It is still one of the best-positioned cloud service providers in the potential artificial intelligence, or AI, market and I expect this to materialize over time. While Oracle is not taking market share quite as rapidly as I hoped, I still believe the company is well-positioned to keep taking market share in the cloud industry, albeit at a slower pace.
Furthermore, OCI remains a top pick by large enterprises and AI-focused businesses in particular, highlighted by the fact that Nvidia (NVDA) mainly uses OCI. Also, Oracle has one of the most robust cloud application portfolios out there through its enterprise software specialty, including ERP, HCM, SCM, and CX applications, giving it a similar advantage to win cloud service contracts as Microsoft (MSFT) has through its office products. These strong customer relationships and superior cloud offerings will benefit the company over the next decade as it aims to win market share in the highly competitive cloud computing market.
While the short-term outlook and analyst estimates need to be downgraded, and the long-term view might have been slightly too opportunistic as well, Oracle is a long-term winner in the cloud computing and AI industry. Considering the lowered outlook, the share price seems to be sitting around fair value after a 10% drop following the Q1 results.
In this article, I will take you through the latest developments and financial results and update my estimates and view on the company accordingly.
Decelerating revenue growth and a top-line miss looks worse than it really is
Oracle reported its Q1 results earlier this week, on September 11, and shares plunged 13% once the market opened the next day as the company missed the revenue consensus. In itself, a minor miss of below 1% would not be a reason for a 13% share price drop, making it look like a major overreaction.
However, investor expectations of Oracle beating the consensus and delivering faster growth driven by a boom in AI had caused the share price to run up quite high, increasing by 50% YTD and leading to the shares being valued at a 40% premium to their 5-year average. Oracle is one of the leading cloud providers globally with a 2% market share. It has been named one of the frontrunners and, therefore, primary beneficiaries of the AI wave, partly due to its close relationship with Nvidia.
Considering the hype and high expectations of AI, especially after the reported blowout Q2 results from Nvidia a few weeks ago, it is safe to say that expectations for Oracle’s Q1 results were high and all eyes were focused on the company’s performance and progress in its cloud operations. This meant Oracle shares were valued for perfection (probably even higher), which the company could not deliver.
For its fiscal Q1, Oracle reported revenue of $12.45 billion, up 8.7% YoY but missing the consensus by $20 million and my estimates by $210 million. This sounds far from tremendous and even somewhat disappointing when considering that many analysts prior to the results expected the company to outperform the consensus as well. Also, revenue growth has slowed down significantly from previous quarters. This is partly due to the company lapping the very strong performance in its fiscal FY23 and increasing economic headwinds. Also being a drag on reported growth is the transition of Cerner to the cloud. This is what management said regarding this:
In addition, we are in an accelerated transition of Cerner to the cloud. This transition results in some near-term headwinds to the Cerner growth rate as customers move from license purchases, which are recognized upfront to cloud subscriptions, which are recognized ratably.
These issues are not fundamentals but simply temporary due to a change in the timing of revenue recognition.
Furthermore, the headlines of an earnings miss and decelerating growth are somewhat deceiving as Oracle’s reported sales growth slowdown and the earnings miss are primarily the result of a weak performance in the license and hardware business, which reported a revenue decline YoY of 11% and 8% respectively. And while decelerating revenue is never a positive, these two segments are not crucial to the Oracle investment thesis and have decreased as a share of total revenue for several quarters.
Crucially, management remains confident about accelerating growth past Q2 again. It continues to see far more demand for its cloud infrastructure than it can currently supply, making building out data center capacity as quickly as possible its biggest challenge. Therefore, management expects its growth in cloud operations to remain high this year.
While cloud revenue came in below my expectations, its growth is still respectable
Much more important to monitor is the company’s performance in its cloud operations and while these are also definitely impacted by the same economic headwinds that lead to decreased IT budgets, AI and cloud computing headwinds are strong enough to keep growth relatively strong. Cloud growth of 29% was down significantly from the 55% reported in Q4, but this includes the impact of Cerner. Excluding this, cloud operations revenue increased by 29% in Q1 to $4 billion, only down slightly from 33% growth in Q4, which is far from bad.
