To understand why Oracle Corp.'s (ORCL) business of selling
long-term maintenance contracts may face pressure in the future,
consider the decision Santa Fe Natural Tobacco Co. recently
made.
Rusty Gaston, the chief information officer of the Santa Fe,
N.M.-based unit of Reynolds American Inc. (RAI), switched the
company's service contract for Oracle software to Rimini Street, a
third-party support company that says it charges half of what
Oracle does.
"We were paying higher fees," Gaston said of the Oracle
contract. "And getting no more for it."
How many of Oracle's customers follow suit is an open question
for the Redwood City, Calif.-based company, which garnered roughly
half of its $22.4 billion in 2008 sales from highly profitable
maintenance revenue.
Oracle's maintenance revenue stream is likely to be resilient in
the short term. The company's databases, accounting and human
resources software are used around the world, and many of Oracle's
customers depend on the company's support. But the economic
downturn might prompt some cost-conscious customers to look for
alternative support services.
To be sure, Oracle has weathered recessions in the past, and the
company's maintenance contracts have a very high renewal rate. In
addition, analyst Peter Goldmacher of Cowen & Co. said
canceling Oracle maintenance contracts is "foolish" because Oracle
provides service others can't match.
Still, evidence suggests Oracle customers want changes to their
maintenance contracts. Some are skirting the issue by moving to
lower-cost, Web-based software tools, such as those from competitor
Salesforce.com Inc. (CRM), which said last month that it had
poached customers, like EMC Corp. (EMC), from Oracle.
An Oracle spokeswoman declined to comment for this article,
saying the company was in a quiet period ahead of its earnings. For
the fiscal third quarter, analysts expect Oracle to post a 7% rise
in per-share earnings to 32 cents when when it reports March 18,
and Citigroup sees maintenance fees growing 8%.
Investors love Oracle's maintenance and service contracts, which
generate margins of roughly 85%, according to analysts. Oracle
charges a fixed 22% of the price of a software package, which can
cost hundreds of thousands of dollars, for maintenance.
The margins and recurring nature of Oracle's maintenance
contracts have helped the company's shares outperform its rivals -
Walldorf, Germany-based SAP AG (SAP), which faces similar
pressures, and Redmond, Wash.-based Microsoft Corp. (MSFT) - over
the past year. Oracle shares, which closed Tuesday at $15.09, have
fallen a relatively mild 24% compared with SAP's 33% drop and
Microsoft's 45% fall.
Critics say Oracle needs to reassess its one-size-fits-all
business model because customers might move away as more outside
options become available and as the recession prompts companies to
become more vigilant in their spending.
Customer irritation over software companies' maintenance pricing
policies began last year, when SAP customers protested a rate hike.
It soon spread to other companies.
In January, trade magazine Information Week published an open
letter by its editorial director to Oracle Chief Executive Larry
Ellison that underscored the building frustration and requested
changes to Oracle's single-tier pricing policy.
Even Oracle, in its 2008 annual report, acknowledges that it
faces rising competitive pressures. "Our competitors may offer
lower percentage pricing on product updates and support, which
could put pressure on us to further discount our new license
prices," the company said. Discounting new software licenses would
eventually lead to lower support revenue, analysts said.
Jefferies & Co. said recently it expects maintenance revenue
to slow as license sales fall off. "At the trough, we expect
support revenues to flatten to very low single digit (growth) in FY
10," analyst Ross MacMillan said.
Not everyone agrees, though, that Oracle's model is
threatened.
Goldmacher, the Cowen analyst, said customers shouldn't switch
to third-party maintenance providers because they will miss out on
product upgrades. Relying on software-as-a-service providers, like
Salesforce.com, for all of their computing needs, would be
imprudent, he said.
"A customer who thinks buying software as a service is a better
deal than (Oracle) maintenance is deluding himself," he said.
And Oracle weathered the 2000-01 technology recession without
seeing a major decline in its maintenance revenue stream, though
sales of new products were hit.
Still, consultants and analysts said the growing list of
alternatives, along with severe pressure to cut IT costs, suggests
a tipping point is approaching. Besides Rimini Street and
Salesforce, new competition is coming from NetSuite Inc. (N), Taleo
Corp. (TLEO), Concur Technologies Inc. (CNQR) and privately-held
Workday Inc.
"There's going to be a breaking point soon where customers say
they're spending too much on maintenance and not getting enough
value," said Forrester Research Inc.'s R. Ray Wang. "Investors
should take note."
-By Jessica Hodgson, Dow Jones Newswires; 415-439-6455,
jessica.hodgson@dowjones.com