Saturday, April 25, 2009

Why Did Sun Have To Sell?

A bit of a departure from what I intended this blog to be about, but I wanted to discuss what's going on with Sun Microsystems and why it was up for sale. First Oracle and HP were going to purchase Sun and split it up so that Oracle would get Sun's software portfolio for $2 billion and HP would get Sun's Solaris and hardware business. The deal was supposedly blocked by IBM, who then made their own $6.5 billion bid for Sun.

When IBM walked out of talks with Sun, Oracle came in with an offer to buy Sun for $7.4 billion.

But why did Sun need to sell at all? The answer will surprise you. It doesn't have to do with Solaris or SPARC or Java or Open Source. This turned out to be a long post, so let me just give the answer to the impatient. It has to do with Notes. (Yup, you heard me. Notes!)

To help answer the question of why Sun needed to sell, I dug into some of Sun's financial reports to see how the company was doing. The chart on the right shows annual financial numbers from 1985 to 2008. It includes Sun's product, services and net revenues, as well as net income and net cash provided by operating activities.

A lot of people seem to think that the dot-com burst is what hurt Sun. I think blaming Sun's problems on the dot-com bubble bursting is too simplistic. It was the bubble itself that caused the problems. But just like with the latest housing bubble, people didn't realize it was a bubble and started investing/spending money that wasn't real. That's what I think the case was with Sun.

During the dot-com bubble, venture capitalist (VC) money was flowing freely. People could afford to buy anything they wanted for their startups, and what they wanted was Sun hardware. Lots of Sun hardware. Sun likely had to ramp up manufacturing capabilities and increase staff. But when the VC money dried up, there wasn't anything to take it's place, and demand for Sun's servers fell.

At the same time, Linux was maturing, and what a startup could do with Sun hardware and Solaris, they could now do with Linux and Intel based servers. I don't think it's so much that Linux and x86 servers had caught up to Solaris and Sun's big iron servers, but people started being realistic about their needs. A large number of start-ups could probably be hosted on nothing more powerful than your desktop because they never took off. There was no need to build out for some theoretical level of traffic that will never be obtained.

Sun's hardware, and its Solaris operating system are still well regarded and have their place. According to IDC's Worldwide Quarterly Server Tracker, Unix servers accounted 36.2% of server revenue compared to 13.6% for Linux servers. They didn't break down by Unix vendor, but in the past, Sun has usually been in the number one or two spot for Unix server revenues. If you look at job trends on, you'll see that demand for Solaris is greater than IBM's AIX and Hewlett-Packard's HP-UX combined in the job market and Solaris jobs are growing.

While Sun's SPARC server revenues have been declining, they still had over $900 million dollars in billings the last reported quarter. That includes their new line of CMT (chip multithreading aka CoolThreads, Niagara, T1, T2, T2 Plus) based servers which is seeing revenue growth in the SPARC line, with revenues nearly doubling to $1.12 billion in FY08 compared to $608 million in FY07.

While Sun was late to the Intel based server game, they have created some very innovative hardware including the first 8 socket Quad Core Opteron Server, the X4600. I like this video of Andy Bechtolstien demonstrating the X4600 server but the marketing produced video of the x4600 might be more informative.

Sun's blade systems have also been showing very good revenue growth according to the latest IDC report.

5 Straight Years of Losses

OK, that all sounded good, but Sun did have 5 straight years of net loss following the dot-com bubble bursting (as was seen in the chart above.) The largest being in 2003. One thing that former CEO (current Chairman) Scott McNealy used to always say is that it's always been cash flow positive. If you look at the net cash provided by operating activities, that figure has always been positive. Even in recent quarters. The last two quarters though, they took some big hits in cash flow from investing activities to total a loss of over $630 million from investments. The last 3 quarters had negative cash flow.

If you look at net revenues, they've also started to recover. One thing many people kept saying is that Sun needed to reinvent themselves and it really looks like they did. While server revenue continues to decline, they made up quite a bit in services revenue. Now services revenue makes up almost 40% of Sun's total revenue.When you also look at all the great software Sun has been putting out, it has become much more than just a hardware company, though hardware is an important part of it's business.

They have fallen quite a bit from their dot-com highs, but revenue is still impressive at nearly $14 billion annually.

Unfortunately, the latest economic crisis is hitting Sun hard, just as they were getting back on their feet with 2 back to back years of positive net income.

Some people think that Sun didn't downsize quickly enough after the dot-com bubble, and I think that might be a fair assessment. Sun has the money coming in, they just aren't keeping it, and in recent quarters had some big losses.

