SAP - Oracle: It's All About That Cloud

Summary

• Oracle's cloud business is growing fast, but its relative valuation doesn't fully reflect its potential success.
• Oracle's cost-efficient cloud services and SaaS/cloud applications can attract mid-market and enterprise customers, including small businesses with limited IT budgets.
• Oracle faces risks such as ambitious targets, competition with more innovative businesses, and balancing growth with margins.

Oracle ( ORCL ) has been attracting a lot of attention lately: its cloud business seems to be growing fast, and many investors are optimistic. The sentiment around Oracle's cloud business is mostly positive, both on the internet and on Wall Street. In this article, we will take a more balanced view in understanding the business, its opportunities and risks.

Oracle Cloud Infrastructure (OCI)

As a result of the maturation of its extensive range of infrastructure and application products, Oracle has opted to shift to the cloud in order to revitalize its growth trajectory.

Despite not offering a market-leading solution, Oracle provides numerous core and essential cloud services that could drive adoption among enterprise customers who have not yet made the transition to the cloud, given that only 30% of enterprise workloads are currently in the cloud. We believe that Oracle intends to substantially expand its cloud business by capturing incremental enterprise workloads, leveraging three factors: 1) the continuing growth of the cloud infrastructure market, 2) the migration of Oracle's extensive on-premises customer base to the cloud, and 3) the trend towards multi-cloud environments. If successful, this could propel Oracle to become the fourth-largest public cloud provider, following Amazon ( AMZN ) AWS and Microsoft ( MSFT ) Azure.

One of the significant value propositions of OCI is its cost-effectiveness compared to competing products, primarily due to its significantly lower charges for network bandwidth. Our research indicates that OCI is around 30% more cost-efficient than leading cloud providers for the same configuration. This price advantage can make OCI an attractive option for businesses that require high bandwidth usage, especially for large-scale data transfers or other network-intensive applications.

In our view, the cost-efficiency advantage of OCI has given Oracle the ability to target not only large enterprises but also smaller companies. By offering a combination of Oracle Fusion cloud applications/SaaS with NetSuite, Oracle can capture both mid-market and enterprise application customers. This can be particularly attractive for smaller companies that may have limited IT budgets but still require robust and reliable cloud solutions.

Cloud Applications

Oracle has placed a strong emphasis on developing its SaaS/cloud applications, which it markets under the brand name Oracle Fusion Applications. This effort began over 15 years ago, after Oracle acquired several other applications companies, including PeopleSoft and Siebel, and began integrating their features into its cloud application modules.

The company has placed a particular focus on developing its HCM offerings, where it competes with Workday ( WDAY ) and SAP ( SAP ) SuccessFactors. As the second-largest player in ERP after SAP, Oracle is well-positioned to compete in ERP cloud applications, which is a growing area of focus for many businesses.

We believe that the continued development of Oracle Fusion Applications could lead to high-teens growth over the next three years.

Valuation

Currently, Oracle trades at a forward 12-month P/E ratio of around 16.4x, which is roughly in the middle of its 5-year range. In comparison to the S&P 500, the company is trading at a 10% discount, which is towards the lower end of its 5-year range.

While Oracle's current valuation may not be particularly noteworthy, it is important to consider that both consensus estimates and management projections indicate a significant acceleration in revenue and EPS growth in the near future. According to these projections, annual revenue growth of 7-9% is expected between FY24 and FY26, while EPS is expected to grow in the low to mid-teens range. This represents a significant improvement over the relatively stagnant revenue growth seen between FY18 and FY21 and suggests that the company will largely meet its ambitious FY26 targets.

Despite these positive projections, Oracle's current relative valuation does not appear to fully reflect the company's potential success. In my view, investors may view it as a "show me" story, waiting for more concrete evidence of the company's growth before adjusting their valuations accordingly.

Risks

Risks to Financial Projections: At its Analyst Day in October 2022, management presented ambitious financial targets for FY26, including $65B revenue and 45% EBIT margins. However, there is a possibility that these targets may be overly optimistic, considering the company's relatively weak position in the market.

Consensus estimates for FY26 revenue are currently at $62.8B, indicating that the market may be skeptical about management's projections. However, the consensus estimates for FY26 EBIT margins are at 45.4%, which implies that Wall Street may believe that the company could achieve its margins target only at the expense of growth. This raises the concern that it could be challenging for Oracle to grow its cloud business, which is a key driver of its growth but with lower margins, while simultaneously meeting its margin target. Achieving both goals may require significant investment, and there is no guarantee that Oracle will be able to strike the right balance between the two.

Competitive Risks: Compared to Amazon, Microsoft, and Alphabet, which are known for their innovative approach to technology, Oracle is sometimes viewed as a more traditional or legacy technology company. While Oracle has been successful in growing its cloud business from a small base, it may face challenges in competing with these more agile and innovative businesses at scale. The ability to quickly develop and roll out new features and services is increasingly becoming a key competitive advantage in the rapidly evolving cloud market, and the leading cloud providers have a well-established reputation for being at the forefront of innovation.

Conclusion

While Oracle's cloud business is projected to grow rapidly, accelerating the entire company's growth, the market sentiment appears to be skeptical. Oracle's cost-efficient cloud infrastructure offering, combined with its focus on developing its cloud applications, may enable it to capture both mid-market and enterprise application customers, including smaller companies with limited IT budgets. If management meets its FY26 projections, the stock's valuation should re-rate upwards considerably and generate very attractive returns. However, the company faces risks, including the possibility that its ambitious financial targets for FY26 may be overly optimistic, and that it may struggle to compete with more innovative and agile businesses such as Amazon, Microsoft, and Alphabet. On balance, we walk away with a neutral view of the company.

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