Sun Is Buying Storage Tech. Is That A Good Move? Part 2

• June 8, 2005
• Melanie Hollands

Fun in the Sun?

 

I’ve got
some follow-up thoughts on my

previous article regarding Sun’s acquisition of StorageTek, following a
couple of reader emails.

 

Management
expects StorageTek to add over $2 billion to Sun’s annual revenue of $11.4
billion — that’s a one-time boost of around 18%. In addition, Sun acquires
1,000 (around 10%) more sales people and the combined entity’s customer base
will total around 17,000. Sun acquired $1 billion of debt in the deal; but I’d
expect that to have minimal impact on the combined entity, which will still have
$4.5 billion of cash.

 

The deal
was popular with the band-wagon day-traders that rushed into buy STK — up over
16% for the day. (There’s nothing like a merger announcement to unleash the
“Inner MoJo” in an otherwise indifferent stock.) SUNW holders, on the other
hand, voted with their feet, and the stock has since sold off around 8%.

 

There are
a few sunny patches with this deal:

• It
  helps Sun’s FCF profile. StorageTek generated $367 million OCF over the last
  four quarters.
• It
  should help Sun’s presence in the SMB (small and medium business) market, by
  leveraging StorageTek’s 1,000 new sales people, its 2,000 storage service
  professionals, and its suite of enterprise storage tape products (which
  account for 77% of its revenues).
• Both
  companies’ target similar markets in the financial, government, healthcare,
  and telecom sectors, so some additional business will probably result.
• 
  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%) the
  last couple of years.

 

But the
long-term forecast doesn’t look sunny: What Sun needs most — sustainable revenue
growth — it won’t get from buying StorageTek.

 

• 
  StorageTek gives Sun new sales channels; but these are focused on mid-range
  companies not the larger, more lucrative enterprise contracts.
• Sun has
  acquired a large, mostly mainframe installed base; but this is a business
  dominated by IBM, so it’s unclear whether those customers will want to buy
  from Sun.
• 
  StorageTek recently won Hewlett-Packard, as a customer, accounting for 3% to
  4% of its revenue; but it’s possible HP, and other OEM customers who are also
  Sun’s competitors, may now look to switch, which means Sun ends up acquiring a
  flat revenue stream.
• Data
  storage tape is a big cash generator, and it can help Sun broaden its
  enterprise product portfolio. However, in reality
  Sun ends up buying an old, maturing cash cow rather than higher-margin
  leading-edge technology, which would drive higher revenue growth.

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; so it’s unclear where the growth is. In
addition, STK for $37 per share translates into a valuation multiple of 10x FCF,
which, in light of slow revenue growth at both StorageTek and Sun, looks a tad
expensive. I don’t expect this deal to help Sun rise again.

 

The deal looks
better for StorageTek than Sun, since it could do better by being incorporated
into a larger, although stagnant company. StorageTek is a more efficient cash
generator. Consider the ratio of OCF to Revenues the last four quarters: a
robust 17.4% versus Sun’s weak 2.2%. So, while Sun has acquired good cash flow;
on 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 Hewlett-Packard / Compaq: two
also-rans bootstrapped together led to one, larger also-ran.

 

Neither
Sun nor StorageTek has been doing all that well the last few years. So combining
two one-legged cripples doesn’t magically result in a strong two-legged
creature. From what I understand, StorageTek has been
doing almost as badly as Sun over the last five years. I’m not clear how
combining these two companies fixes the problems of either one — unless it
becomes a license to rationalize costs (and headcount) with “purchased” revenue.

 

But why buy a tape
business, when it’s mature technology? Tape storage as a sub-sector is growing
at a slower rate (around 4%) than the storage sector at large (around 12%).
Perhaps Sun is making a
defensive move against EMC (NYSE: EMC) — however, since EMC and Sun are in
different leagues, such a move isn’t all that useful against the “heavy”
competition. What EMC and the rest will have to say
about Sun’s move remains to be seen.

 

At 18x P/E and 1.1x
P/S, SUNW is trading at a slight premium to the hardware peer group — including
IBM, HPQ, DELL — at 17x and 1.0x respectively. Since Sun still lacks revenue and
earnings growth prospects, this makes the stock look expensive.

 

On a P/FCF basis,
however, SUNW trades at a 37% discount — 5.3x versus the peer group’s
8.4x (10.1x if EMC is included). Not surprising in light of Sun’s poor cash
generating ability. So, won’t StorageTek’s cash flow contribution propel the
multiple higher? Perhaps; a little; in the medium-term (3 to 6 months) once
integration is complete — although the deal will be initially dilutive. This
view is echoed by looking at the combined entity’s EV/Sales multiple, which, at
0.9 times, suggests potential for SUNW to trade into the $3.9 to $4.1 range. (In
my technical thoughts yesterday, I believed a close above $4 might make me more
comfy owning SUNW.) The risk to this is post-merger integration not going
smoothly. All things considered, I’d consider SUNW to have an unfavorable risk /
reward. Not saying the SUNW stock price won’t go up — it might; just I’d prefer
to put my money to work elsewhere.

 

Long-term, Sun’s
problems also present an unfavorable risk / reward. For my part, I’m not
planning on owning it in the hope of buying some new Manolo Blahnik’s with the
profits. Risks include: losing HP as a customer; Sun’s business model, which can
limit its longer-term development and confine it to being a niche player; slow
growth in Sun’s core businesses; continued revenue and operating pressures at
the combined entity, and the competitive environment, which remains tough. 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.

 

Melanie
Hollands

melaniehollands@yahoo.com