“It’s all about tech today Oracle saying that business is picking up, up 5% and expects European Regulators to say go ahead and buy Sun Microsystems.” — CNBC’s Squawk on the Street 12/18/2009

Technology giant Oracle Corp. (ORCL) reported earnings on Thursday night that topped analysts’ predictions on both the top and bottom line.  Revenue was expected to grow moderately over the period a year ago, but thanks to improved sales to U.S. businesses revenue grew 3.3%.  Net income rose 13% to $1.46 billion, and when excluding one-time costs earnings per share came in at $.39, three cents better than analysts had expected. 

The takeaway from the quarterly report is that enterprise IT spending may finally be returning to more normal levels after some tough years.  Many of Oracle’s customers are also large corporations and as the global economy has been sluggish, these firms have been very reluctant to spend on IT.  Oracle expects new software licenses to grow by -1% to 9% in the current quarter.  Management guided for earnings per share to come in at $.36 to $.38, which makes consensus estimates of $.36 look conservative.  Shares of Oracle are trading more than 6% higher on extremely heavy volume on Friday morning, and although it has cooled since, early in the morning Oracle hit its highest price since early 2001.

Oracle management says that they believe the European Union Regulators are warming to the proposed $7.4 billion merger with Sun Microsystems (JAVA) after months of scrutiny.  U.S. authorities have already signed off on the deal, and the EU remains as the final hurdle.  The deal would make Oracle one of the dominant players in both its traditional software business but also in the hardware/server business.  Oracle is a serial acquirer scooping up more than 60 firms in the last five years, and in most cases the company is able to integrate the new companies into the fold with relative ease.  CEO Larry Ellison said that he hopes the deal will close in the next quarter, and when it does he wants to focus on the high performance end of the server market.

Even as the stock is hitting new multi-year highs, we continue to see Oracle as Undervalued.  This stock has normally traded for a price-to-sales per share range of 4.9x to 7.8x, and the current multiple is only 4.1x.  Similarly, price-to-cash earnings we have observed the stock normal trades between 16.5x and 26.5x, but it is currently well below that range at 15x.  The company is showing the market encouraging signs of the return to corporate software spending, and we are confident in management’s vision for the company going forward including the acquisition of Sun.

Oracle (ORCL) has been very active in the mergers and acquisitions market for some time now.  However, most of Oracle’s recent acquisitions have been smaller, often private, tech companies that they can buy at very distressed prices, as we wrote about back in February (Oracle Looks Downright Visionary).  In a surprise announcement, Oracle reported that they will in fact buy Sun Microsystems (JAVA) for around $7.4 billion.  Sun was in advanced talks with IBM (IBM) that fell apart only days ago.  The deal is valued at $9.50 per share which is a dime more than IBM had offered for Sun.

The new merger with Sun will give Oracle a presence in the hardware business, as Sun was the fourth largest player in the server market and the second largest in the high end server market.  An Oracle spokesman said the company expects the acquisition to bring in at least an additional 15 cents per share for the first full year after integration.  While 15 cents per share does not sound all that impressive, it would be more profitable after one year than Oracle’s previous major acquisitions of BEA, PeopleSoft and Siebel combined in their first year.  The deal has the additional bonus of likely hitting less resistance from regulators because the companies do not have as many overlapping product lines as did IBM and Sun.

Interestingly, among the crowd of those cheering the merger is one major competitor’s CEO.  Steve Ballmer of Microsoft (MSFT) had caught some headlines when referring to the proposed merger of Sun and IBM earlier in the month saying,

“You pick up a lot of stuff when you buy Sun.  [A deal] gives [IBM] a year or two where all they’re doing is digesting it. I relish that year.”

When Ballmer was told of the new arrangement that pits Oracle with Sun instead of IBM, he said he will need to “think about it” but its doubtful he has changed his stance on the challenges that come with integration of a company like Sun.  There is no doubt he will be selling that line in order to try and gain market share from the newly merged entity.  However, it is worth remembering that Oracle is not new to taking companies under its wing with an average of one acquisition each month for the last 4 years.  Most of these acquisitions were far smaller than Sun, but at least the company has experience with integration.  Oracle has been nibbling at smaller tech companies and now they have bitten off a major project. 

