Cloud computing is quickly becoming a massive market. Companies are increasingly forgoing the traditional on-premise computing and storage systems in favor of a cloud-based system. The global cloud computing market size is estimated to reach more than $623 billion by 2023. This is an 18% CAGR from 2018 levels.
While Amazon (NASDAQ:AMZN) and Microsoft (NASDAQ:MSFT) are the leaders in the space, the size of this market makes it likely that other companies will be able to take advantage of growing demand. One company that looks poised to make its mark in this area is Oracle Corporation (NYSE:ORCL).
<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Company background” data-reactid=”20″>Company background
Oracle’s products and services are marketed to a wide variety of corporate information technology settings. The company offers several different ways for customers to access its products. This includes on-premise systems and cloud-based systems as well as a hybrid system. Cloud services and license support contributed two-thirds of revenue last fiscal year, which ended May 31, while cloud and on-premise licenses added 15%. Hardware contributed 9.4% to sales, with services accounting for the remainder. International sales were slightly more than half of total sales for fiscal 2019. Oracle trades with a market capitalization of $168 billion as of Thursday’s close.
Oracle reported third quarter of fiscal 2020 earnings results on March 12. The company’s earnings per share of $0.97 was one cent above estimates and an 11.5% increase from the previous year. Revenue grew 1.9% to $9.8 billion, which topped the average estimate by $46 million. In constant currency, revenues were higher by 3%.
Cloud services and license support, the company’s largest division, improved 4% on a reported basis and 5% in constant currency to $6.9 billion. This was almost 71% of total revenues, an increase of 2% from the previous year. This was mostly due to higher demand for subscriptions, as license revenues were flat year-over-year.
The subscription-based model gives Oracle a steady source of recurring revenue. Customers pay for what they use. Deferred revenues totaled almost $8 billion for the quarter, showing that Oracle has plenty of future revenues in the pipeline.
Net sales for applications as a whole increased 7% to $2.8 billion. Oracle’s family of Fusion Applications, which cover a wide range of business tasks, had sales growth of 32%. Enterprise resource planning grew 38% while human capital management improved 27%.
Oracle Autonomous Database had growth of 150% off a small base. This cloud application has the potential to see a large growth trajectory in the coming years as OAD use machine learning to automatically perform security checks, backups, updates and other routine management tasks. This lessens the burden on database administrators while reducing human error.
Wrapping up the rest of the company’s businesses, on-premise sales totaled $1.2 billion while services generated $778 million, both of which were flat compared to the third quarter of fiscal 2019. Hardware declined 5% to $857 million.
While the spread of Covid-19 has had a major impact on many different businesses, I believe Oracle shouldn’t feel as much of an impact to the economic disruption that the virus has caused. The reason for that is the company’s subscription business, which is about 60% of revenues, is mostly contracted. That means that revenue source should remain fairly constant even in the face of a pandemic.
The company said on the conference call that revenues are expected to range from down 2% to up 2% for the fourth quarter, while adjusted EPS should be higher by 3% to 9%. However, it should be noted that this guidance was given prior to the exceptional growth of Covid-19 cases.
<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Returns and valuation” data-reactid=”30″>Returns and valuation
Oracle’s business model and recent results aren’t the only reason I am bullish on the stock. One of the key reasons I find Oracle attractive is how profitable its cloud services and license support segment is. Gross margins for the third quarter were 86%, a 1% improvement from the previous year. The company’s largest division sees $0.86 of every $1.00 in revenue fall to the bottom line.
This gives the company significant free cash flow. Oracle has generated $12.4 billion of free cash over the last 12 months and ended the third quarter with nearly $26 billion in cash and equivalents. This provides the company plenty of capital to buy back shares and pay dividends.
As with most technology companies, Oracle often offers compensation in the form of stock options to executives and management. However, thanks to a long history of share repurchases, the share count has actually decreased over time. The company retired nearly 1.7 billion shares from 2010 to 2019. This means that Oracle repurchased an average of almost 4% of its share count every year for the last decade. The company has reduced the share count by 28% in just the last five years alone.
