Earnings Preview: Oracle

Oracle Corp. (ORCL) is scheduled to release its third quarter 2011 results on March 24, 2011, after the market closes.

Since the release of second quarter 2011 results, Oracle shares have risen 4.0%. Oracle posted decent second quarter results, which beat the Zacks Consensus Estimate by a penny. Not that good, considering the fact that it beat the Zacks Consensus Estimate by 10.8% on an average in the last four quarters.

However, third quarter guidance was robust, primarily reflecting higher business spending by corporations. Oracle expects to gain from a strong software business (65.5% of second quarter total revenue) in the upcoming quarters.

Second quarter Synopsis

Oracle reported strong second quarter results, with earnings per share (excluding one-time items but including stock-based compensation) increasing 32.4% year over year to 49 cents. The strong growth was driven by new software license sales (sales to new customers) and growth in hardware sales, aided by the acquisition of Sun Microsystems in January 2010.

Revenue increased 47.0% year over year to $8.58 billion, driven by better-than-expected new software license revenues. Excluding revenues related to assumed support software and hardware contracts, which will not be recognized in fiscal 2011 due to certain accounting rules non-GAAP revenues leaped 47.3% year over year to $8.65 billion. Revenues were above the Zacks Consensus Estimate of $8.30 billion.

Despite a whopping 60.6% year over year increase in total operating expenses, mainly due to increased research and development expenses (13% of the total revenue) that rose 58.0% to $1.12 billion and sales and marketing expenses (18% of the total revenue) that increased 36% to $1.53 billion, operating income on a non-GAAP basis increased 33.3% to $3.81 billion, aided by higher revenues in the quarter.

Non-GAAP operating margin of 44.0% was down 500 basis points year over year, due to the addition of Sun’s lower-margin hardware business. Management highlighted that margins were better than its peers and were 15% higher than its closest competitor SAP AG (SAP).

Oracle generated $8.68 billion in free cash flow, which were 128% of net income. Operating cash flow was $9.05 billion in the quarter. Oracle had $24.85 billion in cash and investments at the end of the quarter versus $23.60 billion in the previous quarter.

Third quarter Guidance

For the third quarter of 2011, Oracle expects non-GAAP earnings per share, at constant currency, to range between 48 cents and 50 cents. This was up from 38 cents reported in the comparable quarter last year and above the Zacks Consensus Estimate of 47 cents.

Oracle expects a positive currency effect of 1% on license growth rates and 1% positive effect on total revenue growth. Total revenue growth on a non-GAAP basis is expected to range from 30% to 34% in constant currency. The guidance assumes a non-GAAP tax rate of 29.5%.

New software license revenue growth is expected to range from 10% to 20% at current exchange rates and 9% to 19% at constant currency. Excluding Hardware support revenues, Hardware product revenues are expected to be in the range of $1.1 billion to $1.2 billion.

Agreement of Analysts

Out of the fifteen and sixteen analysts providing estimates for the third quarter and fiscal 2011, respectively, only one analyst revised its estimates in the last thirty days. For fiscal 2012, only one of the fifteen analysts providing estimates, raised expectations in the last thirty days.

The limited number of changes to estimates also signifies the fact that there was no major catalyst during the quarter that could drive results. Consequently, the analysts are sticking to the estimates projected post second quarter earnings.

Oracle’s leadership position in database software business and the applications software market will drive its growth in the near term. Moreover, higher synergies from the Sun acquisition are also expected to drive Oracle’s results in the quarter.

Magnitude of Estimate Revisions

There were no changes to analyst estimates for the third quarter over the past 30 days. However, the Zacks Consensus Estimate for the fiscal year 2011 has increased from 63 cents to 64 cents, in the past thirty days. The upside in estimates, though minor, indicates positive investor sentiment, which might have been backed by an upbeat guidance and positive fundamentals.

Our Take

We believe Oracle will report strong third quarter results based on increasing technology spending in the backdrop of an improving economy. Oracle continues to remain focused on improving profitability based on strong product momentum, improving margins, high recurring revenues and anticipated growth in hardware sales over the long term, in our view.

Oracle’s leadership position in database software is also expected to drive growth over the long term. The analysts covering Oracle expects management to focus more on datacenter evolution where Hewlett Packard Co. (HPQ) is seen as the emerging competitor.

Increasing adoption of cloud technologies is an essential facet of Oracle’s growth story over the long term. Oracle is aiming to provide the infrastructure for companies to move toward cloud computing, where data is handled remotely in datacenters rather than on premises. Apart from HP, we expect Oracle to face significant competition from International Business Machines Corp. (IBM), Cisco Systems Inc. (CSCO) and Red Hat Inc. (RHT).

However, Oracle may see decline in software demand, due to the earthquake and the consequent tsunami in Japan (5.0% of sales in 2010). Further, Oracle is expected to face some supply chain problems in its hardware segment, which may hurt its profitability in the near term.

We maintain an Outperform rating (6-12 months) over the long term. Currently, Oracle has a Zacks #2 Rank, which implies a Buy rating on a short-term basis.

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