Cloud Hangs Over Oracle Conference

We came away from

Oracle's ORCL OpenWorld conference and analyst day with new insights into how the company is approaching the secular shift to cloud computing. The most surprising move came in the unveiling of the company's next-generation infrastructure-as-a-service offering. Previously, Oracle had been reticent about the idea of competing directly with public cloud behemoths Amazon AMZN and Microsoft MSFT , but it appears the company will address this market full bore moving forward. While this move unlocks new opportunities for Oracle, we maintain our $38 fair value estimate, as we remain skeptical of the IaaS strategy. We also maintain our wide economic moat rating.

The bulk of the conversation during Oracle's analyst day focused on the company's cloud offerings spanning software as a service, platform as a service, and infrastructure as a service. In particular, the SaaS and PaaS businesses represent the most developed product offerings for the company and the most readily addressable markets in the cloud. The company has now landed 12,500 SaaS customers (which does not account for the pending NetSuite acquisition), and management highlighted a strengthening pipeline that should yield significant growth over the next several years as enterprises migrate business applications to the cloud more aggressively. The company has 8,000 potential customers in its pipeline (excluding NetSuite), while more than 50% of its SaaS customers are new to Oracle. However, the bulk of its SaaS customer base remains in the midmarket, and we continue to believe that Oracle risks its large customers jumping ship to cloud-native SaaS vendors such as Salesforce.com CRM and Workday WDAY , which have proved their scalability. Further, the PaaS pipeline is growing, with bookings more than doubling between the third and fourth quarters last year; this instills confidence that the company will not be caught flatfooted when considering the long term for its middleware customers.

Oracle offered compelling specifications for its public cloud offering around compute and storage capacity, and it theoretically should have some ability to differentiate its offering from Amazon and Microsoft. Most notably, Oracle's extensive presence in the IT infrastructure of its existing customers could give the firm a leg up in terms of speed and ability to migrate those customers to its cloud over other providers. Oracle says its compute offering will be 24 times faster for analytics and 8 times faster for transaction processing than Amazon Web Services' most premium offering.

Despite the firm's impressive presentation and large potential market opportunity, we maintain some skepticism about Oracle's go-to-market approach for its new IaaS offering. First, the timing of the move is puzzling, considering Oracle's decision to forgo this market for several years. We have already seen vendors such as HP HPQ and VMware VMW exit or pivot away from the public cloud compute and storage markets because they could not attract enough customers to scale with the likes of Amazon, Microsoft, Google GOOG , and others.

Second, given the amount of scale required to generate profitability in the public cloud market, Oracle is behind the eight ball. The company's broad customer base will give it ample opportunity to onboard users to its infrastructure-as-a-service product, but we question how willing these customers will be to further lock in their IT infrastructure (both on premise and in the cloud) with one vendor. We believe enterprises will increasingly look to leverage multiple, at-scale public cloud vendors (for security and reliability reasons) and potentially use a variety of technological architectures (including database and middleware options beyond Oracle's proprietary purview) within those clouds to keep as many options open for development, testing, and deployment of applications.

Third, a strong push into IaaS is likely to hamper cloud (and ultimately consolidated) margins, particularly if Oracle brings its offering to market as a low-cost provider (20% below Amazon pricing, according the company). We are hard-pressed to believe that the company has ample supply to allow for the torrid growth that would be necessary to materially close the revenue gap between it and the largest players anytime soon, which we believe will translate to increased capital expenditures to meet demand and ultimately hamper free cash flow over the next few years. As chairman Larry Ellison pointed out during analyst day, it costs “billions of dollars” to build an IaaS offering. As a point of reference, Microsoft has spent $24 billion in capital expenditures over the past four years, with the bulk of that going toward capacity buildouts for its IaaS offering, Azure, and other cloud services. In the same period, Oracle has spent just $3.8 billion in capital expenditures.

In general, details on the financial impact of a more concerted effort to bring a broader IaaS offering to market were scant during the meeting, and we have not explicitly included any assumptions for the business in our financial model yet. While management contends that Oracle can be the largest and most profitable IaaS vendor on the market based on its technological synergies and superiority, we will abstain from modeling any explicit expectations until we have a more concrete idea of how the new IaaS product will be adopted.