Shares of Oracle (NYSE:ORCL) dropped 9% on March 20 after the tech giant's third-quarter report failed to impress investors. At first glance, the headline numbers looked decent. Its revenue rose 5.5% annually to $9.78 billion, meeting analysts' expectations. Its non-GAAP earnings grew 20% to $0.83 per share, topping estimates by $0.11 per share.

However, the growth of Oracle's cloud revenues -- which offsets the slower growth of its older software license and hardware revenues -- is slowing down. Let's dig deeper into this conundrum, and see if investors' concerns are justified.

A group of workers sit around a cutout of a cloud.

Image source: Getty Images.

Is Oracle's cloud growth slowing down?

The year-over-year growth of Oracle's total cloud revenue has been slowing down over the past year, making cloud revenue's impact on Oracle's overall revenue less significant.

Metric

Q4 2017

Q1 2018

Q2 2018

Q3 2018

Total cloud revenues

$1.4 billion

$1.5 billion

$1.5 billion

$1.6 billion

YOY growth

64%

51%

44%

32%

Percentage of revenues

13%

15%

16%

16%

Source: Oracle quarterly reports.

During last quarter's conference call, co-CEO Safra Katz confirmed the ongoing slowdown with a forecast for just 19%-23% growth in cloud revenues for the fourth quarter, compared to analyst expectations for 23% growth.

That seemingly supports the bearish thesis that the growth of Oracle's cloud businesses can't offset the weakness of its legacy ones over the long term.

Breaking down the businesses

However, we should also break down the growth of Oracle's cloud businesses by its two main categories -- SaaS (software as a service) and PaaS/IaaS (platform and infrastructure as a service).

Oracle's most important SaaS platform is the Fusion Cloud, which provides human capital management, customer relationship management, enterprise resource planning, and enterprise performance management as on-demand cloud services.

Its Paas/IaaS platform, which competes against Amazon (NASDAQ:AMZN) Web Services (AWS) and Microsoft (NASDAQ:MSFT) Azure, offers cloud-based computing power to companies that don't want to install on-site servers. AWS and Azure are currently the two largest public cloud platform providers in the world.

Oracle's PaaS/IaaS unit is actually split further into two halves -- a higher-growth public IaaS business, which competes against AWS and Azure, and a PaaS/IaaS hosting business, which is growing at a much slower pace.

Metric

Q4 2017

Q1 2018

Q2 2018

Q3 2018

SaaS revenues

$1 billion

$1.1 billion

$1.1 billion

$1.2 billion

YOY growth

75%

62%

55%

33%

PaaS/IaaS revenues

$403 million

$400 million

$396 million

$415 million

YOY growth

42%

28%

21%

28%

Source: Oracle quarterly reports.

However, these figures reveal that the source of Oracle's cloud slowdown is its SaaS business, not its PaaS/IaaS business. Moreover, the sequential growth of both businesses remains mediocre, and indicates that they might hit a brick wall.

Understanding the competitive threats

Meanwhile, Amazon is expanding into Oracle's backyard with its own cloud-based database services. Oracle argues that its database services are cheaper, faster, more reliable, and better supported by blockchain and AI-driven tools, but it's unclear if it can stay ahead of Amazon -- which often cuts prices to gain market share in cloud services. Microsoft also integrates its SQL Database into Azure.

A visual depiction of cloud connections.

Image source: Getty Images.

Oracle's Sales Cloud SaaS business also faces tough competition from Salesforce (NYSE:CRM), the king of the cloud-based customer relationship management (CRM) market. Microsoft's Dynamics CRM, which is also tethered to Azure, is another formidable rival.

These headwinds are reflected in Oracle's wobbly gross margins. During the third quarter, its PaaS/IaaS unit reported a non-GAAP gross margin of 35%, down from 46% a year earlier. Part of that drop was likely attributed to its older hosting business, but it was also likely caused by tougher competition. Nonetheless, Catz believes that PaaS/IaaS gross margins "will begin to improve" during the fourth quarter.

On the bright side, Oracle's SaaS non-GAAP margins are still expanding, from 65% in the prior year quarter to 67% in the third quarter. However, that margin expansion doesn't seem sufficient to offset its slowing SaaS sales growth.

The bottom line

Like many older tech stalwarts, Oracle is pivoting from legacy businesses toward higher-growth cloud services. For now, that transition still generates growth -- analysts expect Oracle's revenue and earnings to rise 5% and 7%, respectively, this year. The stock also trades at a reasonable 16 times forward earnings.

However, Oracle's cloud business remains tiny compared to AWS and Azure, and its growth is peaking. Oracle might solve this dilemma with some big acquisitions or investments in new services, but this stock will remain weighed down by cloud-related concerns until that happens.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Leo Sun owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon. The Motley Fool owns shares of Oracle and has the following options: short June 2018 $52 calls on Oracle and long January 2020 $30 calls on Oracle. The Motley Fool recommends Salesforce.com. The Motley Fool has a disclosure policy.