Oracle: The Problem With All The Hype Around AI (NYSE:ORCL)

Identifying attractive investment opportunities, without simply going for high momentum stocks and hoping that their high sales growth would be even better next year, involves a contrarian approach.

That was the case with Oracle Corporation (NYSE:ORCL), which just three years ago was the ugly duckling of the cloud sector that nobody was talking about.

Back in late 2020, when I first laid out my investment thesis on the company, Oracle was trading at levels similar to those of IBM (IBM) and Hewlett Packard Enterprise (HPE) due to its low single-digit expected growth.

* data as of October 2020

I was surprised just how negative the sentiment towards the company was back then and that Oracle was perceived as a dinosaur headed for extinction. Fast-forward to today and ORCL is now expected to grow its topline at a rate of more than 11%.

As it often happens, the investment community has come up with an exciting narrative around the stock as if this is something that has happened overnight and not a product of the company’s long-term strategy.

And all of a sudden, Oracle is no longer the ‘dinosaur’ of the cloud sector it was a few years ago and Wall Street Analysts are rushing to upgrade their ratings on the stock.

Although Oracle’s stock could continue to deliver satisfactory shareholder returns, the probability is quite low at this point in time (at least in the short term). Not only that, but once again delivering a 125% total return over the next 3-year period is next to impossible.

Oracle’s story is also a perfect example of why long-term investors should not be swayed in their judgment by narratives created on Wall Street. The reason why I say ‘perfect example’ is not only because ORCL delivered such an outstanding result over the aforementioned period, but two of Wall Street’s darlings – Salesforce (CRM) and Amazon (AMZN) are now in negative territory.

Both of these businesses have been in a very good position fundamentally, but their stock prices were hijacked by the created narratives and momentum traders that they both failed to deliver in recent years (for my full analyses see here and here).

I could keep going with similar examples, like the one for Exxon Mobil (XOM) for example, but the story with Oracle speaks for itself.

A very important lesson here is that taking advantage of such opportunities takes patience, a lot of it. That’s why I am shortlisting similar opportunities for my subscribers in my investing group, where Oracle has been among my high conviction ideas.

What’s Next For Oracle?

In addition to evaluating business specific metrics and the overall strategy, one should always take into account industry-wide developments. A topic that has not yet received much attention is the issue of lower and more evenly spread revenue growth.

On the graph below we see that since 2020, expected revenue growth within the industry has cooled down significantly for the high growth players and has improved for the so-called value stocks.

The implications from this are:

• High momentum stocks are at increasingly larger risk of multiple compression;
• It is reasonable to expect lower variance of valuation multiples on a cross-sectional basis;
• Lastly, the market would gradually put more emphasis on profitability as opposed to topline growth.

I won’t go into much detail on why high momentum stocks failed to deliver satisfactory returns recently and why they are still at risk. I covered this topic extensively in a thought piece from two years ago and a more recent one that focused on the Vanguard Growth Index Fund ETF (VUG). If you haven’t read these already, I would highly recommend doing so.

The last point, could be easily illustrated by the strong relationship between gross profitability and Price-to-Sales multiples within the sector. In that regard, ORCL is among the industry leaders and is still priced conservatively relative to other players, such as Workday (WDAY).

Even though Oracle is still among the most profitable enterprises within the industry, the company’s gross margin has fallen considerably in recent years and this could be seen as a problem by anyone not familiar with the business.

The reason for the decline has been the evolving mix between support and cloud on one hand and the acquisition of Cerner on the other. This is hardly a problem for Oracle as management remains focused on achieving higher economies of scale in its cloud business and Cerner has been a major stepping stone for the company in the healthcare sector.

Safra just gone back from visiting some prospective customers that are countries that we will be signing contracts with a number of countries to build these national systems. And these contracts are enormous, I mean, absolutely enormous. And there will be several of them. So, as I said in my note in the press release, the scale of this healthcare opportunity is unprecedented but so are the responsibilities that go along with it.

Source: Oracle Q2 2023 Earnings Transcript (emphasis added).

In the meantime, Oracle has been making meaningful progress in the infrastructure space with the combination of Oracle Cloud Infrastructure (OCI) and the Software-as-a-Service portfolio offering a significant competitive advantage for the company. As the infrastructure side of the business scales up, its gross profitability is also expected to improve.

Additionally, I would note that IaaS gross margins improved substantially from last year, and I expect IaaS gross margins will continue to improve.

Source: Oracle Q4 2023 Earnings Transcript.

After the OCI being supply constrained for a number of quarters, Oracle is finally reducing the amount it spends on capex relative to sales, but that could hardly be interpreted as a slowdown in demand.

As we see in the following extract from Oracle’s latest quarterly results, topline growth remains high available capacity remaining to be an issue.

Total revenues for Q1, including Cerner, are expected to grow from 7% to 9% in constant currency and are expected to grow from 8% to 10% in USD at today’s exchange rate.

Additional upside depends on how fast we can put out even more capacity to our customers.

Total cloud revenue, again, excluding Cerner, is expected to grow from 28% to 30% in constant currency and 29% to 31% in USD.

Source: Oracle Q4 2023 Earnings Transcript (emphasis added).

Lastly, as Oracle continues to expand it cloud business, economies of scale are realized and with that the share of fixed costs to revenue has fallen and is likely to remain low.

Conclusion

Contrary to the popular belief and all the talk on Wall Street, Oracle has defied expectations and delivered 125% total return in roughly three years, thus significantly outperforming its peers. As the narrative around the company picks up, however, the opportunity going forward is far less significant than it was a few years ago and many new shareholders could be running the risk of overpaying for ORCL in the short-run. Having said that, the business remains strong, and I still see ORCL as one of the best-positioned businesses in the industry.