Oracle’s self-cannibalization is over rated - it's a solid pivot

We sometimes view Oracle and its transition to the cloud as a self-cannibalization, something that Ravi Parikh did in a recent post on Seeking Alpha. Parikh makes a lot of sense; his logic is fine as are his numbers. But there’s another way to dissect the situation that should also be taken into account.

In any self-cannibalization argument, we tend to worry that a company is throwing away a profitable business and taking on less desirable or less profitable one. (Why can’t they just keep selling licenses?) That seems to be the financial consensus about Oracle’s move to the cloud. But self-cannibalization isn’t what we’re seeing.

When a company gets as big as Oracle it effectively becomes the whole industry with little room for much more than organic growth. That’s only a slight exaggeration for Oracle as there are several big competitors such as Microsoft, SAP, IBM, AWS, Salesforce, and some others with which Oracle competes. But the enterprise market is more or less built out. You can’t get new business without having to take it from elsewhere these days. This zero-sum game is a hallmark of a market top.

So the argument that emphasizing cloud computing over traditional on-premise IT is a bit of a red herring. Having captured as much of the traditional space as it’s likely to get, Oracle is now participating in a pivot driven by commoditization. That’s what cloud computing is at its heart, a commoditization of conventional IT. And the commoditization is so successful, because it offers significant price efficiency, that it is unstoppable.

Oracle and all the others face a Hobson’s choice of either going to the cloud regardless of the price structure or going out of business eventually. The result is a decision that looks like self-cannibalization because suddenly margins are not as good, growth rates are puny, and total revenues look hollow. As Parikh’s analysis puts it,

• Hardware and services that contributed almost 28% to total revenues in 2012 only contributed 20% in 2017.
• Oracle’s total cloud revenues were up 60% in 2017 while total cumulative growth in revenues over the last five years is merely 1.64%.

He goes on,

Although Oracle's total cloud revenues were up 60% in 2017 and have more than doubled in the last two years, they are at best substituting for the decline in its traditional revenue streams - software, hardware, and services. Revenues of new software licenses were down 32%, hardware revenues were down 34%, and service revenues were down 21% in the last five years. Hence, the total cumulative growth in revenues over the last five years is merely 1.64%. In fact, sales in 2017 were marginally lower than that in 2015 and 2014. Despite the scrimpy growth rates, the stock is up over 90% since May 2012.

What to do?

The steep declines are exactly what you should expect to see when a company is pivoting. The new cloud business doesn’t depend on selling hardware or software but selling everything as a service in a new model.

Parikh’s last sentence tells much of what we need to know. The stock is up 90 percent over the last five years, one can surmise because, in addition to some buybacks and increasing dividends, investors are not buying today’s company but tomorrow’s. That company will have customers for three new and distinct product lines in IaaS, PaaS, and SaaS. Moreover, the new revenue model coming into view will have recurring revenue including unbooked revenues that are parked as contracts and bank deposits. All of this suggests that the metrics now in use will either become irrelevant or de-emphasized.

If Oracle sported a five-year cumulative growth rate of 1.64 percent without having a rather compelling cloud story to tell, we’d see panic in Redwood Shores. But the fact is that Oracle is executing a solid plan. Sure it would be nice if AWS, Microsoft, and Salesforce weren’t making headwinds but we should also point out that 1.64 percent is written in black ink not red.

What’s most interesting about Oracle’s pivot to the cloud is that it has barely stirred the huge installed base yet. That will take time as customers have a lot of juggling to do. Their budgets are primarily fixed on maintenance when their leaders would rather be innovating new business processes supported by cloud computing. There are whole systems to depreciate still and ongoing operations to consider.

Nonetheless, Oracle is at the end of a big spending streak that had to be expensed in the absence of immediate demand—what else can you do when you’re in the middle of building a swimming pool? That was a drain on resources and profits. As the pivot continues, the customer base will kick in and revenues will pick up nicely. That’s what’s been driving the stock price uptick, as it should be. After all, a share represents a claim on future earnings.

My take

Oracle is executing well enough for the moment and concerns of financial analysts are valid and part of their job. But some of that analysis misses the point. The big issue to consider is how Oracle will conserve or recapture its customer base as those companies look around at all of the cloud offerings available to them. That boils down to soft skills, marketing, service, and support as well as product development. The message from the last couple of OpenWorld conferences has been that Oracle has been to charm school and is working to move from being a conventional vendor to becoming a solutions provider. The stock is still subject to the vagaries of the market but the business looks solid.