This article was published on RealMoney on February 1, just 4 hours before MicroStrategy surprised investors with a blown earnings report. Although I typically take a long-term view, you can never count on having the luxury to do so.

Looking at my screens this week, I noticed that MicroStrategy’s (MSTR) Zacks rank had jumped from 2 to 1, a rank that puts the company’s earnings revision momentum among the top 5% of companies ranked. Looking further, I found that estimates for both 2007 (yet to be reported) and 2008 had been hiked by more than $0.25 per share in the last 90 days.

Meanwhile, the stock has declined from $110 to $72 during the same period. A declining stock amid rising earnings estimates was something I had to investigate further. Upon doing so, however, my conclusion is that there may still be further downside in the shares.

One thing that has buoyed software stocks in recent years has been the consolidation wave. According to company filings, MicroStrategy “competitors that are primarily focused on business intelligence products include, among others, Actuate (ACTU), Business Objects (BOBJ), Cognos (COGN), Information Builders and the SAS Institute.”

Cognos is being acquired by International Business Machines (IBM - Annual Report) and Business Objects by SAP AG (SAP - Annual Report). Another competitor, Hyperion, was already bought by Oracle. It is increasingly looking like MicroStrategy is among the wallflowers at this dance.

And without an acquisition, things aren’t looking so hot fundamentally. A look at recent customer wins shows a concentration of retail, financial and healthcare markets. Not exactly the clients one wants during a consumer and financial crunch.

Indeed, it looks as though the toll was already being felt when MicroStrategy reported third-quarter results. Although gross accounts receivable were basically flat during the first nine months of 2007, the allowance for doubtful accounts was increased by nearly 50% to $2.8 million. This suggests that the company may be having trouble collecting from some customers.

Both net income and cash flow from operating activities declined during the first nine months of 2007. Though service and maintenance revenue grew, product licenses declined more than 3%. Since customers must license a product before they can service or maintain it, the falling product licenses suggest that profits may continue to fall, especially if customers indeed prefer the convenience of one-stop shopping offered by IBM, Oracle and SAP.

In fact, profits would have been lower still had MicroStrategy expensed all of its software development costs, as it did in early 2006. In the first nine months of 2007 $2.7 million of such costs were capitalized, and the capitalized software balance increased by $1 million. Had the development costs been expensed as incurred, cash from operations would have been $2.7 million (4%) lower and net income would have been $641,000 ($0.05 per share) lower.

The $84 million in free cash flow MicroStrategy generated last year amounts to a 7.5% free cash flow yield. This is more than the 100% premium to Treasuries that I would like to earn from my risky investments. However, the ongoing declines in cash flow mean that I want to be compensated for falling cash flow as well. Each percentage point of expected decline should equate to another percentage point of cash flow yield.

Using the 3% decline in license revenue as a starting point, and the 2.9% Treasury yield as a base, I would want to earn a free cash flow yield of at least 8.8% (2.9 + 2.9 + 3) on MicroStrategy. To get to that yield, the shares would need to fall to $57.

In the meantime, it just looks too risky for me.

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Over the weekend our forecast for Large Cap Watch List (Track at Marketocracy) member Oracle’s (ORCL - Annual Report) earnings report was that “We think acquisitions will result in upside to estimates though organic growth may disappoint.” Then, we noticed an article suggesting that the company would beat estimates due to a late-quarter sales surge. This worried us, and put us on the alert for “linearity” references when we saw the earnings release:

Third quarter GAAP revenues were up 27% to $4.4 billion, while quarterly GAAP net income was up 35% to $1.03 billion. Total GAAP software revenues were up 25% to $3.5 billion with GAAP database and middleware new license revenues up 17% and GAAP applications new license revenues up 57%. GAAP services revenues were $916 million, up 36% compared to the same quarter last year.Third quarter non-GAAP earnings per share were up 31% to $0.25, and non- GAAP net income was up 30% to $1.3 billion compared to Q3 last year.

The consensus number was for $0.23 on $4.33 billion in revenues. We also saw another article putting the guidance for the coming quarter at $0.34, right in line with the consensus figure. So far, so good. But we still have two problems: there is no breakdown of organic versus acquired growth and there is no clarity on the linearity.

On the conference call, CFO Safra Catz partially addressed the organic growth issue, saying:

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 cut 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. Catz provided some perspective on the conference call:

We bought a lot of smaller things that are not at scale, and that is one of the reasons that our margins have not been shooting up higher than they are now going, and that is because we have been — we invest in them for a while before they are at scale and then the revenue comes in and then all the marginal revenue is very, very profitable.

Unfortunately, however, the small initial size means the company doesn’t have to keep track of the initial contribution when comparing year/year results.

One positive indicator on that front is the company’s accounts receivable balance, which declined to $2.8 billion from $3.5 billion last quarter and $3.2 billion one year ago, despite the rise in sales. Since customers are generally given some time after ordering to make payment, the later sales occur in the quarter the higher the receivables balance would likely be. The fact that receivables actually declined suggests that earnings may be of much higher quality than investors were expecting, which would account for the rising share price in extended trading.

Catz also addressed the possibility that a couple of very large deals skewed the results:

I know there are rumors of mega-deals in the quarter, a couple at over $100 million, and those rumors are simply not true. Even if you added up the top five deals in the quarter, you do not get to $100 million in new license revenue. You add the top 20, you do not get to $200 million.

Not that the company wouldn’t mind a mega-deal or two, but investors rightly exclude them from forecasts due to their rarity, and prefer to look at them as gravy.

So all in all, it was a good quarter and good guidance - as far as we can tell.

Analyst: Hyperion Should Nix Oracle Deal: Financial News - Yahoo! Finance

Oracle Corp. will plunk down $3.3 billion to buy Hyperion Solutions Corp., but at least one analyst thinks the transaction is a bad deal for Hyperion investors.Roth Capital Partners analyst Nathan Schneiderman, who has a “Hold” rating on Hyperion, thinks shareholders should vote the deal down.

“We’re all for makin’ a quick buck, don’t get us wrong — what we don’t like is leaving most of the spoils on the table for Oracle,” Schneiderman wrote in a note to investors.

As we said when the deal was announced:

The buyout price would be around $50 per Hyperion (HYSL) share, about a 25% premium [Ed. note: actually the deal was for 10% more than the rumored price] to the closing price. Given that its shares were already up 30% since issuing a strong outlook in January, its shareholders ought to be pretty happy right now.

And, should the shareholders vote down the deal in hopes of either a higher offer from Oracle or a competing bid, they could just as easily see a lower price as a higher one.

We generally think Oracle’s (ORCL - Annual Report) acquisition strategy is the right thing for the company and for the industry. Software companies are generally under-leveraged, and even paying for the acquisition in cash would leave the company with very little net debt and combined annual cash flows of nearly $4 billion to offset the current debt of $5.7 billion. So we say they were overdue for another big buyout.
Right on schedule, according to the New York Times, Oracle to buy Hyperion for $3B:

Oracle Corp., the world’s top database software maker, is near an agreement to buy Hyperion Solutions Corp., which makes software that lets companies analyze and track their performance, for about $3 billion, The New York Times said on Wednesday in its online edition.

If the rumors are correct, the buyout price would be around $50 per Hyperion (HYSL) share, about a 25% premium to the closing price. Given that its shares were already up 30% since issuing a strong outlook in January, its shareholders ought to be pretty happy right now.