Oracle Corporation (NASDAQ:ORCL – Annual Report) is the world’s largest enterprise software company. It has been expanding from its original database offering by acquiring companies that make applications that run on its database. It is organized into two businesses, software (80%) and services (20%). The software business includes software licenses and product support, while the services business includes consulting, education and on-demand services. Its products and services are marketed both through its own sales and service organization and through indirect channel partners. Its primary competitors include SAP (SAP - Annual Report), IBM (IBM - Annual Report) and Microsoft (MSFT - Annual Report), as well as others in specific product areas. Furthermore, open source products such as the MySQL database are gaining traction among users.
Growing Through Acquisitions
Although the enterprise software market grew rapidly in the 1990’s, by the early 2000’s the market had reached maturity and had too many companies chasing too few dollars. While consolidation in some industries occurs because the weaker businesses fail, software balance sheets were too strong to for this to happen. The only way to fix that situation is for an industry leader to soak up the excess capital by leveraging its own balance sheet to acquire other companies – for cash, not shares. Oracle has been pursuing that fix, beginning with the PeopleSoft acquisition and most recently with the buyout of Hyperion Solutions. In addition to large acquisitions, the company is also filling in gaps to offer stronger software suites for industry verticals such as telecom and financials.
Software companies tend to generate significant cash flow, and Oracle has been able to use this cash flow to fund the acquisitions while both maintaining a healthy balance sheet and avoiding dilution to existing shareholders. As an example, consider its first large acquisition – that of PeopleSoft in January 2005 for $11.1 billion in cash. Prior to the acquisition Oracle held more than $9.5 billion in cash and marketable securities on its balance sheet, and had virtually no debt. The company used this cash and a $7 billion bridge loan to complete the acquisition, and by the end of its fiscal year in May, 2005 it had reduced the loan value to $2.6 billion while still maintaining nearly $5 billion in cash and marketable securities and actually reducing its share count.
By May, 2006 the company had made another $4 billion worth of acquisitions (net of the cash held by the acquired companies) and increased its cash and marketable securities to $7.5 billion while restructuring its debt load to $5.7 billion in long-term debt. Even though the debt was $3 billion more than the prior year, most of that was offset by the increase in cash – meaning that the $4 billion in acquisitions was made possible almost entirely through cash flow from operations.
By making these acquisitions, Oracle is also answering one of the priorities of corporate technology buyers – namely, reducing complexity. So many applications have been developed that IT staffs now spend much of their time getting the disparate systems to work together. Although it will take some time, Oracle’s Fusion platform aims to integrate all of the applications – both internally developed and those acquired. Although some buyers will still prefer “best of breed,” many others will choose a suite of applications that work well together. In many ways this is reminiscent of the way Microsoft’s Office platform gained share. The industry leading spreadsheet (Lotus 1-2-3), word processor (Word Perfect) and presentation program (Harvard Graphics) were widely viewed as being equal or better programs than Microsoft’s Excel, Word and PowerPoint. It was the way the Microsoft Suite worked together that shifted the market share permanently in Microsoft’s favor.
Corporate software buyers want their jobs made easier, and that means reducing complexity not only in getting different software packages to work together but also in price structure. Here, too, Oracle’s acquisition strategy is answering the need. Oracle is offering simplified licensing to make pricing more consistent across its portfolio of products. Four basic licensing models will be available for all Oracle products, including J.D. Edwards, PeopleSoft and Siebel applications. The Component Model offers customers simple a la carte pricing, while the Custom Application Suite Model allows them to create their own bundle of applications based on their specific business needs.
Other than acquisitions, the drivers of growth are likely to be macroeconomic. Here the current outlook is quite mixed. U.S. GDP data have shown a significant slowdown in corporate investments in equipment and software, and surveys of Chief Information Officers indicate a slowdown in technology investing ahead.
A general risk for investors in software companies is that quarterly sales tend to be back-end-loaded (meaning most of the sales occur late in the quarter.) This poses two risks: one is that a delay in a large order could cause the company to miss earnings estimates. The other is that management may try to manage earnings by offering customers discounts or other sweeteners to close deals before the quarter ends. This latter risk can be monitored by paying close attention to accounts receivable. If accounts receivable rise faster than sales it could indicate that more late-quarter sales were booked than is normal. For Oracle, the latest quarter’s accounts receivable balance actually declined, so this doesn’t seem to be a current concern.
One concern investors have about Oracle’s strategy is that the frequent acquisitions make it difficult to gauge how well the company is growing. For example, on their recent earnings conference call, CFO Safra Catz said:
Even though we have now owned Siebel for over a year, we got it mid-quarter last year so if you exclude Siebel entirely from both last year and this year, new license revenues were up 32%, still four times the reported growth rate of SAP.
The problem with that statement is that Oracle has since acquired, according to their site, eleven more companies (not counting the recently announced Hyperion deal.) While these were relatively small acquisitions “with most takeovers likely falling in the range of $5 million to $100 million,” as the company described it, five million here and $100 million there and pretty soon you’re talking big money. Still, because the individual acquisitions are not deemed “material” the Company has no obligation to provide pro-forma financial information about them.
Another risk related to the acquisition strategy is that each acquisition means another product to be integrated. In the short term, this increases rather than reduces complexity for customers. Some Siebel CRM users say Oracle has been slow to provide details on its pledge to integrate Siebel and Oracle products and to reveal its long-term plans for its CRM product lines. While the delays aren’t causing customers to switch applications, the uncertainty about future upgrade plans is something customers would rather not face. The sooner Oracle can address such issues, the better.
With a current market capitalization and enterprise value of approximately $95 billion, Oracle shares are trading at a trailing P/E multiple of 25, an EV/EBITDA multiple of 13.6 and an EV/Free Cash Flow multiple of 22, all of which appear relatively rich. Earnings per share are expected to grow by 14% in the fiscal year 2008, which is healthy but probably insufficient to support the current valuation. Investors may want to wait for a pullback in the share price or for estimates to catch up to the current price before taking a position.
William Trent currently has a short position in put options related to Office Depot (ODP).