Database and enterprise software giant Oracle (ORCL) reported fiscal third quarter earnings after market hours on 15 March, 2016. It’s firming revenue picture and improvements in profitability measures that the Street considers important pleased the markets and the stock is trading strongly higher today.
I have written extensively on Oracle and recently suggested two option-based investment opportunities in the firm. This article provides a quick summary of IOI’s take on the earnings announcement and an update on the investment strategies. For more detail regarding the prior strategies, please see the following Tear Sheets:
- Levered Long on Oracle (2 October, 2016)
- Short Put on Oracle (14 October, 2016)
Earnings Announcement Summary
In true IOI style, we’ll look at the Oracle’s announcement from a valuation driver perspective, discussing revenues, profitability and investment spending. To see the reported numbers, please see Oracle’s Investor Relations site.
Revenues
Oracle reported a decline in revenues related to its overseas sales denominated in foreign currency. As I have written before (refer to the Currency Fluctuations section of this article about Oracle competitor IBM), in most cases, foreign currency effects on valuation are unimportant, so I prefer to look at the results on what’s called a “constant currency” basis. The good news on a constant currency basis is that:
- Cloud revenues grew briskly — “Software as a Service” sales were 61% higher than the same quarter of 2015 and overall Cloud revenues were 44% higher.
- Single-digit growth in Oracle’s most important segment — Software Updates — offset a fall in new software licences, so the “legacy” portion of Oracle’s software revenue was flat.
- Hardware sales fell 8%, but the proportion of Oracle’s revenues coming from hardware is relatively modest, so overall revenues increased by 1%.
IOI’s worst-case revenue growth assumption stands at 0% for 2016 and 2017, with a best-case assumption for these years at 2%, so the 1% year-over-year results this quarter look right in line with our assumptions. Revenue growth for the first three quarters of 2016 in constant currency terms are better than our best-case scenario.
There have been several news stories about competitive incursions into Oracle’s database franchise recently — one from Microsoft and the other from Amazon. For reasons I won’t go into in this note, these competitive offerings do not seem like much of a threat to Oracle. Microsoft and Amazon certainly would like to break into Oracle’s database business, but this field favors the incumbent.
News reports about Oracle’s earnings talk a lot about the growth of Cloud revenues because that is the Wall Street flavor-of-the-month when it comes to technology. Oracle’s Cloud offering is displaying strong demand, but the true driver of Oracle’s success as a company is coming from the Software Update segment, and this business looks healthy. Updates Segment revenues were up 5% while nominal GDP has been increasing only in the 3% range, which suggests to me that Oracle’s core demand environment is firm.
Profits
In Morningstar’s note about Oracle’s earnings today, the analyst notes appreciatively that…
SaaS and PaaS gross margins expanded more than 1,100 basis points to roughly 50%…
This sounds great, but the simple fact is that owners of a company don’t get a share of gross profits — companies have a lot of costs to pay out of gross profits!
Looking at profits from an Owners’ Cash Profits (OCP) perspective, I found that the firm had generated roughly $9.2 billion in profits during the first nine months of 2016 versus $9.5 billion during the first nine months of 2015 — a decrease in around $300 million. As a percentage of profits, this works out both years to be in the neighborhood of 35% — compared to our worst-case OCP margin scenario of 34% and very close to the historical median profit margin over the last few years. All things considered, we did not think Oracle profits were much to write home about.
Investment Level
Oracle spent $1.3 billion in investment projects in the first nine months of 2016, compared to $7.0 billion in 2015. The difference is caused by an additional $6.2 billion of acquisitions in 2015 compared to only $0.3 billion in 2016. Oracle did spend more on Property Plant & Equipment this year (around $1.0 billion) in order to build out a service center in Austin, Texas. Investment spending for a firm like Oracle tends to be lumpy and opportunistic, so we see no reason of changing our base assumption that 40% of Oracle’s profits will be spent on investments over time. Information regarding share issuance (for which we estimate a cash cost) is not available in the quarterly announcement and usually represents the lion’s share of Oracle’s investment spending. Even without figures available, we are quite certain that founder Larry Ellison is still egregiously overpaid.
The firm also announced a $10 billion buyback plan — a good portion of which will be spent to cover up the fact that Ellison receives far too much compensation in stock awards.
Investment Strategy Update
When Oracle’s stock price fell to the $37 level in early October 2015, we published a Tear Sheet suggesting a “levered long” strategy (In-the-Money calls overlaying a stock position). However, because we make a point to wait to act on a suggestion until we have published it, we were unable to pay what we considered a reasonable price for the ITM call options. All good things come to those who wait and in January of this year, we were able to purchase LEAPS expiring in January 2018 at a price we felt good about (as mentioned in this article). That strategy is bearing fruit today, with healthy unrealized gains on the position.
In mid-October, Oracle’s stock price fell again and I published another Tear Sheet recommending an unlevered “bond replacement” strategy (selling naked puts options). We were able to do that in October and the put options expired In-the-Money (meaning that I bought the shares at the strike price less the amount received as premium). This unlevered position allowed me a concentrated position in the stock at a price I considered very reasonable.
Together, my long position in the stock from my original 2013 purchase plus the levered long exposure and my new unlevered exposure have returned handsomely in 2016 and I’m happy with my exposure to this great company.
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