The article was written by Amber Zhou, a Financial Analyst at I Know First.

ORCL Stock Outlook

“People are not afraid of AI taking their jobs and instead want to be able to quickly and easily take advantage of the latest innovations” – said Emily He, designated SVP of Oracle’s Human Capital Management Cloud Business

Highlights:

• A Dramatic Slide despite Satisfying Q4 Results
• Grasp Market Demand by Autonomous Database and AI-Featured Applications
• Valuations and I Know First Algorithm Agree on Bullish Long-term Forecast

(Source: Wikimedia)

A Dramatic Slide despite Satisfying Q4 Results

On June 19, Oracle Corporation (NYSE: ORCL) stock price was initially lift up upon the release of its 2018 Q4 results. The operating performance beat analysts’ expectation. According to Thomson Reuters, it reported an EPS of 99 cents, exceeding the 94 cents expectation. Revenue rose 3 percent since last quarter up to $11.25 billion, higher than the $11.19 billion FactSet analyst consensus. Moreover, the 6 percent yearly sales growth reached the highest level since 2011.

Despite the satisfying operating results, Oracle stock then experienced a substantial slide after the company issued a disappointing guidance for the coming quarter. Stock price immediately tumbled down by 7.5% to $42.82, the lowest level since March 2017. In the Q1 guidance provided, the company estimated $9.4 billion for revenue, with 1-3 percent growth, and 67-69 cents for EPS, compared with Wall Street expectation of $9.5 billion and 72 cents respectively.

(Source: Yahoo Finance)

Doubts from Change in Revenue Reporting Structure

Another driver of the dip in price comes from a significant change in Oracle’s revenue reporting format. With a different accounting standard adopted due to the strategic transition to cloud business, Oracle will not provide the revenue breakdown, namely revenue from SaaS (Software as a Service), PaaS (Platform as a Service) and IaaS (Infrastructure as a Service) from this year. Instead, two other aggregated figures will be reported for the cloud business. The market reacted negatively people doubt that the company might be hiding something.

(Source: Oracle Investor Presentation)

However, according to what Safra Catz, CEO of the company, explained during the Q4 earnings call, the change is to reflect and provide a better understanding of their recent introduction of BYOL (Bring Your Own License) program. More specifically, the BYOL policy allows customers to bring their on-premise license entitlements to the Oracle Cloud and get license support through their existing on-premises support contract at a lower cost. This move implicitly helped the company to penetrate deeper in its existing market. That is where the “Cloud services and license support” segment comes from. The other cloud business segment, namely “Cloud license and on-premise license”, focuses on those who buy new licenses and deploy them in their Cloud.

Essentially, the integration of SaaS, PaaS and IaaS in a same standard data center and the extension of SaaS applications with PaaS and IaaS technologies potentially differentiates Oracle Cloud to other companies’ products. Because most of the competitors only specialize in one level, either SaaS or IaaS. At the same time, the new revenue generating model would help Oracle to boost cloud profit margin. According to Oracle CTO Larry Ellison, the company could gain cost efficiency from economies of scale by such consolidation.

Grasp Market Demand by Autonomous Database and AI-Featured Applications

Another core competitive edge of Oracle lies in its new-generation database introduced in late 2017 with autonomous features. Combining with a set of automated administration services that use machine learning algorithms, the world’s first autonomous database allows the system to manage, secure, tune, upgrade and repair itself and hence frees up the human administrators for more strategic and high-level works. From the perspective of customer companies, the automation process would not only guarantee higher level of data security and reliability by eliminating human error, but also enhance their profitability by cutting labor costs and better distributing human resource.

Exhibit: Oracle’s Self-Driving Database

(Source: Company Website)

Besides, within the SaaS sector, a variety of AI features are customized for Oracle’s different cloud products. For example, two of its most popular cloud applications, Fusion ERP (Enterprise Resource Planning) and Fusion HCM (Human Capital Management) were upgraded with new AI features. With the new ERP helping to automate transactional work and analyzing historical trends and business risk data, finance and procurement professionals are able to make smarter financial decisions, optimize cash flow and maintain better relationships with suppliers and buyers. While the new HCM tool with AI-powered capabilities could help HR managers to locate the best candidates more quickly and accurately and even estimate the likelihood of success and longevity.

Exhibit: Adaptive Intelligent Apps

(Source: Company Website)

The automated features provide another big motivation for customers to migrate to Oracle Cloud. Although this new pipeline just began to generate revenue and has not completely shown up in the latest financial statements, much more revenue growth could be expected in the long term, especially as the company is continuously adding more automated features rapidly. As Ellison mentioned, Oracle’s database market share is considerably larger than IBM’s and MSFT’s due to the attractiveness of the autonomous services. The migrating process could take some time but the massive trend is already there.

Valuations Give a Long Recommendation for ORCL

Our 5-year DCF analysis arrives at a target price of $53.79 for ORCL, 10.86% upside from the current price. DCF model was constructed based on 3 main factors: top line and bottom line forecast, capital expenditures, and WACC.

As the company is transitioning its focus to cloud business and the other segments have been shrinking in the past five years, I expect the hardware segment to continue shrinking by 5% per year, service segment to remain stable. The higher margin of software market would bring more profit for the company. For the cloud business, due to the popularity of the newly introduced BYOL program mentioned above and migration is a relatively long process, I expect the cloud support segment to grow 9% annually in the next five years. While the cloud license and on-premise license revenue is assumed to reduce by 4% each year. As a result, the annual total revenue growth in the next five years would range from 4.81% to 6.05%, consistent with the 1-3% quarterly revenue growth and long-term 7% annual revenue growth guidance announced by company’s management. The Capex is expected to grow at 12% per year compared to 14% in the past three years.

For relative valuation, six comparable companies with similar business models and product portfolios are selected, including Microsoft (MSFT), Salesforce (CRM), SAP (SAP), IBM (IBM), Workday (WDAY) and Teradata (TDC). Oracle operates in the technology industry where long-term profitability is much more important than short-term bottom-line figure because heavy upfront investment is needed to acquire more future revenue streams. Therefore, top line is used with P/S ratio and EV/Revenue ratio.

As shown from the average target price calculated below, the valuation indicates that current ORCL shares are undervalued by about 19.88%.

Current I Know First Bullish Forecast

The I Know First machine learning algorithm currently has a bullish forecast for ORCL. The signals for all three time horizons are strong. Especially for the 1-year long-term forecast, the signal is over 100 and the predictability indicator is up to 0.72. This shows that ORCL is a good long-term investment target, which is consistent with the fundamental analysis illustrated above.

How to read the I Know First Forecast and Heatmap

Conclusion

Despite the negative market reaction regarding the guidance report for next quarter, I believe that there is great future potential for Oracle’s cloud business. Although the company started shifting to the cloud much later than other giant competitors such as Microsoft (MSFT), IBM (IBM) and Amazon (AMZN), it has gained core competitive advantage in the market via its autonomous database, AI-driven applications as well as BYOL policy. Given the product strengths, there is strong and steady demand in the market. It just takes time for Oracle to fully meet the demand and boost its top line figure.

Therefore, fundamentally speaking, Oracle’s stock is being undervalued in a long-term perspective.

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