Eyeballing the Top Line at Overvalued Oracle

What's more inflated -- Larry Ellison's ego or Oracle's (ORCL Quote - Cramer on ORCL - Stock Picks) valuation?

Detox

Detox: A Dose of Investing Reality

The latter, believe it or not. The business software giant, captained by Ellison, is one of the best examples of a widely owned tech company that is facing serious challenges, yet has a stock priced for perfection.

But it may not be long before Oracle's shares fall to reflect reality. The trigger for a big drop would be any firm indication that the company is struggling in its all-important push into applications software, which helps companies use the Web to manage operations.

If it fails to capture a large share of the applications market, Oracle will again be pigeon-holed as a provider of relatively slow-growing database software, which still accounts for around three-fourths of the firm's licensing revenue. Though Ellison has certainly proven himself a visionary, and his sale force is formidable, Oracle has disappointed dramatically before, leaving its stock in the dumps.

Ilogging

Oracle, in its fiscal first quarter, ended Aug. 31, notched up reasonable-looking 42% applications revenue growth, but this was lower than expected. And since then, other developments have suggested continued underperformance in this line. Ilog (ILOG Quote - Cramer on ILOG - Stock Picks), a software components company that sells to Oracle, just reported a disappointing quarter, attributing the poor numbers to slower-than-expected sales of Oracle applications software, according to an analyst's report.

Rising Oracle soars over 12 months

George Roberts, Oracle's executive VP for North American sales, responds: "Someone would be mistaken to assume anything about [Oracle's] applications growth" from Ilog's quarter. "It's fair to state that our applications growth is accelerating."

Ilog is a small company, with a mere $14 million of sales in its latest quarter, so it's feasible that its sales data say little about demand for Oracle products.

However, at the same time, Oracle is getting strangely sensitive about giving out information on applications. At the company's October analysts meeting, the company's finance chief, Jeff Henley, said that the company was cutting back on the amount of detail it provides on applications revenue growth. It's never good when a company renowned for openness starts reducing disclosure, especially for a business that's supposed to be leading the firm to a higher plane of profitability. What's more, Henley was brought to Oracle in the early '90s, after it nearly ran itself into the ground, to be its straight-talking finance guy. Strange, then, that he should suddenly be getting tight-lipped.

Big Expectations

Even so, investors remain superbullish. Oracle's stock is up nearly 200% over the past 12 months. At its Monday closing price of $31.62, Oracle is trading at 65 times analyst-projected per-share earnings for its 2001 fiscal year, ending next May. The 30 analysts surveyed by First Call/Thomson Financial expect per-share earnings to increase by 44% in fiscal 2001.

Out of Sight Tracking gains over five years

Oracle's shift to applications looks very much like an attempt to avoid a marked top-line slowdown. Revenue growth was 15% in fiscal 2000, vs. 24% in fiscal 1999 and 26% in fiscal 1998, according to the company. In the fiscal first quarter, software licensing revenue totaled $771 million, up 28% from the year-ago period, reflecting 42% growth from applications and an unusually strong 32% growth rate in database sales.

Without doubt, the software industry as a whole has benefited as companies try to use the Internet to cut costs. Several highflying tech outfits sell specialist software designed for particular business activities. For example, Siebel (SEBL Quote - Cramer on SEBL - Stock Picks) is strong in software for sales force management, and recently posted 135% software revenue growth in its latest quarter.

How Suite It Is

Just entering a new market packed with proven competitors is a risk for Oracle. But Ellison is going one step further. He's betting that many corporations will prefer to get a package of applications from only one software firm to cover the majority of their needs. Oracle's bundling its applications into so-called e-business suites in the belief that customers will stop going to a range of different firms.

Oracle's goal for applications license revenue growth for fiscal 2001 is 50% to 100%, a target so imprecise that it raises questions about Oracle's forecasting abilities. At that pace, Oracle aims to boost applications licensing revenue from $923 million in fiscal 2000, to $1.4 billion to $1.8 billion in fiscal 2001. But Eric Upin, analyst at Robertson Stephens, forecasts $1.3 billion, or a 43% annual rise. (He gives Oracle a long-term attractive rating and Robbie has underwritten for the firm.)

For certain, all eyes will be on the application growth number in fiscal second-quarter results, due in mid-December. Growth in the quarter of between 40% and 50% (or, of course, lower) would fail to clear away doubts. And Henley hinted at the analysts meeting that it would be towards the "lower end" of the 50%-100% range, and seemed to suggest that the fiscal third and fourth quarters could be more impressive.

In addition, Henley told attendees that Oracle has now stopped regularly breaking out separate revenue growth numbers for particular applications, like procurement. Henley's explanation? The company didn't mind giving out these numbers back when certain applications (like procurement) were doing well compared to others (like enterprise resource planning). But now it doesn't want its numbers getting "picked apart." Drew Brosseau, analyst at SG Cowen, concludes: "The company wants to crow when it's doing well, but it appears it's not willing to eat crow when it's not doing well." (SG Cowen rates Oracle a buy; SG Cowen hasn't recently underwritten for the company.)

Looking Around

As Oracle reduces the information flow, investors are bound to start looking for other ways of tracking applications sales. And that's why Ilog's situation warrants inspection. In its first quarter earnings press release, the Paris and Mountain View, Calif.-based firm explained its shortfall by saying it experienced a "four- to six-month delay in the royalty flow" from an unnamed independent software vendor. In a research note on Ilog's quarter, SG Cowen's Brosseau writes that Ilog told him the big vendor was Oracle.

Zooming out, any slowness in applications may have a lot to do with Ellison's bundling strategy. He points out that desktop software is bundled, and businesses will start going down this route.

But there are obvious limitations to this analogy. Here are three: First off, desktop users do go to different places for software (how many people reading this are using a Netscape browser on a Microsoft platform?). Second, buying only from Oracle can mean chucking out possibly higher-quality software already bought at huge expense. And since they are spending big sums on software, businesses probably want the best product, and the applications on Oracle's suites aren't widely recognized market leaders.

There's another risk to Oracle: Ellison himself. If applications growth is poor in the fiscal second quarter, one has to wonder what it would take to get the CEO to jettison his suite-based approach, given his apparent rigidity on matter. In the Q&A session at the October analyst meeting, Ellison took questions on the bundling concept. The responses rolled out fast and smart, but they also contained his usual mind-numbing sophistries and Dr. Laura-style contempt. It must be hard for dissenting insiders to change this guy's mind. It all comes down to the ego.