Struggling tech giant Hewlett-Packard (NYSE:HPQ) and its new nemesis Oracle (NYSE:ORCL) are headed back to court next week. The companies have been embroiled in a major lawsuit for nearly two years over Oracle's support for HP servers running on Intel's (NASDAQ:INTC) Itanium chips. Last year, the court found that Oracle had breached its contract with HP by stating that it would end support for Itanium; now a jury will decide how much to award in damages. Any award is virtually certain to be appealed by Oracle, and media sources have reported a wide range of estimates for damages. Nevertheless, any significant award will be great news for HP, which is trying to rebuild its balance sheet after a string of overpriced acquisitions.
Intel's Itanium architecture (which actually originated at HP) was once hailed as a revolutionary development for the server market. However, sales never lived up to expectations, as most customers have opted for systems based on the common x86 architecture. HP is the only major company that has stuck with Itanium, which it uses in its Business Critical Systems product line. Low sales of Itanium servers eventually led to a loss of developer support. In March, 2011, Oracle announced that it would stop all software development for Itanium. In the press release announcing the decision, Oracle noted that Microsoft and RedHat had already abandoned Itanium as well.
The problem was that HP and Oracle had signed a settlement agreement six months earlier (after former HP CEO Mark Hurd was hired as co-president of Oracle) in which Oracle specifically agreed to continue offering its product suite on HP platforms. While Oracle's management claimed that the settlement merely implied a cooperative relationship, HP maintained that Oracle was required to develop Itanium versions for new software products. The case went to trial last year, and after the judge found in favor of HP, Oracle was forced to resume full support for the Itanium platform.
While HP prevailed in court, the damage to its business was done. In the announcement that it was ending development for the Itanium platform, Oracle stated that the platform was reaching the end of its life (something that has been disputed by HP and Intel). The resulting customer uncertainty played a large role in the rapid decline of HP's Itanium business. For the first six months of FY11 (through April 30, 2011), Business Critical Systems revenue was up 1% compared to the same period in FY10. BCS revenue then posted a 9% year-over-year drop in Q3 and a 23% year-over-year drop in Q4. BCS revenue then dropped another 23% in FY12.
In total, BCS revenue dropped from $2.3 billion in FY10 (the last full year before the dispute) to $1.6 billion in FY12, and is continuing to decline. These systems bring very high margins, and also generate a continuing stream of support/service revenue. At an evidentiary hearing last month, an economist consulting for HP estimated that HP's losses could be $4 billion. Oracle's attorneys counter that Itanium revenue declines may have been driven by other factors -- such as a decline in HP's reputation due to rapid leadership turnover -- but the drop-off in Itanium sales correlates very closely with Oracle's announcement that it was ending development for Itanium. It therefore seems fairly clear that Oracle's actions were the primary driver of the platform's rapid demise over the past two years.
This week, Bloomberg reported that HP might be asking for only $500 million in damages, far less than the $4 billion figure thrown out last month. While it is hard to predict legal strategies, I would be surprised if HP asks for less than $1 billion (although I believe that the company would probably settle the case for $500 million). The high cost of litigation -- especially given the length of this case -- makes it almost self-defeating to take a case to trial over "only" $500 million.
Ultimately, a jury will decide how much Oracle owes HP for the havoc it has caused. If HP can collect $500 million to $1 billion, this will be a significant win for the company. I don't think the market is currently pricing in any significant damages award. HP has scaled back its share repurchase program since Meg Whitman became CEO, in an attempt to rebuild the balance sheet. Generating some additional cash from a settlement with Oracle will accelerate the return of cash to shareholders, which could provide a nice boost to HP stock.
Fool contributor Adam Levine-Weinberg owns shares of Hewlett-Packard. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel, Microsoft, and Oracle. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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