Take Another Look at Oracle's and Red Hat's Reports


By Sam Jaffe When a company beats its quarterly earnings estimates, investors tend to get euphoric. Take Oracle's (ORCL) fourth-quarter earnings, announced on June 18. The company declared that it earned $0.15 per share rather than the consensus expectation of $0.14. And the market quickly bid up Oracle's shares to $17.90 at close on June 21 -- a 20% rise since the announcement was made.

Yep, one penny was all it took for Wall Street to pop the corks and put a lampshade on its head. But now it's time to take a closer look at the rest of Oracle's news. How about the fact that license revenue was down 11% from the fourth quarter of 2000? Or that its core database product is facing heavier competition from Microsoft (MSFT) and IBM (IBM)?

A similar event happened the next day, when Red Hat (RHAT), another high-profile software company, announced its first profitable quarter since going public in 1999. The stock rose 4% on June 19, as the good news leaked out. By the end of trading on June 21, the stock had closed at $4.84, an 11% rise since the news went out.

SELECTIVE BLINDNESS. Investors just ignored the fact that executives withdrew their guidance for the next two years, saying that visibility had become "too clouded." They also didn't seem to mind that Red Hat's profitability was largely an accounting illusion. Thanks to an expense charge, its real income for the quarter was negative -- to the tune of $27 million.

This isn't to deny credit to execs at both companies for turning in good performances in the middle of a massive slowdown in tech spending. But before you decide that these two pieces of news represent a trend in the making and that tech spending is picking up, bear in mind that the complete story for each company is much murkier, as is the outlook for tech overall.

Oracle's earnings report was certainly a welcome breath of fresh air to tech investors who have been suffocating under a constant stream of bad news from other giants such as Cisco Systems (CSCO), Intel (INTC), and Nortel Networks (NT). Unlike many of its bellwether cousins, Oracle went through the whole quarter without preannouncing bad earnings or altering its guidance downward. For a time, that created a pessimistic mood, as analysts started downgrading the stock, assuming that Oracle could never come in on target when so many other tech companies couldn't.

So Oracle fooled them. Trouble is, its revenue picture is far bleaker than that 1-cent better-than-expected finish. Overall revenue declined from $3.4 billion in the fourth quarter of 2000 to $3.3 billion in the 2001 quarter. The only reason why the company met its profit goals was drastic expense cuts, not because of any growth.

"LOSING THE BATTLE." "Management should be commended for being able to cut expenses so quickly in order to beat profit expectations, but they're losing the battle for top-line growth at the same time," says Melissa Eisenstat, who follows the company for CIBC World Markets. "In the long run, what will make the stock do well is revenue -- and they're not showing that."

Even more worrisome was Oracle's revenue breakdown. The company's core database business is indeed profitably handsome, but it has also grown about as big as it can get. There's little hope that Oracle can continue 30% annual revenue growth on its database product alone. To continue to expand, it has to sell more applications licenses. That includes other enterprise software products such as customer-relationship-management packages and supply-chain-monitoring programs.

Fact is, applications revenue declined by 24% in the fourth quarter, despite a wealth of contract signings with such prestigious blue chips as GE Medical, Ford, and Hewlett-Packard. "Management was glowing about momentum in the applications business, but there's a disconnect between that and actual results," says Eisenstat, who has a hold rating on the stock.

Even analysts who are bullish on Oracle worry about the dip in applications revenue. "The key to future growth is in the applications growth, but results have been disappointing there," says Mary O'Rourke, an analyst with AG Edwards, who rates the stock a buy.

FIRST PROFITS. The company itself maintains that the dip in applications revenue is a minor blemish on an otherwise rosy picture. "The key point here is that business bottomed out in the fourth quarter and that we're sensing a rebound," says Oracle spokeswoman Jennifer Glass. "Customers are getting out of the 'frozen-by-fear' mode and starting to make purchasing decisions again."

Perhaps. But Red Hat executives wouldn't be caught making such an optimistic forecast about the company's customers, despite its status as the No. 1 purveyor of Linux software. Along with Microsoft, it's a leading contender in the enterprise market. Like Oracle, it has plenty of major new customer to brag about, having converted thousands of Cisco's workstations to Red Hat Linux.

The company was able to pull off its first profitable quarter, a full quarter ahead of its initia-public-offering projections in 1999 -- quite an achievement during such trying times. But investors who bid the stock up might be seeing things through rose-tinted glasses.

OBSCURED BY CLOUDS. For one thing, Red Hat technically didn't make a profit. It produced operating earnings of $600,000, but once you factor in one-time acquisition- and stock-option-related charges of $27.6 million, the company had negative net income for the quarter of $27 million.

More troubling is the lack of earnings or revenue guidance for the future. "Visibility is just too clouded in the near term to give any meaningful guidance," CEO Mathew Szulik said during a conference call with analysts. He could not be reached for additional comment.

The lack of guidance was enough for WR Hambrecht analyst Prakesh Pratel to downgrade the stock from buy to hold after the earnings were announced. "I can understand how difficult it is to predict top-line growth in this environment, but the fact that they don't know where the bottom line will be worries me," Patel says. "It's great that they're profitable, but they gave me no confidence that they will be next quarter."

The moral of the Red Hat and Oracle stories is that earnings reports don't always tell the whole story -- about that quarter, about the company's prospects, or the trends in a sector. One quarter of meeting or beating expectations shouldn't get investors too hopeful. Jaffe writes about the markets for BusinessWeek Online in our daily Street Wise column

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