What Oracle sees in Sun Microsystems

Over the past 13 years, Sun Microsystems' Java language has become one of the computer industry's best known brands, and under appreciated assets.

The tension wasn't lost on Sun's new owner, Oracle, which on Apr. 20 said it will purchase Silicon Valley pioneer Sun for $7.4 billion in cash. If Oracle has its way, Java will emerge not only as a strong revenue source but also a key component of plans to keep customers loyal for years to come.

During a conference call with analysts on Apr. 20, Oracle CEO Larry Ellison called Java "the single most important software asset we have ever acquired." It's a bold statement from a chief executive who has spent in excess of $40 billion to buy more than 50 software companies since 2005.

Powering PCs and Cell Phones

Ellison is willing to make that call because the Java programming language, widely used to write much of the world's business software, is a key ingredient in Oracle's recipe for ensuring the many products it has already acquired work smoothly together. Java also runs on 800 million PCs and 2.1 billion mobile phones. PC makers and cell-phone vendors, including Nokia, pay royalties to license the software.

"When you look at those numbers, they're enormous," Citigroup analyst Brent Thill says of Java's potential. "Oracle looks at this and says, 'This could be a $1 billion business.' Yet Java supplied just $220 million of Sun's $13.9 billion in 2008 revenue. "Java is the most valuable brand in software that has no value," says Joshua Greenbaum, principal of industry analysis firm Enterprise Applications Consulting.

Oracle hopes to wring value from the deal in part by cutting costs to make Sun's hardware and software businesses profitable. Oracle also wants to sell Sun's Solaris operating system and servers in tandem with its market-leading database software. Citigroup's Thill estimates Oracle could cut between 40% and 70% of Sun's roughly 33,000 employees. Excluding restructuring costs, Oracle expects Sun to add $1.5 billion in profit during the first year after the acquisition closes this summer, and another $2 billion the following year. Oracle executives declined to say how many jobs would be eliminated.

Buying Sun gives Oracle access to popular software it can wield against its competitors. In addition to Java, Oracle gains Solaris, widely used in industries including telecom and finance. Oracle also picks up the MySQL database, which is available free under an open-source licensing arrangement, and could help Oracle check sales of Microsoft's SQL Server database to smaller companies. "Sun is not a well-managed company," says one industry executive familiar with its business. "But it does have assets that can become lethal weapons for the one owning them."

Little Hardware Experience

But to gain those assets, Oracle also has to take on a hardware business, something it has little experience running. Ellison will have to make a success of Sun's server business, which has been losing money. Oracle has made its own forays into the hardware business, striking a deal with Hewlett-Packard last year to produce servers designed to provide a performance boost to Oracle databases that run on them.

Oracle executives suggested during the conference call that they could sell specially tuned packages of Sun hardware and Oracle software in industries including telecom, retail, and banking.

But Oracle's 46% operating profit margins, among the industry's highest, will no doubt be squeezed by the addition of Sun's server business. "There are far more challenges here than opportunities," says James Staten, an analyst at Forrester Research. Some Wall Street and industry analysts suggested Oracle sell Sun's hardware business to help pay for the software with more long-term value.

In that regard, Java could be a trump card for Ellison. For one, Oracle can throw its large and effective sales force at Java, and contracts with Nokia and other handset vendors are coming due for renewal, says one source close to Oracle.

A Counterweight to Microsoft

Second, Java is key to a set of Oracle business applications called Fusion, designed to stitch together the array of programs Oracle has scooped up through its acquisition binge. Controlling the software in house could help Oracle assure customers of a smooth transition from older products to new ones. And owning Java gives Oracle a counterweight to Microsoft as it tries to convince more developers to incorporate its database, middleware, and other software into their products.

Oracle is expected to generate more than half of its estimated $23.1 billion in 2009 sales from technical support and "maintenance" of products its customers have already licensed. Those support contracts carry profit margins of about 90%. Controlling Java "is all about future maintenance streams," says Citigroup's Thill. "This will create stickier lock-in for the Oracle installed base."

One company that notably held its fire about the Oracle-Sun deal is IBM, which also heavily relies on Java. Oracle's bid for Sun edged out IBM's $7 billion offer, which fell apart earlier this month. While Oracle could use the acquisition to make it harder for Big Blue to develop software using Java, a person close to IBM says Oracle would be better served using Java as a bulwark against Microsoft, whose .Net technology competes with Java. "Both IBM and Oracle need, more than anything else, a healthy Java market," says consultant Greenbaum. Now that IBM has taken a pass, Java's fate lies largely in Oracle's hands.