Time will tell whether Ballmer was correct or just getting a jump on the public relations battle.  For now our take is that these two complementary businesses, with long time friends in Oracle’s CEO Larry Ellison and Sun’s Chairman Scott McNealy, will have its challenges but in general its a great fit.

News reports today are saying that talks between Sun Microsystems (JAVA) and IBM (IBM) have broken down, supposedly not over price.  According to the Wall Street Journal, talks broke down when the Sun board rejected the formal acquisition offer from IBM and sent notice that they had terminated the exclusivity of talks only with IBM.  Apparently the Sun board is split over whether to do the deal with the company’s Chief Executive wanting to do the deal, but the company’s co-founder and chairman Scott McNealy is opposed.

While price is certainly a concern of both parties, it seems that there is a difference of opinion on how hard IBM would be willing to push were the deal to face regulatory challenges.  IBM states that they are fully committed to the deal, but Sun believes there was too much wiggle room for IBM to drop the deal if needed.  This may be a very valid concern for Sun that they do not want to be left without a dance partner if the deal does face push back, but Sun needs to be very careful about how they play the situation.  Should they turn negotiations into a confrontation, they may find themselves a stand alone business with no one interested in buying them. 

Sun’s decline has been well documented and they began shopping themselves around last winter.  Sun management needs to think long and hard before it leaves a deal on the table that would pay a 100% premium to the pre acquisition price.  Perhaps IBM rival Hewlett-Packard (HPQ) could be interested but there has been nothing more than rumor to support that.  After all, IBM was the only company that stepped to the plate when Sun began shopping itself around.

“Sun down 25% but up more than 100% year to date. There’s been a lot of talk on the street that if it’s not going to be IBM, who is going to buy Sun Microsystems? It is the number one target in the tech industry right now.” Fox Business Network 4/6/2009

Not surprisingly, Sun stock tanked 22.5% on Monday.  After having an Undervalued stance on Sun for more than a year, we are reaffirming our Fairly Valued valuation on post merger announcement price levels.  Fundamentally, Sun has been able to grow revenues steadily over the past few years but the company swung to a loss last summer.  The fact remains, that Sun Micro needs IBM far more than IBM needs Sun.  At this point the talks are “fluid” but it seems that IBM has all of the power in this situation.  We do not know exactly what has been going on in negotiations but Sun management should tread carefully because there will be a lot of angry shareholders should the deal eventually die.

“The Wall Street Journal beginning to offer more details of an acquisition of Sun by IBM. Now saying that the deal could be valued at between $10 and $11 per share. That would be the $6.5 billion IBM would be offering in addition to the $1.4 billion in cash that sun has on its balance sheet.  More importantly, this deal is expected to be announced this again, according to the Journal, that it would represent a 125% premium over Sun’s trading price earlier on Monday.

This would be a sizable deal. Some are speculating that IBM’s action with Sun is in direct response to Cisco’s entry into the server business announced earlier this week, but everybody I am talking to says that Cisco is not the real target here. This is all about Hewlett-Packard. Cisco going after HP, IBM now going after HP. HP has a lot of new headaches on its hands as far as competition…

I say 125% premium, I can’t help but think back to when Sun was a lot higher than 8 bucks. I’ll tell you what, down here or at least on the trading desks I have talked to, they love this deal, and a lot of deals they think don’t make sense. This makes strategic sense, IBM and Sun are essentially in similar businesses. Sun, of course, is huge in the server business. Huge in the software business in and the street seems to really like it…”

Much of the news today, is surrounding a possible deal between IBM (IBM) and Sun Microsystems (JAVA).  As the caption from CNBC’s reporting suggests, this deal is eliciting a lot of positive feedback from traders.  The motive behind the deal is clearly to better compete with Hewlett-Packard (HPQ).  IBM’s bread and butter is the services business, which brings in more than 50% of revenues and generally has high profit margins.  HP went directly after this revenue source when it went acquired EDS last year, and thus far the results have been mostly positive.  In this case, it seems that IBM is looking to grab some hardware market share away from HP, especially in the area of servers, which is one of Sun’s strengths at about 30% of their revenue. 

