Sun: Oracle May Fall to Earth with This Deal

Oracle is venturing into new spacemaking computer serverswith its acquisition of Sun. It's a risky strategy

Is Larry Ellison getting in over his head?

Since 2005 the Oracle (ORCL) CEO has spent more than $30 billion on 55 acquisitions. All were software outfits. He'd buy a company, fold the products and some engineers into Oracle, and discard the rest—a formula that helped lift operating margins to industry-leading levels. Now, with his $7.4 billion deal for Sun Microsystems (JAVA), he's venturing into unknown territory. Sun is primarily a computer hardware company, a market wracked by the recession. That may make this Ellison's riskiest deal yet. "I think hubris is running wild at Oracle," says George F. Colony, CEO of researcher Forrester Research (FORR). "It will be extremely hard for them to play in this business."

Oracle is the world's leading maker of database software and the No. 2 player in the market for corporate software applications. It's buying Sun primarily for its popular Java programing language, Solaris operating system, and other software. But hardware and related sales account for 80% of Sun's revenues. Although rumors are circulating that Oracle will sell the hardware business, executives say it's central to their plans.

The idea is to focus Sun's server business on a small but promising segment of the market: "computer appliances" preloaded with Oracle software. The software package could, for instance, provide a company with all the software needed to run its business. That way, companies don't have to spend time and money pulling together the different technologies themselves. Oracle says revenue growth will come primarily from additional software sales the company lands as a result of the combination, not from server sales. And officials say this merger won't be harder to pull off than its other deals. "We have a track record of integrating acquisitions very rapidly, and this time will be no different," says President Safra A. Catz.

Problem is, the hardware business is a very different beast than software. While Oracle dominates the database industry, the server market, which accounted for nearly half of Sun's $13 billion in revenues last fiscal year, is hypercompetitive: IBM (IBM), Hewlett-Packard (HPQ), and Dell (DELL) all rank far ahead of Sun in a business where scale matters. And corporate customers switch from one server supplier to another with relative ease. With software, they make long-term commitments to a product.

Adding to the difficulty, the server market seems to be deteriorating with each passing day. IBM, which reported first-quarter results on Apr. 20, said its computer sales had declined by 22%. Overall, analysts expect the market to shrink as much as 15% this year.

Oracle is confident it can squeeze $1.5 billion of operating profits out of Sun in the first year after the acquisition is closed, and $2 billion in the second. But that may be tough. Unlike with its software mergers, Oracle will need to keep a significant number of Sun's managers, marketers, and salespeople, since its own staff doesn't have hardware expertise. Analysts estimate Oracle will need to cut 10,000 people from Sun's staff of 30,000 to make its profit targets— but that will be hard without slicing into muscle.

Ultimately, Oracle may decide it's better to sell the hardware business than run it. Cowen & Co. analyst Peter Goldmacher says even if Oracle slashes Sun's sales, general, and administrative expenses by 22% to 32% and hits its profit goal, hardware will be a drag on the profitability of the software business. "Their margins will take a big hit," he says.

With Aaron Ricadela

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