Oracle (ORCL 1.80%), once a software company with minimal capital spending needs, has been transformed by the AI boom. The company's strategy is to build AI infrastructure and rent it out to AI companies and other tech giants, capitalizing on the soaring demand for AI training and inference workloads.
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Oracle has more than half a trillion dollars of future revenue in its backlog, including a $300 billion multi-year deal with OpenAI. When that deal first came to light, shares of Oracle surged. If everything goes according to plan, the company's revenue growth over the next few years is set to accelerate greatly.
Investors quickly soured on Oracle after that euphoric rally, and following a post-earnings decline on Thursday, the stock now trades for less than it did prior to the OpenAI deal. What are investors worried about? One big concern is whether Oracle's ramped up capital spending on AI infrastructure will produce a reasonable return on investment.
AI infrastructure may not be an attractive business
Is the business of building AI datacenters full of expensive GPUs and renting them out an attractive business model? That's the trillion-dollar question, and the answer is looking like no. In a presentation in October, Oracle predicted that its AI infrastructure business would achieve adjusted gross margins of between 30% and 40%. The company illustrated an AI deal that would generate $60 billion in revenue and $21 billion in gross profit over the course of six years.
It's not clear whether this is a target or the company is producing gross margins within that range today. The Information reported in October that Oracle's AI infrastructure business produced gross margins of just 14% in the quarter ending in August, so it's possible that Oracle has some work to do.
One interesting thing that came up in Oracle's earnings call was a guidance update for capital spending. Oracle increased its full-year outlook by $15 billion from its previous forecast as it tries to capture additional revenue in fiscal 2027 from recently signed deals. That spending will unlock $4 billion in incremental revenue in fiscal 2027.
Do these numbers make sense? Oracle is spending an additional $15 billion this year to generate $4 billion in revenue next year. At the midpoint of Oracle's gross margin target, that translates into a gross profit of $1.4 billion. Operating profit will be lower once any operating expenses are backed out. Oracle's return on investment would be well below 10%, and even lower if its gross margin hasn't yet reached its target range. Given the incredible demand for AI infrastructure right now, that doesn't seem very impressive.
There are a lot of moving parts, and this estimate is very rough. But Oracle's spending on AI infrastructure does not look like a home run.
NYSE: ORCL
Key Data Points
Should you buy the dip in Oracle stock?
Oracle stock is now down nearly 40% from its 52-week high. It's clear that investors simply do not believe the company's AI growth story. Oracle has an enormous backlog, but much of it depends on OpenAI securing sufficient funding over the next few years. Even if it does and Oracle is able to convert everything in its backlog to revenue, there are still questions surrounding profitability.
Oracle is funding its AI data center building spree partially with debt. The company ended the second quarter with $108 billion in total debt, most of which was on the balance sheet prior to the AI boom. Oracle doesn't have the pristine, cash-rich balance sheets of other tech giants, and its AI spending spree is only going to add to its mountain of debt. Oracle's debt amplifies the risk if anything goes wrong over the next few years.
While Oracle has successfully established itself as a key provider of AI infrastructure, investors are rightfully cautious as the company spends heavily on AI data centers. If the industry overbuilds in anticipation of demand that never materializes, Oracle will be in serious trouble.