However, while Oracle is still outgrowing most of its cloud computing peers like Microsoft (MSFT), AWS (AMZN), and Google (GOOGL) (of course, from a much lower revenue base), the gap between the growth rates is closing, and I expected the cloud performance from Oracle to remain somewhat stronger. Oracle’s cloud platform OCI is seen as one of the best to use for large generative AI programs, which is why it is also used by Nvidia, but today we are not seeing this materialize quite as much as I expected it to.
In the end, including license support revenue, cloud services brought in $9.5 billion, accounting for 77% of total revenue, and this was up 12% YoY, driven again by a strong performance in cloud applications adoption and customer migration, Autonomous Database growth, and high demand for Gen2 OCI.
Diving deeper into the cloud operations, we can see that growth was largely driven by growth in infrastructure revenue, up 64% (compared to 77% in Q4) to $1.5 billion. Infrastructure cloud services revenue grew 72%, now representing $5.6 billion in cloud infrastructure services revenue annually and OCI consumption revenue was up 91%, down from 112% in the previous quarter, highlighting the continued high demand for computing space on the company’s cloud infrastructure, driven by customer additions and higher usage by existing customers.
The company’s SaaS segment, which includes enterprise software cloud applications, including ERP, HCM, SCM, and CX applications, saw revenue come in at $3.1 billion, up 17% YoY. Meanwhile, the performance in cloud applications was somewhat stronger, growing 20% YoY, and now has an annualized revenue of $6.9 billion.
Finally, the company’s very important database subscription operations, in which Oracle is a global market leader, were up 6% YoY (including license support). This was mainly driven by cloud database services which were up 44%. Oracle continues to migrate existing customers to the cloud and expects this to drive a third leg of revenue growth together with increased demand for strategic SaaS applications and Gen2 OCI cloud services. This migration also decreases Oracle’s exposure to slow-growing legacy technologies and boosts its cloud potential.
So, where the performance of the cloud operations from Oracle is solid, it is far from impressive and slightly below my expectations for now. Of course, it could take somewhat longer for the AI advantage to materialize and I do not view this single quarter as a reason to turn less bullish on the company’s prospects. Its strength in enterprise cloud applications, cloud databases, and technological advantages through OCI Gen2 gives me confidence in its growth potential.
However, if this believed edge over its competitors does not result in faster growth, even from a lower revenue base, I wonder if the company can take more market share, limiting its revenue potential and my bull case. This is important to keep monitoring in future quarters but for now, there is no reason for concern.
Oracle drives margin improvements despite significant infrastructure investments
Moving to the bottom-line results, the cloud services and license support gross margin reached 78% in Q1, driven by significant margin improvements in the company’s cloud infrastructure business as built-out cloud capacity fills up, boosting its economies of scale benefits. As this part of the business accounts for 77% of revenue, this meaningfully boosted the company’s operating margin as well, expanding by 140 basis points YoY to 41%. This resulted in operating income growth of 23% to $3.3 billion.
It’s positive to see that Oracle is able to boost margins despite continued significant investments in R&D and the build-out of cloud capacity. R&D investments grew by 6% in Q1 and accounted for 18% of revenue, and Capex over the last 12 months now totals $8.3 billion. Furthermore, while Oracle has seen its margins decline in recent years following a shifting product mix and high capital investments in its data center capacity and technology, recent margin improvements are a good sign for years to come as investments should eventually slow down and cloud margins should improve as capacity fills up and economies of scale benefits kick in more significantly.
Finally, these margin improvements also boosted the bottom-line performance and drove EPS growth of 14% to $1.19 per share, beating the consensus by $0.04 or 3.5%. Free cash flow (“FCF”) also grew rapidly by 21% to $5.7 billion in Q1, bringing the 12-month total to $9.5 billion, up 76% YoY. Oracle has always been strong at generating FCF, but in the last two years, the performance has declined quite significantly due to significant investments. However, today, the company is clearly starting to see these investments pay off, boosting its cash flow again. As a result, management expects the FCF performance to stay strong for the year.
As FCF increases again, this should easily cover the company’s dividend obligations, which now stand at $3.9 billion annually. Shares currently yield 1.26% on a payout ratio of just 29%. I view this as a decent starting yield, considering Oracle is still a growth company in one of the most exciting industries. Also, as FCF grows over the next several years, I see plenty of room for significant dividend increases in the high-single to low-double digits.
