Sun's best option remains selling to IBM

Sun Microsystems (JAVA.O) has endured annual restructurings it keeps straight by naming them with classic-sounding Roman numerals. It needs to make sure Round IX is its last, part of a deal to merge with IBM (IBM.N).
The company's investors and its entrenched corporate customer base have been left to wonder about Sun's shrinking prospects and, unless it can find woo IBM back or find a new suitor, its future looks dim.

The company's annual revenue tops $13 billion, its cash position is strong and its old fans remain loyal. However, a steep sales decline brought on by the financial crisis means March quarter sales are set to fall 12 percent.

The other obvious candidates have better things to do with their money than buy Sun. Hewlett-Packard (HPQ.N
) recently paid $13.9 billion to buy computer services firm EDS and is busy digesting that deal. Dell (DELL.O) is short of the cash and expertise needed to do a Sun-sized deal.

With a huge cash pile of $29.5 billion, Cisco Systems (CSCO.O) is a dark horse favorite among pundits looking for alternatives to IBM. Cisco could leapfrog its way into new computer hardware and storage businesses with Sun.

However, Cisco showed its lack of interest this week by acquiring Tidal Software, a small maker of data center software for $105 million, continuing its long-held preference for small-scale mergers rather than big deals.

Sun was an early champion of distributing computing power to users over networks rather than tying them to specific machines. In recent years it has become a victim of its success in winning over most of the rest of the industry to thinking as it did long ago.

Sun's motto "The network is the computer" may end up becoming its epitaph, as the value of the software and services available over the Internet has exploded while computing hardware itself has headed toward a commodity.

It is an aging rock star in an industry where tastes long ago shifted to bubble-gum pop and boy bands. The company has struggled to remain competitive when its core computer hardware products rely its own chip designs instead of the cheap and plentiful Intel processors that most of the industry have adopted.

IBM was the only bidder, despite month of efforts by Sun to shop itself around, and remains the odd-on bet to acquire Sun. Sun's shares fell sharply after merger talks broke down with IBM but remain 30 percent higher than before talks between the two emerged on a bet they would find a way to do a deal.

IBM's advantage is that it is consolidating a rival maker of computers, storage and software and can justify a big part of any deal with expected cost savings. Consolidation players are far more likely to find favor with investors than deals based on strategic prospects.

Like Sun, IBM continues to develop its own chip to advance its lines of mainframe and high-server computers. Switching Sun's customers away from Sun SPARC chips to similar machines using IBM Power chips would help the economics of IBM's computers.

No one but IBM has stepped forward, for good reasons.

IBM's initial offer of a 100-percent premium to buy Sun made the tentative deal look a sure bet, so much so that Wall Street analysts didn't see the point in calculating the value of the parts of Sun's businesses.

Consolidating chip production could shave $500 million from Sun's annual research and development budget of between $1.8 billion and $2.0 billion. Rationalizing corporate expenses in the merged organization could realize another $1 billion in savings off its roughly $4 billion SG&A accounting line. These potential cost savings are what gives IBM the edge over other bidders.

Differences between IBM and Sun over the deal's price and protections demanded by Sun in the event that competition regulators seek to delay the deal look like negotiating tactics to drive a better price than reasons to derail the merger.

Sun investors see an obvious parallel with last year's Yahoo debacle, when brinksmanship by the company's then leadership cost Yahoo investors a premium north of 50 percent on Yahoo stock after Microsoft pulled its offer.

IBM originally was talking to Sun about paying $10-$11 per share to buy Sun, but reportedly cut its offer to between $9.10 and $9.40 after due diligence, leading Sun to walk away. Whether Sun gets $9 or $10, it should seize the deal. The company's board has overseen a plunge in the stock price from $275 to $5 and there is little hope of seeing Sun trading at $20 a share in the near future except as part of IBM.

The best way to get this deal done may be for IBM to offer Sun a mix of stock and cash, allowing Sun investors to participate in future gains from IBM stock. This could prove the lever that that IBM uses to woo Sun back to the negotiating table.

-- At the time of publication Eric Auchard did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Eric worked at a unit of Sun for a short time in the late 1980s.

BY Eric Auchard

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