The Real Reason Sun is Selling is Because of Notes

At least that's my feeling. For the most part, Sun has a lot of cash, large revenues, demand for it's products, a large customer base, they are innovative, they have some good partnerships, so why are they selling?

Sun is selling because of Notes! At least that's what it looks like to me.

You may be confused, but also thinking that's why IBM was so interested in Sun, but no, I don't mean Lotus Notes. During the dot-com era (1999), Sun issued $1.5 billion dollars in unsecured senior debt securities in four tranches. The only remaining tranch is $550 million in Senior Notes that mature in August 2009. These notes pay interest semi-annually at a rate of 7.65%. When they reach maturity this summer, Sun will need to pay back the $550 million.

This is really bad timing. With Sun's revenue posting losses again, it's going to eat into their cash reserves. While they should be able to cover it, it's going to be a big dent. If they don't cover it, it's going to kill their credit rating (which isn't that great right now) and would make it very difficult for them to raise capital in the current economic climate.

In addition, Sun has $700 million in Convertible Notes issued to KKR PEI Solar Holdings, II, Ltd. Half due in 2012, the other half in 2014. While those notes aren't looming over sun like the $550 million due in August are, it's something to consider.

Sun has also been restructuring lately (laying off employees). It will save the company plenty of money, but right now they have to deal with severances and other associated costs, which just makes the situation worse. Had they restructured earlier, and gotten the costs out of the way by now, they would have been in a better situation. The executives at Sun might have not anticipated just how inflated their sales were as a result of the bubble and that those days were never coming back.

Mind you, I'm not a financial analyst, expert, or someone you should trust with your money, so I may be completely off base here. I also haven't seen anyone else reference this situation, but it looks to me like that's the kingpin here. It's not that alone, it looks like a perfect storm of financial misfortune and bad decisions. Sun borrowed during the good times, struggled, then came out of it and would have had no problem paying off the notes. But the current conditions hurt them again. They can't borrow to pay off the note. Getting new investors to pay off old investors is what got Bernie Maddoff into an orange jumpsuit.

They could probably afford it, but combined with the expected revenue shortfalls and the costs of restructuring too late, it would likely kill their credit rating, which Standard&Poor's already put on watch. You can't run a multi-billion dollar business, especially in hard times, with bad credit.

It's pretty sad, had the notes been due just a few quarters earlier, things might have been different.

Like other companies, Sun doesn't keep all their money in cash. Only 11% is in cash and cash equivalents. In addition, they have $268 million in asset backed securities, including $118 million in mortgage backed securities. We know how shaky those have been. Even though 80% of what Sun holds is rated AAA by S&P, many MBS ratings have been questionable. The expected weighted average maturity of their asset backed securities is more than 2 years, so that's not money they can tap into right away.

How could Sun have Saved Itself?

There are a lot of things Sun could have done. At their lowest point post bubble, Sun's annual revenues were $11 billion dollars. That's a whole lot of money! They just didn't use it effectively. The probably should have laid off more staff earlier. In 2002, when their revenues fell by over 30%, they should have laid off 30% of their staff right away or found other ways to cut expenses. They did something to account for losing 1/3 of their revenue, but clearly not enough.

In my opinion though, the biggest mistake Sun made was buying MySQL for $1 billion. That money could have come in handy to keep them afloat during this time. Half would have gone to pay off the Senior Notes, the rest to deal with the financial crisis. Since so many of Sun's customers are in the financial sector, maybe they could have told them that the party was going to be over soon. Some of them actually knew and started making money shorting the housing market.

MySQL revenues were only around $50 million a year at the time Sun was buying them. The price tag of MySQL AB was 20 times revenues! That's just insane. Sun is selling itself for 50% of revenues.

Sun should have continued partnering with MySQL AB, but focused more on PostgreSQL. PostgreSQL is a more feature rich open source database. It doesn't have the market share that MySQL has, but converting that market share into Sun customers that buy expensive hardware and justify the $1 billion price tag is risky and even if it works, would take too long.

With PostgreSQL, they have a database that could get clients off of Oracle and DB2 and Sun has already invested in the software and had some success with Solaris/PostgreSQL over Oracle and Linux.

IBM made the right move to invest in PostgreSQL based EnterpriseDB after Sun bought MySQL and again after Oracle announced it will be buying Sun.

While there were likely many bad decisions, the timing and cost of this one, seems to be the worst in my view.