ORCL faces a downward spiral from rising debt costs and negative free cash flow; avoid investing.

When Oracle signed a $300 billion deal with OpenAI, the stock skyrocketed and investors were really bullish on the company's future as an infrastructure play in artificial intelligence.

But it's been nothing but downhill for the company since then. Shares are down over 50% over the past year. And there's a huge problem that is rearing its head for Oracle and really all of the Neoclouds out there.

As the industry has burned through all of its free cash flow, it's now relying on debt to fund the AI buildout. And that debt is getting more and more expensive.

I'm going to dig into why this is a huge problem for Oracle and may make it difficult for this buildout to be profitable long term. And that's ultimately the price that investors are going to pay for owning the stock.

$430 billion market cap price to earnings multiple on a forward basis is only about 16. That looks pretty cheap. But look at this price to free cash flow negative 11 times.

So, first of all, you can see this is the one-year chart for Oracle and it's just been a devastating year since we had that pop, which was after the OpenAI announcement. That's what happened right here.

I think shares were up about 40% just in that single day. But the market has really rethought that bullish thesis since then.

One, the company seems to be pulling back on its core business, laying off tens of thousands of people. This article was from last week. They had already laid off 20,000 people in the past year at that time.

And then earlier this week, we got news of even more layoffs that started on Monday. Those emails went out at 6:00 a.m. citing broader organizational changes. Today is your last day at Oracle.

Now, despite all of that, you can look at their income statement and actually come away pretty bullish on the company. Look at the inflection in revenue growth that happens in 2022. start to see this growth of them investing in their cloud business and that has accelerated over the past few quarters and even net income is moving higher.

That's shouldn't be all that surprising because the investments that they're making today are depreciated over sometimes 20 30 years at the very least going to be 5 or 6 years for a lot of the computing equipment.

So some of the costs that they're incurring are not necessarily hitting the income statement.

Where they are hitting is the cash flow statement. You just add in the capital expenditures and this chart looks very very different. You can see that over the past year they've spent more on capital expenditures than they have generated in revenue.

No surprise then that this also exceeds the operating cash flow about $47 billion in the past year. And even that operating cash flow is a little bit misleading because it has $17.5 billion of what's called unearned revenue.

Basically prepaid for revenue. This is from companies like OpenAI who said, you know what, we'll basically put a deposit down on this infrastructure that you're building for us that we're going to use as soon as it's completed.

So the real operated cash flow really only about $30 billion and it's actually down slightly from fiscal 2026.

So if you're investing that much in capital expenditures, you're not yet able to pay for that with the cash flow that's coming from the business. How do you fund the operations?

Well, the simple answer for Oracle is they have taken out a lot of debt. As of the most recent quarter, which was reported earlier this month, the company has about $125 billion worth of debt.

There is also about $37 billion worth of cash on the balance sheet.

And the other thing that I wanted to bring in here is something that has grown over the past couple years. That is other long-term liabilities. So these are going to be obligations that the company has on the balance sheet is going to be a little bit like debt, but not quite the same financial structure, but something to keep an eye on because some of these off-balance sheet obligations is something that all of these tech companies are putting in place much more.

It's going to increase the risk of the business long term if we don't see the profitability that investors are hoping for.

So with all of this in mind, what's the big problem for Oracle? What we don't yet have an answer to is is Oracle going to be able to generate a return on the tens of billions, hundreds of billions of dollars that they're investing in AI infrastructure.

One of the metrics to look at is what is their return on assets. That's what this chart is showing. You can see that few years ago right around 10% return on assets. That's actually declined over the past few quarters to more in the 8% range.

Why is that 8% number important? Oracle is selling debt and stock to be able to fund this buildout. There are costs associated with that. With debt, you have the cost of interest.

With stock, you have returns that investors are expecting. So, if the interest rate goes up, that's going to make it more expensive. You're going to have a higher interest expense for all the debt you have outstanding.

If the cost of capital goes up on the equity side, your stock starts to drop.

So, what we see here, this debt was actually issued earlier this year in February. And this was issued at a 5.7% coupon rate. You can see this right here at the top on Trading View.

Where is that interest? Where's that that debt trading today? trading at about a 7% interest rate. So the interest rate has gotten 1.3 percentage points higher.

Now you may say, well interest rates are up over that period of time. So you would expect that to be higher. Well, interest rates are up, but since February, we're looking at an increase of about.7 percentage points in the 10-year Treasury.

And this is 10-year debt that we're looking at 2036. So it should be pretty comparable to the 10-year. So the in increase in the interest rate for Oracle is about double of the increase that we see with treasuries.

That means that investors are demanding more to give Oracle debt.

The problem here is that companies like OpenAI have made performance obligations. 664 billion worth of performance obligations as of the most recent quarter. And the market at least is expecting capital expenditures to continue increasing up to over hundred billion per year by fiscal 2028.

That ends in May 2028. As we discussed, the company doesn't have that much cash to be able to build out that much infrastructure. So, they're having to go to the market and issue stock. $20 billion of stock sold in the fiscal first quarter.

They're going to have to issue more debt in the future.

All of this becomes a huge problem if there's a downward spiral. If your interest rate starts to go up, your stock starts to drop, then where do you go for that ne next round of financing?

Well, what if that interest rate in the future is 9%, 10%. And your stock continues to fall. This is the downward spiral that is a real risk for companies like Oracle,

For Oracle, I think this is a canary in the coal mine. Their costs are increasing dramatically. Financing has never been an issue for the company because they have positive operating cash flow and positive free cash flow.

But that's no longer the case because of the scale of the AI buildout. Unless they pull back soon, which is something they probably can't do because their valuation is predicated on being part of this buildout.

This is going to be a be a real financing problem.

This is actually how bubbles build in financial markets. Everyone is rushing after the same thing. And if the pot of gold isn't there at the end of the rainbow, if the cost to finance those projects starts to go up, if stock prices start to go down, it can be a big problem for these companies. I think Oracle is a clear example of that.

We're seeing it in other NEOClouds. This is not an area that I would be investing right now. I think there's much better opportunities, particular outside of this AI trade right now.