Global CIO: Oracle's Incredible Profit Machine: 22% Maintenance Fees

Amid higher second-quarter revenue for new software licenses and annual maintenance fees, Oracle last month also reported higher net income due in large part to its phenomenally profitable annual maintenance business, which posted a dazzling operating margin of 91.9%. Yes, you read that right: an operating margin of 92%.

In a moment I'll share some comments from Oracle execs on that maintenance-fee performance (the formal name is "software license updates and product support"), but first, because you don't see 92% operating margins too often, let's take a closer look to see how this one came about.

For its second quarter ended Nov. 31, Oracle posted revenue of $5.858 billion, up 4% from the same quarter a year ago. That revenue comes from three buckets:

--New software licenses, where revenue was $1.653 billion, up 2% in U.S. dollars;

--Software license updates and product support (maintenance) of $3.247 billion, up 14%; and

--Services revenue of $958 million, down 15%.

For the second of those three—the maintenance bucket—Oracle breaks out specific expenses as well as revenue, and Oracle reported that the $3.247 billion in second-quarter maintenance revenue was associated with expenses of $264 million. If we subtract that $264 million in expenses from the $3.247 billion in corresponding revenue, we get operating income of $2.983 billion, which corresponds to an operating margin of 91.9%. Hats off to Oracle for a strong quarter overall and particularly in this category of software-license updates and product support (aka "maintenance").

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With the maintenance business performing so spectacularly, how was the profit performance in other parts of Oracle's business? Well, not so good; not so good at all. Now, it might be the case that Oracle chooses to jam all of its discretionary expenses into categories other than maintenance to make it look exceptionally good—but I don't think so.

No, the fact of the matter seems to be that Oracle has developed a maintenance business whose 22% annual fees not only provide all of the company's profits but also cover enormous losses stemming from all other parts of Oracle's business:

Oracle's total quarterly revenue of $5.858 billion, as noted above, included maintenance revenue of $3.247 billion; $1.653 billion from new software licenses; and $958 million from services. So other than maintenace, Oracle's revenue was $2.611 billion.

On the expenses side, Oracle reported total operating expenses for the quarter of $3.68 billion. While Oracle doesn't break out specific expenses for new software licenses or for services, it does for its maintenance business, and that figure was $264 million. So if we subtract that maintenance expense line from Oracle's total operating expenses of $3.68 billion, we come up with $3.416 billion in expenses other than maintenance.

That isolates non-maintenance revenue of $2.611 billion and non-maintenance expenses of $3.416 billion, which leaves a non-maintenance operating loss of $805 million for the quarter. Compare that to the maintenance numbers: $3.247 billion in revenue, $264 million in expenses, operating income of $2.983 billion with an operating margin of 91.9%.

Again, it's entirely possible Oracle structures its financial results in a way to minimize the volume of expenses it associates with its maintenance/support business. But such possible policies aside, the facts within Oracle's own numbers tell us that in in the last three months, Oracle made almost $3 billion from your 22% maintenance fees, and it lost more than $800 million from all other parts of its business combined.

No matter how you choose to parse the accounting, those numbers are absolutely stunning. And that's a reality not lost on Oracle president Safra Catz, who had this to say about the maintenance performance in the Q&A portion of the earnings call with financial analysts: "Regarding your maintenance question—software updates and support—obviously, that is really our subscribers—those are our users—they're paying both for support and the right to receive a new, without buying new licenses, our new products, and that's a number that's always going to go up because customers feel they're getting a fantastic value for it," Catz said. "But maintenance for us is really who our customers are and they're renewing at record rates because they're very satisfied with our products and we're advancing so quickly right now."

Other than Catz going a little Zen-y with the 'maintenance is who our customers are' riff, her answers were consistent with what she's said the past couple of quarters: that Oracle customers are renewing at record rates (would love to see Oracle's data on that) because satisfaction's high and Oracle is cranking out lots of new stuff that customers are eager to have.

Again, the numbers don't lie: even in a quarter when Oracle was able to stop the decline in new software licenses and in fact grew that number 2% from the year-earlier quarter, maintenance continued to claim an increasingly large slice of Oracle's overall revenue as it doubled the revenue of new licenses and more than tripled the revenue from services.

So it's unmistakably clear that Oracle has become increasingly dependent on maintenance fees for its financial health and its long-term survival. Even with the imminent acquisition of Sun and the expansion into new product lines that will immediately provide, it's essential to bear in mind that without its massive profits from your 22% maintenance fees, Oracle loses a ton of money. And it therefore needs to take its maintenance business incredibly seriously, which is a point i made three months ago in a column called Global CIO: Where Do Oracle's Profits Come From? after Oracle released its first-quarter numbers:

Catz didn't offer any detail on those renewal rates or satisfaction levels, but as I've said before, Oracle should charge what the market will bear—and if the market bears 22% and Oracle customers feel that's a fair price for the value Oracle is delivering, then bully for Oracle and for its customers. Most people are smart and will not put their money where it is not delivering a good return.

But—it is also possible that Oracle customers feel that at this time they don't have viable options to switch away from Oracle, and that while they are frustrated by the 22% fees and do not feel they're getting good value in return, the lack of options is forcing them to bide their time.

From many many conversations with CIOs, I believe this latter scenario is the real story. If that is indeed the case, then Oracle's playing a dangerous game of "Chicken," hoping that no viable alternatives emerge in the near term while dawdling its way along with its own leisurely cloud initiatives, which are most unlikely to provide the fantastic financial returns that the on-premise model currently does.

So kudos to Oracle but also a word of caution: any company that can build a business with a 92% publicly disclosed operating margin deserves a great deal of credit. And at the same time, any company with 92% operating margins will also draw a great deal of competition—so Oracle better not take that runaway customer satisfaction for granted.