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Sun - Analsis financiaro

Analsis financiaro (Universidad UNIVER)

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CASE 48

SUN MICROSYSTEMS
Teaching Note

Synopsis

This case calls for students to reevaluate the price Oracle should pay to acquire its long-
term business partner, Sun Microsystems. The emergence of new suitors (e.g., IBM) forces
Oracle’s corporate development team to go back to the drawing board and reevaluate all the
assumptions they have made in putting together the initial bid of $7.38 million, or $9.50 per
share, on April 17, 2009. Students are invited to value Sun’s stock and take a position on whether
there is any room left to sweeten the offer if a bidding war unfolds. The case outlines the Oracle
strategy and how long-term partnering with Sun contributed to it to date. It also allows for an in-
depth discussion of the changing competitive landscape of the technology industry.

The case is an exercise in valuing a potential acquisition target. It presents an opportunity

for students to develop appreciation for valuing a company using both discounted cash flow and
multiples in their analysis. Particular attention should be paid to the inclusion of synergies and
their relevance to the valuation. The bidding dimensions of the case are highlighted by the
presence of other potential acquirers.

Topics and Course Placement

This case is designed for core corporate finance MBA courses or for an advanced
undergraduate corporate valuation class. The primary objectives of this exercise are to introduce
or reinforce valuation tools in the context of mergers and acquisitions:

 Analyzing a variety of strategic, organizational, financial, and economic issues associated

with mergers and acquisitions
 Developing a framework for valuing acquisition candidates
 Evaluating both quantitative and qualitative factors affecting merger agreements

The case could benefit from being assigned together with the technical note “Methods of
Valuation for Mergers and Acquisitions” (UVA-F-1274).1

1 Susan Chaplinsky, Michael J. Schill, and Paul Doherty, “Methods of Valuation for Mergers and Acquisitions,”
UVA-F-1274 (Charlottesville, VA: Darden Business Publishing, 2000).

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Suggested Assignment Questions

The instructor may consider the following study questions:

1. Is Sun Microsystems a good strategic fit for Oracle?

2. What approaches would you use to place a value on Sun Microsystems?
3. Assuming a discounted cash flow valuation:
a. What rate of return should Oracle require on the acquisition?
b. What base-case cash flows do you forecast?
c. What is your estimate of terminal value?
d. What is the enterprise value of Sun Microsystems? What is the equity value?
4. Conduct a multiples analysis to value Sun. What economic fundamentals are reflected in
the multiples?
5. Identify the synergies and conduct a sensitivity analysis to estimate the effect of synergies
on enterprise value.
6. If a competing bidder appears, how high a price should Oracle be willing to offer?

Suggested Time Allocation for a 90-Minute Class

5 minutes: What is the managerial decision?

15 minutes: Should Oracle acquire Sun Microsystems?
45 minutes: How much is Sun worth as a stand-alone company?
15 minutes: What is the value of Sun as a part of Oracle?
10 minutes: What would your bidding strategy for Sun be? At what point would you stop
negotiating any further?

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Teaching Plan

Should Oracle acquire Sun Microsystems?

In 2009, two longtime business partners, Oracle and Sun Microsystems, found
themselves in very different financial situations. Led by Larry Ellison, Oracle was a leviathan of
the enterprise software market with $23.6 billion in annual revenue and healthy profit margin. In
contrast, Sun was slowly but surely losing its market share in business hardware. Its bets on
software products like MySQL and Java did not work out. So the company found itself ripe for
acquisition. Students immediately see the benefit of a merger between two companies with
almost fully complementary product and customer bases. Sun presents a unique opportunity for
Oracle to be the Wal-Mart of the enterprise software market.

