Oracle: A GARP Name For This Very Perilous Market

Jun. 27, 2022 2:03 PM ETOracle Corporation (ORCL)5 Comments10 Likes
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Bert Hochfeld
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Summary

  • Oracle reported a quarter that marked its return to double-digit, constant currency organic growth.
  • The company has also completed its planned acquisition of Cerner.
  • Company's management was quite forthright in proclaiming the company had achieved a growth inflection.
  • Shares, with a forward P/E of less than 12X and a free cash flow yield of almost 4%, certainly do not reflect any growth inflection.
  • The likely cost synergies of the Cerner transaction have yet to be translated into consensus estimates, further enhancing the outlook for the shares.

Oracle To Report Quarterly Earnings

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Oracle: It has reached an inflection point

Oracle (NYSE:ORCL) hasn’t been the best loved or best performing software investment for many years. The company’s transition to the cloud has been long, arduous, and probably has not achieved the results for which investors were hoping when it got started. Over the past decade - that’s right, decade- Oracle revenue has risen by just 7% and most of that came from the growth of the last three reported quarters. Operating cash flow was $13.7 billion 10 years ago, and contracted to less than $10 billion in the latest fiscal year (That contraction was basically a function of acquisition expenses, mainly related to the purchase of Cerner which closed just beyond the end of the fiscal year. Excluding the cash expenses of the transaction that Oracle incurred, Oracle’s cash generation actually grew slightly last year). Overall, non-GAAP operating income of $19.6 billion last year was marginally higher than the prior year, and was up by 44% over the past decade. Oracle shares have more than doubled in the past decade, although they have fallen by 35% since their high point in December of 2021.

Oracle has been about to turn the corner for years, but for every corner turned, there have been pitfalls and detours that have prevented the journey to any kind of sun-filled upland. Simply put, many of its plans and strategies have simply not come to fruition… until now. Most readers are well aware of what has happened to the valuation of high growth IT shares-and even IT companies with far more modest growth and valuation. There are some, and I acknowledge I am in this camp, who believe that the valuation carnage has created an existential opportunity. Oracle, even after what I believe to be a highly visible inflection point, doesn’t have the multi-hundred percent appreciation potential of the road kill in the IT space. On the other hand, Oracle’s constant currency, organic revenue growth reached 10% last quarter, compared to 7% the prior quarter, and just 4% growth at the start of the fiscal year. The prior fiscal year had experienced constant currency growth of 2%, so the growth acceleration is quite substantial for a mature company such as this.

What Oracle does have is a reasonable dividend yield (about 1.9%), a very substantial free cash flow margin, and now the reasonable potential of sustained double digit growth. Not 30% growth or 20% growth, but growth in the double digit range, in combination with very high and probably slightly growing operating margins. And the shares really haven’t reacted significantly to the growth accelerating the company has just announced. Overall, Oracle shares have fallen about 35% since the high they reached after the company’s Q2 earnings release last December. The shares had reached a low of $64 just prior to the earnings release, and while they rose 10% on the day after the earnings, release, they have backed down again, and stood just 6% above their low for the year at the market close on 6/23.

Oracle shares aren’t the kind of investment I typically recommend. For many years now, I have always looked for growth and share gains and a winning strategy. Oracle has been defending its turf, and it has certainly not been a share gainer. Some of its strategies have taken a very long time to reach fruition; some have simply not paid off in terms of achieving durable double digit growth. Investing in IT is a perilous undertaking, at best, and after having invested in and commented on IT companies for literally decades, I am more disposed to look for growth even when I have to pay what might seem as an elevated valuation to do so. But while I might be slightly, although by no means wholly, inured to the volatility and the potential drawdowns seen these last 8 months, this period in the market has been as difficult as any similar period I have ever experienced. While the circumstances of this crash are quite different than the last two or three through which I have lived, the results are reasonably similar. And so I have come to reconsider Oracle as an investment.

