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Oracle Remains Cheap Despite Headwinds

The pandemic has weighed heavily on the U.S. economy, with the country losing nearly 40 million jobs since the virus began spreading. Many companies have felt the pinch as consumers and businesses curtail spending. The virus has hit the hospitality, retail and transportation sectors hardest. These sectors have seen spending grind to a near halt, which has impacted business in other areas of the economy.

Oracle Corp. (NYSE:ORCL), a name I first wrote about in early April, felt the impact in its most recent quarter, but there remains a lot to like about the company. Shares of Oracle continue to look cheap from my perspective, even with the headwinds that the company is dealing with.

Quarterly highlights

Oracle reported its fourth quarter and full year earnings for fiscal 2020 on June 16. Revenue declined 6.3% to $10.4 billion, missing Wall Street analysts' predictions by $240 million. On the other hand, adjusted earnings per share increased 3.4% to $1.20, which was 5 cents ahead of estimates. A stronger U.S. dollar played a factor in reduced results as currency exchange was a 2% impairment to revenue and a 2 cents headwind to EPS.

For fiscal 2020, which ended May 31, revenue decreased 1.1% to $39.1 billion while adjusted EPS increased 9.5% to $3.85. In constant currency, revenue was flat and EPS was higher by 11%.

For the quarter, total cloud services and license support revenue grew 1% year-over-year (3% in constant currency) to $6.8 billion. In my previous article, I stated that I felt that this segment would really be the growth engine for Oracle as the global cloud computing market is expected to increase at a high rate over the next few years. This segment represented 66% of quarterly revenues, up from 61% in the previous year.

As with the previous quarter, growth in cloud services and license support was due to higher subscription revenues. Application subscriptions improved 3%, led by a 31% increase in the company's Fusion Applications business. These applications cover a whole host of business tasks. Netsuite ERP, which allows companies to perform tasks such as inventory management, track financials and maintain customer relationship management, had revenue growth of 25%. Infrastructure subscription revenues climbed 3%, led by strength in database subscriptions.

Cloud license and on-premise revenues decreased 21% to $2 billion. This follows 15% growth in the fourth quarter of 2019. Hardware revenues were down 9% to $901 million whiles services declined 11% to $735 million.

Oracle generated $13.1 billion of operating cash flow and $11.6 billion of free cash flow for the year. The company's balance sheet remains strong with more than $43 billion in cash and equivalents. Deferred revenue stands at $8 billion, the same as the third quarter.

Oracle also bought back $5.2 billion worth of its own stock in the fourth quarter. The company retired a total of 361 million shares in fiscal 2020 at an average price of ~$53. Buybacks have been a common theme at Oracle for quite some time, with 40% of shares outstanding having been retired over the last decade. Operating margins of 44% for fiscal 2020 were up just slightly from the prior year. Oracle also issued $20 billion in debt during the quarter. Interest expense from this activity lowered EPS by 3 cents.

Oracle wasn't caught completely flat-footed by the pandemic. The company's global workforce worked from home and expenses were reduced by 8%, showing that Oracle is a fairly nimble business. The company also offered free training through its Oracle University for certification on its Oracle Cloud infrastructure and autonomous database. Hundreds of thousand of people spread out over 150 countries took the company up on its offer. What amounts to basically free advertising for the company's products could help bring in future business.

Oracle did see weakness in certain industries, especially in retail and hospitality. The company does expect that this business will eventually return and demand for products will come back. Oracle believes payments that weren't made during the quarter by struggling businesses will be made up over the course of the new fiscal year.

According to Yahoo finance, the analyst community expects $4.07 of EPS for fiscal 2021 on revenue of $39.3 billion. This would be an increase of 0.6% in revenue and a 5.7% improvement in EPS from fiscal 2020.

Valuation analysis and potential returns

Oracle closed Friday's trading session at $54.40. Using fiscal 2020 results, the stock trades with a trailing price-earnings ratio of 14.1. Using analyst estimates, the stock has a forward price-earnings ratio of 13.4.

Shares of the company have traded with an average price-earnings ratio of 13.8 over the last decade. The average multiple expands to 15 when looking at just the last five years.

The switch to a work at home model due to Covid-19 will likely result in further cloud growth. Prior to the pandemic, it was believed by market analysts that the global cloud computing market size could reach more than $620 billion by 2023, which is an average annual growth rate of 18% from 2018.

Microsoft (NASDAQ:MSFT) is the leader in cloud computing, but trades with a price-earnings ratio of more than 34 today. The company generated just under $39 billion in cloud related revenue in fiscal 2019. While Microsoft's leadership position dwarfs that of most other companies in the space, Oracle is no small player in this sector, having produced almost $27 billion in cloud service revenue in fiscal 2020.

Therefore, given Oracle's strength in this area and the percentage of revenue that comes from the cloud computing business, I continue to have a target price-earnings ratio range of 15 to 17 for the stock. Using analyst estimates for fiscal 2021, shares would then be worth $61 to $69. Investors buying at the current price could see returns of 12% to 27%.

This potential return doesn't include the current dividend yield of 1.8%. At the low and high end of my price target range, the yield would be 1.4% to 1.6%.

Final thoughts

The pandemic was a headwind to Oracle's fourth quarter results, but the company's most important business continued to see growth. Cloud service and license also now accounts for a higher percentage of total revenues. As this is an industry that continues to see higher levels of spending, Oracle is well positioned to capture future business.

Oracle trades below its five and 10-year average valuations. Due to its cloud business strength, I feel that the market continues to undervalue both the business and the stock. Investors looking for a company with a large cloud presence and a very reasonable valuation may want to consider buying Oracle.

Author disclosure: the author is long Microsoft

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This article first appeared on GuruFocus.