Oracle (ORCL) fell sharply last week on the heels of a disappointing Q3 (quarter ending Feb.) earnings report. Some investors may feel the need to rush into a position here because the stock has been down more than 10% in only a few days. Rushing into a stock following a large sell-off, or rushing to short a stock following a sharp spike, can often times be a losing strategy and this time it probably is. Oracle is not a bad company. In fact, investors that initiated positions five years ago have received large returns. The current problem pressuring the stock is that Oracle is going through a sort of transitioning period in a couple of ways. First of all, the sales force is green and this is causing orders to close sporadically rather than smoothly. Secondly, the hardware systems are being refreshed during Q4 (quarter ending in May) and it will take some time to integrate the new systems into the market. Moreover, management did not sound too convincing about the near-term outlook and analysts have year-end earnings estimates set too high.
Oracle has traditionally been a leader in business enterprise systems. The company's services range from server hardware all the way to software as a service. The software offerings are diverse and include database management and customer relationship management software. Oracle is also focusing resources in providing cloud services to all sizes of businesses. The company has a large global footprint with around 60% of total revenue coming from outside the United States. There is not a large concentration of sales coming from any particular country so the company's international exposure is diversified well. Oracle typically holds large cash balances and has been growing through strategic acquisitions over the last decade.
Last week's Q3 earnings miss was ugly. The street's consensus was a top line number of $9.4B with earnings of $0.66 a share. Oracle missed the revenue estimate by $400M and the earnings estimate by a penny. The most disappointing aspect of the report was the guidance. Management guided a range of Q4 revenue growth of [-1%, 4%] and earnings of [$0.85, $0.91]. The miss turned out to be worse than the numbers appeared because many analysts were looking for nice improvements in new license sales but the company actually printed a 2% decrease in this number. Additionally, the company is battling against a strengthening dollar.
Management attributed the poor Q3 earnings mostly to the sales team not being able to close deals during the quarter. The President and CFO, Safra Catz, stated during the last earnings call,
"Since we've been adding literally thousands of new sales reps around the world, the problem was largely sales execution especially with the new reps as they ran out of runway in Q3. As expected, many of the pushed out deals have already closed."
Long-term investors like certainty and this type of statement causes them to wonder if perhaps Q4 deals will be pushed into Q1 because the sales force is catching up on Q3 deals during Q4. It causes them to wonder how many open deals are still floating around out there. After all, Catz did say "many" of the Q3 deals have already closed, she did not say "most." She did not give a percentage. In fact, she acknowledges the lack of urgency in the sales force during Q3. This absence of sales execution stems from poor management and could ultimately lead to a decline in sales growth if left unaddressed.
Hardware sales comprised 17% of overall revenue during the last quarter and will continue to be an impediment to overall revenue growth for the next couple of quarters. There is a silver lining here. Oracle has now completed the entire upgrade of the hardware offerings since acquiring Sun Microsystems in 2010. It will probably take a couple of quarters for these new systems to show up in the sales numbers but at least Oracle has a chance to revive the hardware segment. Oracle will be in big trouble six months from now if businesses have not adopted these new systems because a lot of time and resources have gone into the production of them. The CEO, Larry Ellison, describes these upcoming quarters as an inflection point for Oracle's hardware segment.
The lowest analyst estimate for Oracle's current year earnings is $2.55. The year-end number will be reported in May and Oracle will have to earn $1.09 during the current quarter in order to earn the low estimate. The upper-end of management's guidance is $0.91 for the current quarter. Analysts are already disappointed over last quarter's earnings. Some of them may come out over the next few weeks and lower year-end estimates. The market has priced a lot of this adjustment in already but nevertheless, the downgrades generally lead to increased price volatility. The trailing price to earnings ratio over the last five years is plotted below. This graphic was generated using YCharts.com.
Oracle's year-end earnings reported this May would be $2.37 if Oracle was to earn $0.91 during this quarter, which is at the top end of management's guidance. At 15 times earnings, Oracle would be trading around $35.55. This price is more than 12% higher from current levels but this is a best case scenario. The uncertainty surrounding the sales force and the hardware refresh makes earning $0.85 with a 14 P/E multiple more likely. That would put the stock price around $32.34, not much higher than the current price.
Oracle has been and will probably continue to be a solid company, but it will be easier to buy the stock a couple of quarters from now after sales have a chance to smooth out. The company competes in tough markets against strong rivals like IBM (IBM) and young rivals like Salesforce.com (CRM). Missing another quarter would be terrible for Oracle's stock price and investors' confidence. There are other places investors can put capital while waiting for Oracle to complete this transition period. There is no arguing against the fact that the stock looks cheap at current levels, but this is an instance where the stock is cheap for good reasons.