Oracle shares are highly unlikely to have the greatest potential percentage appreciation in the IT space. On the other hand, I think the combination of rising growth, and conspicuously elevated operating margins have left the shares undervalued, even on a relative basis, and that many readers will find the combination of reasonable growth, and great profitability and visibility to be attractive in this perilous market for high growth IT names. Oracle, for the most part, has ceased to be a share donor (it is still, and will likely continue to lose share overall in the database space), and while it is never going to have the market dominance it once enjoyed in the relational database world, it is not going to be excluded from some of the opportunities, both in the cloud infrastructure and cloud application space. And that is good enough, I believe to make recommending the shares a reasonable judgement despite the company’s checkered history of over-promising and under-delivering.

Reviewing Oracle’s recent quarter and its outlook

Oracle reported the results of its fiscal Q4 on June 13th. Revenues rose by 5% as reported, 10% on a constant currency basis. Its cloud revenues rose by 19%. Non-GAAP operating income rose 3% as reported and 7% in constant currency. While these numbers may not seem all that exciting, in fact, the constant currency organic growth of 10%, was a couple of percent above the previous forecast, and the highest rate of constant currency organic growth the company has reported since 2011.

The company’s EPS for the quarter of $1.54 was $.20 above guidance. Part of this beat was because Oracle’s income tax expense this past quarter was only 10%; the EPS guide had assumed a non GAAP tax rate of 19%. That tax rate difference accounted for about half of the headline earnings upside. The company’s non-GAAP operating margin for the quarter was 47% a bit lower than that reported for the prior year, but certainly at a high level. The decline in year on year operating margins was essentially a function of a 16% year on year, constant currency increase in research and development expense. It has been many years since Oracle has ramped research and development spending at that kind of rate and as will be detailed later in this article some of its innovation is starting to bear fruit. For better or worse, the senior management of Oracle has made a rather significant bet on its strategy that can have long-term positive business consequences.

Oracle had a much stronger data base quarter than has been the case for years now. Of course Oracle competes with MongoDB (MDB) these days as well as a host of what might be described as ankle-biters, and Mongo as well as the ankle biters win a substantial number of competitive engagements-in particular, Mongo’s Atlas offering provides both developers and users with superior noSQL functionality. And, equally, the large cloud companies all offer their own data base products, which have drained market share from Oracle for the last several years. Further, a company such as Snowflake (SNOW) while not often considered a direct Oracle competitor, is certainly a beneficiary of some of the stronger trends in cloud data warehousing. But this quarter, although not specifically reported, Salesforce (CRM), an Oracle data base customer for many years, apparently renewed/expanded its usage of Oracle’s database. So, too, did other significant enterprise software companies who use Oracle as their database platform. Quite surprisingly, therefore, total license revenues rose by 25% year on year.

Of course these kinds of transactions and that kind of growth are not to be expected every quarter, but the rumors that Salesforce was going to leave the Oracle platform have not turned out to be accurate and the company’s database market share within the application cloud vendors has remained far stronger than many observers have felt would be likely. While the company’s data base revenue have remained stronger than expected, its infrastructure software revenue rose, and in particular, what Oracle calls infrastructure cloud services grew 49% and the autonomous data base, showing a bit of life, saw a 29% increase in revenues.

Oracle is obviously not in the same league as the “cloud titans” which consist of AWS (AMZN), GCP (GOOG) and Microsoft’s (MSFT) Azure when it comes to providing public cloud infrastructure. Most of its cloud infrastructure customers are users of the company’s portfolio of apps. I don’t anticipate that Oracle will ever achieve the kind of revenues from its infrastructure offerings as the cloud titans are enjoying, but I expect that the company’s IaaS offering will be one factor in keeping Oracle’s revenue growth in double digits. In this last quarter, Oracle’s cloud consumption revenues grew by 83% year on year.

