On December 17, I noted in this article that it was time for Oracle (NYSE:ORCL) to deliver upon past promises. I noted that the company reported slower growth in its key cloud business in the second quarter, with a further slowdown foreseen in the third quarter. The slower pace of growth of this key business does not rhyme with comments made by management, which continues to talk up the business in recent quarters and on its conference calls.
Shares fell to $48 back in December following the disappointing news as I patiently waited for a further pullback to levels in the low $40s before initiating a sizeable position. After having risen to a recent high of $53 in March, it appears that the sizeable pullback has now arrived, with shares having fallen towards the $44 mark, although still not at $40.
Softening Trends
The reason for the pullback can be directly traced to the guidance for the current fourth quarter, as third-quarter results were quite reasonable. Third-quarter revenues were up by 6% to $9.8 billion, as the annual growth rate was in line with the growth percentage reported in the second quarter and down a point from 7% reported in the first quarter.
While this sounds rather stable, it really is not, as the weaker dollar continues to provide a greater tailwind to the reported numbers, with revenue growth amounting to just 2% in constant currency terms. While a 32% growth number or the $1.6 billion cloud business looked good and surpassed the initial guidance, it marked a slowdown from the 44% growth in the second quarter and even the 51% growth rate reported in Q1.
The fall in growth was most pronounced in cloud software SaaS revenues, which were up by 33% to $1.2 billion, as this was still up 55% in the second quarter, in part offset by a slight acceleration in PaaS and IaaS revenues, which grew by 28% to $415 million.
Traditional on-premise software revenues were up 4% to $6.41 billion, although flat if you account for currency moves. Hardware and service revenues were down by 7% and 6% in constant currency terms, respectively.
As total expenses were up just 2%, Oracle has seen real leverage in terms of operating earnings, which jumped 15% to $3.41 billion. The company reported a big loss, but that is mainly the result of the changed tax legislation.
Oracle reported an adjusted earnings number of $3.5 billion, for earnings of $0.83 per share. Excluded in this adjustment is a pre-tax $879 million combined adjustment, split pretty evenly between stock-based compensation expenses and amortisation charges, as well as a small restructuring item. If we assume that half these costs are real structural costs to investors, that works out to nearly $0.10 per share, or perhaps 8 cents if we account for taxes. That means adjusted earnings probably come in at $0.75 per share on a realistic basis.
Big Cash, Solid Earnings Power
For the first three quarters of this year, Oracle reported adjusted earnings of $2.15 per share, as the seasonally stronger fourth quarter makes a $3.05-3.10 per share number look reasonable for the current fiscal year. If we assume that realistic charges to adjusted earnings trend at $0.30-$0.40 per share, realistic GAAP earnings come in at around $2.70 per share.
Note that Oracle furthermore has a fortress balance sheet with cash holdings of $70.4 billion, although debt has risen to $60.7 billion, for a shrinking net cash position of roughly $10 billion. With 4.2 billion shares outstanding on a fully diluted basis, net cash holdings have risen to just little over $2 per share.
Operating assets are valued at levels closer to $42 per share, which, combined with the estimated realistic GAAP earnings, means that multiples have compressed to 15-16 times earnings.
The good news is that following the changed lax legislation, which involved a big tax bill in the fourth quarter, Oracle no longer has to engage in huge overseas borrowings. The company spent $1.5 billion on interest last year despite the fact that it has a net cash position. After applying a 20% tax rate, that works out to $1.2 billion, or $0.30 per share, as this expensive financing scheme gets wound down over time, resulting in both declining cash balances and debt levels as well, allowing Oracle to forfeit on the expensive "spread".
This creates another road map to pro forma earnings of $3 per share by now, reducing valuation multiples another turn to just 14 times earnings.
Expectations Are Coming Down
The third-quarter results were actually a little stronger than Oracle guided for itself back in December, aided in part by the weakening dollar since the start of the year. The reported $0.85 per share in reported earnings is seen comfortably ahead of the company"s own guidance of $0.71-0.73 per share provided alongside the release of the second-quarter results.
For the current fourth quarter, adjusted earnings are seen at $0.89-0.92 per share, which looks very decent given the $0.85 per share number posted for this past quarter. Truth be told, adjusted earnings came in at $0.85 per share in the final quarter of 2017, indicating that annual earnings growth is slowing down quite dramatically. I have to stress that the guidance is based on constant currency terms, as reported adjusted earnings are seen three cents lower following the change witnessed in exchange rates.
More worrisome, perhaps, are the projected revenue trends for the quarter, with dollar sales seen up just between 1% and 3%. In constant currency terms, revenues are seen flat at best, but could fall by 2% as well. What"s worrisome is that it is not just the legacy business which is slowing down, but that despite all the great talk, the cloud business is moving lower as well, with growth projected to go down to 19-23%.
As always, if you exclude the numbers, you get the sense that this is an amazing growth company listening to the conference call, while in reality, growth is flat at best in constant currency terms. Hence, the valuation is depressed quite a bit. Using potential realistic GAAP earnings of close to $3 per share if the interest spreads come down a bit, operating assets trade at 14 times earnings for a 7% earnings yield. The problem, however, is that underlying growth is close to zero despite all the talk about growth and focus on the growing areas, while nothing has been said about the lagging legacy businesses either.
This makes the company a perfect value play, as the transformation will in all likelihood take many more years, resulting in another round of disappointment for investors. While more M&A could be a solution, the net cash position has been coming down quite a bit already. Given that Oracle has great assets and underperforming legacy assets, a split of the business might be an idea, to the extent possible. By doing so, the company could take advantage of the 10 times sales multiple which this market is often attaching to "cloud" plays, thereby creating value through the sum-of-the-part calculations.
The cloud currently makes up $6-7 billion of the near-$40 billion conglomerate, as a 10 times multiple could value this at $65 billion. If we assume that the very profitable $33 billion remaining business might fetch a very reasonable 4 times sales multiple and we apply net cash, we end up with a $50 per share valuation already.
Following the latest plunge, I have bought a quarter of my desired "full" position, as I remain sceptical about Oracle, but am simply too attracted to the valuation of the business at this point.
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Disclosure: I am/we are long ORCL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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