Why Cloud Services Account For 60% Of Oracle’s Value Despite Just 10% Revenue Contribution

Software giant Oracle (NYSE:ORCL) has witnessed rapid growth in its cloud services business in recent years, while its core on-premise software business has slowed down. Furthermore, ancillary hardware and services segments have also declined in recent years. Accordingly, Oracle is largely dependent on cloud services for growth. Cloud services revenues, including Platform-as-a-Service (PaaS), Software-as-a-Service (SaaS) and Infrastructure-as-a-Service (IaaS), have become more relevant to Oracle in recent years, as shown below.

According to our estimates, the SaaS and PaaS segments combined make up over 50% of Oracle’s value, while IaaS makes up around 7% of its total value. Cloud services combined account for around three-fifths of Oracle’s value despite a 10% contribution to net revenues in 2016. Below we take a look at why these segments are so much more valuable to Oracle than its core businesses.

Outpacing Global Market In Cloud Services

Oracle’s cloud services (combined SaaS and PaaS) revenues have grown at 55% from 2012 through 2016. In the same period, the global SaaS and PaaS markets combined grew at a CAGR of 25% to just under $110 billion by 2016. Consequently, the company’s implied share in the combined market went up from 1.2% in 2013 to 2.7% in 2016.

The last few quarters have been a major turnaround period for Oracle in terms of transitioning more of its customers to cloud-based offerings. As a result, cloud revenues have grown faster than historic levels despite a large base factor. As shown below, cloud revenues have increased by 57% on a y-o-y basis through the first three quarters of the year. We forecast the company to continue to gain share in the combined SaaS+PaaS market.

Similarly,  IaaS revenues have also grown by double digits in recent years. Oracle’s management has indicated that this segment is expected to continue to grow faster than SaaS in the future. The company plans to compete directly with Amazon’s AWS (NASDAQ:AMZN) and Salesforce (NYSE:CRM) in the IaaS market.

We forecast Oracle’s strong revenue growth in cloud services to continue to drive the company’s top line in the coming years. As a result, the contribution of cloud services to Oracle’s net revenues is expected to increase from less than 10% in 2016, and an estimated 12% in 2017, to over 40% in the next five years.

The company is targeting gross profit margins of around 80% for its SaaS business. Strong demand for SaaS offerings can help the company achieve its targeted margins in this segment. Comparatively, the IaaS segment’s margins have shown a negative trend in recent quarters, as the company is undergoing higher expenses and investments in the initial phase. As a result, gross margin for IaaS stood at around 41% in 0 2016. This is expected to remain in this range for a couple of years before picking up by the end of the decade.

As customers increasingly opt for cloud-based services including SaaS, IaaS and PaaS, the demand for on-premise deployment of software and applications will likely continue to suffer. As shown above, on-premise software deployment and corresponding software support revenues are expected to fall from $25 billion to under $18 billion over our forecast period. Additionally, hardware and new licenses revenues could witness limited growth in the coming years. Revenues from all other segments except cloud services are expected to remain low in the coming years.

You can modify the interactive charts in this article to gauge the impact of changes in individual drivers on our price estimate for Oracle. We have a $51 price estimate for Oracle, implying a market cap of $210 billion. Our price estimate is slightly higher than the current market price, which has risen from $39 at the beginning of the year to $49 currently.

See our complete analysis for Oracle

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