Oracle also enjoyed a particularly strong quarter in terms of its Apps bookings. Specifically, the company’s cloud application software revenues (Fusion ERP) rose by 24%. In particularly, NetSuite ERP revenues grew by 30%, which has to be considered a significant surprise. The company’s traditional apps business continues to decline; that said, the cloud component of the apps business has now crossed 50% of the revenues from that segment which should enable the Oracle to continue to achieve double digit growth for its ERP offerings for some years to come.

I like to look at RPO balances as providing the best insight in terms of the growth of a company’s sales. The Oracle’s RPO balance grew 17% year on year, after absorbing some impact from FX. This is indicative of a very strong bookings quarter, which does include the tailwind from what was apparently the significant booking made by Salesforce.

What’s Oracle’s Outlook/How will a recessionary climate impact its growth?

These days, the top issue on the minds of investors relates to how a particular company might fare in what many assume is an impending recession. It is hard to look at any kind of business streaming news service without seeing another prognostication of the probability of a recession. Given all the technology and all the individuals involved in making such forecasts, anything I might write on the subject would be superfluous and just opinion, not substantiated by quantitative models.

The consensus forecasts from the economics community seems to be that Fed tightening has about a 50% chance of tipping the economy into a recession. The further consensus seems to be that a recession will be of brief duration and mild.

How does Oracle stack up in that environment? The specifics of management guidance, after adjusting for the impact of the just completed Cerner merger seem to imply that its adjusted percentage growth rate might slacken in this current quarter, although it is difficult to triangulate the exact forecast because of not knowing how much conservatism has been baked into the contribution from Cerner. The CEO, on the call, however, talked about accelerating adjusted organic growth, and the facts as presented seem to substantiate that kind of forecast-specifically the strong growth in the company's RPO balance.

Specifically, the company forecast that the organic growth of its cloud business will accelerate from 22% in the year just reported, to more than 30% in the current year. The company’s cloud revenues were about $2.5 billion last quarter, and are now 21% of total revenues. So, the organic, currency adjusted revenues growth from the cloud will produce 700-800 basis points of growth at the company’s forecast levels in the current fiscal year.

The company hasn’t explicitly provided a forecast for the full year of fiscal ’23; its forecast for Q1 is for reported revenues to reach about $11.5 billion. Cerner’s revenue run-rate had been a little bit greater than $1.4 billion/quarter. So, the organic growth rate that Oracle is forecasting is about 4%, net of a 400 basis point FX head wind, and about a 100 basis point headwind for the end of the company’s operations in Russia. The estimate is probably conservative, as the company CEO said that she had added conservatism to the Cerner revenue outlook because of acquisition related friction.

The analyst consensus is basically congruent with guidance. The 1st Call revenue consensus for the year is published at $48 billion+ but that includes a couple of analysts who have not updated their forecasts and thus haven't included the contribution from Cerner. The “real” consensus is probably about $49 billion+ which implies organic growth adjusted for currency impacts, and the end of the company’s business in Russia of about 8%. That is almost certainly a hyper-conservative set of expectations. Based on the company’s business momentum, and the investments the company is making in its business, I would be surprised to see adjusted organic growth of less than 10% next year, and some further acceleration beyond as some of the revenue synergies that are likely to be achieved through the merger with Cerner are realized.

The further questions that I think need discussion is how will this be possible in a recessionary climate and with the plethora of competitors the company faces. Reaccelerating to 10%+ organic growth after years of not having much growth at all is a considerable inflection, especially given the size of this company, its market share, and the competitive environment in the enterprise software space.

Oracle runs much shorter conference calls than most other software companies. That has been the case for many years, and remains so. And thus, company commentary addressing the issues above is a bit sparse:

So my question is, Safra, Larry, can you give us more color on what's driving that reacceleration in license revenue in particular? Even as cloud revenue inflected to its highest growth rate in more than 4 years, is this BYOL bringing the heat? Is this autonomous database getting big enough and growing fast enough to lift the overall number, et cetera. And is this the broad-based demand that you mentioned on the Q3 call? Or is this more big deal driven?

