Analyst Opinion: NEUTRAL

Summary

We believe Oracle is fairly valued. Oracle is a successful software and IT services company, which has exhibited strong growth, fuelled by an aggressive acquisition-driven strategy. It is a multibillion company with a strong brand name and large customer base. However, the company has been relying on acquisitions for its growth and faces very strong competition, represented by such industry giants as Microsoft, IBM and SAP. The latter is a leader in many business software segments and is developing its own set of SOA tools, an area heavily targeted by Oracle. However, unlike Oracle, SAP has reported strong organic growth and is in no position to give up its market share. Currently, Oracle has built a strong portfolio of companies, but it will need to consolidate them efficiently, recovering the margins that suffered in the past two years. It will also have to make an effort at pushing organic growth to rates comparable with SAP's to keep and gain market share.

Highlights:

Company size

Large size provides numerous benefits: credibility, rich resource base (including human capital, research facilities, intellectual property), cross-subsidization possibilities, relative ease of entry into new industries/segments, possibility to work with large customers (governments, multinationals etc), economies of scale, bargaining power and lobbying, purchasing power for acquisitions.

Wide range of products

Oracle targets the corporate segment of the software consumer market and offers a wide range of business software, developed both internally and acquired through purchase of subsidiaries. The products include:

Technology Products: Database and Grids, Middleware, Data Hubs, Developer Tools, Security, Search, Enterprise Management, Business Intelligence, Collaboration, Content, Data Warehousing, Linux;

Application Products: Customer Relationship Management, Financial Accounting, Human Resources, Supply Chain, Public Sector Applications, Banking Applications, Retail Applications, Telecom Applications, Higher Education Applications and other;

Services: Support, Education, On Demand, Financing, INSIGHT, Consulting.

The company is also developing a new integrated product suite planned for initial release in 2008 - the Fusion Project (discussed below). With such an extensive portfolio and significant expertise, Oracle is a world-class leader and a standard-setting player in its domain.

Expansion into industry subsectors through acquisitions

Oracle has been acquiring subsidiaries in other market segments, benefiting from existing customer bases, technology and trust already gained by the target companies. Oracle's size and customer base both allow and require the company to keep looking for new directions to expand to. In the past several years, Oracle has been very active in terms of acquisitions, buying both small and big IT companies.

* As of August 31, 2006.

Source: http://en.wikipedia.org/wiki/Oracle_Corporation, SEC filings.

Oracle leads in many market segments

Oracle is an experienced multibillion company, present in several key software markets. The company is a leader in many of the market segments it is present in, This leadership is the result of both internal developments (such as its database business) and acquisitions (such as the acquisition of Siebel, which allowed Oracle to narrow the gap between itself and SAP in the CRM market from 20 to just 3 percentage points[1]).

Fusion Applications scheduled for release in 2008

Oracle plans to launch a new business software suite that will combine the functionality of its currently separate software packages, offering greater data management capabilities to businesses than standalone applications. An analyst notes that "if Fusion works as advertised, Oracle could wind up dominating the software world this decade much as Microsoft dominated the last one."[2] Fusion Middleware already has 30,000 users[3] allowing customers to use software from different vendors. However, SAP is planning to launch its own SOA-based suite in 2007, with its NetWeaver SOA platform launched in 2004.

Aggressive business strategy

As illustrated by Oracle's move to provide low cost support to Red Hat Enterprise Linux users and by the announcement to create and offer its own version of Linux operating system, Oracle uses a very aggressive business strategy, trying to 'steal' customers from competitors or at least to make competitors' lives harder. This strategy is also exemplified by the acquisition activity discussed above and by numerous partnerships that Oracle keeps establishing with various industry players.

Partnerships with industry leaders

Oracle has partnered with a number of leading companies in the IT industry, among which are Dell, HP, Intel and others. Through such partnerships, Oracle benefits from greater exposure to potential customers, from increased trust inferred from the expertise of its partners and from cross-marketing opportunities. Of course, competitors also rely on partnerships and Oracle partnering with other companies mostly offsets similar relationships between competitors.

Sound financials with healthy balance sheet

Oracle has exhibited accelerating revenue growth rates in the past several years following revenue stagnation in 2003, resulting from its aggressive business strategy and partly fueled by acquisitions. Such high growth rates are not typical for multi-billion companies and represent a strength on their own. However, much of the revenue growth came from acquisitions:

Fiscal year ends May 31.
Pro forma data includes only Siebel and PeopleSoft acquisitions.
Source: SEC filings, our calculations

Nonetheless, in H1FY07, organic revenue year-over-year growth was 17% with 28% total revenue year-over-year growth. In the Q1FY07 Earnings Call[4], the company's CFO noted that in Q1FY07 Oracle had its strongest Q1 licensed growth in more than five years and that the company was gaining share across all product lines. This was also the third consecutive quarter in which Oracle had applications license growth greater than 75%[5].