Students tend to quickly point out a number of dimensions where Sun products either
complement those offered by Oracle or allow Oracle to serve a new customer base (see case
Exhibit 8). While Oracle mainly offered commercial software, Sun’s core value proposition was
hardware. By pairing Sun’s expertise in hardware and its own proprietary software, Oracle had a
potential to build best-in-class workstations. Sun also owned an operating system (OS) called
Solaris, as well as the JAVA programing language, both of which were the underyling
technologies for the majority of Oracle’s software since 1997. Finally, MySQL database
management software did not directly compete with Oracle database management software, as
the two appealed to different customers. By adding MySQL to its portfolio, Oracle could add
smaller clients to its customer base.

Alongside the direct synergies between the two companies, the students may also note the
changing landscape of the technology industry. In the 1990s, the software industry was
extremely segmented with each company serving a particular niche: hardware, software and
services, and storage and peripherals segments. By the end of the first decade of the twenty-first
century, the lines between the segments became more and more blurry. The Apple concept of a
one-stop shop for consumers to acquire all their technology needs became the gold standard. By
acquiring Sun, Ellison could achieve his vision of building a company “that can engineer an
integrated system application to disk—where all pieces fit together.” Acquiring Sun would allow
Oracle to deliver high-quality, seamlessly integrated consumer products where software and
hardware components were developed in conjunction with each other, thus minimizing the
customer setup process.

Finally, the acquisition fits the overall Oracle strategy to innovate through acquiring and
successfully integrating other companies. With a history of $30 billion spent on 50 acquisitions
over five years, Oracle was looking at a company with the most potential to generate synergies.
Overall, the students usually come to the strong conclusion that buying Sun is a very good idea
from a strategy perspective—at which point it is natural to ask how much they would be willing
to pay for it.

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How much is Sun worth?

Before diving into the valuation of the company, it might be beneficial to stop and discuss
the difference between the stand-alone value of a corporation and its value to the acquirer after
factoring in potential synergies. In my experience, the question, “How much is Sun worth to
whom?” naturally leads students to a discussion of two different values. This short discussion
might be followed by the question of the price at which one might buy Sun relative to the stand-
alone and with-synergies valuations. This question leads students to think about the surplus the
acquirer and target would receive as a result of the acquisition. Here, an instructor might
introduce the concept of Pareto efficiency. Exhibit TN1 presents a simple way to graphically
reflect this prevaluation discussion.

Once the students understand the notion of a stand-alone value of a company and a value
with synergies, it is natural to move to actual valuation of the target company. The case provides
enough data to perform a valuation of Sun using discounted cash flow analysis (DCF). Since the
decision to purchase the assets or equity of the target firm has not been made, students must
consider both enterprise and equity values.

The DCF valuation contains three components that could be discussed in any order
preferred by the instructor: (1) free cash flows (FCFs); (2) terminal value (TV); and (3) weighted
average cost of capital (WACC).

The WACC could be computed using the Sun financials presented in case Exhibit 9
(Table 1):

Table 1. WACC calculation.

Data in the Exhibits WACC Calculations

(case
Exhibit 9)

(case Exhibit 10)

(case Exhibits 6 and

10)

Source: Created by case writer.

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Alternatively, students might pursue a different path and compute the WACC for Sun
using comparable companies’ discount rates. Exhibit TN2 presents an estimate of the weighted
average cost of capital (WACC) following this approach. Although case Exhibit 9 provides
financial data for companies in both primary hardware and primary software segments of the IT
industry, only hardware companies were selected to represent comparables for Sun
Microsystems. Within this segment, students may choose to exclude Advanced Micro Devices,
EMC and/or NetApp as companies with business lines and strategic development inconsistent
with Sun. The case affords a good opportunity for students to debate what constitutes a good
comparable. Exhibit TN2 considers all the primary hardware companies from case Exhibit 9,
excluding the three companies mentioned above.

