Oracle Earnings Preview: Can Cloud Growth Offset Organic License Segment's Erosion?

| About: Oracle Corporation (ORCL)

Summary

Oracle's Cloud Business still just 6% - 7% of total revenue but growing nicely.

Oracle's traditional license business has contracted "high-teens" the last 4 quarters.

The License segment faces much easier compares starting May '16.

I think the stock is Fairly-to-modestly undervalued in the high $30's with potential to return more capital.

Oracle needs to return to growth to breakout out of this multi-year consolidation between $33 - $45.

Oracle (NYSE:ORCL) the database software giant in the midst of a tectonic shift to the Cloud, reports their fiscal Q4 '16 after the bell on Thursday, June 16th, 2016.

Street consensus is expecting Oracle to print $0.82 in earnings per share on $10.47 billion in revenue for expected year-over-year growth in EPS of 5% on a 2% y/y revenue decline.

If Oracle hits the $0.82 EPS number it will be the fastest y/y growth in EPS since the August, 2014 quarter for the software giant.

What's even better - if Oracle leaves the fiscal Q1 '17 (ends August '16) guidance unchanged at $0.59 and $8.5 billion, revenue is expected to grow 1% y/y and EPS 11%.

That would be the first positive quarter for y/y revenue and EPS growth also since August '14 if guidance is left unchanged.

For full-year fiscal'17 the Street is expecting $2.81 on $37,68 billion in revenue for expected y/y growth of 7% and 2%.

My guess is given the environment, we might see Oracle temper forward guidance a bit for the next quarter and the next year.

There is little incentive these days for management to stretch the envelope in terms of meeting numbers. Tempering expectations and delivering upside or UPOD (under-promise and over-deliver) is the hallmark of this market since 2009.

A brief history:

Oracle was slower to make the switch to the Cloud but has committed with both feet although the switching costs are thought to be higher for Oracle's middle-ware and database app's (per Morningstar) thus the transition is taking longer than might be expected.

The real issue as I see it looking at the numbers is that - as PAAS (platform-as-a-service) and software-as-a-service (SAAS) has grown 25% - 35% y/y quarter in and quarter out - "license" revenue growth or Oracle's traditional mainstay database business has declined mid-teens for the last 12 - 18 month. Here is the table:

y/y growth 2/16 11/15 8/15 5/15 2/15 11/14 8/14
New s/ware license -15% -18% -16% -17% -7% -4% -2%
Cloud SAAS/PAAS 57% 34% 34% 30% 30% 39% 33%
Cloud Inf AAS -2% 6% 16% 25% 28% 60% 27%
S/ware update/support 0% -2% -1% -21% 2% 6% 7%
S/ware and Cloud rev (total) -1% -13% -2% -17% 1% 5% 6%
Hardware -15% -20% -1% -6% -2% 0% -14%
Hardware support -10% -11% -5% -1% -2% 1% -1%
Hardware rev's -13% -16% -3% -4% -2% 1% -8%
Service rev's -8% -8% 1% -4% -3% -3% -7%
Total revenue -3% -6% -2% -14% 0% 3% 3%
% of rev's 2/16 11/15
New s/ware license 19% 19%
Cloud SAAS/PAAS 6% 5%
Cloud Inf AAS 2% 2%
S/ware update/Support 52% 52%
S/ware & Cloukd rev (ttl) 79% 71%
H/Ware 7% 6%
H/ware support 6% 6%
Service rev's 9% 10%
Total revenue

Source: Oracle earnings reports and 10-Q's

Here is what readers should take away from the above numbers:

1.) The Cloud business is growing quickly, but the traditional organic license business, or the traditional organic database business or what Oracle calls "standalones" (presumably PC or server based) has stagnated or even contracted sharply over the last 18 months.

Is it a zero-sum game? Not exactly, I think the Cloud will be a driver of decent growth for some time for Oracle.

2.) The organic license starts to lap much easier compare's in the May '16 quarter or starting last month, so if Oracle can just stabilize that portion of the business, mid to high single digit organic growth can return for the software giant.

3.) The Hardware biz, roughly 12% - 13% of total Oracle revenue has also been a drag for a while so - again - stabilizing organic license software and the hardware segment - will bring a nice lift to Oracle revenues, if the Cloud segment continues to grow unabated.

4.) Currency or f/x has been a formidable drag for Oracle. Here is the last 4 quarter's results for Oracle both in reported revenue and shown "constant currency" or cc.

