact of the matter is that Oracle has become a highly acquisitive company over the past couple of years. Besides NetSuite, Oracle has also made several other high-profile acquisitions this year including Ravello Systems ($500 million), Textura ($663 million), and Opower ($532 million). Oracle has acquired about eight companies this year alone, and 56 in total since January 2010.

The biggest reason why Oracle is in a seemingly never-ending acquisition spree can be chalked up to the company's new cloud strategy. Unlike cloud leaders Amazon (NASDAQ:AMZN) and Microsoft which are stronger in IaaS, Oracle is stronger in SaaS/PaaS. This is actually by design since the company has not been very interested in growing the low-margin IaaS business to avoid diluting its rich margins.

For instance, Oracle finished last quarter with IaaS revenue of $171 million after growing a modest 10% Y/Y. Meanwhile, SaaS/PaaS revenue clocked in at $798 million after growing a robust 79% Y/Y. Unlike Amazon and Microsoft whose cloud growth is almost entirely organic, Oracle has been leaning a lot on inorganic growth. The company has been acquiring companies in different verticals and then folding them into its cloud ops. For instance, Textura is a financial services business, BlueKai is a database management company, and Opower is a provider of energy efficiency services. Meanwhile, Micros Systems, which the company acquired in 2014 for $5.3B, is a leading provider of software for the retail and hospitality industries.

But is Oracle's cloud strategy working? The true test of whether a company's acquisitions are value-accretive partly depends on the purchase price and partly on whether the company is able to successfully integrate them into its broader product portfolio. These are both quantitative and qualitative tests that would be hard to perform due to the sheer number of Oracle's acquisitions. Perhaps an easier test would be to check whether these acquisitions have had any effect on the company's cloud growth.

And it appears this is clearly the case. Two years ago (Q1 FY15), Oracle's SaaS and PaaS grew 32% while IaaS grew 25%. Total cloud revenues were 4% of the company's revenue, compared to 7% last quarter. The 79% growth recorded by Oracle's SaaS/PaaS clouds last quarter is in fact the highest in the company's cloud history. That growth is more than twice that by other SaaS cloud players including Workday's (NYSE: WDAY) 33% or NetSuite's 30%.

Buybacks and dividends

To that extent, we can say that Oracle's cloud strategy that involves acquiring companies then integrating them into its cloud appears to be working just fine. Oracle's highly acquisitive strategy has been helping the company's cloud grow considerably faster than the SaaS market average.

Investors are, however, not likely to buy that line of thinking if Oracle's cloud growth is accompanied by squeezed dividends and buybacks. Now, Oracle is not exactly a dividend champ - forward yield of 1.5% is considerably lower than Microsoft's 2.7% and nowhere near Cisco's (NASDAQ:CSCO) 3.28%. The company has, however, been quite generous with buybacks, with the company authorizing another huge $10 billion buyback program in March. When a company buys back its own shares aggressively, it basically means that it strongly feels that the shares are undervalued, though some investors will argue that that this is simply some financial engineering to prop up weak earnings. Other investors would prefer fatter dividends over buybacks any day.

But overall, looking at Oracle's cash return program, we really cannot complain. The company has consistently been returning 80% of its free cash flow to investors in the form of dividends and buybacks, leaving only 20% for acquisitions. Oracle has been relying more on debt to fund its acquisition spree, as is clearly evident in its debt-to-EBITDA ratio which has ballooned from 1.1 in 2013 to 3.7 currently. But with interest rates remaining low investors have little to fear.

Investor Takeaway

It could very well be that Oracle has been destroying shareholder value through its numerous acquisitions. After all, many studies have consistently shown that mergers more often than not end up destroying shareholder value. A good case in point is Cisco, which acquired 70 companies in 1993-2000. The general verdict is that the company overpaid for many of those purchases while others added little value to the company's core business.

Oracle's cloud business is still a small part of the company, which makes it quite hard for investors to fully appreciate the company's cloud strategy. It should, therefore, not come as a surprise if ORCL stock continues lagging the market, maybe until cloud revenues exceed 10% of corporate revenue. That might take another 6-8 quarters.

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.