Using the tax rate of 35% provided in the case, the beta of each comparable company is
unlevered to give a median value of 1.10. The difference between Sun’s unlevered betas and the
set of comparable companies is rather significant (1.49 versus 1.10). This calls for a discussion
of why the market perceives Sun’s operations to be riskier than those of its competition. The
unlevered beta is then levered to reflect the median debt-to-equity ratio for the industry (17.4%)
with a resulting levered beta of 1.22. This assumes that, although Sun was carrying a debt-to-
equity ratio of 25%, the median industry value would better reflect Sun’s target capital structure.
The cost of equity (Ke) of 9.73% is calculated using the capital-asset-pricing model (CAPM),
with a risk-free rate equal to the yield on long-term U.S. government bonds (2.82%) and a
market-risk premium of 6%. The target debt-to-equity ratio is converted into a target debt-to-
capital ratio of 14.7%. The cost of debt (Kd) is assumed to be the median industry value of 6.3%.
Then the WACC is estimated as 9.25%. 2 Alternatively, students may choose to simply calculate
the WACC for each comparable company and use the median value, which is 9.15% and is very
close to 9.25% estimated above. Note, however, that if one computes WACC using only Sun’s
financials, the resulting estimate of 12.05% (above) is still significantly higher than the 9.25%
(9.15%) estimated via comparables. The market assigns a higher cost of capital to Sun relative to
the competitors. The students should note that Sun is in financial trouble. Despite the projected
recovery, it should be considered a riskier company than the set of fairly healthy companies
constituting the comparables.

Exhibit TN3 presents the stand-alone valuations of Sun using the cash flow estimates
from case Exhibit 14. The operating income reported by Sun is effectively EBIT, which, under
assumption of 35% tax rate, leads the class to NOPAT numbers. This opens the discussion for
how to compute the capital expenditures (CAPEX), depreciation, and change in net working
capital (NWC). Case Exhibit 14 provides the forecasts for net property plant and equipment (Net
PPE). Net PPE increases due to CAPEX and decreases as a result of depreciations.

Net PPE 2010 = Net PPE 2009 + CAPEX 2010 − Depreciation 2010
which is equivalent to

2 If students argue that the target capital structure for Sun differs from the industry median, then the WACC can
be adjusted by estimating the cost of equity with the newly levered beta and the new capital weights.

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CAPEX 2010 − Depreciation 2010 = Net PPE 2010 − Net PPE 2009

Thus one can estimate annual depreciation less CAPEX via first differencing the Net
PPE.

Estimating the necessary investments in NWC is a bit more complex. The students might
need some guidance in realizing that each dollar of sales would require a fixed level of inventory,
accounts payable, and accounts receivable. Hence, it is reasonable to assume that the level of
NWC should be proportional to sales. Using the past balance sheets presented in case Exhibit 11,
one can compute the levels of NWC to be $1,485 and $1,093 for years 2008 and 2009
correspondingly. The NWC across those two years is on average 10.1% of net revenue reported
in case Exhibit 14. Students can then project the levels of NWC as percentage of sales and obtain
the changes in NWC estimates. Armed with these estimates, the students can compute FCFs.

The final part of the analysis is the determination of the terminal value of the company.
One can adopt two different approaches to make this estimation: (1) the perpetuity growth model
and (2) using multiples of comparable companies. The first would lead to a debate about which
perpetuity growth rate to assume, the second to one about the proper choice of comparable
companies. Exhibit TN3 presents valuation using both approaches.

“DCF with Perpetuity Growth” assumes that Sun would grow with the economy in
perpetuity and hence would realize a growth rate equal to the risk-free rate of 2.82% (case
Exhibit 10). The sales and net operating profit after tax has to be grown by 2.82% to estimate the
respective values in the steady-state year. To obtain the correct estimates of the CAPEX,
depreciation, and the change in the NWC, we first forecast the levels of Net PPE and NWC for
the steady-state year by growing the 2014 values by 2.82%. This approach ensures correct
estimates of CAPEX, depreciation, and change in the NWC that are in line with the company’s
projected growth rate. Armed with the FCF estimate for the steady-state year students can
estimate the terminal value in 2014 using the perpetuity formula (Equation 1):