Rpt Revenue constant curr / CC
Q3 '16 -3% +1%
Q2 '16 -6% +2%
Q1 '16 -2% +7%
Q4 '15 -5% +3%

Source: conf call notes, Street research

5.) The Cloud is the future for the mega-cap software giants as Microsoft proved yesterday. Oracle's Cloud biz is growing nicely but at 6% - 7% of total revenue, and growing about 1% of total revenue each quarter, it is going to be slog for the mega-cap database giant to continue to convert the existing customer base to the Cloud.

6.) Does the Hardware segment fit with the Cloud business ? As someone who is technologically challenged pumping gas, I simply watch the numbers and the trends. The Hardware business was I thought the old Sun Microsystems Unix-based mainframe business and I just don't have good insight on where that fits with the future of Cloud. Presumably with the Cloud being server-based, Oracle can utilize the Unix platform, but I'm really reaching in terms of my understanding and expertise.

Return of capital:

Oracle like a lot of software companies is a big free-cash-flow generator but like a lot of the Silicon-Valley based mega-cap giants from the 1990's is a serial stock option issuer which necessitates the Treasurer utilizing that free-cash-flow to offset that dilution.

Oracle is however doing a better job of stock option issuance: at one point three years ago, the incentive stock options and the stock selling was consuming 30% of the free-cash-flow. In the February '16 quarter, that selling consumed just 7% of Oracle's free-cash-flow.

That means Oracle can hike the dividend which is still just 25% - 28% of free-cash-flow (average over last 5 quarter's is 29% and as of last quarter was 21%) and represents a 1.5% dividend yield today.

Valuation: Morningstar recently re-launched coverage on Oracle and reduced their intrinsic value estimate from $44 to $38 per share as the Morningstar analyst noted the erosion in the traditional organic license business relative to the move to the Cloud, which is roughly the same conclusion I arrived at looking at the numbers while I probably have a little more optimism for Oracle's outlook given the ability of the company to navigate the transitions of the past.

Using the current consensus revenue and EPS estimates, the Street is expecting an average of 8% EPS growth and 2% revenue growth over fiscal '17 and '18 with no consensus estimates on fiscal '19 as of today. (Fiscal '16 ends with this earnings report so I am looking forward over the next 2 years for readers.)

Trading at a 15(x) multiple and 8(x) cash-flow multiple (ex-cash) the stock is not expensive at all for a software giant, but it also isn't growing as fast as the younger software companies.

The one thing I don't like to see is that fiscal '18 and '19 revenue and EPS estimates are still coming down for those forward years as of the end of May '16 so for the stock to get traction I think investors need to see those forward estimates stabilize.

Conclusion: Oracle is definitely in a tough transition between the cloud and their traditional applications business and while one segment is growing nicely, the traditional business is contracting.

In the February '16 quarter the SAAS/PAAS business grew 57% y/y while License contracted 15% (see the first table above) which strikes to the heart of Oracle's issue: good growth from what is today a still-small part of the business.

Client have a 1% - 1.25% position in Oracle today spread throughout many account as I am awaiting some things to go right for the database software giant: the license and hardware businesses to stabilize, the currency effect to start to diminish, and the Cloud business to prove it can grow uninterrupted (note the 3rd line in the first table, i.e. the IASS or the infrastructure-as-a-service, which has suddenly stopped growing and might be seeing some competitive headwinds). I'd rather be a little bit late in this instance and wait and see what management has to say about fiscal '17 on Thursday night.

There is no incentive to be a hero today in this market and load up on a stock pre-earnings.

Technical analysis: there is a lot of negative sentiment around Oracle today which I supported by a view of the technicals: If Oracle trades below the 200-week moving average and then the 2016 low of $33 on heavy volume, the stock is likely busted for some time and is likely indicative of transition issues from License applications to the Cloud. The stock is trading below the uptrend line off the March '09 low presently so there is a lot riding on whether management affirm the current 2017 Street consensus which is a return to growth for the next 2 years.

The March, 2000 high of $45 is Oracle's true technical litmus test.

My own opinion is Oracle is fairly-to-modestly undervalued pre 4th quarter '16 earnings with not enough of a compelling discount to load the boat on the shares. I expect a decent quarter from the software giant and currency impact to start to diminish.

The fiscal '17 guidance will be key.

Disclosure: I am/we are long MSFT, ORCL.

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.

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Tagged: , Application Software, , Earnings
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