Safra Catz

So it's a little of both. You see, first of all, large enterprises understand that having an unlimited agreement for some period of time, an unlimited agreement gives them unbelievable flexibility. Any large customer, large database user that does not have an unlimited agreement with us is really not optimizing for their spend because it gives them incredible flexibility.

They can use on-premise for as long as they need it. They can move to the cloud and get a much lower price in the cloud with BYOL, and they can move back and forth. And it just gives us the kind of flexibility. Those agreements are the ultimate sort of the foundation of so much of what goes on.

In addition, of course, in technology, we also have our leading Java business, which on-premise is an extensive use and in the cloud is at no charge. So customers can be motivated to bring their Java to the Oracle Cloud and to use it at no charge, their Java program and to use it at no charge.

So we have a lot of things that incent bringing your Oracle databases to our cloud and, of course, all your Java work to our cloud. So both of those are absolutely critical for our license numbers to be as strong as they are. And the Oracle database, I've been following Oracle for, well, since the '80s. And I always -- we always hear about some new product that's about to overtake Oracle. And the reality is that the Oracle database is beyond the gold standard.

If you really need work done and if you want to protect your most critical data and you want to use large amounts of it, it is going to be the Oracle database that is head and shoulders above every other product. And invariably, some folks try other things when they get bigger, they always come back to the Oracle database It is irreplaceable because of its technical capabilities that are so far superior. And that becomes very, very, very clear to customers and more and more of them license -- continue their license and extend those unlimited agreements, whether for on-premise and in the cloud. It's not either or it's both, and that is the best use of it.

Lawrence Ellison

I'll add 1 thing to that, which is the Oracle Autonomous Database is interesting because it's autonomous. In other words, it doesn't require human beings to run it like database administrators, things like that. Recently, inside of Oracle, inside of our cloud, virtually every database going up for -- to run our cloud, the autonomous database because people don't want to hire database administrators inside of Oracle Corporation. It's just much cheaper to run.

And I think in that sense, the Autonomous database is countercyclical. You do save a huge amount of money just by moving from conventional Oracle database to the autonomous database. It's actually more secure, more reliable and cost Wales to run. You don't need a bunch of experts running it. You don't need anyone to run it.

There is a programming language called APEX, which uses -- it's a low code programming environment where you use 10% the name amount of programmers that you would use if you were programming in our other programming language called Java. And APEX is also becoming very popular inside of Oracle to build applications. I see this as 2 interesting trends as people using more modern technology to dramatically reduce their labor costs, which I think will play very well in the next couple of years in this economy.

Safra Catz

Yes. I think people don't realize how exorbitantly expensive it is to run those large SAP systems. They have data centers associated with them. They have hundreds, sometimes thousands of technicians to run them. They're old, they're clunky and moving to Fusion ERP. It's just a totally different world and costs So - the costs are tiny in comparison. I think people sort of forget that. And this applies really to all on-premise systems, but even more so to those old SAP systems.

And our cloud offering in that area really is unrivaled. Frankly, unrivaled. And we -- our win rates just continue. And we're very optimistic about it, and we've sold a lot. A lot is still being implemented, and we expect that you'll see that in the numbers, while our customers end up spending less than what they use to spend with on-premise.

Oracle has been run by the same team for many years now, with the exception of the passing of former co-CEO Mark Hurd. And the team has certainly had its shares of miscues and wrong choices. The team is also very promotional. That doesn’t mean that everything management says is inaccurate or should be disregarded.

For example, I believe that MongoDB has an excellent and widely respected database solution. And it is really difficult to gainsay the market penetration in the database area achieved by the cloud titans as well as the extraordinary growth of Snowflake. What I believe is happening is that Oracle is starting to realize some of the benefits of its extensive product line. Oracle is a bit unique in having both a competitive, enterprise grade set of ERP solutions and a full featured database. It is not necessary to believe all of the competitive propaganda above in order to believe that Oracle has created a set of offerings that provide users with benefits in terms of flexibility and costs that have reaccelerated growth. That said, I do believe that the benefits of the autonomous database are not all hype, and anecdotal checks I have made suggest it is finally starting to achieve traction with some users.

