Oracle underwhelms...

Oracle reported Q2-07 results after the close today and I found them summarily underwhelming. Judging by the recent price action and the after market trading, I apparently am not alone.

The headline results were good enough in that they were within company guidance [all figures GAAP unless otherwise noted]:

• Total revenues = $4.16B [up 26% YOY]
• Total software revenues = $3.27B [up 23% YOY]
• Software updates and support revenues = $2.01B [up 29% YOY]
• New software license revenues = $1.21B [14% YOY]
• Services revenues = $949mm [41% YOY]
• Operating income = $1.36B
  • Operating margin = 32.6%
• EPS [GAAP] = $0.18, EPS [Non GAAP] = $0.22

As always, the devil is in the details and that's where the "underwhelming" descriptor comes into play:

• New software license growth weakens against an easy comparison
  • New software license revenues of $1.21B grew just 14% [including 4% positive impact from currency]
  • That's a major deceleration from the last two quarters [32% and 28%]
  • It's coming off Oracle's weakest Q last year [Q2-06 growth was a meager 9% YOY]
• Application license revenue was light of expectations
  • Apps revenue of $340mm grew just 28% YOY compared with Q1 (80% YOY growth)
  • Growth slowed despite Q2 being the easiest compare (Oracle apps revenue only grew 24% in Q2-06, but grew 77% or better in each of the other three quarters)
  • Excluding Siebel, i-Flex and Portal, apps revenue was $268mm; just 1% YOY growth (and certainly down YOY on a constant currency basis)
• Database license revenue fell back to single digits
  • Database license revenues of $867mm represented 9% YOY growth despite coming off a 5% compare last Q2
  • This reverses a two quarter trend of double-digit database growth
• Services revenue growth rate the highest in recent memory
  • 41% YOY growth in services revenue is the fourth consecutive quarter of accelerating YOY growth

On an Oracle call, it's not just about what you hear, but about what you don't hear...

1. In an age of web-based transcripts, a lot of investors no longer listen to live conference calls. That can be a mistake because you lose context. In my view, Larry, Safra and Chuck were clearly less enthusiastic than in recent quarters. Their tone, brevity and level of detail were all markedly lower than in the last two conference calls.
2. Unbreakable Linux already broken? ...Oracle spent more time talking about Secure Enterprise Search, a product announced in March, than it did Unbreakable Linux, the much ballyhooed Red Hat killer.
3. Oracle spent a lot of time detailing its success in the retail vertical versus SAP...specifically, Ellison noted:

But we are actually in a situation now where 8 out of 10 of the largest retailers in North America now use Oracle retail applications, where only one uses SAP, and that one is now also using Oracle retail software.

While that's an impressive data point, it's not a new one. According to Oracle's own website, 8 of the top-10 North American retailers were using Oracle Apps dating back to a Stratascope Report in 2005!

 

Let's not forget that Oracle's M&A strategy isn't just about gaining market share. All that aside, it's important to understand what Oracle is trying to accomplish. In recent quarters, as Oracle's stock had enjoyed a resurgence, it seems the market has forgotten the method behind Oracle's M&A madness. It's become de rigeur to think Oracle's acquisition strategy is all about fueling market share growth to keep up with SAP. While that's absolutely part of the equation, there are other reasons driving Oracle's strategy including:

1. Larry Ellison's belief in the maturation of the software industry -- Ellison was one of the first software industry veterans to acknowledge the maturation of the enterprise software market.
2. The value of maintenance revenue streams -- For a long time, license revenues were the key driver of investor sentiment and, coincidentally, multiple growth. But as the industry has matured, the importance of maintenance revenue streams have become more widely recognized and respected. Maintenance revenues are predictable (annual renewals), unbelievably high margin (15%-22% of the initial license fees, without the expense of the initial sale), and sustainable (even mediocre software vendors can sustain 80%+ annual maintenance renewals for years after their license revenue growth ebbs.
3. The financial disconnect between software company valuations and present value of future cash flows -- There's a reason LBO firms are buying up software companies at a far faster pace than ever before. They, like Oracle, believe that many companies in the industry are fundamentally misspriced. In most of Oracle's acquisitions, it hopes/believes it's getting strategic value, but at a minimum it's pricing the deals in such a way that financially it makes a lot of sense. Paying 4x-6x EV/maintenance revenues is hardly financially onerous, or risky as long as Oracle is confident in the sustainability of customer renewal rates.

While the fundamental momentum Oracle showed in the last few quarters appears to have ebbed, the financial momentum continues at an impressive rate. Trailing 12-month free cash flow growth grew at a 32% clip (for the 2nd consecutive quarter); after running at a meager 4% clip this time last year. Free cash flow continues to run above net income, as well.

Oracle has plenty left to prove in the second half of fiscal 2007, but let's not pretend that Oracle's financial future is predicated primarily on organic revenue growth. For better or worse, Larry, Safra and Chuck are thinking differently.

Note: At the time of this writing I, and/or funds I maintain discretionary control over, maintained a long equity position in SAP but did not maintain a position (long or short) in BEAS, IBM, ORCL or RHT. We also may, at times, carry derivative options on underlying positions as a hedge.

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Comments

[Yaser Anwar]

Excellent breakdown JW!