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|  | MAY 24, 2004
 CREDIT WEEK FOCUS By Philip Schrank Head-to-Head: Microsoft, Oracle, CA Standard & Poor's Ratings Services stacks up the credit strengths of the three software giants How do the credit strengths of three leading software providers -- Computer Associates (CA ; corporate credit rating, BBB-;CreditWatch Negative; commercial paper rating, A-3); Microsoft (MSFT ; AA; CreditWatch Stable; no rating); and Oracle (ORCL ; A-; CreditWatch Negative; no rating) -- compare? In its evaluation of software outfits in the Information Technology (IT) industry, Standard & Poor's balances the attributes of the business-risk profiles against the financial risks of the companies it rates. These companies compete directly and indirectly in certain software segments but have different rating levels, strategies, and capital structures. Together, CA, Microsoft, and Oracle are a very small portion of the fragmented IT industry, which continues to consolidate. All three companies possess above-average business-risk profiles, based on: • Superior R&D capability; • A diversified product portfolio; • Brand-name recognition; and • Well-established distribution and support functions. Each company leverages a large installed software and technology base to expand existing customer relationships. Also, all three companies generate very strong free cash flow, despite ongoing technology challenges and continued investment in emerging technologies. Within that context, however, Standard & Poor's views Microsoft as having a significantly better business profile than its two peers. This assessment is supported by Microsoft's dominant position in operating systems, which we consider to be defensible from alternative emerging technologies such as Linux—at a minimum—over the next five years. In addition, Microsoft's huge cash position—$56 billion on March 31, 2004—affords it the luxury to make investments in new areas of technology without the fret of immediate payback. The business positions of Oracle and CA are viewed as comparable. The end markets of both contain very formidable competitors, and both have a mix of mature product lines as well as pockets of emerging technologies. In addition, acquisition risk remains a rating concern for both. While CA has had an excellent track record for integrating software product acquisitions, the company's financial policy is viewed as aggressive, and has limited the rating over time. Oracle—which historically had a very conservative financial policy and shied away from acquisitions—currently is on CreditWatch with negative implications, as a result of its hostile bid for unrated PeopleSoft Inc. Product offerings: Redmond, Wash.-based Microsoft is the dominant supplier of operating system software for personal computers, is a leader in software applications and development tools, and is aggressively expanding into the Internet technology market space. Redwood Shores, Calif.-based Oracle is a leading independent developer and marketer of relational database management software and application development tools and consulting services. Islandia, N.Y.-based Computer Associates is the third-largest independent software company and supplies a broad range of standardized computer software products, including systems software, database management systems, and business applications software. Microsoft's desktop operating systems are 31% of revenues; office and stand-alone applications are 29%; and server platforms are about 25%. At CA, subscription license revenue generated about 45% of the company's $3.1 billion in fiscal 2003 revenues, with about another 38% coming from maintenance and royalties. CA's Unicenter product is a market leader in systems management software, running neck-and-neck with that of International Business Machines Corp. (IBM ; A+; CreditWatch Stable; A-1), each possessing about a 15% market share. Oracle's database averages about 80% of total license revenues, while applications account for 20%. Framingham, Mass.-based International Data Corp., a market research and consulting company, shows Oracle's share of the market for object and relational database management software slipped just below 40%, with IBM reaching a total of 33.6%, and Microsoft at 11.1% of the market. The gap between Oracle and IBM is narrowing, Microsoft continues to grow, and the three companies increasingly are well ahead of the rest of the field. The market for database tools was essentially flat, growing less than 1% worldwide. Although the recent economic slowdown has stalled unrated competitors SAP AG, PeopleSoft, and Siebel Systems Inc., the decline of Oracle's applications business has been even steeper, 23% in 2001- 2002. Business-Risk Comparison: Increasing stress from economic factors affects almost all suppliers to the IT marketplace. These factors include a weak IT spending environment, the slowing of PC/server unit demand and growth, and corporate buying patterns. Each company is heavily reliant on specific market-leading platforms for a significant portion of revenues and profitability: Microsoft