The company's EPS has also been growing steadily as a result of both revenue increase and share buybacks. The company plans to buy back $1 billion worth of shares every quarter until the end of the fiscal year. Since the inception of Oracle's share repurchase program in 1992 through FY06, the company repurchased 1.8 billion of its shares for a total of $20.7 billion, and in July 2006 the company's Board extended the repurchase program so that another $4 billion worth of shares could be repurchased. During the six months ended November 30, 2006, ORCL repurchased 121.3 million shares for $2.0 billion.

The Q2FY07 balance sheet exhibited decent liquidity, with the current ratio at 1.75, cash & equivalents and marketable securities together accounting for 27% of all assets, and net working capital standing at $5.6 billion. At the same time, financial debt stood at $5.9 billion, or 20.4% of total assets.

Positive guidance provided by management for Q3FY07[6]:

• New software license revenues are expected to be up 16% to 22% year-over-year;
• Total revenue is expected to be up 23% to 25% on a GAAP basis;
• Net income is expected to growth 24% to 29% on a GAAP basis;
• GAAP EPS is expected to be $0.18-0.19, up from $0.14 last year.

Risks:

Company size

Large size also brings some disadvantages: multiple levels of management increase bureaucracy, small but highly lucrative niches may remain unnoticed/unattended and left to smaller players to fill in, difficulties to implement corporation-wide changes, antitrust attention from governments, any errors/malfunctions in products immediately create bad publicity.

Strong competition

SAP is one of Oracle's main competitors. SAP is the market share leader in the CRM, ERP, and SCM spaces, according to Gartner Dataquest[8], and has partnered with Microsoft to make its applications integrate easily with MS Office applications. SAP is also developing a Services Oriented Architecture suite which may be launched as soon as in 2007, one year before Oracle's Fusion application suite. It's SOA platform - NetWeaver - was launched in 2004. At its recent European TechEd conference in Amsterdam, SAPd the NetWeaver platform to a broader development community[9]. Via the online SAP Developers Network, developers will be able to purchase individual subscriptions to SAP software, allowing them to test, evaluate and develop tools in NetWeaver. Previously, access to development tools was available only for companies that had purchased SAP software. The subscription program will include access to technical support, premium content and online access for testing enterprise services. The program is scheduled to begin in 2007.

SAP also has a large customer base and a strong brand name. Just like Oracle attacked Red Hat, SAP attacked Oracle earlier this year, offering support to Siebel customers at lower rates[10] than Oracle's. SAP also boasts growing revenues, including in Oracle's home market - the US, where it had 15% growth of Software revenues in Q3FY06, and has issued a positive outlook for the year in October, while stating that SAP was gaining market share and growing mainly organically, as opposed to Oracle's acquisition-driven growth[11]. SAP expects full-year 2006 product revenues to increase by 13-15% year-over-year, based on the expectation for full-year 2006 software revenue growth in the range of 15% to 17%, compared to 2005.

Relative security weakness of Oracle databases

The company's key product suffers from weak security compared to competitors. Recently, a security researcher from NGS Software published a white paper comparing security robustness of database software from several producers[12]. Oracle's products were recognized to contain more security bugs than Microsoft's SQL Server products.

The number of security flaws in the Oracle and Microsoft database servers that have been discovered and fixed since December 2000 until November 2006:

Source: http://www.databasesecurity.com/dbsec/comparison.pdf

Another report by the Enterprise Management Group[13], also notes Oracle's relatively poor security record. In fact, security vendor Argeniss has announced that it will have a "week of Oracle Database bugs" in December focusing on Oracle's poor security record.

Such poor security record can cast a shadow of doubt on Oracle's other products and reduce customer trust, especially when data security is being addressed on national level in many countries.

Fast expansion and tight competition have eroded Oracle's profit margins

Rapid expansion came at the price of margins, with both operating and net margins experiencing a decline during 2005-2006.

Fiscal year ends May 31.
Source: SEC filings, our calculations.

SWOT Analysis

Industry

Enterprise resource planning (ERP) applications market: Oracle is the fastest market share gainer

The ERP applications market is expected to reach $29 billion in 2006[14] or 14.2% higher than in 2005. Also, for the next five years the market is expected to grow at a CAGR of 10%.