When it comes to ERP, I confess that the conflicting claims amongst the major competitors, and some of the point players as well, are simply impossible to resolve. Oracle Fusion and SAP S/4 Hana have been mortal rivals in terms of their apps offering for decades now. Oracle and Workday have battled as well. Microsoft Dynamics 365 is another successful competitor in the space that has enjoyed market share gains and excellent growth. The link shown here is quite positive for Oracle’s competitive positioning. Interestingly, the chief competitor listed by this evaluation is NetSuite, which is Oracle’ small/medium business ERP offering. Here is a link to an evaluation which compares the differences between the flagship ERP products offered by SAP and by Oracle. SAP is far larger than Oracle in terms of its revenue from apps, and this is one area in which Oracle can and is apparently achieving market share gains. This evaluator, who is a 3rd party consultant with Oracle experience, maintains that Oracle is his choice between the two leading vendors in the space.

Oracle, which is the largest enterprise focused software company, seems likely to experience at least some cyclical perturbations. But in a mild and brief interruption of overall economic growth, its improving competitive position is likely to buffer the impact. It isn’t necessary to totally believe the comments by Larry Ellison and Safra Katz regarding all of the counter-cyclical demand drivers in order to believe that Oracle’s business will really be able to achieve double digit growth over the next year and beyond.

Oracle’s purchase of Cerner: Will Oracle achieve the necessary synergies?

Cerner is by far Oracle’s largest single acquisition, and it will represent more than 10% of the revenues of the combined entity. In the past, Oracle was an acquisitive organization, but subsequent to the 2016 acquisition of NetSuite, this is the first significant acquisition made by the company. When the Cerner acquisition was announced in December, a few days after the company had announced a strong quarter, Oracle shares fell by about 16% over a two week span, which was noticeably worse than the software ETF, the IGV, which only fell 3% over the same period. Many of the analysts who cover Oracle were skeptical that the acquisition would produce synergies. The company, in the press release announcing the merger said it would be accretive to non-GAAP earnings in the current fiscal year.

Oracle wound up paying $28 billion, or $95/share, for Cerner which was about a 40% premium above Cerner’s share price before the acquisition was announced. Cerner’s growth has been at a glacial pace over the past several years. Since 2018 revenue growth has been less than 10% in total; that is less than 3%/year. On the other hand, the company has been reasonably profitable, although adjusted operating margins in the mid-teens range are far below the levels at which Oracle operates.

This was an all-cash transaction and as Oracle had a cash balance of $22 billion before paying for Cerner, it had to borrow some money. The company already had $76 billion of debt and substantial lines of credit. The cost of debt for Oracle these days is about 3.2%; the weighted average cost of capital calculation is around 6.5%. So, for the transaction to make sense, Oracle has to assume some substantial synergies, both in terms of revenues and expenses, although the expectation of the acquisition adding to non-GAAP EPS in the current year seems a fairly safe projection.

Cerner is one of the leading competitors in the field of health information systems. I have linked here to an analysis of the company's solutions. The company has suffered through years of execution issues and management change. The company's principal competitor is privately held Epic Healthcare. Epic is slightly larger with a 31% share of the relevant market, compared to 25% for Cerner. The link here, delves into the differences and similarities between the two offerings. Most software companies grow by expanding their TAM into adjacencies. Cerner has not been successful with such a strategy which left it vulnerable to being acquired. I feel reasonably sure that Oracle will take the steps necessary to develop a vision and solutions to encompass more of the health care information systems market than Cerner had been able to accomplish.

