Stop Worrying About This Tech Titan!

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Oracle (NYSE: ORCL),a bellwether of the tech industry, recently disappointed investors with third quarter earnings that missed analyst estimates on both the top and bottom lines. The Redwood City, Calif.-based company, which specializes in enterprise software and database management products, has been struggling to make a transition from software as a product (packaged solutions) to software as a service (cloud-based solutions), and making its maligned acquisition Sun Microsystems work. Although Oracle faces some tough challenges ahead in the coming year, have these issues derailed the company’s once promising growth prospects?

Third Quarter Earnings

For its third quarter, Oracle earned $0.52 per share, or $2.5 billion, barely up from the $0.49 per share, or $2.5 billion, it earned in the prior year quarter. Excluding one-time charges, the company earned $0.65 per share, coming in a penny short of analyst estimates. Revenue also declined 1% from $9.04 billion to $8.96 billion, also missing the $9.38 billion that analysts had expected.

Oracle’s reported considerable weakness in its two largest business segments, software and hardware.

Software Sales Growth

Oracle’s software segment is split into three tiers - database software, middleware and applications. Database software is the lowest tier, which manages and organizes a company’s vital data. Middleware recompiles the database data into a more manageable format for software applications. Applications, the final tier, are customized for the needs of different companies to allow employees to quickly access their organized data for productivity needs.

Total software revenues rose 3.7% to $6.68 billion. By region, sales were flat in the Americas year-on-year, which comprise 52.4% of total revenue. EMEA (Europe, Middle East & Africa), which generates 30.6% of total revenue, reported a 1.5% decline. Asia, which accounts for 16.9% of total revenue, fared the worst, sliding 1.9%.

New software licenses, which include its cloud-based services, slid 1.5% from the prior year quarter to $2.34 billion, completely missing the company’s own forecast for 3.0% to 13.0% growth.

Oracle has been attempting to shift its software license business to its cloud-based platform, Fusion, but the transition has been slow and painful. Cloud revenues only came in at $238.0 million during the quarter. A report from Forrester Research claims that many customers have shown that they are content using Oracle’s older Applications Unlimited program, which has slowed the adoption of Fusion. In rebuttal, Oracle claims that the two software suites are not cannibalizing each other, and that Fusion’s problems are simply ‘growing pains’ for a young product.

Hardware Sales Growth

Oracle’s hardware segment, which consists of hardware systems and services, reported a  16.0% decline to $1.24 billion. Hardware systems sales plunged 22.8% while hardware support revenue dropped 6.2%. By region, sales slid 25% in the Americas, 24% in EMEA and 16.0% in Asia-Pacific.

Those disappointing results have cast doubts on CEO Larry Ellison’s earlier claim that Oracle’s hardware business would halt its decline by February and start growing in May.

Ellison has been harshly criticized in the past for even getting involved in the hardware business, a result of his $7.4 billion acquisition of Sun Microsystems in 2010. Ellison’s original plan was to split Sun’s software and hardware businesses with Hewlett-Packard (NYSE: HPQ), acquiring the former while letting HP take the latter.

However, when HP backed out, Oracle still decided to buy Sun, inheriting its troubled hardware business and prompting some of Oracle’s executives to claim, “we bought a dog.” The Sun acquisition also turned longtime partner HP into a competitor on the hardware front, which caused HP to sue Oracle for $4 billion in damages.

Despite all this drama, Ellison is optimistic regarding the future of the hardware business, which he claims will turnaround by the end of the first quarter in August. During the quarter, the company’s T-series servers sold the best, but were offset by losses from its higher-end M-series servers.

Oracle claims that the lower sales of its M-series was due to customers waiting it out for the next generation of servers, built on its SPARC T5 microprocessor, and its upgraded M5 servers. Meanwhile, ZFS storage sales posted a double-digit gain.

To offset these losses, Oracle has been steadily moving away from these server products and focusing on “engineered systems”, which combine hardware and specialized software in a single package. Demand for these new engineered systems, such as Exadata, Exalogic and Exalytics, has been brisk over the quarter, posting 30% sequential growth in unit bookings. During the quarter, Oracle sold over 800 engineered systems to a wide range of customers, including Dow Chemical and Office Depot. 

Expenses and Margins

Investors have been increasingly concerned with rising expenses and declining margins at Oracle, due to the transition to cloud-based services and its poorly performing hardware business. During the quarter, total operating expenses rose 10 basis points to 55.3%. Meanwhile, operating margin was flat from the previous year at 44.7%.

Overall, expenses and margins appeared under control during the third quarter, a continuation of a longer term trend over the past three years since the Sun acquisition.

