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Oracle's $19 Billion Gamble

By Zaineb Bokhari After all the technology IPOs that occurred in the 90s, today's glut of software companies isn't surprising. Consolidation is a natural next step in an overcrowded industry. One of the biggest dealmakers has been Oracle (ORCL

; ranked buy; recent price: $12), which has used acquisitions to significantly bulk up its enterprise software portfolio, with an aim to lower its dependence on its database business.

The Redwood Shores (Calif.)-based company will have spent approximately $19 billion, by our count, on acquisitions between 2004 and 2006 (including those that are still pending).

SO FAR, SO GOOD. At times, Oracle's strategic rationale for individual acquisitions has been an issue -- whether it has been to gain sizeable installed customer bases or market share, acquire best-of-breed technologies, obtain industry-specific software and services expertise, pursue hot growth areas, or prevent competitors from gaining a toehold in a coveted geographic region.

Whatever the rationale, when the dust settles, Oracle will have bought itself multiple varieties and brands of business software for customer relationship management (CRM) and enterprise resource planning (ERP) applications, among others, in addition to its internally developed products.

Ultimately, when these acquisitions close and technology integration work begins, we believe it will be several years before Oracle is able to offer a true unified enterprise software product. While the company has been quick to integrate acquisitions by eliminating headcount, back-office systems, and other administrative redundancies, acquired technologies will likely not be integrated for many years to come.

REDUCED DEBT. With acquisitions come significant integration risks and considerable unrest among customers. While competitors will continue to try to benefit from the uncertainty by wooing customers with large credits on software or cheaper service and support deals, the attrition seen by Oracle so far has not been significant. And the company has avoided some serious strategic mistakes. Although it's still too early to predict if the company will ultimately succeed in integrating these acquisitions, we believe Oracle has enhanced its chances for future success.

A key issue facing earlier software roll-ups has been the significant leverage companies assumed to finance acquisitions. Oracle assumed significant short and long-term debt in the months following its $11 billion acquisition of PeopleSoft/JD Edwards in January, 2005. However, it has been able to pay down this debt quickly due to what we view as the company's impressive free cash flow generation.

In its most recently reported quarter (ending August), Oracle had $2.1 billion in net cash and equivalents on its balance sheet. We believe the company's significant financial resources greatly increase its chances of succeeding with its current acquisition strategy.

CALMING CUSTOMERS. Keeping acquired customers from defecting is also paramount to Oracle's success, in our opinion. We believe the company has shown a great deal of flexibility in committing to provide support and product development for the PeopleSoft and JD Edwards products through 2013 (see BW Online, 9/23/05, "Oracle: Nice Guys Finish...."). As a result, while cost synergies were realized from the reduction of 5,000 Peoplesoft/JD Edwards employees, the majority (an estimated 90%) of developers and support staff were retained.

In our view, these steps likely went a long way to remove customer uncertainty. Keeping acquired customers intact also increases the value of the acquisition due to the sizable maintenance revenue streams they generate.

Oracle has previously stated its intent to continue to build up its technology offerings and expertise for different industries. While we think it has a solid footing in the financial-services and retail industries (particularly following its April 2005 acquisition of retail-focused software provider Retek), we note that competitor SAP (SAP

; buy; $43) has been offering specialized software targeting certain industries for some time and Oracle is still playing catch-up, in our view (see BW, 10/24/05, "SAP's End Run Around Oracle"). As a result, we believe additional acquisitions will be necessary to broaden the company's technology and industry expertise. However, we expect these acquisitions to be more of the tuck-in variety.

ASTUTE INVESTMENT. Another area of focus is On Demand, the delivery of software as a service over the Web. To date, we view Oracle's On Demand success to be relatively minor, both strategically and financially. For example, in the company's fiscal first quarter, ending in August, On Demand accounted for just $84 million, or less than 3% of revenue.

