Oracle Corp (ORCL) — Q2 2017 Earnings Call Transcript

Thank you, Holly. Good afternoon, everyone, and welcome to Oracle’s second quarter fiscal year 2017 earnings conference call. A copy of the press release and financial tables, which include a GAAP to non-GAAP reconciliation and other supplemental financial information, can be viewed and downloaded from our Investor Relations website. On the call today are Chairman and Chief Technology Officer, Larry Ellison; and CEOs, Safra Catz and Mark Hurd. As a reminder, today’s discussion will include forward-looking statements, including predictions, expectations, estimates, or other information that might be considered forward-looking. Throughout today’s discussion, we will present some important factors relating to our business, which may potentially affect these forward-looking statements. And these forward-looking statements are also subject to risks and uncertainties that may cause actual results to differ materially from statements being made today. As a result, we caution you against placing undue reliance on these forward-looking statements, and we encourage you to review our most recent reports, including our 10-K and 10-Q, and any applicable amendments for a complete discussion of these factors and other risks that may affect our future results or the market price of our stock. Finally, we are not obligating ourselves to revise our results or publicly release any revisions to these forward-looking statements in light of new information or future events. Before taking questions, we’ll begin with few prepared remarks. With that, I’d like to turn the call over to Safra.

Thanks, Ken. Good afternoon, everyone. I’m going to focus on our non-GAAP results for the quarter, I’ll then review guidance for Q3, as well as give some direction on FY17 and turn the call over to Larry and Mark for their comments. Clearly, we are pleased with our results as both total revenue and earnings per share exceeded the midpoint of my guidance. Our pivot to the cloud has been phenomenal. We continue to see accelerating growth rates in our cloud business, while our key competitors are slowing down. More importantly, the increase in revenue from our cloud business is starting to overtake our new software license business decline. Our cloud revenue will be larger than our new software license revenue next fiscal year when the transition will be largely complete. While the investments we’ve made to transition our business to the cloud have limited our ability to expand earnings per share in the near term, they’ve been important to ensure that Oracle remains the technology leader. With cloud overtaking new software license revenue, we expect our business to once again exhibit the same pattern we delivered over the previous decade during our license business, increasing revenue that results in EPS and cash flow that grow even faster. We continue to use constant dollar growth rates on our quarterly calls, so that we can have some measure of consistency across the quarters, as well as to reflect how we measure the business. This quarter, the effects of currency movement were more than what I had included in my guidance, mostly because of the strengthening U.S. dollar after recent elections in U.S. and Europe, resulting in currency headwind of 1% in total revenue, 2% in some revenue categories, and one penny to EPS. The devaluation of the Egyptian currency last month also negatively impacted EPS by an additional penny. None of this was in my guidance for the quarter. Cloud, SaaS, and PaaS revenues for the quarter were $912 million, up 89% from last year. You can also see the continuing acceleration of our cloud business in the SaaS and PaaS billings and deferred revenue. The gross deferred revenue balance is now over $1.6 billion, up 51% in U.S. dollars; and SaaS and PaaS billings grew 39% in U.S. dollars this quarter. We’ve put the billings numbers up on our website for you to see the detail as usual. When you add together cloud, SaaS and PaaS revenues, and new software license revenue, they grew 5% in constant currency. And by the way, Database as a Service and database new software license revenue together also grew. These are significant milestones in our transformation with the combination of our cloud and new software license businesses added together are growing. As cloud becomes an even larger percentage of the total, the growth will only accelerate with earnings and cash flow following along. As our SaaS and PaaS business continues to scale and grow dramatically, the gross margin continues to expand. Q2 gross margin for SaaS and PaaS was 61%, up from 43% last year, and I expect to see further improvement in Q3 and Q4. And from there, we’ll be targeting 80%. Cloud infrastructure as a service revenue was $175 million, up 9% from last year. The Q2 gross margin was 37%. Now, that’s lower than prior quarters as we are making the necessary investments to scale out this business. Now, I want to spend a moment explaining it to you, because you’re going to see some effects. What’s happening with the infrastructure as a service gross margin is similar to what we experienced with the SaaS and PaaS gross margin, except that