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Email UpdatesBy Ryan Barnes. Edited By Douglas A. McIntyre
Sun Microsystems (SUNW) – Price $6.28; Break-up Value $6.61
Remember when Sun was one of the “Four Horsemen of the Internet”? It wasn’t all that long ago in calendar terms, but in terms of the stock market it might as well be as old as the Old Testament itself. Sun has seemed so close to breaking through again for quite a while now, but even when sales growth is strong for new product offering, the success never makes it to the bottom line. The reason is a bloated cost structure where annual SG&A and R&D combined amount to nearly 50% of gross revenues.
Sun paid $4 billion for StorageTek in 2005 with the stated reason of bolstering the company’s presence in storage products; less than a year later the company blamed revenue shortfall on a weak storage product sales. Sun’s balance sheet had long been the best thing they had going, and they wiped out half of their cash balance to acquire a company that has not been as immediately accretive as most investors would have liked. Still, Sun’s balance sheet is quite strong, and by all accounts they seem to be picking up market share in their core server businesses, thanks in no small part to partnering up with AMD and Intel on the chip side to make them more marketable to customers.
Which leads us to the one of the problems with Sun. They make processors. They produce high-end servers and storage products. They design their own software and middleware applications. Sun is all over the place. They spend $2 billion a year on research & development, which is all fine and good until they try to go out and sell what they’ve designed in their brain labs only to find they can’t turn a profit. To be sure, Sun has plenty of geniuses in its ranks – I have known a few of them myself. Sun is visionary by many accounts, from their early adoption of open-source initiatives to their “The network is the computer” slogan (time will tell just how visionary that statement is).
But visionary will wear thin very quickly if a profit can’t be turned with all the great ideas. This leads us to the other big problem at Sun. It is appalling to think that a company with gross margins above 45% and no debt can barely turn a profit. The geniuses over there must be making too much money, because the SG&A is out of control – recent workforce reductions have helped, but that’s only a linear solution. Something bigger needs to happen, and KKR’s recent $700m investment may be a sign that others are in agreement.
Now that private equity has taken a public interest in the company, it is a good time to inspect what the company could be worth upon break-up. Before beginning I need to lay out the underlying assumption that the SG&A can be brought under control and end up near industry averages. Without further improvement here, Sun will be a dead stick.
Sun operates in two main segments, Products and Services. The products group includes the servers and storage hardware, and actually has decent top-line growth of late for the first time in years at nearly 9%. Because the company has stated they intend to further integrate storage products into their core servers, we will keep these segments together and look at a spin-off value of the combined products group. If we make our stated assumption that SG&A costs will make their way to industry norms, this group would show operating margins of 8%, which is slightly less than HPQ and Hitachi. Based on the low end of industry multiples, this segment could be sold for 11-13x operating profit, or about $8.1b.
The Services segment contains two groups – one dealing with ongoing support and maintenance contracts and the other doing high-end tech consulting worldwide. The segment would make for a pretty attractive IPO or spin-off, with revenue growth in the mid-teens and possibly even allowing for some “genius premium” for the folks in the consulting group. Services revenue amounted to more than $5b in the last 12 months, so this segment could easily stand on its own as a listed company. Based on the solid growth prospects and again using our necessary SG&A assumption, this group could trade for 14-16 operating profits, giving it an estimated cap of $8.4b.
The easy task is to add in the cash & related liquid securities, which are worth nearly $5 billion. The more difficult one is estimating the value of their intellectual property. Solaris, Java, and in-production research is definitely worth something, but because they’ve been giving so much away for free it is hard to tell what the monetary value of these products are. Unfortunately we have to give it little monetary value ourselves, simply for the reason that whatever future earnings value these free-for-anyone products has is wrapped in the human capital at Sun. It’s the engineers and consultants themselves who have been using the various software and platforms to drive sales and form relationships. We do think that Java is worth $2-3 billion based on the high levels of adoption in mobile devices worldwide, but that is all we’ll be adding in for IP at this point.
Add it all up and Sun Micro could be worth nearly $24 billion, or right at $6.61/share. But this is implicit on the employee and stock costs coming down in coming quarters. If we see incremental improvement in the next quarter we can expand on this assumption and narrow our break-up range for the stock.
Ryan Barnes
Ryan Barnes has over 10 years’ experience in portfolio management and investment research, covering equities, fixed income, and derivative products. Ryan spent the past 5 years working as an institutional trader & manager for high-net worth investors, working with Merrill Lynch, Charles Schwab, Morgan Stanley, and many others. Ryan is currently working as a writer and financial modeling consultant on hedging and capital appreciation strategies, and does not own securities in the companies being covered.