Oracle retired 73.5 million shares for a total of $4 billion in the third quarter. The board of directors added an additional $15 billion, or 9% of its current market capitalization, to its share repurchase authorization.
Aside from share buybacks, Oracle also returns capital to shareholders through dividends. Though the company has only paid a dividend since 2009, the dividend quadrupled between 2010 and 2019. That growth rate has slowed a bit in recent years, as the average annual increase over the last five years is just under 10%.
Oracle last raised its dividend for the April 25, 2019 payment, which resulted in a 26.3% increase. The company has maintained the same dividend for the past five quarters. I don’t believe a cut is in the future due to payout ratios, but investors should monitor this situation. It should be noted that the company has gone more than the customary four quarters in a row without increasing its dividend before.
<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Confirming my belief that the dividend is safe are the earnings per share and free cash flow payout ratios. The company is scheduled to pay out $0.96 in dividends per share this fiscal year while EPS is expected to be $3.87. This means just 25% of expected profits will be distributed in the form of dividends. If accurate, this would be Oracle’s highest payout ratio since the company started paying dividends in 2009. The average payout ratio over the last five years is 22.5%. The company does not appear to expect Covid-19 to have a material impact on results for the current fiscal year.” data-reactid=”41″>Confirming my belief that the dividend is safe are the earnings per share and free cash flow payout ratios. The company is scheduled to pay out $0.96 in dividends per share this fiscal year while EPS is expected to be $3.87. This means just 25% of expected profits will be distributed in the form of dividends. If accurate, this would be Oracle’s highest payout ratio since the company started paying dividends in 2009. The average payout ratio over the last five years is 22.5%. The company does not appear to expect Covid-19 to have a material impact on results for the current fiscal year.
Oracle has distributed $3.1 billion of dividends over the last twelve months. Recall from above that the company has had $12.4 billion of free cash flow over that same period of time, giving Oracle a free cash flow payout ratio of 25%. Oracle’s free cash flow payout ratio for the previous three years was 22.5%. The company’s free cash flow would likely have to be decimated before it was cut.
Shares of Oracle yield 1.8% as of Thursday’s close. While the yield is on the low side, it’s the stock’s total return potential that should peak investor’s interest. Based off the recent closing price of $53.18 and expected EPS for the current year, shares have a forward price-earnings ratio of 13.7. This compares to the five and 10-year average price-earnings ratios of 15 and 13.8, respectively. For context, Microsoft, one of the kings of cloud computing, trades at 29 times forward earnings. Oracle isn’t in that tier as of yet, but the company’s results and the potential size for the cloud lead me to believe the stock deserves to trade with a slight premium to its historical average valuation.
If shares were to trade with a price-earnings ratio of 15 to 17, then shares would be worth $58 to $66 using current estimates. This would be a 9.2% to 24% gain from the most recent close. This is a solid return for a stock that shouldn’t be too heavily impacted from the effects of Covid-19.
<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Final thoughts” data-reactid=”45″>Final thoughts
Cloud computing remains a big business and should expand at a high rate for at least the next few years. While there are some undisputed leaders in the space already, the market for these services is vast. This will likely allow for other names to stake out a sizeable piece of the cloud business.
Oracle is one company that is already doing that. The company saw an uptick in revenue in its cloud service division, with solid growth in its applications business. Fusion growth was particularly strong. The company also doesn’t believe that Covid-19 will impact fiscal year results as much of its revenue base, i.e. subscriptions, is already under contract.
Oracle is also a free cash flow producing machine, which has allowed it to spend considerable amounts of capital on share repurchases and dividends. This trend should continue as well. Given all of this, I feel that the stock is undervalued and deserves to trade with a higher multiple than it currently does.
Author disclosure: The author is long Microsoft.
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<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="This article first appeared on GuruFocus.
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