Oracle Corp. (ORCL) reported strong third quarter results, which beat the Zacks Consensus Estimate based on strong top-line growth. The robust results were driven by approximately 29.0% year over year growth in new software license revenue. Shares were up $1.30 (4.04%) to $33.44 in after-hours trading.
Oracle continued to gain market share from its closest rival SAP AG (SAP) in the applications market during the quarter. Total revenue as well as earnings surpassed management’s guidance. The company achieved strong hardware sales boosted by the acquisition of Sun Microsystems in January 2010.
Moreover, Oracle continues to penetrate the cloud computing market based on its collaboration with Amazon Inc. (AMZN) and strong performances from Exadata and Exalogic.
Earnings
Excluding one-time items and stock-based compensation expenses, non-GAAP earnings came in at 54 cents per share compared with 38 cents per share in the year-ago quarter. This is above management’s guided range of 48 cents to 50 cents per share.
Net income rose 43.8% from the prior year to $2.64 billion. The rise in earnings was attributable to higher revenues from new software license sales, which grew for the sixth consecutive quarter and are expected to drive higher revenues from support and maintenance contracts going forward. This also reflects upside in software demand.
Earnings (excluding one-time items but including stock-based compensation expenses) of 51 cents per share shot up 41.7% from 36 cents in the year-ago period and surpassed the Zacks Consensus Estimate of 47 cents.
Revenues
Total revenues, in the third quarter, increased 37.0% year over year to $8.76 billion, driven by better-than-expected new software license revenues. Considering revenues of $43.0 million 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 36.1% year over year to $8.81 billion. Revenues were also above the Zacks Consensus Estimate of $8.30 billion.
Oracle is expected to benefit from its growing software business (67.8% of third quarter total revenue), which was robust across all regions (America, EMEA and Asia) and rose 18.4% year over year to $5.97 billion.
Included in the Software segment are new software license revenues (25.1% of total revenue and 37.1% of total software revenue), which shot up 28.9% to $2.21 billion. New software license sales were better than the company’s expected growth of 10% to 20% at current exchange rates and 9% to 19% at constant currency.
Software license update and product support revenues (42.6% of the total revenue and 62.8% of total software revenue) grew 13.0% to $3.76 billion. Customer support attachment and renewal rates were high in the reported quarter.
Database and middleware revenues were $4.09 billion, up 19.4% from the year-ago quarter. Applications revenues were $1.86 billion, up 17.2% from the year-ago quarter.
Technology new license revenues were $1.6 billion, up 27.0% year over year. Service revenues totaled $1.1 billion, up 23.0% year over year.
Oracle’s Hardware Systems revenues of $1.69 billion represented 19.2% of total revenue. Revenues from hardware systems products were $1.04 billion (below the company’s expectation of $1.1 billion to $1.2 billion at constant currency) while revenues from hardware systems support amounted to $656.0 million.
Hardware systems support revenue was up 263% (234% in constant currency). The significant increase from last year was because the year-ago quarter included only partial results for Sun which was acquired during the quarter.
Operating Performance
Total operating expenses increased 36.5% in the quarter, mainly due to increased research and development expenses (13% of the total revenue) that rose 37.0% to $1.13 billion and sales and marketing expenses (19% of the total revenue) that increased 30% to $1.62 billion.
Despite this strong growth in expenses, operating income on a non-GAAP basis increased 35.7% to $3.76 billion, driven by increased revenues. Non-GAAP operating margin of 42.7% was down 200 basis points year over year, due to the addition of lower-margin hardware business.
Management noted that higher margin Exadata and Exalogic systems (sequential unit and revenue growth of over 50%) sold at a higher rate in the quarter and may be expected to grow even higher in the fourth quarter, thereby driving software margins going forward.
Although Oracle cannot specify Sun’s exact operating profit contribution, the company expects more than $1.5 billion in operating profit for fiscal 2011.
Liquidity
Strong quarterly results helped Oracle to generate $9.51 billion in free cash flow, which was 123% of net income. Operating cash flow was $9.95 billion in the quarter. Oracle had $24.36 billion in cash and marketable securities at the end of the quarter versus $24.85 billion in the previous quarter. Days’ sales outstanding were 46 days.
In the reported quarter, Oracle repurchased 7.9 million shares for a total of $250 million. Oracle increased its quarterly dividend payout by 20.0% to 6 cents.
Guidance
For the fourth quarter, Oracle expects non-GAAP earnings at constant currency to range between 69 cents and 73 cents per share. Assuming the current exchange rate, earnings are expected to range between 65 cents and 69 cents. This was up from 60 cents reported in the comparable quarter last year and also above the Zacks Consensus Estimate of 64 cents.
Oracle expects a positive currency effect of 5% on license growth rates as well as on total revenue growth. Total revenue growth on a non-GAAP basis is expected to range from 9.0% to 13.0% at the current exchange rate and 4.0% to 14.0% in constant currency. The guidance assumes a non-GAAP tax rate of 28.0%.
New software license revenue growth is expected to range from 9% to 19% at current exchange rates and 4% to 14% in constant currency. Excluding Hardware support revenues, Hardware product revenue growth is expected to range from 6% to 12% at current exchange rates and 2% to 8% in constant currency.
Oracle does not expect any near term negative impact from the earthquake and tsunami in Japan.
Recommendation
We believe Oracle will continue to report strong results based on its innovative product pipeline, improving margins, high recurring revenues, growth in hardware sales and increasing adoption of cloud computing over the long term.
According to research firm Gartner, Worldwide IT spending is forecast to total $3.6 trillion in 2011, a 5.1% increase from 2010. Of this, both computing hardware and enterprise software are expected to grow 7.5% year over year, respectively.
We believe Oracle will benefit from this trend, as it remains well positioned with Sun hardware and Oracle software. The fact that both the Sun hardware and Oracle software are relatively higher-margin is an added bonus, indicating sustained profitability improvement in the ensuing quarters.
Currently, less than 10.0% of global IT spend is on cloud computing. According to market research firm In-Stat, businesses in the United States will spend more than $13 billion on cloud computing by 2014. Oracle, through its Exadata and Exalogic product lines, provides the infrastructure for companies to move toward cloud computing, where data is handled remotely in datacenters rather than on premises.
Oracle is collaborating with Amazon Web Services (“AWS”) to promote its cloud computing offerings. Customers can build enterprise-grade solutions hosted by Amazon Web Services (AWS) using database and middleware software by Oracle, and also launch entire enterprise software stacks from Oracle on Elastic Cloud Compute (Amazon EC2). This improves scalability, reliability and cost-effectiveness.
We expect this partnership to help Oracle increase penetration in the cloud computing market as AWS has significant market share of more than 45.0%. We believe Oracle’s customer base will improve going forward, based on strong customer demand for both Exalogic and Exadata.
However, Oracle is expected to face strong competition from Hewlett Packard Co. (HPQ), International Business Machines Corp. (IBM), Cisco Systems Inc. (CSCO) and Red Hat Inc. (RHT) in the cloud computing market that may hurt its profitability over the long term.
We maintain a long-term (6–12 months) Outperform rating on Oracle shares. Currently, Oracle has a Zacks #2 Rank, which implies a Buy rating on a short-term basis.
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