TO: Real Client Managed Portfolio

MEMORANDUM

TO: Real Client Managed Portfolio

FROM: Evan Scherer and Billy Nand

SUBJECT: Oracle

DATE: March 2, 2004

Overview

We currently own 800 shares of Oracle. We hold them at a loss of approximately $14,000. This presentation was done by the two of us to decide the fate of our shares in Oracle.

Oracle is the world’s largest enterprise software company. It develops, manufactures, markets and distributes computer software that helps customers manage and grow their businesses and operations. Its offerings include new software licenses, software license updates and product support and services, which include consulting, advanced product services and education. Oracle also offers an integrated suite of business applications software and other business software infrastructure, including application server, collaborative software and development tools. Finally, Oracle consults on these products. Oracle relies on having new software with which professionals will seek to use. The continuing consulting and updating of the software is what grows Oracle’s business along with new clients.

Competitors

Though Oracle has many competitors in terms of software and consulting, the two closest competitors are SAP and PeopleSoft. Oracle is bigger than both of these companies, with its total assets twice the amount of SAP and 5 times the amount of PeopleSoft. However, the two statistics most worrisome are the fact that SAP has a $1.11 earnings per share while Oracle’s was only $.46. Also worrisome is the fact that Oracle’s revenue growth in the last 12 months was -2%. These numbers pale in comparison to SAP which had 18.7% growth. (PeopleSoft’s numbers will be discussed below). In addition SAP’s revenues are very close to Oracle’s, within 1 million dollars, even though Oracle has a more assets and a higher market capitalization.

Economy

According to a report by the Federal Reserve, an important aspect of Oracle’s current position is the lack of growth in software sales, while the industry as a whole (including other smaller competitors) is growing. Private non-residential investment in equipment and software, which increased at an average rate of 7.0% per year during 1970-2000, decreased by 5.2% in 2001 and 2.8% in 2002. While investment increased by 5.5% in 2003, Oracle was not able to translate this into increased sales, as its total revenue for 2003 decreased by 2% to $9.475 billion.(From the Federal Reserve Economic Data) This leads us to the opinion that coming out of the decline in the industry, Oracle may not be making the move back to higher sales the way in which other companies have. This makes us question whether Oracle has lost its competitive advantage all together.

Oracle's sales are primarily to government and business customers. Therefore, the state of the global economy has a direct effect on Oracle's revenues. Other factors are businesses’ need for enterprise software, governments' budgetary constraints, and political uncertainty from the war on terrorism. The company specifically cites lower capital spending as a result of weak domestic and international economic conditions.Revenues decreased by 2% in 2003, and revenues earned form large transactions (those over $500,000) decreased by 11% in fiscal 2003.

PROJECTIONS

Note about projections

Our projections were made using information from previous financial statements and annual reports, current news about Oracle, economic statistics, and information about competitors. What we present here is what we believe to be the most realistic projection for Oracle.

Sales Projections

Oracle's sales have decreased by 13% over the past two years, driven by the decrease in licensing revenues. Oracle continues to compete primarily against SAP and PeopleSoft in the enterprise software market. Both SAP and PeopleSoft have experienced softer declines in their revenue during the past two years than Oracle has. Additionally, following Oracle's "pipeline method" for forecasting future revenues, we see few opportunities for growth in the short-term. Because of these factors, we forecast revenue growth of 0% in 2004, 3% per year during 2005-2007, 6% growth in 2008-2009, and 8% growth in 2010. Following 2010 we forecast Oracle's growth to fall in line with anticipated long-term GDP growth of 3.7%.

Sales and Marketing

Oracle decreased its sales and marketing expenditures in both total dollars and as a percentage of 2003 sales. It cites tighter discretionary spending as well as lower personnel expenditures. After reviewing Oracle's annual reports and financial statements, we forecasted this value to be 20.37% of sales in 2004. This percentage of sales would decrease .5% per year thereafter, as Oraclecontinues to focus on keeping costs down.

Cost of Services

Cost of Serviceshas decreased in both total dollars and as a percentage of sales for the past three fiscal years. As with most other costs, Oracle is concerned with maintaining a tight control over its costs. We forecasted this value to be 24.72% of sales in 2004, and then decreasing .5% per year thereafter.

Research and Development

Oracle cites research and development as an integral part of its operations. The company uses a "pipeline" method for forecasting future revenues, using products currently in development to predict the future value of the company. Oracle realizes the importance of research and development, and has put forth an increasing amount of its revenue into research and development. Expenditures, which were $1 billion in 2000, increased to $1.18 billion in 2003 amidst decreasing revenues. Because of this, we forecasted research and development to account for an increasing amount of Oracle's revenues, with 19% of 2010 projected revenues used by this part of the company.

General and Administrative Expenses

General and administrative expenses have remained stable for the past four years. We forecast this to hold true in the future, with general and administrative expenses accounting for 4.41% of all future revenues.

Other Income

Other income, which is comprised of interest income, interest expense, and other unnamed income, has remained small part of revenues for the past four years. We forecast the same to be true in the future, with net other income accounting for less than one percent of all revenues.

Net Income

Oraclehas averaged a net margin of 23.64% for the past three years. After projecting out Oracle's revenues and expenses for 2004-2010, we forecast its net margin to fall between 24% and 25% per year. Using projections for asset activity and leverage multiplier, we forecast Oracle's return on equity to be 30.94% in 2004. This value will fall to 13.25% in 2010 due to declining asset activity and changes in the capital structure of the company over time.

Cash Flow and Value

Given our assumptions, our forecasted free cash flow grows at an average rate of 7% per year. Using a long-term growth rate of 3.7% per year for all years after 2010, and a WACC of 10.15% (from Bloomberg), we arrive at an intrinsic value after debt of $33.3 billion. This translates to a per share price of $6.37, which is far below the current price of around $13-$14.

Changes

We believe that we have made the best assumptions given the information we have, and present the most probable outcome for this company. However, there is a significant chance that our projections will be wrong. Still, when making adjustments to our assumptions and giving Oracle a very optimistic forecast, we cannot justify its current price.

PeopleSoft Merger

As we mentioned before, many problems exist concerning the possible merger with PeopleSoft. First and foremost in our minds is the legal battle in which Oracle is going to have to pursue to make this deal happen. The justice department has already said that they are against this merger and will fight it. Few companies have ever defeated the Department of Justice in court. Even Microsoft, a company far bigger than Oracle, was not able to defeat the Department. This is something noteworthy and worrisome to us. In addition, the estimated cost to Oracle for legal fees is $20 million per quarter to pursue this legal battle. As investors, we need to question whether this is a good use for the money that the company has. This is especially prudent with the current financials of the company. The price on PeopleSoft has been raised three times already, and yet its supporters still rally against Oracle. This makes us question if the merger goes through whether or not there will be customers that are gained. Larry Ellison is and always has been a headstrong manager. This is good when he makes decisions that are the best for Oracle and its shareholders. However, we question his decision-making on this deal, and do not feel comfortable with him as the CEO of Oracle.

Conclusion

Our summary decision is to sell all 800 shares of Oracle. This is due to the plethora of reasons listed above. A positive of this sale will be the tax loss that our client can take against his capital gains (the sale of his bank) this year.