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Therefore, although Oracle is having some short-term problems with meeting growth expectations, the company has bounced back from the Sun acquisition fairly strongly. Its cash position has risen, free cash flow is being efficiently used, margins are rising and expenses are flat - all positive long-term catalysts for growth.

The Bottom Line

In the enterprise business, Oracle competes with the heavyweights of the IT industry - IBM (NYSE: IBM), SAP (NYSE: SAP) and its former ally Hewlett-Packard. How does Oracle stack up fundamentally against these peers?

<table> <tbody> <tr> <td><br /><span></span></td> <td> <p><strong>Forward P/E</strong></p> </td> <td> <p><strong>Price to Sales (ttm)</strong></p> </td> <td> <p><strong>Return on Equity (ttm)</strong></p> </td> <td> <p><strong>Debt to Equity</strong></p> </td> <td> <p><strong>Profit Margin</strong></p> </td> <td> <p><strong>Qty. EPS Growth (y-o-y)</strong></p> </td> <td> <p><strong>Qty.Revenue Growth (y-o-y)</strong></p> </td> <td> <p><strong>Div. Yield %</strong></p> </td> </tr> <tr> <td> <p><strong>Oracle</strong></p> </td> <td> <p><span>10.91</span></p> </td> <td> <p><span>4.12</span></p> </td> <td> <p><span>24.29%</span></p> </td> <td> <p><span>45.11</span></p> </td> <td> <p><span>28.46%</span></p> </td> <td> <p><span>0.20%</span></p> </td> <td> <p><span>-0.90%</span></p> </td> <td> <p><span>0.80%</span></p> </td> </tr> <tr> <td> <p><strong>Hewlett-Packard</strong></p> </td> <td> <p><span>6.45</span></p> </td> <td> <p><span>0.37</span></p> </td> <td> <p><span>-41.00%</span></p> </td> <td> <p><span>121.28</span></p> </td> <td> <p><span>10.86%</span></p> </td> <td> <p><span>-16.10%</span></p> </td> <td> <p><span>-5.60%</span></p> </td> <td> <p><span>2.30%</span></p> </td> </tr> <tr> <td> <p><strong>IBM</strong></p> </td> <td> <p><span>11.49</span><span></span></p> </td> <td> <p><span>2.26</span><span></span></p> </td> <td> <p><span>84.67%</span><span></span></p> </td> <td> <p><span>175.25</span><span></span></p> </td> <td> <p><span>15.89%</span><span></span></p> </td> <td> <p><span>6.20%</span><span></span></p> </td> <td> <p><span>-0.60%</span><span></span></p> </td> <td> <p><span>1.60%</span></p> </td> </tr> <tr> <td> <p><strong>SAP</strong></p> </td> <td> <p><span>20.26</span><span></span></p> </td> <td> <p><span>20.26</span><span></span></p> </td> <td> <p><span>21.03%</span><span></span></p> </td> <td> <p><span>37.02</span><span></span></p> </td> <td> <p><span>17.42%</span><span></span></p> </td> <td> <p><span>-7.80%</span><span></span></p> </td> <td> <p><span>11.60%</span><span></span></p> </td> <td> <p><span>0.90%</span></p> </td> </tr> <tr> <td> <p><em>Advantage</em></p> </td> <td> <p><span>HP</span></p> </td> <td> <p><span>HP</span></p> </td> <td> <p><span>IBM</span></p> </td> <td> <p><span>SAP</span></p> </td> <td> <p><span>Oracle</span></p> </td> <td> <p><span>IBM</span></p> </td> <td> <p><span>SAP</span></p> </td> <td> <p><span>HP</span></p> </td> </tr> </tbody> </table>

Source: Yahoo Finance, 3/25/2013

Since each company has a slightly different approach to database management and enterprise software, the results are mixed. While HP is the cheapest stock fundamentally, the headwinds it faces in the personal computers business are too strong to ignore. SAP is the most expensive fundamentally, which could be justified by its higher revenue growth, lower debt levels, and robust margins. Meanwhile, IBM is the most stable, but its fundamentals don’t point to explosive growth down the road.

Oracle has one key strength - its margins, which are extremely important in the tech world. Tech companies often get ahead of themselves with revenue growth while completely neglecting margins and profits. Although Oracle’s top and bottom lines are likely to remain under pressure in the coming year, I believe that its long-term transition will pay off in the end. The company’s operational efficiency is clear with its tight control of expenses and tight use of cash. Therefore, Oracle is a sound long-term investment - as long as you don’t expect it to double overnight.

Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of International Business Machines. and Oracle.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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