(1)

“DCF using multiples” assumes a set of comparable companies and utilizes the EBIT
multiples computed from case Exhibit 9. Exhibit TN2 reports the EBIT multiples for the
comparable companies and their median value of 9.4.3

The two approaches produce significantly different per-share prices of $6.14 and $8.19,
respectively. Students tend to struggle with this ambiguity. I recommend pushing them to
evaluate which of the approaches is more appropriate or more accurate to utilize in valuing Sun.
The discussion is bound to hit upon the idea that the comparable companies used to set the value
3 Case Exhibit 3 provides the financial data necessary to calculate median, high, average, and low multiples of
sales, earnings before interest and taxes (EBIT), EBITDA, and the price-to-earnings ratio (P/E) for the comparable
group.

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multiple are in much better financial and operational health (e.g., Apple). Students are then likely
to converge on an opinion that the multiples used to estimate the terminal value are potentially
optimistic and don’t reflect the company’s future on a stand-alone basis. This notion is consistent
with the current price per share being $6.69. I find this conversation a nice gateway to revisiting
the fundamental ideas behind the multiples approach.

Students generally believe that perpetuity growth based solely on Sun would better reflect
the true value of the company. Some would raise the issue, however, that this method assumes
that, from 2014 onward, the company would not experience any significant growth. They would
argue that such an assumption is too harsh in evaluating the company. This debate would allow
the instructor to compare and contrast two valuation methods and push students to consider
which approach would be more effective in capturing an enterprise value.

Once students settle what price they consider to be a better estimate, the instructor can
ask, “If we believe that Sun is worth [amount] why are we (Oracle) willing to pay $9.50 per
share for this company?” This question opens the discussion of the value with synergies
(presented in Exhibit TN4.) The case suggests that there are three sources of synergy costs that
would affect valuation. First, there is an integration cost of $1.1 billion—$750 million of which
will be incurred in 2010, followed by the remainder being incurred in 2011. Second, the team
assumed a $45 million loss in revenue right after a merger, due to customers reprioritizing away
from the newly formed company. Finally, the Oracle team members were famous for being
effective cost cutters and transforming margins of acquired businesses. So there is an expectation
of a profit boost of as much as $900 million per year. Exhibit TN4 reflects all three sources of
synergy and conservatively assumes that the $900 million benefit will kick in gradually and will
only reach its full potential in 2013. Both valuations provide us with a per-share price above the
bid price of $9.50. Students will recognize that the offered price still leaves some money on the
table for Oracle to capitalize on.

I recommend concluding the class with one of two questions. The instructor can ask the
students to summarize a negotiation strategy they would pursue with the Sun team if IBM steps
into the picture with a competitive bid, or the instructor can ask students to identify their walk-
away price and relate back to Exhibit TN1 to discuss the synergy value that would accrue to
either Sun or Oracle shareholders.

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Exhibit TN1
SUN MICROSYSTEMS
Value of Sun

Surplus to Target Surplus to Acquirer

Company Shareholders Shareholders

Stand-Alone Acquisition Value with

Value Price Synergies

Potential Value Range for the Acquisition Price

Source: Created by case writer.

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Exhibit TN2

SUN MICROSYSTEMS
WACC Determination

Beta Debt to Beta Debt to EBIT

Ticker Ke Kd WACC
Levered Equity Unlevered Capital Multiple
Primarily Hardware
Apple AAPL 1.11 0.0% 1.11 9.50% 0.0% 0% 9.50% 10.67
Dell DELL 1.12 9.4% 1.06 9.55% 8.6% 6.35% 9.08% 4.38
Hewlett-Packard HPQ 1.25 23.3% 1.09 10.32% 18.9% 6.35% 9.15% 9.47
Intel INTC 1.20 5.0% 1.16 10.02% 4.7% 6.27% 9.74% 3.70
International Business Machines IBM 0.93 24.9% 0.80 8.42% 20.0% 6.27% 7.55% 9.40

Sun Microsystems JAVA 1.73 25.4% 1.49 13.22% 20.3% 11.42% 12.05% -
Median 1.15 9.4% 1.09 9.73% 8.6% 6.3% 9.25% 9.40
Median WACC 9.15%
Source: Created by case writer. Based on case Exhibit 9.