Oracle and Cerner were not competitors before the merger. But there are enormous cross-sell/up sell opportunities. Health Care has been Oracle’s leading vertical for some time now. Just a few major installations that will be sales targets for the new entity include Indiana University Health, Northwell Health, CarolinaEast Medical Center and Atrium Health. Cerner is the 2nd largest health care software vendor. Some high profile customers include the NHS in the UK, Emory Healthcare and Johns Hopkins Children’s Hospital. Obviously the opportunities to sell Oracle data bases and its Fusion ERP to the Cerner installed base is huge. And the opportunity to leverage Oracle’s healthcare installed base to buy some of the large suite of Cerner apps is substantial as well. Quantifying just what these synergies will represent over time is not really something that I can realistically estimate; I imagine it will be a substantial number compared to Cerner’s current revenue run rate of $5.8 billion.

The cost synergies are easier to triangulate. Oracle’s non-GAAP margin last year was 46%, and the company has forecast that its operating margin would rise from that level. But at the least, it is 3000 basis points above Cerner’s most recent operating margin. Adding 3000 basis points to Cerner’s operating margins and using its latest 12 months of revenue would yield $1.74 billion to Oracle’s operating profits, or about $.50 in incremental EPS after taxes. That is an uplift of 8% to the earnings anticipated in Oracle’s fiscal 2024, and since the company hasn’t explicitly guided to synergistic accretion, it is almost certainly not part of the currently published 1st Call consensus. At the least, assuming that the contribution margins from Cerner will be at rates comparable to Oracle's operating margins will justify the acquisition.

In the last conference call, the CEO talked about a strategy to review Cerner’s entire product portfolio, with a view toward replacing 3rd party products with comparable Oracle solutions. In addition, Cerner’s cloud product will move to OCI. I think the contribution margin from the merger, will, over a couple of years, serve as a decent tailwind to Oracle’s total operating margins, and will serve to fund the research and development effort needed to build the transformative health care solutions management environs.

As might be anticipated, Oracle, has a dramatic vision of how the product strategy incorporating Oracle is going to play out. The vision is pretty dramatic, but like many things with this kind of complexity and scope, execution is going to be key, and there will be elevated expenses and an extended payback. Rather than me interpreting the company’s healthcare software product roadmap, here are the deliverables the company is planning on releasing (from the Q4 conference call):

In health care, we’re in the process of building a complete suite of applications for the entire health care ecosystem, starting with health care providers like hospitals and clinics.

We’re modernizing Cerner’s clinical systems by adding capabilities like a voice user interface and applications like disease-specific AI models for cancer and other diseases. We’re including an IoT device network to improve patient diagnostics and monitoring. We’re adding administrative systems, including managing the incredibly complex contract workforce that hospitals have as doctors are not bolt-on employees nor are nurses. We are going to help recruiting, scheduling and paying those contract workers according to their contracts.

Inventory at hospitals is enormously complicated. Inventories aren’t in a central location. You find inventory in nurse’s stations outside operating rooms, outside the intensive care unit. There’s inventory everywhere. Managing that inventory is very complicated. We’re adding RFID tags and maps on handheld phones to help people find what they’re looking for quickly. For payers, including insurance companies and governments, we’re automating payment authorization and billing systems. For pharmaceutical companies, we’re integrating our clinical trial system directly into the hospital clinical system, making clinical trials easier to start and faster to complete.

Of course not all of Oracle’s mergers have achieved their objectives. Oracle bought Sun Microsystems back in 2009. The company, somehow, may have gotten a return on the $7.4 billion purchase price, and some of what Sun brought to Oracle’s product offering such as Java has had some level of success. Oracle’s Exadata appliance, while still being sold and supported, certainly turned out to be far from the growth driver the company had expected. Health care software is certainly an opportunity, and Oracle starts with significant assets in its ambition to transform the space. But at the end of the day, given that the transaction is fully justified simply on cost synergies, and the share price certainly doesn’t in any way reflect the potential Oracle has to drive revenue growth through its transformation strategy, if the company is successful in its aspirations, it will be lagniappe for shareholders.

