Oracle Disappoints in 2Q; Shares Still Undervalued

The performance of  Oracle's (ORCL) core software business during the second quarter of fiscal 2012 was below the range of our expectations. New license revenue, which generates a future stream of recurring and highly profitable maintenance fees, grew at the weakest pace since the June-August 2009 quarter. Furthermore, the results of the hardware segment, which posted the third straight year-over-year decline in quarterly revenue, were disappointing. Not surprisingly, results from Europe and North America reflected difficult business conditions. While year-to-date revenue is slightly trailing our current-year projection, operating income is ahead of our expectations. We are leaving our fair value estimate unchanged.

Oracle's subpar quarterly results were partially a result of some delayed deals caused by clients' additional approval processes and by some customers' desire to evaluate the company's new SPARC T4 processor (introduced in late September) before placing hardware orders. Nonetheless, Oracle's meager results in light of its position as a provider of core software products (for example, databases), its exclusive focus on large enterprises and government entities, and recent quarter-end (Nov. 30) may also be an early sign of an upcoming downturn not only in the enterprise software industry, but also in the wider information technology sector.

Overall, we believe Oracle's long-term hardware strategy--staked around Exadata, Exalogic, and an expanding array of highly engineered systems--remains intact. Nonetheless, management acknowledged that achieving the previously stated goal of selling 3,000 Exadata systems during the current fiscal year will be challenging. In fact, management's third-quarter guidance for the hardware segment foretells further challenges to this business.

Still, looking below the aggregate numbers, there were some positive underlying trends in the hardware segment. For instance, the Exadata business grew more than 100% year over year, and Exalogic increased more than 100% sequentially. We believe the solid growth of these high-end products was a driving factor behind the 4 percentage points in gross margin expansion for the overall hardware segment. Meanwhile, despite adding 1,700 salespeople during the first half of the fiscal year, management has kept costs under control. Operating margins for the quarter increased 3 percentage points to 35.4%.

We continue to believe that the shares remain significantly undervalued and view the board's decision to authorize as much as an additional $5 billion in stock repurchases as a good way to deploy the company's growing cash balance.

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