In the past companies used to buy a database, install it on their hardware, and deploy it locally. But what we've seen over the last few years is the rise of cloud computing, a significant evolution in the way in which we save, store and access data, and that has resulted in companies like Oracle needing to make a considerable transition in the way they run their business. These companies have gone from receiving a significant upfront payment from customers, most of which flows through to revenue and straight to the bottom line, to a more subscription based-income stream. Subscription revenues are nice to have as recurring revenue from one year to the next allow you to manage your business more smoothly. When you consider the mission critical nature of the database for Oracle’s important customers, it should become a highly dependable earnings stream. While selling the database licence shifts from upfront revenue recognition to an annuity revenue stream, it also allows Oracle to compete for a bigger share of the pie, as the company is now also effectively selling the hardware that runs the database, as well as the labour used to install, update and run the software, effectively expanding their addressable market.
Markets have been very uncertain as to how Oracle will manage this transition, while the decline in upfront revenues have led to concerns that the company is losing market share. But in the last couple of quarters, we have seen signs that Oracle is emerging on the other side of this shift, in a stronger position. The stable and persistent subscription based income stream generates strong free cash flow (FCF) which will support returns to shareholders in the form of dividends and share buybacks (Oracle is currently returning 80-100% of FCF in dividends and buybacks). At $50 the shares are up around one quarter from where they were at the end of 2016, but still appear undervalued to us, especially in the context of an increasingly expensive technology sector.
Exposure to Oracle provides investors with access to a leading player in databases and enterprise applications, but also one which is successfully getting through a transitionary period and starting to deliver solid revenue growth, which is feeding through to the bottom line.