The recent artificial intelligence boom has upended the traditional dynamics for many legacy tech companies, including Oracle Corp. (ORCL, Financial), which has quietly emerged as a significant beneficiary of this revolution.

Year to date, the stock has climbed around 30%. As the company approaches the end of its fiscal 2025 year (next May), it anticipates a notable acceleration in revenue growth, fueled by substantial AI-related deals.

The company's trajectory is reminiscent of Amazon (AMZN, Financial), with a robust cloud business propelling its growth, while other segments lag. Oracle Cloud, encompassing both SaaS (cloud versions of Oracle software) and IaaS (rentable infrastructure akin to AWS and Azure), is the primary growth driver. The shift by customers to managed SaaS versions of Oracle database software has contributed to the relative underperformance of the traditional segments. However, I believe this drag will diminish in the coming years as the cloud segment, particularly IaaS, continues to thrive.

My focus remains on Oracle's cloud business, which is transforming it into an AI powerhouse. The legacy segments may not be as impactful during this transition, but the rapid growth of the cloud portion, especially IaaS, is where the real potential lies.

Expanding capacity

Oracle's transformation is pushing the boundaries of its capabilities, with the only significant growth limitation being the speed at which it can establish new data centers. Oracle Cloud Infrastructure (OCI) is reigniting the company's growth story. By leveraging automation and scale, the company is turning its platform and database services into a powerhouse, enabling enterprises to seamlessly migrate and expand their data operations.

Management has indicated Oracle is planning to build some of the largest data centers by capacity in the coming years, including one at 200 megawatts and another at 1 gigawatts, equivalent to the size of a city. These large-scale data centers will significantly benefit both the machine learning and energy industries as more companies adopt AI applications. A key value of OCI is its entirely modular and automated processes, which ensure each data center is identical and scalable.

This strategy has allowed Oracle to rapidly expand its regional data center presence, minimizing human error and enhancing security. It also enables faster and more cost-effective data consumption for users. Management expressed enthusiasm about the company's capability to build diverse data centers tailored for AI needs, providing flexible, scalable solutions for enterprises.

Strategic partnerships driving AI growth

One of the largest contributors to Oracle's recent strength is its strategic partnerships, the most significant of which is with OpenAI. Announced in June during an earnings call, this partnership leverages the company's extensive database technologies and OCI to enhance OpenAI's models. The importance of this collaboration cannot be overstated, as it is likely to serve as a foundation for future AI-related partnerships, positioning Oracle to secure additional high-profile contracts. While the OpenAI deal is just part of a broader pipeline that includes $12 billion in AI contracts signed last quarter, it represents a pivotal milestone for Oracle's future in the AI market.

Oracle's cloud services division, particularly OCI, is leading the company's growth. This unit is poised to drive significant revenue once these partnerships fully roll out. The company has also closed a similar partnership with Alphabet's (GOOG, Financial) Google, further solidifying its position in the AI market. This expansion into AI partnerships aligns it with companies like Nvidia (NVDA, Financial), making it an indispensable player in building the future of the technology.

Position in cloud services

Oracle may not be the leader in PaaS and IaaS, nor in SaaS, with a market share of around 2% in the first two categories, trailing far behind Amazon (31%) and Microsoft (24%). However, it has substantial potential to capture market share from these competitors. Recent quarters have shown the company is growing its cloud revenue at a faster pace than its main competitors, indicating a stronger growth trajectory.

The question remains whether Oracle can leverage AI to overtake Azure or even Amazon's AWS. While I do not expect Oracle to achieve this in the short term, I believe the company is well-positioned to capture market share from these giants. Even a modest gain in market share would be significant for Oracle, positively impacting both its top and bottom lines.

Source: Statista

Financial performance

Oracle's stock has seen a significant rise since June, not just in line with the broader markets, but due to robust fiscal fourth-quarter (May quarter) results and optimistic outlook for the future.

On June 11, the company reported its quarterly financial results. Although both revenue and earnings per share missed consensus estimates, the stock price reacted positively due to substantial growth in remaining performance obligations and significant deals with Google and OpenAI centered around OCI.