it’s off a much smaller revenue base and thus the margin impact is more at the beginning. To refresh for everyone, when we invested in our SaaS, PaaS business in advance of the revenue scale out, the gross margin declined 16 percentage points before bottoming at 40%; it’s now up to 61%. And as I just mentioned, will climb to 80% over time. Similarly, I expect the infrastructure as a service gross margin will decline further over the next few quarters, as we make investments in the business to hit our expenses immediately while the revenue is recognized over time. But for modeling purposes, I would use 20% as a trough gross margin. Probably, it doesn’t need to go quite that low, but just for modeling purposes you can aim there, after which I expect the gross margin will climb to nearly 40% as the business scales probably higher. Total cloud revenue in the quarter was over $1 billion for the first time at nearly $1.1 billion, up 69% in constant currency from last year. Total on-premise software revenues were $6.1 billion with software updates and product support revenues at $4.8 billion, up 3% from last year. Attach and renewal rates remained at their usual high levels, as our installed base of customers continues to grow. New software license revenues were slightly over $1.3 billion; now that is down 19%, reflecting the continued emphasis on and migration to cloud. Total hardware, including hardware support, was down 9% with hardware systems product revenue of $497 million and hardware support revenue of $517 million. Just so that you know, we are proactively evaluating our expense infrastructure needed to support the on-premise hardware business in light of on-premise hardware revenue declines and the new availability of IaaS for their customers. For the Company total revenues for the quarter were $9.1 billion, up 2% from last year. Non-GAAP operating income was $3.8 billion, up 3% from last year and operating margin was 42%, up from 41% last year. The non-GAAP tax rate for the quarter was 25.5%, considerably higher than last year’s 20.4%, which had been favorably impacted by some one-time benefits. Now, in view of possible changes to the U.S. corporate tax system, normalization of our geographic earnings, and other factors, the likelihood of a favorable impact to our tax rate over time is higher but obviously not certain. Non-GAAP earnings per share was $0.61 in U.S. dollars, the GAAP tax rate was 24.3%, the GAAP EPS was $0.48 in U.S. dollars. Operating cash flow over the last four quarters was $14.2 billion. Capital expenditures for Q2 was $757 million with cloud CapEx accounting for approximately 40% of the total with the rest being real estate. Free cash flow over the last four quarters was $12.6 billion, up 10% from last year. We now have approximately $68 billion in cash and marketable securities. Net of debt, our cash position is approximately $4 billion. The short-term deferred revenue balance is $7.4 billion, up 8% in constant currency. This quarter, we purchased nearly 30 million shares for a total of $500 million, which is less than the prior quarter, due obviously to the use of our cash for the acquisition of NetSuite. Over the last 12 months, we’ve repurchased 172 million shares for a total of $6.7 billion and we paid out dividends of $2.5 billion. The Board of Directors again declared a quarterly dividend of $0.15 per share. Now to the guidance. I am going to provide guidance for Q3, then some updated comments about the whole year. Given recent currency movement, we expect to see continued volatility in exchange rates and significant currency headwind. Today again was a very significant day in currency with the dollar strengthening. I am going to give you constant currency guidance, but if current exchange rates remain just about where they are right now, we expect to see a currency headwind of at least 1% on revenue and at least $0.01 to EPS. All of my guidance today is on a non-GAAP basis. With that, my guidance is as follows. SaaS and PaaS revenues including NetSuite is expected to grow 82% to 86%. Software and cloud revenue including SaaS, PaaS and IaaS, new software license and software support is expected to grow 4% to 6%. Total revenue is expected to grow 3% to 5%. EPS is expected to be between $0.61 and $0.64 in constant currency. Now, this assumes a non-GAAP tax rate of 25.5%, which is considerably higher than the 22.6% reported last year. As a reminder, last year's tax rate was lower, mostly due to the catch-up of benefits related to the U.S. R&D tax credit. Of course, the Q3 tax rate could end up being different. Over the full year FY17, I am raising the outlook for FY17 SaaS and PaaS revenue growth from 67% to 80% with NetSuite now added and continued strengthening in our SaaS and PaaS business. I continue to expect SaaS and PaaS gross margins will exit Q4 higher than the 61% reported today as our cloud business continues to grow dramatically. Lastly, I expect our total CapEx spend for the year will be in the range of about $2 billion with over half of it being due to non-cloud real estate investments that we made this year that we'll not be repeating next year. With that, I'll turn it over to Mark for his comments.

