Aggressive Selling Tactics Likely to Have Lifted Oracle’s Cloud Revenues in Q1, But at What Cost?

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Software behemoth Oracle Corp. (NYSE:ORCL) is slated to report its fiscal 2016 first quarter results on September 16th. (The company follows June – May fiscal year.) [1] Oracle’s cloud business has grown steadily in the last few quarters on the back of aggressive selling tactics and competitive pricing. On the other hand, the expansion in cloud has come at the cost of a decline in its legacy on-premise software business and the overall profitability. The situation is being further exacerbated by strong currency headwinds. (Read: Currency Headwinds Dampen Rapid Growth of Oracle’s Cloud Business in Q4) Consequently, we believe that Oracle’s cloud business is likely to continue its robust growth in the first quarter of fiscal 2016. But the cost of propping up the cloud business, and whether that cost is sustainable over the long term, remains to be seen.

For the first quarter, Oracle guided revenue from software-as-a-service (SaaS) and platform-as-a-service (PaaS) to expand by around 40% year on year in constant currency terms. Software revenue (including cloud, on-premise, and maintenance and updates) is guided to grow between 6% – 8%, while total revenue growth is expected to range from 5% to 8% year on year. [2] The company does not provide separate guidance for on-premise software license sales, maintenance and update revenue, and revenue from the hardware business. In GAAP terms, the consensus estimate for Oracle’s first quarter revenue is $8.54 billion, which is a decline of 80 basis points year on year.

Our price estimate of $42 for Oracle Corp. is over 10% higher than its current market price.

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Can Oracle’s Tunnel Vision on Cloud Backfire?

It is no secret that Oracle has aimed almost its entire sales and marketing machinery at promoting its cloud products over the legacy on-premise products. The company is repotedly using aggressive selling tactics to strong-arm its existing on-premise customers in switching over to the cloud or a hybrid model. [3] The tactic, called the “nuclear option”, involves declaring a “breach” during regular audits of a customer’s compliance with the very complex contracts that govern Enterprise software use.  Because the penalties of a breach are very onerous, customers are inclined to pay up for additional services to avoid them, according the these cited reports.

The company is also offering its cloud products at heavily discounted prices compared to competitors like Amazon (NYSE:AMZN) and Google (NYSE:GOOG) to sway customers towards its products. While the aggressive pricing strategy may drive sales higher, it is already pushing Oracle’s margins lower – in the previous quarter, Oracle’s non-GAAP operating margin contracted by over 600 basis points. [4] Therefore, we believe that while Oracle’s tactics can propel the growth of its cloud business in the short term, the company may have to rethink its strategy to ensure sustainable long term growth.

Cloud Expansion Alone May Not be Enough

In fiscal 2015, Oracle’s revenues declined nominally by 10 basis points even though revenues from its cloud business expanded by over 30%. This is because revenues from Update and Support account for almost half of Oracle’s total revenues. Further, sales of on-premise software licenses still account for over 20% of Oracle’s revenues. In comparison, revenues from cloud subscription comprise a mere 5% of the company’s total revenues. [4] This implies that in order to drive revenue growth of the entire company, Oracle cannot ignore its legacy on-premise software licenses business. After all, half of its revenues are derived from providing update and support services to its on-premise software customers. It should be noted that in pure cloud (and not hybrid) contracts, the cost of update and support services is built into the subscription price.

Consequently, it follows that to maintain overall growth, Oracle either needs to protect its update and support revenue or find an alternative avenue large enough to drive the entire company forward. The latter is obviously impractical given the scale of Oracle’s operations. With sales of new on-premise software licenses on a decline, it appears that Oracle’s most lucrative revenue source may be under pressure. This is clear from the fact that growth of update and support revenues slowed from 6% in fiscal 2014 to 4% in fiscal 2015.

This fact has not escaped Oracle’s notice, which may be why it is attempting to promote hybrid cloud solutions. [5] In hybrid cloud products, additional cloud capabilities are added to a customer’s existing on-premise software and hardware infrastructure. The customer’s existing software licenses continue in entirety or in part, which may allow Oracle to charge fees for update and support services. Nevertheless, how much incremental update and support revenues may be derived from such agreements is unclear. Hence, unless Oracle can find a way to prop up its Update and Support revenues, it may find that the cloud business alone is not sufficient to drive the company forward.

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Notes:
  1. Oracle Investor Relations []
  2. Oracle Fiscal 2015 Fourth Quarter Earnings Call Transcript, Seeking Alpha, June 17, 2015 []
  3. Oracle is using an ugly ‘nuclear option’ to boost cloud sales, says consultant, Business Insider, July 10, 2015 []
  4. Oracle Fiscal 2015 Fourth Quarter SEC Filing [] []
  5. Oracle offers software to ease hybrid cloud management, Computer World, June 10, 2015 []