Readers will remember that IBM largely got out of the hardware business some time ago as it has much lower profit margins.  This move could represent a shift in strategy back into the hardware business.  Sun also has substantial revenue streams outside of servers in network computing systems, data management and other services.  However, revenue had begun to plateau in that last couple of years and is expected to decline this year.  Sun has also struggled to be consistently profitable and estimates call for them to lose 34 cents in 2009 and make just 9 cents in 2010.  So, the question we have is, does the company command a 100% mark-up from what the market believes it is worth?

In the short term, Sun may not justify such a premium; IBM might have been able to acquire Sun for less.  However, over the long term, this deal could be a winner for IBM, as it gives them a stronger footing in server hardware and some software solutions.  Of course, time will tell and there are many things that remain to be seen, such as how corporate cultures will mesh at the straight laced IBM and somewhat more freewheeling Sun.  By most accounts though, this deal is worth doing for both companies.

This morning Hewlett Packard (HPQ) offered preliminary results for the company’s fourth quarter that ended in October. HP expects to report net income of $1.03 per share on revenue of $33.6 billion, with $.19 of earnings coming from the acquisition of Electronic Data Systems. These results beat Thomson-Reuters First Call estimates of $1.00 per share on revenue of $33.09 billion. As the global economy entered what appears to be a worldwide recession, HP grew sales by 19% year-over-year. Other perennial tech leaders such as Cisco (CSCO), Sun (JAVA), Dell (DELL), and Intel (INTC) have warned of an increasingly difficult operating environment going forward because of slowing IT spending, but HP seems to have thus far remained above the fray. The company will officially report results next Monday November 24^th, but this news was just too good to keep secret.

HP should be very proud of its continued success in a brutal economy, but the company did not stop there.  HP offered upbeat guidance for the year ahead, continuing to project per share earnings of $3.88-$4.03 versus First Call’s estimate of $3.85 for the upcoming fiscal year ending October 2009. It is certainly refreshing to see a tech company both having success in the current environment and remaining confident of its future earnings prospects. Most other tech companies are being defensive and just trying to maintain sales and earnings; HP is not satisfied with stasis and believes that it has the ability to outperform its peers in a rough climate. Thus far in Tuesday’s trading its bullishness is contagious and HPQ is trading nearly 11% higher than yesterday’s close.

Time will tell if HP is out over its skies, but for right now it is breath of fresh air for a company to be realistically optimistic. The technology sector has been particularly affected by the market drop, especially in October. Year to date, the S&P 500’s technology component is down close to 50% and Bloomberg’s IT tracking index has fallen to below 12 times earnings, the lowest level since Bloomberg began tracking the sector more than 13 years ago. We at Ockham Research upgraded HPQ following the massive losses in October because the stock was still fundamentally strong but those fundamentals are supporting a much reduced price (down 37% since the start of October). The stock is also cheap compared to what the market has traditionally been willing to pay for given levels of sales and cash flow. For example, HPQ over the last 10 years has sold for .72x to 1.23x revenue per share, but the current price-to-sales is well below that normal range at .65x. Price-to-cash flow is an even wider difference, as the historically normal range is 10.05x to 18.37x but it’s currently only 5.65x.

HP has shown strength while its competitors are flailing. Sales continue to grow and the acquisition of EDS has started to boost its bottom line. Management continues to cut costs, especially in workforce redundancies from the EDS purchase. What’s more, the company is cash rich, which is a highly sought after attribute right now. We are maintaining our Greatly Undervalued rating for HPQ as it is the class of the technology sector. HP’s Chairman and CEO Mark Hurd said it this way,

“Our ability to execute in a challenging marketplace differentiates HP, enabling it to increase share, expand earnings and emerge from the current economic environment as a stronger force.”