Thank you. As usual, I'm just going to give you a lot of numbers here and try to give you some context on our quarter. Everything's year-on-year in constant dollars, unless I say otherwise. Cloud bookings for the quarter were $377 million in USD. And Q2 was the best non-Q4 we have ever had. I'll make a prediction that Q3 has a chance to be our best ever quarter, period. SaaS bookings were $270 million in USD and positive to structured bookings were $160 million in USD. Just let me give you some numbers by pillar as it relates to our SaaS and PaaS revenue. We were up 89%, more than 30% higher than Amazon, Salesforce, or Workday. ERP had a 104% growth quarter-on-quarter, eighth consecutive quarter with sequential growth greater than 50%. HCM grew 131% again this quarter, that's four times the growth rate of Workday. CX, Customer Experience, grew 15% organically, service was up 24%. Data as a Service was up 71%. Database as a Service was up 700% and already had $100 million in quarterly revenue. PaaS was up 600% and overall SaaS and PaaS grew 89%. SaaS and PaaS billings grew 39% in USD, SaaS and PaaS deferred revenue 51% in USD. Now, just some customer metrics. IDC recently released their SaaS market share estimates. And Oracle is now the number one market share leader in Enterprise SaaS. In the quarter, we got almost 1,100 new SaaS customers and 1,082 to be exact, and have 810 expansions. In CX, we had 443 new customers, 517 expansions. In HCM, we had 224 new customers and 212 expansions. In ERP, we had 532 new customers and that does not include NetSuite; we had 91 expansions. Over half of the new ERP customers never had an Oracle app before they bought. Our active base now is 3,269 with 1,275 live, over 10 times greater than Workday. In total, we now have almost 13,000 customers in our SaaS active base and 25,000 if you actually include NetSuite. Fusion Cloud is now nearly two-thirds of our new customer wins. This is a big deal for us because we spent 10 years writing this code, and it is now the bulk of our SaaS business. We had 348 go-lives, the best quarter ever; 2,116 customers are now live on Fusion. We got 2,225 new platform customers in the quarter and our install base now sits at 12,168. We got 2,148 infrastructure customers; they are buying standalone infrastructure services. Together, our install base of PaaS and infrastructure now sits at 21,219 customers. Now, as a point of clarification, PaaS and infrastructure customers are accounted for in each service that they use. Now, let me just give you the names of a few customers in the quarter. I’m going to go through just a couple of pillars. First in ERP, I'm giving you a list of ERP customers who purchased in the quarter: Canon, Deutsche Telekom, DICK'S Sporting Goods, FedEx, Ferguson, Hasbro, Hill-Rom, Koch Industries, Noble Energy, Ricoh, Skanska, Texas Instruments. I’m going to give you a list of HCM customers in the quarter: Berkshire Hathaway, Cummins, Dubai Airport, Kaiser Foundation Hospitals, Netgear, ON Semiconductor, Siemens, Skanska, Sonic Automotive, Tesco, Hertz Corporation. It was a solid quarter for us. And lastly, let me sort of describe where I think we are. We not only have strong revenue and billings as well, but our Q2 billings were solid at 39%; Q3 has a chance to be our best quarter ever. Q2 revenue was fantastic at 89% and we clearly crossed the revenue gap. We are clearly the fastest growing cloud company with scale. With that, I’ll turn it over to Larry.

