Here Comes the Sun

By Avi Deitcher

On Tuesday, 2009.06.24, Oracle posted its fiscal fourth quarter results for the period ending 2009.05.31, as well as the "guidance" for future earnings. We won't get into the value of this guidance, and the impact it has on running the business. However, an interesting nugget - perhaps a daydream - was buried in the announcement. Oracle stated that the current guidance does not include expected revenues from its pending acquisition of Sun Microsystems. It does expect the deal to close in the current quarter, i.e. before the end of August 2009; Sun shareholders are scheduled to vote on the deal on 2009.07.16. However, Oracle did state that it expects Sun to contribute $1.5BN in operating profit to Oracle in the first year after the deal closes.

Of course, when a company executive predicts the value of an acquisition, especially in the short-term (one year), it is always worth looking at the numbers.

Sun Profits

According to Sun's SEC filings, in the three years 2006-2008, it had total revenues of $13.1BN, $13.9BN and $13.9BN. It also had costs of sales of $7.4BN, $7.6BN and $7.4BN, respectively, for gross margins of $5.6BN (43%), $6.3BN (46%) and $6.5BN (47%). However, its "operating expenses", primarily R&D and SG&A, were $6.5BN, $6.0BN and $6.1BN.

Over the three years, that left Sun with an operating profit (loss) of ($870MM -6.6%), $309MM 2.2%  and $372MM 2.7%.

A number of observations stand out:

  1. Sun's gross margins are too low. Although reasonably respectable in most businesses, in the tech business, margins in excess of 50% or even 60% are common and expected. This is largely because the tech business is very R&D intensive, but R&D is written off as a current year expense. By contrast, in the same period, Oracle had gross margins of 56%, 55.5% and 56.9%.
  2. Sun's operating costs - R&D and SG&A - are too high. In the last three years, Sun had costs, as a percentage of revenue, of 49.6, 43.8% and 44.3%. Again, comparing to Sun's new partner in Oracle, we see costs of 23%, 22.5% and 22.1%.
  3. As a result, Sun's operating profit has been pitiful.

However, the absolute numbers tell the strongest story. Sun's best year in terms of operating profit, over the last 3 years, was 2008, with $372MM in operating income. To add $1.5BN to Oracle's bottom line, Sun's operating profit would have to quadruple in just one year. Even assuming Oracle could massively cut costs at Sun - whether on the gross margins side or on the operating costs side - there is an enormous uplift required. Additionally, Sun's revenue has been essentially flat over the three years.

Let us take it one step further, however, let us assume that Oracle can, with a quick wave of the wand, get Sun, at its same revenue levels, of around $13.9BN, to Oracle's margins. Reprising 2008, that would mean Sun would have gross margins of around 56%, for gross profits of $7.8BN, and fixed costs of around 22%, or $3.1BN, for operating profit of $4.7BN. If Oracle could, indeed, get Sun to its same margin ratios, its profitability could be very high indeed. The problem is getting Sun to the right level.

  1. Oracle is notorious for overpriced products and services. Sun was in the same position for many years, but had to switch in order to stave off the threat of Linux plus commodity hardware that nearly sunk it. It is entirely possible that Sun may not be able to improve its gross margins, because pricing may be lower, relative to variable costs, than Oracle can get away with.
  2. Sun has a significant investment in the open-source business. This business is of great value to many customers, but may not be as profitable as Oracle would like, and may need lower margins.
  3. Sun is very much a hardware company. Margins in hardware are known to be notoriously thin. Without internal information, we do not know what its per-product-line margins are. However, if Sun is playing its cards right, then high-value products like its Thumper arrays have greater margins than its commodity servers.
  4. Sun has a significant investment in Java. This is a very valuable commodity to many other players, but few more so than Oracle. To some extent, Oracle reaps the benefits of Sun's investments. Oracle is not likely to kill that source of value for itself.
  5. Sun revenues may suffer. Oracle is often reviled among the open-source community, not that differently than Microsoft, which is ironic, given the years of intense rivalry between Bill Gates on the one hand and Scott McNealy & Larry Ellison on the other. Sun, on the other hand, tends to get positive reviews. Many companies who currently do business with Sun may shy away from Oracle-Sun.

Finally, it often takes a long time to get to these levels. Let us assume that Oracle gets Sun halfway there in 12 months, and that the improvement is linear over those 12 months. This is highly unlikely, as there will be an enormous investment in organizational transition, not to mention merging HR, closing the books, SEC requirements and the rest. Nevertheless, if Oracle gets Sun halfway there, then its annualized profit at the end of the year would be improved from $372MM to $2.3BN, an improvement of $2BN, which is not bad. However, Oracle claimed that the contribution to the bottom line would be $1.5BN. Using this model, the total annual contribution would be $1.3BN (average of $372MM at beginning of year and $2.3BN at end of year), close but still 13.3% below target.

Of course, all of the above is terribly optimistic. Nonetheless, it appears that this is the approach Oracle is likely to take. I do not believe Oracle will be able to execute anywhere near as quickly, and will spend far more time digesting the acquisition than it predicts. Further, the turmoil within Sun, especially among the engineers and sales staff who have a very different culture from that of Oracle, is likely to have a significant drag on integration and extracting value. It is more likely to add around $500MM, barely more than its current profitability, and at most $1BN. If Oracle manages the acquisition correctly, it is likely to see better profitability in future years.