- As Oracle Corporation continues its transition, operating margins are down on a rolling year basis.
- Hardware and Software declined in 2016 for Oracle. These have to remain stable for the cloud to operate as predicted.
- Analysts have some lofty numbers for this year and next. If the company comes up short, the share price would be adversely affected.
Oracle Corporation (NYSE:ORCL) is a company I'm watching closely as its current valuation is a good bit lower than the Industry's average. For example, Oracle's competitors have an average earnings multiple of 32.6 compared with Oracle's price to earnings ratio which is just under 20. The share price at $41.42 is basically trading flat since mid-March which has resulted in the technology ETF (NYSE:XLK) outperforming it over the last 4 months or so.
Despite the transitioning that is taking place at the company (mainly towards the cloud), Oracle has distinct advantages over its competitors that warrants attention. Firstly, although margins have suffered in recent quarters, its database business, for example, achieves peer leading margins and contributes about 30% of the company's net sales. Switching costs are huge as the clients mainly decide to stick with tried and tested solutions. Furthermore, its application software business also ties customers to the company. The challenge here will be to bring these customers onto the cloud (something Oracle came late to) but given the speed the company has been going at recently, I don't see this becoming an issue long term. However, despite its valuation and obvious sound fundamentals, I see Oracle stock as a hold right now. I would need to see more before investing and here is why.
Firstly, with fiscal 2016 out of the way after reporting earnings for its latest quarter, bearish analysts focused straight away on the declining revenue as well as the falling operating margins (compared to fiscal 2015). Oracle's top line fell to $37.05 billion and operating margins fell to 34% despite an uptick in net margins since Q1-2016. However, this didn't affect the trajectory of the stock on the 16th of June when it announced its fiscal 4th quarter earnings as the stock charged higher primarily because of both cloud results and guidance. In fact, total cloud revenue reached $859 million last quarter and from the guidance provided, things are only getting started.
The street really favors strong trending divisions in companies that have re-initiated growth and that is what Oracle now has with the cloud. Although cloud revenue is under 10% of total revenue, the street and analysts alike (plenty of upgrades) see potential going forward and it will be interesting to see how the company executes. Moreover, since Oracle is playing catch-up in this area, I'm expecting a big acquisition or takeover in the near term. This is where the risk would lie in my view as its competitors are presently going like gangbusters.
Secondly, it is quite evident that Oracle and analysts alike are expecting sales from all of the cloud offerings to offset declining sales in other segments. This is another risk and was highlighted both in fiscal 2016 and the last quarter of fiscal 2016. The software segment (which made up 70% of the top line in 2016) dropped by 5% to $26.1 billion and the hardware segment dropped by 5% to $4.7 billion. These two divisions alone make up 83% of the company's annual top line. Yes, the cloud segment is growing much faster but it doesn't even add $1 billion to its top line yet, which is why Oracle has to deliver on its cloud guidance as the fate of the company seems to depend on it.
If we look at the technical chart, we can see that the stock is sure to come up against heavy resistance at the $44 level and will find it difficult to push through. Nevertheless, if analysts are correct and the company reports higher revenues and earnings for both 2017 and 2018, then the $44 level will get broken through sooner rather than later. However, I wouldn't buy the stock until that scenario plays out. All you would lose would be less than $3 of stock. However, if cloud income keeps on accelerating and legacy businesses remain strong, Oracle stock will go much further than $44 per share. Maybe a limit order at that price is the best option at present.
To sum up, Oracle has a wide moat but its rush into the cloud may bring risks to the table going forward. Furthermore, its signature divisions (Hardware and Software) are in decline which is why the company showed its intent by borrowing $14 billion from the bond markets. Expect a lofty acquisition or takeover soon would be my line of thinking here.