Thank you, Mark. Historically, I’ve measured Oracle performance by comparing our technology and our market share to our two primary competitors, SAP and application, and IBM and infrastructure and database. That changes as we move to the cloud. In the cloud, we measure Oracle against salesforce.com and application, and Amazon Web Services and infrastructure and database. Our cloud applications’ goal is to be the world’s largest and most profitable SaaS Company. We are growing our cloud business much faster than salesforce.com and we can beat them to the $10 billion mark, but it’s going to be close. IDC already recognizes Oracle as the number one in annual SaaS sales to large enterprise; salesforce.com is number two. We will book more than $2 billion in annual cloud sales this year, much more than salesforce.com. We are catching up to them, and we’re catching them very quickly. Our goal in infrastructure and database is to be number one running database workloads in the cloud on our infrastructure as a service. The Oracle database has a huge technical and market share lead over the Amazon Web Services databases, Azure, and Redshift. But much more importantly, the Oracle cloud infrastructure as a service runs the Oracle database workloads much faster, more reliably and at a significantly lower cost than the Oracle database running at Amazon IaaS. We are making a multiyear generational shift to the cloud and we’re well on our way to being number one in both cloud application and cloud database. And we are doing it with very little or no compromise to our earnings or our cash flow. With that, I’ll open it up for questions.

Thank you. My question is to Mark. Mark, our field check this quarter led us to believe that cloud traction accelerated beyond what you had been doing, which was pretty good, very good. And we thought this might have a negative effect on license, which sort of comes through in the increased decline in license. But with ARR growth of 30%, that doesn’t seem to be indicative of increasing cloud traction. Can you help us resolve this? I mean, what we’re hearing in the field and the numbers, what the numbers seem to indicate, is it simple as 30% ARR growth may not be the 42% last year, but it’s still pretty good off such a large number or is there something else going on?

Let me go into figures and the math. Our pipeline is substantial, and our wins are significant as well. As I mentioned earlier, we had a good quarter in annual recurring revenue. While 30% growth is solid, I believe we can achieve even more, especially looking ahead to Q3. To emphasize, Q2 was our best non-Q4 quarter ever in terms of bookings. I truly believe Q3 could be our best quarter overall. This reflects the strength of our pipeline and our favorable position. Although I typically refrain from discussing early Q3 wins, it underscores how confident we are as we enter the quarter. I believe that's why you're hearing positive feedback from your field checks regarding our recent deals. While these deals may not yet be formalized, we feel very optimistic about where we stand. Larry mentioned the $2 billion target for the full year, and that encapsulates my response.

Thank you. Can you provide us more details and insight into NetSuite, its impact on Q2 revenue, margins, etc., and its impact on the quarter? I really appreciate it. Thanks.

We acquired NetSuite in Q2, specifically around November 7, so we didn’t have a complete month of data. Its contribution is approximately $50 million. Overall, it's fairly neutral across our other revenue lines since we just started with it. The revenue trend for NetSuite is consistent with its previous performance, but it's important to note that its growth rate does not match the pace of our cloud business, and it is less profitable. Over time, we plan to enhance its performance and accelerate its growth, particularly because our product offerings are much broader, including areas like EPM. For this quarter, I would describe its impact as neutral, but as we continue to own it, we anticipate leveraging its potential, even though it will not grow as quickly as our ERP business.

You mentioned during the conference call that database and Databases as a service have once again shown growth, and I believe this is the second quarter you've made that observation. A common question I receive from clients, which I wanted to pose to you, is whether we are witnessing the positive effects of the 12C cycle. Is it already reflected in higher license numbers due to options, and is the new 12C offering for Database as a service attracting customers to that cloud offering, or is it still too early in this cycle and we are merely seeing growth from core databases?

It’s really early days, and actually 12.2 is only available right now in our cloud in Database as a service, so it really isn’t available on premises yet. So our policy is cloud first, including the release of our latest technologies. So again, we’re very, very early on in terms of the 12.2 cycle and it’s impacting our database license system.