Source: Oracle

For the fourth quarter, Oracle reported revenue of $14.30 billion, which, despite a 3.25% year-over-year increase, fell short of analyst estimates. Non-GAAP earnings were $1.63 per share, down 2.40% year over year and missing estimates by 2 cents.

The cloud infrastructure segment shone with a 42% revenue increase in constant currency, while the Cloud Application segment grew 10% to $3.30 billion.

For the full year, total revenue reached $53 billion, growing 6%, with non-GAAP earnings at $5.56. Despite missing top and bottom-line estimates, the stock surged over 13% following the earnings release, primarily due to 44% growth in RPOs, reaching $98 billion. Management expects 39% of this amount to materialize in the next 12 months, equating to $38.20 billion.

Margins and free cash flow growth

I anticipate Oracle's margins will continue to expand alongside top-line growth, driven by the its automated, modular data center capacity. The company's non-GAAP operating margins showed strong growth in the fourth quarter, reaching 46.70%, despite overall weaker revenue and earnings growth.

For the full year, operating margins stood at 44%, indicating potential for further improvement. Oracle has also become a significant free cash flow generator, producing $11.80 billion in fiscal 2024, a 39% increase. The company's confidence in sustained FCF generation was evident in its dividend declaration and capex announcement. Investors should monitor Oracle's capex spending closely. However, the company's ability to generate substantial FCF, coupled with its customer base of major AI players, mitigates concerns surrounding capex figures.

Oracle's management anticipates strong sequential growth in 2025 as it scales OCI capacity to meet demand, expecting cloud infrastructure services to grow by 50% year over year. Additionally, management reiterated its fiscal 2026 revenue goal of $65 billion, suggesting this target might be conservative given the accelerated growth momentum observed in 2024.

Attractive pricing and upside potential

Despite the expected acceleration and AI deal-making, Oracle still trades at an attractive valuation compared to many of its large-cap software and internet peers benefiting from similar tailwinds. Currently, the stock trades at a forward price-earnings ratio of 16.40, which is comparable to Alphabet at 16.30 but significantly cheaper than Microsoft (MSFT, Financial) (27.20), Amazon (24.20), Workday (WDAY, Financial) (23.80) and Salesforce (CRM, Financial) (22.20). This relative undervaluation offers investors an opportunity to capitalize on AI-driven growth without paying a hefty premium.

While Oracle shares have not experienced the same growth rate as other AI stocks, this provides a favorable entry point for investors to build a position. Given the impressive growth trajectory in OCI as it scales and integrates with other cloud providers, I believe Oracle should trade at a peer average of 21.40 times. Setting this as the target, I derive a target price of around $174 per share, representing about a 25% upside from current levels.

Source: Alpha Spread

For a more detailed valuation, I conducted a discounted cash flow analysis using a discount rate of 9% and a terminal growth rate of 5% beyond the five-year mark. During the five-year growth period, I anticipate a compound annual growth rate of around 9%, in line with Wall Street estimates, along with a 2 percentage point margin improvement from Year 1 to Year 5. These assumptions are based on the strong demand for Oracle's IaaS services and their rapid expansion of new data centers, which are expected to drive significant revenue growth.

Additionally, the company's existing remaining performance obligations are poised to contribute substantially over the next few years. The $65 billion revenue target for 2026 is also factored into my analysis. Based on these assumptions, I derive a target price of approximately $206 per share, indicating an upside potential of about 33%.

Source: Alpha Spread

Conclusion

Oracle's strategic pivot toward AI and cloud services, exemplified by its significant partnerships and rapid expansion of data center capacity, positions it for substantial growth. Despite lagging in market share behind giants like Amazon and Microsoft, the company's cloud division is on a robust trajectory, indicating strong future potential.

The solid financial performance, combined with an attractive valuation relative to peers, makes Oracle a compelling investment opportunity. With continued focus and execution in its AI and cloud initiatives, the company is well-placed to capture significant market share and drive long-term value for shareholders.