Oracle Bear's Den
Jim Surowiecki ([email protected])

What determines a company's real value to investors is its ability to deliver rapid and consistent earnings growth in the foreseeable future. While companies' stock prices often get ahead of themselves, in the long run the stock market will value a company based on its ability to generate profit, regardless of whether that profit is distributed in the form of dividends or channeled back into the company's coffers. Oracle has done an excellent job of generating profit throughout this decade. As the second-largest independent software maker in the world and the dominant player in the database software market, Larry Ellison's company has seen both its earnings and its stock price rise precipitously since the end of 1992. As a result, it has been rewarded with a valuation worthy of consumer giants like Coke <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KO)") else Response.Write("(NYSE: KO)") end if %>and Gillette <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: G)") else Response.Write("(NYSE: G)") end if %>, trading at a price-to-earnings ratio of better than 35.

The problem for investors today, though, is that Oracle is not a consumer giant like Coke or Gillette, nor is it enjoying the kind of explosive growth in revenues and earnings that would justify that valuation. Instead, Oracle is a company still trading, in some sense, on the past, and is still valued on what it was doing a year or two years ago instead of on what it will be doing six or nine months from now. When the market finally catches up to Oracle's present and adjusts its valuation accordingly, the results might not be pretty.

The numbers do, in a sense, speak for themselves. In Oracle's second quarter, it reported earnings of $0.19 a share, up one penny (5.5%) from a year before. Annualized revenue growth was just 23%, and sequential revenue growth was considerably smaller than that. Oracle's gross profit margins for this fiscal year are 5-8% lower than they were in FY 1997, while net margins have also dropped. The company's expenses for sales and administration rose sharply in the middle of last year and have remained at historically high levels even though gross profits have not risen proportionally, which means that operating margins have also declined noticeably.

Oracle's balance sheet does, of course, remain strong, with well over one billion dollars in cash and just $300 million in long-term debt. But a company trading at a P/E ratio of above 36 needs more than cash in hand. It needs to be hitting on all cylinders, and the company's recent performance -- not just in the second quarter, but also in the one preceding it -- is a long way from that.

Now, it's possible that all of Oracle's recent problems are due to Asia and currency problems -- even so, these will continue to afflict the company throughout 1998. But the crucial number in the second quarter earnings report was not the decline in sales to Asia. It was, instead, the minuscule growth in sales of Oracle's flagship applications software. Analysts had expected these sales to rise as much as 40%, but they were up just 7%. For a relevant comparison, imagine Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> reporting that sales of its flagship software grew just 7% in the last quarter. Then imagine what that would do to Microsoft's stock price.

In the wake of the firestorm that swallowed Oracle's stock after its last earnings report, company execs were anxious to assert that the market for database software was not mature, and that it was still growing rapidly. But in the conference call that followed that report, executives did describe the telecommunications market -- one of the key propellants of earnings growth -- as "saturated," and Fortune, for one, argued that Oracle is confronting "a meaningful slowdown in its core business."

A meaningful slowdown does not mean, of course, that Oracle is going to start losing money. I fully expect Oracle to turn in solid earnings growth over the next five years. But with a P/E above 36, Oracle is not being valued as a solid, steady company. It's being valued as a tech high-flier, and its prospects for the foreseeable future certainly don't justify that. Nor, despite Larry Ellison's best efforts, is Oracle's brand name such that investors should value it at a premium to earnings growth (as they do with Coke and Gillette). At this point, in my opinion Oracle is about as good an example of an overvalued company as you can find among the major players in the technology industry.

The striking thing is that Oracle has been having all this trouble producing solid earnings growth even while its two main competitors, Sybase <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SYBS)") else Response.Write("(Nasdaq: SYBS)") end if %> and Informix <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INFX)") else Response.Write("(Nasdaq: INFX)") end if %>, have been tripping all over themselves. It's a miracle, in fact, that these companies are still in business. But what does that suggest about the database management software industry in general, if the complete floundering of its two competitors has not allowed Oracle to reap the benefits of what has often appeared to be a near-monopoly position? Larry Ellison has done a great job of marketing himself and of marketing his company, but at some point, marketing fades away and bottom-line growth speaks loudly. Just look at Oracle's earnings and decide if you like what you're hearing.

Next: The Bull Responds