So really all of you are seeing just the strength of our database business. A very, very strong business generally because it is by far the best and we’ve been gaining market share now really for years and that just continues because it meets the needs of so many customers.

Thanks, and if you could give us over time a little more color on that, that would be great. I really appreciate it. Thank you.

I had one for Safra then maybe one related for Larry. When you think about CapEx this year guided to $2 billion, a bit less than half on cloud. So that billion run rate, is that the right level of CapEx that we should be thinking about even beyond this year or will it grow as the total cloud grows? And then related to that for Larry, is infrastructure as a service a necessity as opposed to platform as a service? If you are going to be able to migrate existing on-prem database workloads to the cloud? Thanks.

So two things are happening; as we grow in both IaaS and PaaS, you do get, first an investment period and then you really have economies of scale which we should see. So it will not grow linearly at all. It will grow as depending on how successful we are, but it’s growing up front then it's going to slow down, get used, and then grow as a smaller and smaller percentage. And that's what we are expecting as far as our capital expenditure this year we’re obviously very much front-loaded, both some of our cloud investment and also our real estate investments, which will not be sort of the big chunk it is right now as it was this year.

The question about whether infrastructure as a service is essential has a clear answer: yes, it is crucial if you want to transfer existing database workloads to the cloud while minimizing the adjustments customers must make during migration. This process should be smooth and straightforward. We can set up our cloud network using available resources, configure additional servers to meet capacity needs, and manage storage and data delivery with minimal disruption to ongoing operations. When customers initiate the migration of their databases and workloads, everything should function just as it did before, without needing to reconfigure the applications. Therefore, having both infrastructure as a service and platform as a service is vital for a seamless transition. We have been enhancing our infrastructure as a service technology for quite some time and are now introducing it to our customers. The initial feedback is promising. Ultimately, we aim to outperform Amazon by providing a more graceful, reliable, cost-effective, and secure service, which will significantly enhance our competitiveness.

Great, thank you so much for taking my question. Safra, this one’s really for you, so one of the big things we get asked about and would love some help on is, as more and more customers are pivoting to Oracle cloud, it still maintains its very high renewal rate on the maintenance stream, and I'd love to know a little bit more about how we should be thinking about the maintenance stuff that you can support longer time and the trajectory on that line? Even as new licenses are declining, you're still selling licenses, so how should we be thinking about that longer term, Safra? And then a real quick second one for Mark around the hardware business, and we didn't spend a whole lot of time on that today. I would also love to hear how you're thinking about that business longer term as well. Thank you guys.

You're correct that our renewal rates are quite high, but we don't renew all of our licensed updates and product support. As the number of new software licenses decreases, it's possible that software support could eventually stabilize and even decline. However, this is a long way off, and we currently see no signs of that because we continue to sell a significant number of new software licenses. Ultimately, it may seem hard to envision a positive result, but it would indicate that our SaaS and PaaS numbers are growing substantially, even surpassing the new software licenses and any decline in the software support network. This means that the overall software ecosystem, which includes SaaS, PaaS, new software licenses, and support, is all increasing and actually gaining momentum.

Before I discuss the hardware sector, I want to share that our software renewal rates for the quarter have actually improved, with cancellation rates declining. This indicates a strong performance in our software business. We are also working to transition many customers to cloud solutions, which should increase our revenue and margins. Our goal is to move on-premise application customers to our cloud offerings, and similarly, transition our database customers to our cloud infrastructure and platform. This shift is expected to provide us with a larger recurring revenue stream, which in turn will enhance our earnings while delivering a better experience for our customers. Regarding hardware, we haven't focused on it much recently, but we had a strong performance in engineered systems, with growth in both bookings and revenue. However, we have seen declines in our traditional server business that offset this growth. Essentially, we have contrasting trends: engineered systems are performing well while traditional server product lines are declining. This quarter, Q2, will be the last one where we see these declines due to acquired GBU products. Changes we made in our micros business, including stopping several third-party products, have impacted our hardware growth rate, but we expect this to improve as we move into Q3. The three key factors to consider are the third-party products in our micros business, growth in engineered systems, and the decline in traditional servers.

