Pop quiz. What does a company do when it can't generate organic revenue growth?
It buys other companies' revenue.
Case in point: Sun Microsystems
That's $37 per share for StorageTek -- an 18.5% premium over the share's closing value the day before the announcement. Sun management, in turn, expects StorageTek to add more than $2 billion to Sun's annual revenue of $11.4 billion, for a one-time boost of around 18%. In addition, Sun acquires 1,000 more salespeople (boosting its sales force by about 10%), and the combined entity's customer base will total around 17,000.
There's nothing like a merger announcement to unleash an otherwise stagnant stock. Bandwagon day traders rushed in to push StorageTek up by more than 16% after the announcement. Sun shareholders, on the other hand, voted with their feet, and the stock has since sold off by around 8%.
Even with the apparent lack of investor enthusiasm, Sun is making a big bet that the deal will do three things: increase its presence in the data-storage market, expand its product offerings to the enterprise market, and deliver revenue growth -- something Sun has lacked for three years.
Second, by leveraging StorageTek's 1,000 salespeople, its 2,000 storage-service professionals, and its suite of enterprise storage tape products (which account for 77% of its revenues), the move should help Sun's presence in the small- and medium-business markets.
Third, since both companies target similar markets in the financial, government, health-care, and telecom sectors, the combined entity can probably generate additional business in those areas.
Fourth, StorageTek's higher operating margins, at 10%, should benefit Sun's, which have languished in the range of 1.4% to -9.8% (yes, that's negative 9.8%) over the past couple of years.
Finally, in theory, the acquisition could be a more productive use of Sun's $7.5 billion cash balance, which had been relatively unproductive.
But the long-term forecast doesn't look quite as sunny. For all practical purposes, this acquisition is more or less meaningless. What Sun needs most -- sustainable revenue growth -- it won't get from buying StorageTek.
Yes, StorageTek gives Sun new sales channels, but not ones that will lead to larger, more lucrative enterprise contracts. Sun has also acquired a large, mostly mainframe-installed base, but this is a business dominated by IBM
StorageTek recently won Hewlett-Packard
Of any business Sun could have bought into, storage was definitely the way to go. First, Sun's competition -- HP and IBM -- have considerably larger tape businesses. Second, with storage, Sun can offer a more complete enterprise solution; since StorageTek has a better attachment rate to servers, Sun could leverage StorageTek's new channels as a kind of "can opener" to secure more server sales. In theory, that is.
But why buy a tape business, when it's mature technology? Tape storage as a subsector is growing at a slower rate (4%) than the storage sector at large (12%). Perhaps Sun is making a defensive move against EMC
Bottom line: Sun has spent $4.1 billion (net $3.1 billion, taking into account StorageTek's $1 billion cash balance) of its $7.5 billion cash balance to get into the mature storage-tape business. It's unclear to me where the growth is. In addition, buying StorageTek for $37 per share translates into a valuation multiple of 10 times FCF, which, in light of slow revenue growth at both StorageTek and Sun, looks to be a tad expensive. I don't expect this deal to help Sun rise again.
Who wins -- Sun or StorageTek?
The deal looks better for StorageTek than Sun, since StorageTek could do better by being incorporated into a larger -- although stagnant -- company. StorageTek is also a more efficient cash generator. Consider the ratio of operating cash flow to revenue the past four quarters: a robust 17.4% versus Sun's weak 2.2%. So while Sun has acquired good cash flow, on a post-merger basis, this could take a while to benefit the combined entity, since acquisition costs will cause the deal to be initially dilutive on a GAAP basis.
The Sun/StorageTek merger could end up being like the Hewlett-Packard/Compaq pairing, which resulted in two also-rans bootstrapping into one larger also-ran. I'm not clear how combining these two companies fixes the problems of either one -- unless it becomes a license to rationalize costs (and head count) with "purchased" revenue.
Acquisitions often allow an entrenched management team to hide the true underlying performance of the company for a year or two. Bear in mind that Sun is approaching year No. 4 of delivering no profits and has been EPS-positive only three times in the past 15 quarters. This deal, and the subsequent accounting charges and write-offs, could obscure the combined entity's true performance; it could also buy more time for Sun's turnaround. However, lack of top-line growth is one thing Sun will not be able to hide forever.
Better uses for Sun's cash hoard
I'd rather have seen Sun use its cash to issue a dividend than acquire a company. Maybe it even could have instituted an aggressive share-buyback program to soak up some of the excess cash. A dividend would actually do something for the shareholders. It would also express confidence that management can replace Sun's cash balance instead of just burning it.
At a P/E of 18.2 and a price-to-sales ratio of 1.1, Sun is trading at a slight premium to its hardware peer group -- including IBM, HP, and Motley Fool Stock Advisor pick Dell
On a price-to-FCF basis, however, Sun's stock trades at a 37% discount -- 5.3 versus the peer group's 8.4. This makes sense in light of Sun's poor cash-generating ability. So won't StorageTek's cash-flow contribution propel the multiple higher? Perhaps so in the medium term (three to six months), once integration is complete, even though the deal will be initially dilutive. There's a risk that post-merger integration may not go smoothly, but I think it's a moderate one.
Sun's risk/reward balance
In the long term, I'd consider Sun shares to have an unfavorable amount of risk relative to their potential return. The deal could cost the merged company HP as a customer; limit Sun's longer-term development and confine it to being a niche player; and slow down growth in Sun's core businesses, which will feel continued revenue and operating pressures at the combined entity and take bumps in the still-tough competitive environment. After 12 out of 15 EPS-loss quarters, Linux and the new Java initiatives -- neither likely to drive meaningful revenue growth -- appear to be the brightest spots in Sun's business.
Fundamentally, Sun doesn't look like a "buy and hold" company that lets you sit back and relax while you watch it appreciate. To this Fool, the company's long-term outlook continues to look overcast.
Disagree? Want to talk to other Fools about Sun? Check out our Sun Microsystems discussion board.
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