Oracle Is Undervalued

Currency effects masked the underlying resilience of Oracle's core business, as revenue increased 7% on a constant currency basis, despite declining 2% on an as-reported basis. Cloud revenue came in at $611 million, or 9% of the software total, growing nearly 30% versus the prior year. Maintenance revenue, representing 73% of software revenue, also grew a strong 8% on a constant currency basis. In isolation, the results in the cloud business are encouraging; still, new cloud revenue is probably cannibalizing traditional on-premises opportunities. The blended growth rate is more representative of the strength in Oracle's business, and we are not overly ebullient about the company's growth trajectory.

Despite the lack of a secular growth story, we think Oracle's cloud assets will defend against disruption, and the firm should benefit from continued increases in the IT spending mix toward software and away from hardware. Our forecast for mid-single-digit annualized growth in revenue and operating income remains, and it may prove to be conservative if the company can increase its win rates in the cloud application segment. For now, we encourage investors to be sensitive to valuation and to view near-term cloud growth as a pertinent but small part of the story.

The ratable nature of cloud businesses is probably causing a modest drag on operating margins. Management noted that gross margins for the cloud businesses are likely to double (from 40% to 80%) as the company digests heavy capital investments in its data center asset base. Directionally, we agree with management's qualitative guidance, although the revenue mix is likely to tilt away from higher-margin maintenance revenue over a longer period, which will limit the expansion of operating margins. We continue to expect noise in quarterly growth rates and believe the short-term uncertainty has provided an attractive entry point for investment. We encourage investors to consider Oracle's competitive advantages, pricing power, and defenses against disruptive forces as support for our investment thesis.

We Think Oracle Can Hold On to Customers Oracle doesn't have to be the first innovator to maintain its dominance in enterprise software. While there have been many critics of Oracle's long-date acquisition strategy, we believe the company has shored up its defenses, successfully anticipating the threat of cloud computing and providing its customers with a path for technology and service upgrades.

Oracle's database and middleware businesses have high switching costs, and we anticipate customers will likely move to cloud versions of the similar software. Databases contain the key data for companies to manage their business through applications, dashboards, and analytics programs. These databases must exhibit high performance, security, and accessibility. Generally, companies are extremely sensitive to the cost and risk of switching out their database technology.

Cloud computing represents a real threat to Oracle's application businesses, although we believe the company will navigate this industry shift. We also believe switching costs for cloud software are likely to be higher than those of on-premises products. During the next couple of years, the power of Oracle's switching costs will truly be put to the test as the company attempts to sell products that slowly migrate customers from legacy to cloud solutions.

We think Oracle's support of public, private, and hybrid cloud offerings will provide an important value proposition for most of its customer base versus public cloud providers. Customers with significant security and compliance concerns may be unable, at least in the short term, to move many of their processes to a public cloud. In these instances, whether the risk is actual or psychological, Oracle is likely to hold on to its customers, in our view.

While revenue declines in Oracle's legacy hardware businesses are a drag on overall growth, the company's engineered systems have been a bright spot. By integrating hardware and software, Oracle is successfully leading a small but fast-growing segment of IT spending.

High Switching Costs Result in Wide Moat Oracle's customers have high switching costs--particularly in the database and middleware markets--that provide extensive competitive advantages, support industry-leading profitability, and deliver excess returns on capital. While we cannot deny the potential disruptive force of cloud computing, we believe Oracle maintains the widest moat in our software universe.

Databases store vast amounts of enterprise and customer data, arguably the crown jewels for most companies. Databases have high performance and reliability requirements in order to manage and measure the business in the most efficient and profitable manner. Transplanting this data is not only expensive; most companies view replacing their databases as extremely risky, underpinning our wide moat rating for Oracle's database business.

Although we do not believe the switching costs are as great for software applications, Oracle has significant advantages as it cobbles together numerous legacy applications. Importantly, Oracle is providing a path for customers that allows them to upgrade to a hybrid platform, keeping some of the functionality and workflows on premise and some in a public cloud. Additionally, the company has extended the lifetime of legacy products (by offering support), and support contracts are typically lower cost than signing up for new licenses. Furthermore, many customers may prefer to work with a single vendor in order to ensure that the applications, middleware, and database will work together in the future, regardless of the upgrade cycles.

Also, cloud software firms have predictable and more frequent upgrade cycles, diminishing the likelihood of a customer incurring large expenses that would create a lumpy and unpredictable cost structure. Typically, renewing a contract with an existing cloud application vendor is the easiest and least disruptive choice to make, as opposed to constant switching among different cloud vendors. Also, integration can become quite complex; the training and cost required to switch a provider is unlikely to outweigh the benefit of modestly cheaper annual costs. In other words, we believe cloud computing can maintain or increase vendor lock-in, and software firms will be able to build and maintain economic moats.

Moderate Amount of Risk, Very Good Financial Health Our investment thesis assumes that Oracle customers are slow to adopt cloud computing solutions because of switching costs and general risk aversion. If their cautious stance changes and they accelerate spending on cloud applications, Oracle's installed base may be more likely to switch vendors. The company's growth prospects in its core database business may be at risk as well. In-memory technology (including SAP's HANA) may shrink the overall demand for database software as companies need a smaller number of licenses to replicate databases in order to perform analytics. Another risk is that Oracle may find it challenging to earn its cost of capital in the hardware business. Hardware companies have notoriously low returns on invested capital. Lastly, the company is investing in relatively new areas including cloud infrastructure and social analytics, areas in which it is arguably well behind competitors.

Over the next few years, we expect the company to generate annual free cash flow of $12 billion or more, before acquisitions. We believe this should be sufficient to enable Oracle to comfortably service its debt while continuing to invest in opportunities to invigorate and expand its product portfolio. We fully expect Oracle to continue pursuing acquisitions, using its balance sheet as a key competitive weapon. In our view, Oracle's objective to acquire enterprise technology companies focused on industry verticals supports the firm's wide moat and is likely to serve shareholders well. For example, we expect the acquisition of Micros to deliver an in-place customer base and a product suite focused on the specialized needs of the hospitality and retail sectors. While immediate opportunities for direct cost savings from the merger appear limited, we believe there may be longer-term opportunities for cross-product sales to Micros' existing customers to broaden and deepen these relationships.