on its Windows operating system, CA on its Unicenter systems management suite, and Oracle on its relational database. The products are relatively mature, very well positioned in their worldwide markets and, coupled with new product and service initiatives, should fuel continued moderate growth. Significant R&D expenditures–-more than 15% of revenues for Microsoft, 12% for Oracle, and about 20% for CA—and the ability to attract and retain product developers, should help sustain their leadership, notwithstanding the potential for shifts in technology or delivery. Each company does, however, have challenges in its respective markets. Linux-based server and other noncommercial software deployment remains strong, which we view as a long-term potential risk to Microsoft's dominant market position. In addition, Microsoft faces obstacles presented by potential litigation remedies. Oracle faces limited growth in its core database market and, even with a successful acquisition of PeopleSoft, would significantly trail SAP in applications for the large enterprise sector. CA faces stiff competition in each of its business segments and continues to be saddled with investigations regarding its accounting practices. Partly offsetting these challenges are growing areas within each portfolio. Software spending priorities continue to favor security software, application server software, and storage software, which are three prominent segments of CA's product portfolio. New Oracle initiatives, which include grid computing—i.e., linking geographically distributed computers for maximum efficiency—could gain traction over the next few years. Also, if the PeopleSoft acquisition succeeds, it would give Oracle scale as a consolidated entity. Microsoft continues to innovate in such areas as mobile computing, entertainment, and standards of interoperability. Both Microsoft and Oracle have ample flexibility at the current ratings to pursue strategic activities; CA currently is constrained. While the U.S. Court of Appeals ruling affirmed that Microsoft holds monopoly power, and the European Union Commission handed down its antitrust decision, the company possesses the financial capacity to absorb behavioral remedies that could limit its business tactics and strategies and to fund significant monetary remedies. Oracle's current $21 per share, or $7.7 billion offer for PeopleSoft is dependent on a court challenge to the Justice Department's decision to block the transaction. While this offer is almost $2 billion less than its previous bid, Oracle has changed the price three times since the takeover was initiated back in June 2003. Therefore, the potential exists for the bid to be revised further. Additionally, the final cost to Oracle could exceed the stock purchase price because potential restructuring charges, as well as the liability stemming from a PeopleSoft rebate and customer assurance program. CA's internal product development has been bolstered by strategic investments, with more than 70 acquisitions to date. Although CA has had an excellent track record for integrating software product acquisitions, the additional debt burden from past acquisitions, coupled with restructuring charges, has weakened its financial position. The company's strong free operating cash flow generation has, however, somewhat mitigated the impact of these transactions, because a portion has been deployed for debt repayment. Financial Profiles: Standard & Poor's views Microsoft's financial profile as exceptional; Oracle's is above average, while CA's is considered average. Robust internal cash generation has been a common theme for all three, coupled with modest fixed-capital requirements, affording significant flexibility to make strategic acquisitions, dividend payouts, and share repurchases without detracting much from overall corporate credit quality. Microsoft's free operating cash flow has averaged more than $9 billion for the past five years, while Oracle generated $2.4 billion. Under CA's new business model, GAAP revenue recognition has changed, but cash flow has remained consistent, with free cash flow averaging about $1.2 billion. Microsoft recently doubled its dividend and will pay out about $1.7 billion this year, and it could potentially increase that amount or declare a special distribution should cash continue to build. Oracle has spent about $17 billion over the past four years under its stock-repurchase program, while CA has been less aggressive and focused on debt reduction. Liquidity is ample for all three. At the end of its last quarter, Microsoft had $56 billion and Oracle had about $8 billion of cash and securities with minimal debt. As of Dec. 31, 2003, CA had $1.8 billion cash and full availability under its credit facilities with minimal debt maturities over the next two years. We expect CA's total debt to EBITDA ratio to be managed under 2.5 times for the rating.  Schrank is a credit analyst for Standard & Poor's Ratings Services 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. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
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