Here Comes the Sun - Part II

In the prior article, we analyzed the likelihood of Oracle meeting their comment, at their fourth quarter 2008 results conference, of having Sun add $1.5BN in operating profit to their bottom line within one year of closing the acquisition, essentially in fiscal 2009. The conclusion we reached was that it was a highly aggressive target, and unlikely to be reached by half. Nonetheless, if Oracle could get Sun halfway to Oracle's gross margins and fixed costs as a percentage of revenues by 12 months from acquisition, they would get fairly close.

In this short follow-up, we will look at the political drivers behind Oracle's $1.5BN announcement.

According to the April 20, 2009, announcement, Oracle agreed to pay $9.50 per share for Sun's stock. As of this writing, the total number of shares issued and outstanding for Sun is 746.25MM, for a total value of the transaction as $7.1BN, which differs slightly from Sun's announcement that the value is $7.4BN. We will ignore that discrepancy, as it is not material to this article. After accounting for Sun's debt and cash, the net cost to Oracle is $5.6BN.

Sun, like Oracle, is in a fairly risky business. In its latest annual report, Sun ranges the estimated weighted average cost of capital, and hence discount rate for in-process R&D (IPRD) for its acquisitions, as between 12% and 22%. As some of these are much riskier projects than Sun as a whole, we will stay in the middle and assume a discount rate of 17%. Using a basic perpetuity schedule, for Oracle to break even on its $5.6BN investment in Sun, and ignoring the actual cost of closing the deal - legal fees, filing/regulatory fees, investment banker fees - all of which can add up to well in excess of 10%, as well as the operational costs of merging the businesses, Sun will need to add almost $1.0BN ($952MM to be precise) to Oracle's bottom line.

Now, let us add 10% for closing costs, and another 10% for operational costs, for a total deal cost of $7.1BN: 10% of the transaction cost of $7.4BN (not the net cost of $5.6BN - those investment bankers are in a very good place), another 10% for operational costs, gives about $1.5BN in additional costs. Add that to the net costs of $5.6BN for $7.1BN in total cost to Oracle in the first year. Returning to our 17% discount rate calculation, and the Sun acquisition needs to $1.2BN to Oracle's bottom line. Of course, Oracle's managers do not want to have taken all of this risk in the deal, just to get the same return as if they had done nothing. This is especially true during an earnings report where they did not do quite as well as they would like. As we recall, the headlines indicated that Oracle was "not immune" to the recession. Clearly, many had expected it to be. Thus, it was critically important that Oracle's managers show not only that the Sun deal would break even, and in one year, no less, but that it would actually do 25% ($300MM on top of the $1.2BN break even is 3/12 = 25%) better than break even, and thus return higher than its cost of capital.

To be fair, it would be reasonable to also use Oracle's weighted average cost of capital and discount rate, and those that apply to the company as a whole, or perhaps its internal projects, rather than its acquisitions. The only discount rates provided in Oracle's latest annual report is for its BEA acquisition, where it uses discount rates of 7% to 17%. For a tech company, this is quite low. The Corporate Executive Board, in its November 17, 2008, report, indicated that the typical company expects to see WACC rise to between 9% and 12%. A tech company such as Oracle or Sun should expect a good few percentage points higher, given the volatility and riskiness of the business; anyone remember DEC? when Dell was the undisputed leader? when Yahoo ran search and there was nothing new in that space? Thus, our 17% rate will suffice.

Conclusions

Oracle should, and possibly could, achieve significant improvements in Sun Microsystems' bottom line, by bringing its margins more in line with Oracle's. This is in addition to any reductions in cost due to redundant activities, as well as additional revenue due to cross-selling opportunities. Its $1.5BN is challenging but not absurd. However, it is highly likely that its selection of this number target was driven as much by public/investor/political relations incentives as actual financial benefits.