Oracle Looks for Inside Track on Outsourcing

For more than three years, Oracle (ORCL) has been trumpeting outsourcing applications as a way to diversify away from its core database business.

But now that the world's second-largest software maker is taking more concrete steps to develop outsourcing, analysts are expressing doubts about whether it is as lucrative as Oracle suggests. Despite all the recent hype, virtually no analyst has yet included outsourcing revenue in his financial model.

The latest step taken by Oracle to build that outsourcing business will come Tuesday when the Redwood Shores, Calif., company announces it is extending beyond applications to databases and application servers.

That move comes on top of recent changes in Oracle's salesforce to push more outsourcing deals, including dedicating 18 North American sales consultants to the effort, and spending about $60 million to expand its data infrastructure.

Oracle CFO Jeff Henley has said Oracle can build outsourcing into a $1 billion business in the next five years, assuming one-quarter of its existing customers sign up. The sales pitch is that customers can lower their costs by outsourcing. Oracle's more than 200 customers have lowered IT costs by up to 46%, according to the company.

But at least one analyst, David Hilal of Friedman Billings Ramsey, has called the $1 billion a "lofty goal" for a company whose revenues have declined four straight quarters. Outsourcing currently generates less than $50 million in annual revenue -- a drop in the bucket given Oracle's total revenue totaled $2.2 billion in the most recently completed quarter.

Analysts say while the cost savings may prove attractive to small and medium-sized businesses, Oracle faces a tough road ahead convincing large companies to outsource their software. After Oracle touted the new business at a recent analyst day in New York, Deutsche Banc Alex. Brown analysts Jim Moore and Matthew Kelly said in a research note that success could be hampered by risk-averse CIOs fearful of handing over critical corporate data and applications to a third party -- a sticking point for application service provider failures in the past. Moore or Kelly own Oracle shares.

Lisa Arthur, Oracle's vice president of outsourcing marketing, disputed that point, saying outsourcing appeals to small and large companies alike. "The larger the company, the larger the IT budget, the more ability they have to make an impact to that budget," she said. In addition, she said Oracle offers several outsourcing options, including allowing companies to house the hardware and hire Oracle to manage, administer and maintain its software remotely.

Merrill Lynch analyst Chris Shilakes agreed it could take companies some time to digest and become comfortable with the new business proposition. Shilakes, who has a neutral rating on Oracle, did not change his estimates after hearing the company's pitch in New York. He said Oracle is fully valued for his estimates for long-term earnings growth of 10% to 15%. His firm hasn't done any business with Oracle.

So how long will it take for outsourcing to have an impact on Oracle's income statement? "We think meaningful traction is two years away," Hilal of Friedman Billings Ramsey said in a recent interview. Hilal suggested Oracle is using outsourcing to accelerate customer upgrades and differentiate its products from competitors like PeopleSoft, Siebel Systems and SAP.

Indeed, none of those players have begun outsourcing their software. Microsoft, through its .Net initiative, has made a push to eventually deliver software as a service.

Another point of uncertainty, however, is what effect outsourcing will have on Oracle's margins, which the company has managed to hold steady even as revenue and earnings slide. "You will have to invest upfront to be able to do this," said Eric Upin, an analyst with Robertson Stephens. "So there could be some margin implications."

Upin, who rates Oracle a market perform, said he has declined to include revenue for outsourcing in his models for Oracle because "we're still a little dubious near term." His firm hasn't done any banking business with the company.

Oracle's Arthur countered that outsourcing is a "very scalable model" and said that margins can benefit because Oracle is able to address customer problems much faster, which also improves customer satisfaction.

Despite the uncertainty, Upin acknowledged that getting into outsourcing makes sense. "The benefit of the ASP hosting model is you have long-term contracts. You almost have a utility business model, which is great for visibility and predictability. And investors will pay a premium for that," said Upin. "It's a smart move for them to continue to try to diversify the business and pursue other growth areas."

But, Upin added, "it also looks like they're off to a small start."

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