While Oracle is expected to maintain its second position in terms of market share, it is likely to enjoy the largest growth in the ERP application segment compared to other Top 5 ERP vendors and at 2x the overall market growth rate.

Source: AMR Research (2006)

Business analytics software and data warehousing tools market: Oracle is the market leader

Oracle was recognized as the leading business analytics software and data warehousing tools vendor for 2005, retaining a market share of 13.1% or $2.2 billion of the $16.6 billion total market[15]. This market grew by 11% in 2005.

Oracle is the world leader in the data warehousing tools market with a 19.3% market share and $1.9 billion[16] in 2005 software revenues. Oracle is also the leading vendor in the data warehouse management category with a 39.8% market share and $1.6 billion in revenues for 2005. Oracle's closest competitor in the category had a 22.7% market share.

Worldwide relational database market (RDBMS): Oracle is the market leader

Worldwide relational database management systems (RDBMS) total software revenue increased by 8.3% in 2005 reaching $13.8 billion[17]. Of the top 5 vendors, just Microsoft experienced a growth rate above the industry average, primarily due to pent-up demand for SQL Server 2005.

Source: Gartner.

Customer relationship management (CRM) software market: Oracle is much closer to the leading position after the acquisition of Siebel

Worldwide CRM software market reached $5.7 billion, experiencing 14%[18] growth in 2005 over 2004, driven by companies looking for more opportunities to drive revenue and expand business lines.

In 2005, SAP was the top CRM vendor in terms of revenue (26% market share), followed by Siebel (17%), Oracle (6%), Salesforce.com (5%) and Amdocs (5%). However after the acquisition of Siebel Systems in January 2006, Oracle attained a 23% market share.

Application integration and middleware (AIM) market: Oracle has the strongest momentum in the segment

The application integration market reached $8.5 billion in 2005, a 7.1% increase over 2004. The main players were: IBM (a clear leader with market share of 37%), BEA Systems (14.5%), Oracle (8.7%), Microsoft (4.7%) and Tibco (3.7%).

Oracle - with the highest momentum in the segment - witnessed revenue growth of 40% in 2005.

2005 Worldwide Vendor Revenue Estimates for AIM Software (Millions of Dollars)[19]

Source: Gartner Dataquest (May 2006)

Oracle versus Peers

Despite its aggressive acquisition strategy, ORCL maintains superior profitability level compared to other giants from the IT space; in terms of operating and net margin being exceeded just by Microsoft.

Source: Yahoo! Finance, SEC filings.

Valuation

• We expect ORCL to report:
• $18 billion in sales for FY07 and $21 billion in FY08;
• GAAP diluted EPS of $0.76 (FY07) and $0.86 (FY08).

While estimated P/S ratio unveils a premium of ORCL over peers multiple, we believe it is warranted by superior profitability. According to peers' median P/E multiple, ORCL seems fairly valued.

Overall, we are quite optimistic about ORCL and consider it may show further positive developments. But we consider that at current stock price, the investment gain is limited.

Source: Analyst estimates for ORCL, other stocks - consensus.

FORECAST: Income statement

US GAAP, $ million

Source: SEC filings, analyst estimates.

[1] Based on 2005 data, source: Gartner.

[2] Source: http://news.zdnet.com/2010-3513_.html.

[3] Source: Q1FY07 Earnings Call, available at http://seekingalpha.com/article/17179.

[4] Transcript available at http://seekingalpha.com/article/17179.

[5] Data from management in this paragraph reflect non-GAAP measures.

[6] Oracle F2Q07 (Qtr End 11/30/06) Earnings Call from December 18, 2006, transcript available at http://seekingalpha.com/article/22626.

[7] Some of these opinions can be found here: http://news.zdnet.com/2100-3513_.html.

[8] Source: http://www.destinationcrm.com/articles/default.asp?ArticleID=6162.

[9] Source: http://searchsap.techtarget.com/originalContent/0,289142,sid21_gci1225126,00.html.

[10] Source: http://news.zdnet.com/2100-9593_.html.

[11] Source: Q3FY06 earnings call, available at http://seekingalpha.com/article/18842.

[12] Source: http://www.vnunet.com/vnunet/news/2169225/microsoft-beats-oracle-security, white paper available at http://www.databasesecurity.com/dbsec/comparison.pdf.

[13] Source: http://www.microsoft.com/presspass/itanalyst/docs/ESGNov2006SQLServerSecurity.pdf.

[14] Source: AMR Research

[15] Source: IDC.

[16] Source: IDC.

[17] Source: Gartner.

[18] Source: Gartner.

[19] Source: http://www.gartner.com/press_releases/asset_153343_11.html.

[20] Software segment only; annual (2005) values.

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