Oracle (ORCL) reported first quarter earnings for its fiscal year 2016 after the market close on September 16.
The earnings numbers were heavily influenced by currency translations brought about by the rapid rise in the value of the U.S. Dollar versus other global currencies and both revenues and net income missed Wall Street expectations largely due to the currency factor. I will write in more detail about my valuation of the company in a later post, but in brief, here is what most stood out to me while analyzing the company’s earnings release.
- The demand environment remains very strong for Oracle, despite the currency fluctuations.
- Profitability, using IOI’s preferred metric of Owners’ Cash Profits (OCP) was phenomenal.
- Expansionary Cash Flows (ECF) appear modest so Free Cash Flow to Owners margins are likely also very high.
- It appears that the company is issuing relatively less stock to managers while at the same time buying back more stock in the open market.
Demand Environment
Currency effects are a bookkeeping detail that do not necessarily reflect underlying demand for a company’s products or services. Excluding currency effects, all of Oracle’s revenue lines increased in comparison to the first quarter of FY 2015 except for the New Software Licenses segment. By far and away the most important portion of Oracle’s revenues — the Software License Updates segment — grew by 8% year-over-year. The Updates segment represents 73% of all software revenues and 56% of total revenues, and is far and away the most profitable segment in Oracle’s line-up, so the evidence of strong continuing demand is very encouraging.
Perhaps more encouraging than the currency-adjusted 34% increase in Cloud revenues was the fact that the Hardware segment also grew at a 6% clip. This shows me that, after having run down the obsolete hardware product lines it acquired from Sun Microsystems, Oracle’s Hardware segment is finally providing a boost to revenues rather than a hindrance.
The 9% drop in the New Software segment is a result of the company pushing more of its customers into one or more of its Cloud products. New Software makes up 14% of total revenues this quarter, so simplifying the math and assuming it will decline by 10% per year means we can expect a (14% * 10% =) 1.4% drag on revenue growth from New Software. That said, Cloud revenues make up 7% of total revenues this quarter and if we again simplify the math and say that this business will grow at 35% over the next year, we see Cloud is providing a (7% * 35% =) 2.5% tailwind to revenues and more than offsets the drag from declines in New Software.
Overall, the company’s revenues grew at a currency adjusted basis of 7% year-over-year, which represents IOI’s best case revenue scenario for FY 2016.
Profitability
Profits as measured on the Income Statement were disappointing, and I found several analysts bemoaning Oracle’s drop in profit margins. However, if we look at profitability on an OCP basis — which is a cash measure of profitability — margins are nearly twice what IOI’s valuation model for Oracle assumes.
Why such a discrepancy?
Oracle’s shift into the Cloud means that it cannot recognize all of the revenues it generates during a quarter (for more information about “revenue recognition,” please see this post) but must hold them as an asset that translates slowly into revenues as the term of the Cloud contract shortens. However, the company does have to count most of its cost as they are incurred. This means that Oracle’s revenues look weaker and costs look proportionally higher.
These issues disappear when looking at profitability from a cash perspective because the increase in deferred revenues result in an inflow of cash whether they are recognized as revenues or not. In fact, this quarter, the increase in deferred revenues (which indicates again a strong demand environment) was the second largest source of operating cash inflows. The largest source was generated as customers paid amounts they had previously been billed (also a good thing).
One of the things I most want to do is to sharpen my pencil and look again at Oracle’s best-case profitability level. The IOI model presently assumes a best-case OCP margin of 36%, but on the basis of the last few quarters of results, I think that assumption may be too low.
Expansionary Cash Flows and Free Cash Flows to Owners
I will not be able to calculate a firm number for ECF or FCFO until the 10-Q (the financial statement filed with the SEC a month after quarter end) is published because not all the data I use is available in the information the company releases during its quarterly announcement.
That said, capital expenditures only represented roughly 8% of total OCP during the quarter — a very modest level. In addition, share issuance appears to be lower this quarter (I estimate the cash cost of stock issuance to executives and employees as a reduction of free cash flow), which bodes well for FCFO generation.
The IOI model’s assumption for ECF as a percentage of OCP is 40%, a value that looks much higher than the numbers I can presently see. That said, quarterly stock issuance and capital expenditures can vary a good deal, so I see no evidence yet for adjusting my 40% assumption.
Stock Buybacks
The company called out an increase in the value of the stock it was repurchasing in the open market and said that if stock prices remain as low as they are, the company is likely to purchase shares even more aggressively. While I don’t view stock repurchases with undiluted pleasure, as long as the company is cutting back on its stock issuance (which Oracle appears to be doing) buybacks are a positive for investors.
Future Investment Strategy
I purchased a large amount of Oracle stock during the recent market drop and am happy that I did. After I analyze the last few quarters of numbers more closely and refine my valuation of the company, I may well decide to use options to prudently increase my levered exposure to this investment as well.