PeopleSoft's Prevarication

It's not over.

An impressive earnings report and a memo from new CEO Dave Duffield suggest that business software maker PeopleSoft (Nasdaq: PSFT  ) is not about to sell to rival Oracle (Nasdaq: ORCL  ) anytime soon.

The third-quarter financials were the attention-getter, though. After a trial in which the database king has tried to paint PeopleSoft as fading fast, PeopleSoft reported higher sales, net income, and margins. Revenue was $699 million, up 12% from the same quarter a year ago. Earnings improved from a loss last year to $24 million, or $0.06 per diluted share, and from $11 million, or $0.03 per diluted share, in the prior quarter. Operating margins widened to 5% from 2.2% in the previous quarter.

Unfortunately, all this good news obscures two really important pieces of information critical to judging PeopleSoft: the cost of expensing stock options and the company's contracts that require refunding billions to customers if there is a takeover.

First, let's touch on the options. According to PeopleSoft's second-quarter 10-Q filing with the Securities and Exchange Commission, the net cost of stock options-based compensation was $25 million for the quarter and $54 million for the first six months of the year. It seems only reasonable, then, that PeopleSoft had roughly $30 million in stock-based compensation expense this quarter. But let's be conservative and say it was $20 million. Even then, net income would have been cut by 85% to $4 million and a penny per diluted share.

Moreover, options expense makes PeopleSoft's structural free cash flow, otherwise known as owner earnings, look downright anemic. Take a look:

Metric Six months ended June 2004 Nine months ended September 2004
GAAP net income $35 million $59 million
Net stock options expense $54 million $74 million*
Net depreciation and amortization $112 million $168 million
Capital expenditures $89 million $143 million
Structural free cash flow $4 million $10 million
Cash flow margin 0.3% 0.5%
*Estimate based on PeopleSoft's SEC filings

Think that's unfair? You shouldn't, because options expensing is coming whether you like it or not. Heck, PeopleSoft's owners even voted for it earlier this year.

Now let's tackle the second, and arguably more insidious, piece of the puzzle: PeopleSoft's poison pill rebate. The program says customers who license PeopleSoft software would be entitled to two to five times their investment if the company were acquired by Oracle. Oracle says the program would add $2 billion in liability to its bid and is seeking to remove it and PeopleSoft's other anti-takeover provisions in court.

Interestingly, PeopleSoft extended the program earlier this month, just as it was announcing it would exceed license revenue targets. Some good detective work by zoningfool on our Oracle discussion board found that management extended the program to "achieve successful results for the quarter ended September 30, 2004."

No wonder PeopleSoft's sales were way up. Customers are signing on the dotted line with the prospect of getting not only good software but also a huge wad of bills if there is an acquisition. How on earth could anyone be surprised by PeopleSoft's results given that sweet deal? Only an ostrich could fail to see that coming.

So let's face it, folks, any talk of PeopleSoft suddenly being stronger than originally expected is either misguided drivel or intentional overhyping. Don't fall for it.

For related Foolishness:

  • I still think OracleSoft would make for a great combination.
  • Oracle CEO Larry Ellison's testimony in the latest courtroom battle between his company and PeopleSoft was nothing more than a stock striptease.
  • Despite popular belief, PeopleSoft's firing of Craig Conway hasn't changed all that much in its relations with Oracle.

Does all this talk of structural free cash flow and SEC filings leave you dazed and confused? Not to worry. No matter your tastes, we've got an investing newsletter that can handle the heavy lifting for you. You just sit back and reap the returns.

Fool contributor Tim Beyers owns shares of Oracle. You can view his Fool profile and other stock holdings here.


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