This is a question that’s mostly for Safra and for Mark. New software licenses declined 19% constant currency. Does this mean that license declines could continue to steepen going forward? Maybe I’ll answer the second part of my question at the same time, which is database as a business overall grew. So if you could talk to us about how database license did within license overall.

Let me start by saying that I do not expect next quarter to see any decline, even at the 19% range, because the significant drop has primarily been in the application sector as SaaS has really taken over our app business. As apps have become smaller, their base is not declining. When there is a decline, it has a smaller impact on our overall new software licenses. Eventually, we will see something similar happen in the database area, but currently, that is not the case since our installed base of usage is continuing to grow at all levels, both on-premise and in the cloud.

There will need to be an interruption, but I see this as a good opportunity to address it nonetheless. Let me clarify: if you transition from the Oracle on-premise business suite to Fusion ERP in the cloud, which we strongly encourage, you must cancel your support for the Oracle on-premise ERP, also known as the e-business suite, and start paying a monthly fee for Fusion. As a result, not only does the cost of the new license decrease, but support costs also lessen as you make this transition, and we want you to do this because it benefits us financially. However, regarding the database, if you move your database to infrastructure as a service, you must own the database license; you never cancel your database license and support, as that continues indefinitely. So, if you migrate your Oracle database to Oracle infrastructure as a service, your support remains in place, and if you need additional database capacity, you must purchase more licenses. If you move the Oracle database to Amazon, you still need your Oracle database and have to acquire more licenses and maintain your support payments. Hence, these two areas are distinct businesses with different profiles. As Safra mentioned, a significant part of the decline in licenses relates to our applications business, particularly as the on-premise application business shrinks. In contrast, the database license business appears to be on the rise, and these sectors will respond differently to the cloud landscape. It's quite possible that our database licensing and associated support will persist indefinitely, even as customers operate that database not on their own hardware but on our infrastructure or those of Amazon or Azure. Therefore, it's essential to model these two businesses in entirely different ways.

Thanks for taking my question. And it's great to see your CTO so busy on the call. My question is actually for Mark. Mark, can you talk a little bit about what you see in the different regions? You talked about the products, but just wanted to hear how you see the regional performance. If I look at the numbers, Asia was very strong, U.S. and Europe moderated a little bit. Can you just talk about what you see in terms of that region? And then Safra, did I understand, did I hear you correctly that you talked about double-digit EPS growth in 2018? Just wanted to clarify that.

To clarify the CTO's earlier point about our applications business, we do not compensate our sales team for on-premise applications. Our sales team in the applications ecosystem is focused on selling FAS. We have small teams within our Oracle direct organization that assist existing users with purchasing additional seats for their on-premise applications. This approach aligns with our strategy to transition to SaaS, which has positioned us as leaders in enterprise SaaS. Regarding regional performance, Latin America faced challenges this quarter, though it has historically been one of our strongest regions. Despite current difficulties in Brazil and Mexico, Latin America is making significant gains in market share. While the numbers may not meet our expectations, their performance relative to peers is commendable. I am proud of their efforts. In Europe and North America, we saw results in line with expectations. Our European team has excelled, particularly in transitioning to the cloud, and overall bookings have grown significantly. North America performed as we anticipated. In contrast, Asia has shown remarkable improvement. After addressing previous performance issues, Asia's results in hardware, SaaS, PaaS, infrastructure, and licensing have been very promising. I am pleased with the outcomes in that region.

Yes, sir, I wanted to just make sure, you did hear me right we are expecting to have double-digit earnings growth next year.

Okay. A telephonic replay of this conference call will be available for 24 hours; dial-in information can be found in the press release issued earlier today. Please call the investor relations department for any follow-up questions from this call. And we look forward to speaking with you. Thank you for joining us today. And with that, I’ll turn the call back to the operator for closing. Happy Holidays.