However, on a more negative note, the company’s balance sheet is still far from pretty after a decade of many acquisitions and a growing debt load. The long-term debt currently stands at $84.4 billion, which is far from a comfortable level for a technology company. Oracle ended the quarter with $12.1 billion on the balance sheet, which is an improvement from the $10.2 billion at the end of Q4 thanks to the strong FCF performance in Q1.
While I expect the financial position of the company to improve over the next few years, the large debt pile will remain a drag on the company’s valuation multiple and will keep share buybacks lower. Overall, I believe the current debt pile is manageable if Oracle indeed starts reporting more significant FCF levels again, limiting the risks involved.
Outlook & ORCL stock valuation
For Q2, management expects revenue growth to fall in the range of 5% to 7% based on today’s exchange rate. Excluding the headwinds from the Cerner transition, this growth should sit closer to 8% to 10%. This would put Q2 revenue at around $13 billion at the midpoint of guidance, approximately $500 million below my projections.
Near-term growth, as highlighted by the Q1 results and Q2 outlook, is meaningfully lower than anticipated by analysts and myself. The company is impacted more heavily by economic headwinds than expected and has yet to be able to show significant financial benefits from its strong positioning toward AI. To me, the Q2 outlook is simply disappointing.
Cloud operations revenue is expected to grow by 29% to 31%, falling roughly in the same range as the 29% growth reported in Q1 and remaining comfortably above most of its peers. Depending on the level of investments in Q2, EPS is expected to show growth of between 7% to 11%, highlighting further margin improvements and to be between $1.30 and $1.34 in USD. Given the current high demand, management expects Capex in FY24 to be flat YoY.
Based on this lower-than-expected Q2 outlook and the mixed Q1 results, I have been forced to lower my short-term expectations. I remain confident in the company’s long-term potential for now, but this will require improved results and growth in the second half of its fiscal year. Following these developments, I now expect the following financial results through FY27.
(Includes Q2 revenue of $13.12 billion and EPS of $1.34.)
Moving to the valuation, shares are currently valued at 19.5x my FY23 EPS projection, which is still a 22.5% premium to its 5-year average but down meaningfully from the 22.5x multiple it was priced at prior to the Q1 earnings release.
However, Oracle is still far cheaper than most of its cloud peers like Google, Microsoft, Amazon, and Salesforce (CRM). Furthermore, a premium to its 5-year average seems more than justified as the growth outlook for the next five years is far better than the last five.
Considering the operational risks, high debt load, disappointing near-term performance, but also its strong medium-term outlook, I am confident that a 20x P/E multiple is fair for the company today. Based on this belief and my FY25 EPS estimate, I calculate a target price of $125 per share. Going with a 10% annual return, I believe this puts the current fair value share price at around $107 per share, meaning shares are currently trading around fair value at a share price of $110.
Considering all aspects, the over 10% drop in Oracle’s share price following its Q1 results seems fair. Shares had run up to far YTD, driven by investor enthusiasm around AI, resulting in expectations rising to high as well.
However, while the company missed revenue consensus, the magnitude of the miss seemed disproportionate to the actual performance. It’s important to note that this setback is primarily attributed to temporary factors, such as the transition of Cerner to the cloud and a slowdown in the license and hardware business.
Oracle’s core strength lies in its cloud operations, which still exhibited respectable growth, even though it has slightly decelerated from previous quarters. The company’s emphasis on cloud infrastructure and applications, supported by technologies like OCI Gen2, remains promising for future growth.
Financially, Oracle has improved margins and generated significant free cash flow, enabling it to cover dividend obligations and potentially support future dividend increases. However, its large debt load remains a concern, albeit manageable if FCF levels continue to rise.
In the short term, Oracle faces challenges from economic headwinds and must demonstrate more significant benefits from its AI positioning. Nevertheless, its long-term potential remains intact. Taking into account operational risks and the current economic climate, a fair valuation suggests that Oracle’s shares are trading around their fair value.
I have slightly lowered my target price from $128 to $125 to account for the mixed Q1 results and disappointing Q2 outlook, causing me to lower my FY24 outlook. Still, I remain bullish on the company’s long-term prospects and believe investors should be well-positioned for strong returns at a share price of around $107. Therefore, I rate shares a careful buy at a current price of $109.