The Vultures Are Gathering Around Sun

Implications: At a market cap of $7-8B and $2+B in the bank, along with healthy free cash flow, Sun is starting to look ripe for an acquisition.  It’s becoming increasingly clear that Sun’s current business model isn’t working, but their IP, customer base, brand recognition and employee base makes them attractive.

Analysis: Time is running out on Sun as they attempt to remain independent and prove their business model is working.  They are still in an enviable position in many respects:  They have more than $2B in cash, a solid free cash flow, huge IP and employee assets, unparalleled brand recognition and a blue-chip customer base.  Despite these factors, their business seems to be stagnating or slowly declining.  They’re essentially treading water in business terms – doing well enough to keep going but not able to demonstrate solid growth.  At the same time their competition is going from strength to strength and pulling away. 

The commodity server market is taking more and more of the overall server market, largely at the expense of the proprietary Unix market (e.g., Sparc).  IBM is maintaining a solid leadership position, HP has staged a remarkable comeback in the last few years and shows no signs of slowing, and Dell seems to be making a solid recovery from their problems of a couple of years ago. 

In the storage market EMC is both moving ahead with their basic product mix while offering a wider array of storage-related software.  Network Appliance and Hitachi are doing well.  Meanwhile Sun, despite their arguably excellent products, seems to be losing mindshare as well as market share.

In the open source world Sun has a major presence, with Open Solaris and MySQL.  Unfortunately, Sun has not yet demonstrated how they plan to monetize open source, at least not at the level of revenue they need.  Red Hat has made a successful business model from open source, but their revenues are still a small fraction of what Sun needs if open source is to rescue them.

At the same time, Sun still has around 30,000 employees and a cost structure rooted in the days when they had a high-margin revenue stream from proprietary servers.  Their Sparc/Solaris-based server market is starting to look like IBM’s mainframe market in the late Eighties or early Nineties – still profitable but an ever-shrinking share of the market.  Sun cannot expect that product line to sustain them.   Commodity (x86) servers are a low-margin business that cannot maintain Sun’s business model.  Open source similarly doesn’t have the margins for their business model. 

These are the factors contributing to Sun’s current market cap, which is likely to go much lower if/when the large cap funds are forced to drop Sun.  At a market cap of $5-8B Sun becomes a prime target for a takeover.  As discussed in the article, Fujitsu must be considered a prime candidate, given the existing partnership and synergies.  HP should also be considered a strong possibility.  Although there is an overlap on some of their products, Sun has sufficient independent resources to be quite attractive to HP at their current market cap.  Further, with HP’s recent experience in cost-cutting, it seems likely that HP could make Sun a very profitable company within a couple of years, albeit perhaps with a headcount closer to 15,000 than 30,000. 

An acquisition by IBM doesn’t seem likely.  The fit just isn’t that good and the product overlap is very strong, both on hardware and software.  Dell is a possibility, but the culture clash would seem to doom that marriage.  The high-cost R&D-focused culture of Sun would not fit with Dell’s low-cost, low-R&D approach.  A private equity buyout could also be in the cards, if the funds are available somewhere in today’s financial climate.  The price is low enough to make such a buy-out reasonable, and 2-3 years private would be time enough to strip a lot of the costs out of Sun and prepare the company for re-emergence as a leaner and more profitable entity.

Sun may remain independent, but with their current market cap so low, it would be easy for a suitor to offer a 50-75% premium.  And as Yahoo’s current travails demonstrate, resisting such an offer would be very difficult.