Oracle has used its free cash flow to significantly reduce outstanding shares which are now at 2.78 billion down from 3.02 billion a year ago and down from 4.2 billion just 5 years ago. Because of the consideration Oracle has paid to acquire Cerner, it has indicated that its recent tempo of share repurchases which has been $600 million/ or about 9 million shares/quarter will continue until it has paid down much of the debt associated with the transaction. I suspect this absence of massive share repurchases has been one factor that has muted the share price performance of the shares in the days since earnings were released and the CEO described her plans for the future share repurchase cadence. For long term investors, this pause in high levels of share repurchase shouldn't greatly matter.

Oracle’s Business Model

Oracle has been one of the most profitable software companies for the past decade and more. There are many reasons for the company’s profitability; one of these is that it still derives a significant level of very high margin service renewal revenues, particularly from its database customers who find the expenses associated with migrating to more modern technology simply not worth the problem. Of course, over time, these revenues will continue their decline, and they are being replaced by revenues from cloud solutions which have lower gross margins now, but which eventually will have a significant positive impact on Oracle's margins as the company scales its infrastructure and starts to benefit from very high margin renewals.

In considering Oracle’s model, it is important to note that its business has very seasonal characteristics. In particular, Q4, which is the quarter recently reported, is invariably the strongest quarter of the year with revenues typically growing 10%+ sequentially. Q1 is the company’s smallest quarter, and typically Q2 shows sequential progression from that low point. So, there is no reason to examine quarterly progression. Because Q4 is the seasonal high point for Oracle revenues, operating margins in Q4 have almost invariably been at the highest level in the year. The acquisition of Cerner is going to have a modest impact on dampening seasonality, as Cerner’s model has never been particularly seasonal.

Last quarter, Oracle’s non GAAP operating margin was 47% compared to 49% in the same quarter the prior year. As mentioned earlier, the major factor in the year on year decline in operating margins last quarter was the higher percentage of research and development expense. General and administrative costs rose 21% in constant currency although that cost ratio remained at 3% when rounded. Some of that increase costs related to the merger with Cerner which has now been completed.

For the full year, year research and development expense rose by 11%, and general and administrative expense rose by 5%. Stock based compensation expense rose noticeably last fiscal year, primarily because of Oracle’s hiring activity in the highly competitive research and development cost bucket. The company is projecting that the costs of the merger will lead to some margin contraction in Q1, and EPS is expected not to show material increase compared to the year earlier period. This is net of absorbing about a 4% impact from currency moves. As mentioned above, Oracle has not provided full year 2023 guidance other than to say that the Cerner acquisition, even including the expenses that will be absorbed in Q1.

The company is projecting that it will increase capex somewhat next year. At this point, capex for Oracle is mainly a function of the rate at which it expands its regional data centers to support Oracle's Cloud Infrastructure. It plans to add 6 new regions in the current fiscal year, and increase of a bit more than 15% to its current count of data centers. Thus capex seems likely to be greater than $5 billion, and this probably means that free cash flow generation will be around $10 billion for the full year.

The company’s backlog as mentioned rose quite a bit faster than the increase in reported currencies. On the other hand, the company’s deferred revenue balance did not follow suit. If bookings growth percentages remains at the levels in Q4 and suggested by the company’s guide, at some point it seems likely that deferred revenue growth will become a tailwind to operating cash flow. I have projected that Oracle’s free cash flow margin will reach 17% next year, and it should proceed higher from that point.

Valuation/Wrapping Up

Writing about GARP software companies sometimes seems a contradiction in terms. Most investors in the enterprise software space, at least until the last 8 months, have wanted to see growth, and a reasonable path to profitability and cash flow generation. Now... well given the negative sentiment of that has grown over the past few months, at least until last week, it has been more than a bit unclear what investors have been seeking. Oracle is a bit Janus-faced as an investment. I believe that it now offers shareholders double digit organic growth and sky high operating margins, as well as rising cashflow margins. The cost synergies that Oracle will reap from its recently completed acquisition of Cerner don’t really seem to be reflected in current estimates, perhaps because the company itself, has not provided full year projections. The current published consensus for EPS of $5.27 clearly is at odds with management’s projection that the Cerner merger will be accretive in the current fiscal year.

