Image Source: Peter Kaminski
By Kris Rosemann
Oracle (ORCL) is still working to transform its operations to a cloud-based business model, but it is already selling more new software as a service (SaaS) and platform as a service (PaaS) annually recurring cloud revenue than any other company in the world, including key competitors Salesforce.com (CRM) and Workday (WDAY).
Oracle competes in large SaaS markets that Salesforce.com does not, such as Enterprise Resource Planning (ERP) and Human Capital Management (HCM). After many years of developing the most complete ERP suite in the cloud, Oracle Fusion ERP is the overall market leader in the enterprise cloud ERP market. The firm has more than 10 times the number of ERP customers than Workday, and Oracle believes that the breadth of its cloud product portfolio will enable it to maintain a high level of cloud growth for an extended period of time. The transition is still in its early phases.
Despite cloud SaaS and PaaS revenues jumping 57% in the third quarter of Oracle’s fiscal 2016, total revenue fell 3% as reported–or 1% on a constant-currency basis–from the year-ago period; revenue fell in every non-cloud related category. Total cloud revenue rose to 8% of total revenue from 6% in the same quarter of fiscal 2015, a positive sign for the transformation but still a long way from a complete transformation. Total on-premise software revenue and total hardware revenue fell 4% and 13% on a year-over-year basis, respectively. New software licenses fell 15% and made up 18% of total revenue compared to 21% in the year-ago period, largely due to the high growth in cloud-based revenue.
However, short-term deferred revenue increased 7% on a year-over-year basis to $6.9 billion thanks to strong bookings and deferred revenue growth from its cloud offerings. SaaS and PaaS deferred revenue nearly doubled in the third quarter of fiscal 2016, and SaaS and PaaS bookings grew 77% in constant currency in the quarter from the year-ago period. These growth ates are much higher than those of Oracle’s competitors, and the company is encouraged with the market share continues to take.
Operating income and operating margins have also been affected by Oracle’s transitional period. GAAP operating income in the quarter fell more than 10% to $3 billion, and GAAP operating margin fell to 34% from 36% from the third quarter of fiscal 2015. Earnings per share have been pressured as well, declining nearly 11% on a GAAP basis from the year-ago period. The company did beat its expectations for earnings per share in the quarter, a positive sign for its roadmap to a successful transition.
Despite the earnings headwinds, management continues to trumpet its rising gross margin in its SaaS and PaaS offering, which jumped to 51% in the quarter from 43% in the second quarter of fiscal 2016. The company is targeting an 80% gross margin in this category in the long run, an attractive figure that may not be attainable for multiple years as its cloud business continues to scale. It is also quick to note that only 15% of total capital expenditures in the quarter were cloud related and expects this to continue to fall compared to last fiscal year as past investments are utilized. This aspect of the cloud-business will improve with scale as well.
Through the first nine months of fiscal 2016, free cash flow too has been suppressed as a result of Oracle’s change of strategy. Lower cash from operations and increased capital expenditures led to a nearly 5% decline in free cash flow generation in the first three quarters of 2015, and though management expects its cloud-based capital expenditures to decline in coming quarters, it may not be enough to boost free cash flow in the near term. Over the last 12 months, the company has returned nearly 120% of free cash flow to shareholders via dividends and share repurchases, and it recently approved an additional $10 billion in buybacks.
In the past, “Oracle’s Cloud Performance Leaves a Hazy Overall Outlook,” we have pointed to the company’s large cash balance as a source of cushion as it continues its transition to a cloud-based business model. At the end of the third quarter of fiscal 2016, Oracle had $50.8 billion in cash, equivalents, and marketable securities, down from $54.4 billion at the end of fiscal 2015, while non-current notes payable increased to $40.1 billion from $40 billion in the same period–Oracle issued $20 billion in senior notes in fiscal 2015.
Though this still amounts to a sizeable net cash balance, the nearly $4 billion decline in cash, equivalents, and marketable securities in three quarters is not as good as it could be. The substantial increase in debt points to the fact that Oracle, like many other multinational corporations, is hesitant to bring home the cash it is holding in foreign countries to avoid paying US taxes. As of the end of fiscal 2015, the company held $42.7 billion of its cash, cash equivalents, and marketable securities overseas.
Despite the large hit to its cash balance, Oracle remains upbeat about the long-term potential of its transition. Cloud computing requires lower costs and less complexity and offers more reliability, better security, and rapid innovation than on-premise software systems. Lower capital expenditures and a growing gross margin are key positives that are expected to come from the transition, but a large portion of the benefit is anticipated on the transitioning of revenue from on-premise software to cloud-based services and the growth in customer wallet share.
While the firm realizes that it will not be able to complete a one-to-one transition of all of its customers from on-premise to cloud offerings, it is confident that its enormous installed base will provide a reasonable amount of its new cloud bookings. The company has more applications in the cloud that will attract new customers and additional revenue from existing customers, and as on-premise customers switch to the cloud, Oracle will deepen its wallet share of the process via additional services required on its end to run the cloud. As the firm’s on-premise software exists, customers manage their own hardware and do all the labor themselves. In the cloud-based business model, customers will end up paying and additional support fee, which will actually cost the customer less than it would to run its own on-premise database.
The full transition will not be completed for some time, as evidenced by cloud revenue only accounting for 8% of total revenue. The near-term pressures will continue, but management surely paints nothing but a rosy picture for its long-term opportunity. The firm has a ways to go before fully turning the corner with respect to completing the transition, and it could take years to complete. However, we like the fact that the company is able to lean on its strong free cash flow generating software business as it wanes. We cannot disagree that the transition would create value over the long-term if successfully executed, but that “if” remains. Investors in Oracle are betting on the notion that that “if” will turn into a “when.”
Oracle remains one of the better ideas in big cap technology, but readers have others to choose from as well, including Apple (AAPL), Microsoft (MSFT), Cisco (CSCO), and other constituents of the newsletter portfolios.