Furthermore, its On Demand revenue grew 16% in fiscal year 2005 (ended May) after posting flat growth from fiscal 2003 to fiscal 2004. This growth pales in comparison to much higher double- and triple-digit growth rates posted by CRM competitor, (CRM

; not followed by S&P; $23).

However, Oracle will gain additional On Demand revenue and customers after its pending acquisition with Siebel Systems (SEBL

; hold; $10), scheduled to close in early 2006 (subject to approvals) (See BW, 9/26/05, "Tech Deals: Back With A Vengeance "). We credit Oracle with recognizing the need to invest in this small but growing area, and believe that while it would have been far more efficient to acquire a pure-play, Siebel's sizable maintenance revenue streams should not be overlooked.

BIG BLUE'S SHADOW. Based on our optimistic outlook for future success of the company's current acquisition strategy, we have a buy recommendation on Oracle shares and a 12-month target price of $15. Our target price is derived by applying a p-e of 18 to our calendar 2006 EPS estimate of 85 cents, which is the midpoint of the historical range for the shares and a modest discount to peers, and a PEG ratio of 1.5 (modestly below peers), which assumes 12% long-term earnings growth. At this level, the shares would trade at 6.1 times enterprise value/forward sales, modestly above the midpoint of their historical average range.

Risks to our recommendation and target price include the significant acquisition integration risks that we believe the company will face over the next three to five years. Other risks include a rapidly changing technology landscape, such as rapid adoption of open source database technology; intense competition from IBM (IBM

; hold, $84) and Microsoft (MSFT

; strong buy; $25) on the database side of Oracle's business and SAP on the applications side. Other risks include a significant downturn in corporate spending on enterprise software.

Required Disclosures

S&P Global STARS Distribution

In the U.S.

As of September 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 28.7% of issuers with buy recommendations, 60.3% with hold recommendations and 11.0% with sell recommendations.

In Europe

As of September 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.8% of issuers with buy recommendations, 44.8% with hold recommendations and 20.4% with sell recommendations.

In Asia

As of September 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 28.1% of issuers with buy recommendations, 51.1% with hold recommendations and 20.8% with sell recommendations.


As of September 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 29.3% of issuers with buy recommendations, 57.7% with hold recommendations and 13.0% with sell recommendations.

5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.

Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500, in Europe the S&P Europe 350 Index, in Asia the S&P Asia 50 Index, and in Malaysia the KLCI or KL Emas Index.

For All Regions:

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request.

Other Disclosures

This report has been prepared and issued by Standard & Poor's and/or one of its affiliates. In the United States, research reports are prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). In the United States, research reports are issued by Standard & Poor's ("S&P"), in the United Kingdom by Standard & Poor's LLC ("S&P LLC"), which is authorized and regulated by the Financial Services Authority; in Hong Kong by Standard & Poor's LLC which is regulated by the Hong Kong Securities Futures Commission, in Singapore by Standard & Poor's LLC, which is regulated by the Monetary Authority of Singapore; in Japan by Standard & Poor's LLC, which is regulated by the Kanto Financial Bureau; in Sweden by Standard & Poor's AB ("S&P AB"), in Malaysia by Standard & Poor's Malaysia Sdn Bhd ("S&PM") which is regulated by the Securities Commission and in Australia by Standard & Poor's Information Services (Australia) Pty Ltd ("SPIS") which is regulated by the Australian Securities & Investments Commission.

The research and analytical services performed by SPIAS, S&P LLC, S&P AB, S&PM and SPIS are each conducted separately from any other analytical activity of Standard & Poor's.

S&P and/or one of its affiliates has performed services for and received compensation from Oracle, SAP, IBM, Microsoft and Siebel Systems during the past 12 months. is not a customer of S&P or its affiliates.


This material is based upon information that we consider to be reliable, but neither S&P nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. With respect to reports issued by S&P LLC-Japan and in the case of inconsistencies between the English and Japanese version of a report, the English version prevails. Neither S&P LLC nor S&P guarantees the accuracy of the translation. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Neither S&P nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results.

Analyst Bokhari follows software stocks for Standard & Poor's Equity Research

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