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Exhibit TN3

SUN MICROSYSTEMS
Stand-Alone Valuation of Sun

2008 2009E 2010E 2011E 2012E 2013E 2014E SS % Sales

(1) → Ex. 14 SALES 13,880 11,449 12,665 13,047 13,526 13,885 14,243 14,645
(2) → Ex. 14 EBIT 372 (2,236) 141 472 670 747 796
(3) = (2) × 35% TAXES 49 165 235 261 279
(4) = (2) − (3) NOPAT 92 307 436 486 517 532

(5) → Ex. 11 NWC 1,485 1,093 1,282 1,321 1,369 1,406 1,442 1,482 10.1%
(6) → Ex. 14 PPE 1,611 1,616 1,788 1,520 1,566 1,623 1,666 1,713 12.0%

(7) = ∆ (5) − change in NWC (203) 39 48 36 36 41

(8) = ∆ (6) − DEPR + CAPEX 172 (268) 46 57 43 47

(9) = (4) − (7) − (8) FCFs 123 536 341 392 438 444
DCF with Perpetuity Growth DCF with Multiples
NPV of FCFs 1,276 1,276
Terminal Value 4,814 = FCFss/(WACC − growth) 7,480 = EBIT2014 × Median EBIT Multiple
NPV of TV 2,725 4,235
ENTERPRISE
VALUE 4,001 5,510
DEBT 1,249 Ex.11 1,249
CASH 3,061 Ex.11 3,061
EQUITY 4,537 6,047
SHARES 739 Ex.9 739
PRICE PER
SHARE $6.14 $8.19

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Source: Created by case writer. Based on case Exhibits 4 and 19.

Exhibit TN4

SUN MICROSYSTEMS
Valuation of Sun with Synergies
% of
2008 2009E 2010E 2011E 2012E 2013E 2014E SS
Sales
(1) → Ex. 14 SALES 13,880 11,449 12,665 13,047 13,526 13,885 14,243 14,645
EBIT without
(2) → Ex. 14 Synergies 372 (2,236) 141 472 670 747 796
Loss in Operating Income 45
Integration Expense 750 350
Net Operating Profit Increase 300 600 900 900
EBIT with Synergies (654) 422 1,270 1,647 1,696
(3) = (2) × 35% TAXES 148 445 576 594
(4) = (2) − (3) NOPAT (654) 274 826 1,071 1,102 1,133
(5) → Ex. 11 NWC 1,485 1,093 1,282 1,321 1,369 1,406 1,442 1,482 10.1%
(6) → Ex. 14 PPE 1,611 1,616 1,788 1,520 1,566 1,623 1,666 1,713 12.0%
(7) = ∆ (5) − change in NWC (203) 39 48 36 36 41
(8) = ∆ (6) − DEPR + CAPEX 172 (268) 46 57 43 47
(9) = (4) − (7) − (8) FCFs (623) 503 731 977 1,023 1,046
DCF with Perpetuity Growth DCF with Multiples
NPV of FCFs 1,564 1,564
Terminal Value 11,330 = FCFss/(WACC − growth) 15,937 = EBIT2014 × Median EBIT Multiple
NPV of TV 6,414 9,023
ENTERPRISE VALUE 7,978 10,587
DEBT 1,249 Ex.11 1,249
CASH 3,061 Ex.11 3,061
EQUITY 8,226 10,835
SHARES 739 Ex.9 739

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PRICE PER SHARE $11.14 $14.67

Source: Created by case writer. Based on case Exhibits 4 and 19.

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