November 25, 2020

Oracle Needs To Start Clocking Some Real Growth (NYSE:ORCL)

It’s been a long time since I’ve written on Oracle (ORCL), mostly because it gets kinda boring saying the same things about the same companies – there are only so many ways to say “They generate good cash flow, but they haven’t made the right strategic choices to drive meaningful growth”. Since that last write-up, where I thought the shares had some value but weren’t necessarily compelling, they have generated a total return of around 33% – better than the S&P over that time, but below the returns from the likes of Microsoft (MSFT), Salesforce.com (CRM), and SAP (SAP).

Not a lot has changed. Oracle hasn’t seen a mid-single digit quarterly billings growth rate since mid-FY’18, though an easier comp in this year’s fourth quarter should allow another one. I like the growth in Fusion and opportunities like Gen2 OCI and Autonomous DB, but to borrow a concept from hockey, Oracle strikes me as a company that’s always chasing the puck, not one that reads the action on the ice and skates to where the action will be. The shares do look modestly undervalued, and I don’t think investors will get hurt badly here (unless the entire market, or at least the tech sector, gets trashed), but I also don’t think they’ll outperform over the long term with Oracle.

The TikTok Deal Is A Nice Win But Not A Game Changer

Late Sunday, word came out that Microsoft wouldn’t be acquiring the U.S. operations of TikTok from its parent company ByteDance (BDNCE), and that instead, ByteDance had reached some sort of technology partnership agreement with Oracle. While the U.S. government has yet to formally approve this transaction, initial comments from Treasury Secretary Mnuchin would seem to suggest that this deal may well satisfy President Trump’s mid-August executive order that directed ByteDance to divest the U.S. operations within 90 days.

Very little hard information has come out so far, but Oracle is definitely not acquiring the U.S. operations of TikTok, nor is it getting access to the core technology (like the algorithms or source code). Instead, it looks as though Oracle will basically house the data for TikTok’s US operations.

I don’t personally see how that really resolves any meaningful security issues regarding TikTok, but it does still look like a good deal for Oracle. This deal should add meaningful scale to Gen2 OCI, and while the company will still be a distant #4 among North American IaaS providers, combined with the Zoom (ZM) win earlier this year, it does lend more credibility and momentum to a business that Oracle had already highlighted as a key potential growth engine.

The Growth Engine Needs More Horsepower

Oracle needs whatever profitable growth it can find.

The results from the recently reported fiscal first quarter were better than expected, with revenue 2% ahead of expectations and billings 3% ahead after misses in the prior quarter, but 2% overall revenue growth and 3% overall billings growth are not really all that exciting overall. On a more positive note, operating leverage remains strong, with gross margin up more than a point and operating margin up almost three points, with operating income up about 9% in the quarter.

Oracle clearly has some growth businesses. Fusion remains a good example, with ERP up 33%, HCM up 22%, and Apps up 26%, and NetSuite ERP was up 23%. Oracle also saw good annualized consumption revenue growth in Gen2 OCI (up 130%), as well as positive contributions from Autonomous DB.

Still, they’re only big enough to do just so much good; Oracle has missed a lot of the more transformative opportunities in enterprise software over the last decade, and while some of its large rivals have successfully pivoted to new growth opportunities, it seems like Oracle is always playing catch-up (or chasing the puck, as I said before).

Now, it’s not all bad news. Part of the problem is the simple scale of Oracle’s business. The company has a huge installed base with high recurring revenue; that makes growth more challenging, but it does generate a large amount of high-margin free cash flow every year. Between internally generated cash flow and borrowings, Oracle has returned net cash to shareholders (dividends and buybacks minus options) of $12 billion, $37 billion, and $21 billion in the past three fiscal years, and will likely return something on the order of $20 billion this year as well.

Outlook

Oracle’s business is fine for what it is – a stable enterprise software giant that throws off huge cash flows, but seems unlikely (and quite likely unable) to take the sort of chances necessary to generate a meaningfully higher growth rate.

I expect low-single digit revenue growth over the next decade, and as some of its more recent growth investments mature, I believe adjusted FCF margins can move back into the 30%’s, perhaps sustainably in the mid-30%’s, driving mid-single digit FCF growth. The only possible downside from that is that returns of capital to shareholders will have to decline unless management wants to continue to lever up.

Bottom Line

I use primarily two approaches to value software companies: long-term discounted adjusted free cash flow and a shorter-term EV/revenue model that uses revenue growth and margins as the primary drivers of the multiple. Both suggest a fair value in the $60s, or a long-term annualized total return potential in the mid-to-high single digits. That makes Oracle a decent idea today, and the stock could perhaps outperform if and when the recent preference for growth over quality in the software space reverses (or at least moderates to “growth and quality”).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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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