At this point, my projection suggests that Oracle’s 12 month forward EV/S is 4.45X, and as mentioned I believe the company will be able to achieve a free cash flow margin of 17% in that period after absorbing over $5 billion in capex as it ramps the investment in its cloud infrastructure. Those projections result in a free cash flow yield of just less than 4% on the company’s enterprise value. I project that earnings will be greater than $5.80 over the coming year, so the forward P/E ratio is about 12X.

The company's weighted average cost of capital based on the link I provided earlier in this article is about 6.5%. Using 6.5% in a DPV calculation suggests that Oracle's "fair value" is more than 70% above the current share price based on the company achieving 10%+ growth and a free cash flow margin rising to the mid-30% range.

Will those projections be upended by an economic contraction? The kind of contraction that is being forecast by most seems unlikely to really change the trajectory of enterprise IT purchases. That said, there is certainly more uncertainty in the outlook for growth in IT spending than has been seen in recent years; there is certainly reason to be cautious in terms of expectations given the many unknowables in the environment.

I usually prefer to recommend share gainers in writing about IT investments. Although last quarter was exceptional in terms of data base growth, I doubt that the elements that led to its strength will continue for a full year. There really are many competitors of varying shapes and sizes who have made Oracle’s domination of the data base market of less substance than has heretofore been the case. That doesn’t mean that Oracle’s database revenues won’t grow - they just aren’t likely to grow at the elevated levels achieved last quarter. Oracle, I believe, can be a share gainer in the apps space, and while its cloud infrastructure business isn’t likely to challenge the cloud titans in the foreseeable future, it has a strong growth trajectory which is part of the double-digit growth story as well. Most users perceive performance and functionality advantages to running Oracle apps on it cloud infrastructure.

There are loads of undervalued IT shares out there; it would take weeks of performance like that of Thursday/Friday, 6/23-6/24 to undo the carnage of 8 months, particularly as regards to valuation. But for readers looking for a bit of safety in what has been a hyper-treacherous environment in which to invest in higher growth IT names, Oracle seems to be a reasonable haven. It will never be able to develop the growth or the potential returns of high growth IT, but from current levels there can be significant percentage appreciation.

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Bert Hochfeld graduated with a degree in economics from the University of Pennsylvania and received an MBA from Harvard. Mr. Hochfeld has enjoyed a long career in the tech world, working for IBM, Memorex/Telex, Raytheon Data Systems, and BMC Software. Starting in the 1990s, Mr. Hochfeld worked as a sell-side analyst and won awards from the Wall Street Journal for his coverage of the software space. In 2001, Mr. Hochfeld formed his own independent research company, Hochfeld Independent Research Group, which provided research services to major institutions including Fidelity, Columbia Asset, SAC Capital, and many other prominent institutions and hedge funds. He also operated the Hepplewhite Fund, a hedge fund that specialized in technology investments. Hedge Fund Research, an independent 3rd party firm that specializes in ranking managers, rated the Hepplewhite Fund as the best performing small-cap fund for the 5 years ending in 2011. In 2012, Mr. Hochfeld was convicted of misappropriating funds from a hedge fund he operated. Mr. Hochfeld has published more than 500 articles on Seeking Alpha, all dealing with companies in the information technology space. Highly esteemed for his investment wisdom accumulated over decades, Mr. Hochfeld ranks in the top 0.1% of Tip Ranks analysts for his selection of information technology stocks and their subsequent successes.
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Disclosure: I/we have a beneficial long position in the shares of ORCL either through stock ownership, options, or other derivatives. 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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