By Jacob Sonenshine

Oracle stock has dropped, but earnings next week could showcase the company's growth in artificial intelligence -- and spur stock gains.

Shares are down 20% to $150 since peaking in late November. Part of the problem is that a broad basket of U.S. software stocks has fallen 13%. Valuations took a hit when Chinese start-up DeepSeek said in January it can produce AI software at a fraction of the usual cost, posing a competitive threat to U.S. software companies. The stock declines continued after President Donald Trump's tariffs roiled the entire market, forcing investors to question valuations across the board, given the potential economic destruction that could result from the policy change.

Oracle's pain has been a bit worse, partly because of a stronger dollar. A higher buck pressured the company's fiscal third-quarter sales guidance when it reported results in December. Oracle sees almost half of its revenue from overseas, and when the greenback rises, foreign revenues are translated into fewer dollars. The broader software group sees about 40% of its revenue from abroad, so Oracle's earnings are more vulnerable to a stronger dollar.

The other issue -- perhaps a minor one -- is that the market hasn't yet gotten a full beat on new customer deals. Oracle is transitioning its existing base of enterprise customers from outdated, traditional data storage software to new, cost-efficient and higher-valued cloud products, including AI-driven ones. The company only made one mention on its December fiscal second-quarter earnings call of new, larger deals. It said it expects those deals to ramp up in the second half of the year, which could have caused some skepticism from the market.

Skepticism, and the resulting drop in the stock, provides opportunity in a company that's executing fairly well, by and large. First of all, the entirety of the mild sales guidance shortfall was on the back of the currency issue -- not any competitive concerns. The guidance would have met Wall Street's expectations if the dollar hadn't jumped.

Secondly, Oracle historically tends to surpass expectations, so higher sales and earnings versus current analyst's estimates would move the financial results from mildly disappointing to at least satisfactory. The company has beaten earnings estimates in 10 of the past 15 quarters.

The reality is that Oracle has a massive growth opportunity in front of it that it is executing on. Of its $61.9 billion in total sales that analysts expect this year according to FactSet, it's expected to see about $13.2 billion come from older software and hardware offerings, revenue from which has been declining mildly for the last several years. But the company's new cloud offerings are projected to drive 15% growth year over year for the rest of the business in 2025, driven by even higher growth in its AI-specific sales, bringing total revenue up 11%, excluding the impact of currency. That would be an acceleration from the second quarter's 9%.

The AI-specific revenue is key. It is been on track to reach a little under $10 billion annually, given the second-quarter results. It is part of an overall "infrastructure-as-a-service" segment that grew 52% in the quarter. Total customer spending on this new service is expected to reach over $700 billion annually by 2032, according to Fortune Business Insights. While Oracle is up against competitors such as Microsoft, Alphabet, Amazon Web Services and International Business Machines, there is plenty of the pie for sharing -- and Oracle's overall cloud growth has been strong versus its competitors' growth. That signifies it's taking a little bit of market share as it ramps up its AI business, and has the potential post aggressive growth fairly sustainably.

That brings third-quarter earnings on March 10 into focus. Analysts expect sales growth of just over 8% because of the impact of currency. The market wants to see that the 51.5% AI growth drives the results.

"Attention will probably shift back to whether Oracle can deliver on infrastructure-as-a-service revenue growth expectations (51.5% consensus) which will likely be the primary catalyst for the stock," writes Guggenheim analyst John Difucci, who says the estimates are reasonable. "We trust management's visibility into the timing of deal signings."

Those types of results would boost the market's confidence that growth can accelerate throughout the rest of the year. That would help drive profit margins higher this year, as the revenue growth is expected to be faster than the growth of key costs such as marketing and research and development. The result is that analysst forecast earnings per share to grow 13% for 2025 to $6.65.

The one wrinkle is that analysts expect capital investments to rise by almost 40% this year, weighing on free cash flow growth, but once the company moves past this spending as it invests in its growth, cash flow in the long-term would jump higher.

This picture makes the stock look ready to pop after earnings -- especially if the AI results prove that the growth is durable. Shares trade at 22.2 times expected earnings for three coming 12 months, below the software group's 34.2 times, a wider discount than when Oracle was more in favor with investors at other points in the past several years, even though Oracle is expected to boost profits about as rapidly as the group over the long-term.

Buy it before earnings.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

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March 07, 2025 04:00 ET (09:00 GMT)

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