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How Do SaaS and PaaS Fit into Oracle’s Net Margins?

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Oracle’s deferred revenues

Looking at the Oracle’s (ORCL) recently announced fiscal 2Q17 results, it’s apparent that the company, like its enterprise software peer IBM (IBM), is finding it challenging to see revenue growth. Oracle is still in a transitional phase, shifting its operations from license sales to subscriptions.

In the cloud business, rather than booking revenues when a sale is made, revenues are recorded over the course of a contract. As a result, revenue is recognized only as the software service is delivered. This lag time leads to deferred revenues on balance sheets.

Deferred revenue refers to billings to customers for subscription fees, and it’s one way to gauge a company’s future subscription revenues. Oracle’s deferred revenues grew 6% to$7.4 billion. In constant currency terms, this equals 8% growth.

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Factors impacting Oracle’s net margins

Oracle’s better-than-expected SaaS (software-as-a-service) and PaaS (platform-as-a-service) revenues generate hope, as SaaS revenues are usually more predictable than licensing deals. As a result, SaaS revenues are increasingly preferred by software companies.

Oracle posted not only strong growth in cloud revenues but also in its margins. In fiscal 2Q17, the gross margin for SaaS and PaaS stood at 61%, compared to 43% in fiscal 2Q16. Oracle expects to see further improvements in its cloud margins in the coming quarters and expects 80% cloud margins in the future.

As the above chart shows, Oracle’s net margins improved in fiscal 2Q17 on the back of improvement in its SaaS and PaaS margins. Defending its IaaS gross margins of 37%, Oracle stated that it is “making the necessary investments to scale out this business.”

Timing of revenues

Oracle’s (ORCL) IaaS business is in an expansion mode where expenses are incurred upfront. However, revenues are recognized only as the software service is delivered. Thus, the timing of revenues and expenses can be misaligned in the cloud business, which impacts its margins and cash flows.

This mistiming of cash flows leads to the late realization of profits. Apart from the mistiming of cash flows, the task of building data centers to provide cloud services also puts pressure on the margins. This could be the case with Oracle’s IaaS.

Moreover, Oracle’s spending on R&D continues to rise. In fiscal 2Q17, it spent ~$3.0 billion on research and development, which corresponds to 17% of its overall revenues. Given Oracle’s focus on increased R&D expenditures, the company’s margins could suffer in the short term. However, Oracle and its offerings could benefit in the long run.

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