oracle buys sun, what should oracle do?

Oracle Sun Merger 0 Eric Li

Oracle: Why pay dividend &

How to Finance the Acquisition of Sun

By:Eric Li

Evening MBA 09

UNC Kenan-Flagler Business School


Introduction:

Oracle Corporation is a firm specializes in developing and marketing enterprise software

products — particularly database management systems. Through organic growth and a

number of high-profile acquisitions, Oracle enlarged its share of the software market. On

March 18, 2009, Oracle announced it will pay dividend to its shareholders. It was its 1st

dividend after the company went public1. On April 20, Oracle announced it will acquire

Sun Microsystems, paying cash $7.4B. Sun Microsystems is a firm providing standards-

based computing infrastructure, including enterprise computing systems, software and

storage. Until end of May, this merger is still in process. In this paper I look into these

two events. I observed the details of Oracle’s dividend announcement and how Oracle

managers utilize dividend to build investor’s confidence before the merger. I also view

the acquisition event as a project of Oracle, using theory and principles of Corporate

Finance. I’ll evaluate how this merger affects the equity value of Oracle, and how Oracle

should finance this acquisition project.

Investors worried; what should Oracle Managers build their confident?

Traditionally Oracle is a 100% software company. It has no experience managing

hardware or Software-hardware integrated solutions like Sun. Acquiring Sun will put

Oracle share holders worrying about Oracle’s future profitability2. Oracle management

needs to communicate with investors about its profit-making capabilities and get

market’s attention about its finance performances. In my opinion, giving dividend payout

is one of the tricks that managers trying to get buy-in from shareholders before the

merger was announced.

1st Dividend announcement and payout

March 18th, Oracle announced its 1st dividend of 5 cents per share, or 20 cents annually

to its share holders. The first payout of 5 cents will happen on April 6, the ex-dividend

day. At the announcement date 3/18, Oracle stock went up from $15.83 the previous date


closing price, to $17.37. Normalizing with S&P 500 as a normal return rate, the

“abnormal return” of the 1st day for this dividend accouchement is 12.78%, far higher

than the industry average of 4.7%. See Exhibit 1 for the chart for this abnormal return. In

“Perfect capital market” dividend policy is the cash out of company’s profit. Investors

should not expect any abnormal return, and the price difference of cum-dividend and ex-

dividend should be the exact dividend amount. Apparently in this situation, Oracle’s

investors view dividend as extra money the company pays to investors. 20 cents of

annual dividend will transfer to present value of $0.2/0.05 = $4. The stock price raised

almost $4 to $19.29 cum-dividend price before the dividend day. The Ex-dividend price

on April 6th is $19.11. Dropping of 18 cents, is much more than 5 cents, the dividend

amount. Much of this drop due to market fluctuation at that day. Exhibit 2 shows Oracle

stock has consistently outperformed Nasdaq by 10% after the dividend announcement,

even after the 1st dividend payout of 5 cents. If Oracle manager’s purpose of paying

dividend is to jack up shareholder’s confident, it really works!

Sun Microsystems on sale

Recent economic recession has put Sun Microsystems in a difficult situation. It faced a

net loss of $200m at the quarter ends in Dec 08. In November 08, Sun has been seeking

buyers to sell its business. Stock price for Sun was about $3 per share in November.

Potential buyers included HP, IBM, Dell, Cisco and Fujitsu3. At mid of May 2009,

Fujitsu and IBM were on the final list of buyers. It seemed that IBM will strike the deal

with Sun any time. Sun investors were exited about that deal so the stock price rallied up

to $6-$8. Until the day before the Oracle-Sun deal was announced, the Industry still

believed IBM will buy Sun. Sun’s stock price closed at $6.69, and Oracle’s $19.05 on

Friday April 17.

On Monday morning April 20th, both Oracle and Sun announced4 the deal of Oracle

acquiring Sun with $7.4B, or $9.50 per share paying in Cash. In business M&A

situations, paying cash usually means managers of the Acquiring company i.e., Oracle,

thinks its own stock performed worse in the market than it should be. (Otherwise it will


pay by shares). Oracle stock price should rise and Suns’ price should drop. I cannot see

this pay-in-cash effect. Oracle’s price is closed at $18.82 (dropped 23 cents or 1.2%) and

Sun’s at $9.15 (jumped 37%) at the merger announcement day. As a matter of fact, Sun’s

stock price has outperformed 40% against Nasdaq, and Oracle is 5% below Nasdaq after

April 17th. See Exhibit 3 for performance chart for details. If this deal have been by

exchange of stock, Oracle’s stock price would have been hurt even worse. The main

reason of Oracle underperform, and Sun over perform, is because Sun’s investor don’t

have to worry about Sun’s potential bankruptcy or uncertainty of Sun’s future. On the

other hand, Oracle’s shareholders worrying about Oracle taking over a money looser, and

whether Oracle has capability of running Sun’s business.

How should Oracle finance this $7.4B to buy Sun?

Oracle has several options to finance these $7.4B to buy Sun. Oracle has $8.2B cash

sitting on the balance sheet on Feb 09. Oracle can use the Cash (Option 1), Issue new

stock (Option 2) or Oracle can Borrow more (Option 3). Looking at cost of capital for

both companies (Exhibit 4 for WACC calculations), Sun is an all-equity firm but runs a

riskier business. The WACC for Sun is 16.4%, higher than Oracle’s WACC 10.25%.

The NPV of acquiring is $0.79B according to my calculation. (Exhibit 5 )

Option 1, Use Internal Equity, using Cash

Let’s look at internal Equity financing first. It has $8.2B cash and $10.5B retained

earnings as the balance sheet on Feb 09, just before the dividend payout. Paying dividend

will cost Oracle 1B per year. Oracle may have just enough cash to buy Sun that will leave

zero cash after acquisition.

Value of Equity = 0 + ($92.94+$8.19) = $101.3B

Option 2, Use External Equity, Issue New Stock

In perfect capital market, the result of equity value for issuing new stock will be the same

as internal equity. Assume the stock price would change to undermine the current

$92.94B equity value. Share holders can keep the cost of Sun $7.4B for future dividend.


Existing share holders will keep 100% - 7.317% = 92.683%

Value of Equity = $7.4 + ($92.94+$8.19) * 92.683% = $101.3B

However, in the real world, the market value of equity is not equal to the manager’s

estimate, situations are different. Exhibit 6 shows two scenarios of insider’s view. In the

case of Bearish managers, Oracle’s equity value = $61.89B and for Bullish managers,

Oracle’s equity value = $130.65B. Outsiders do not have this information.

• For Bullish managers: E=130.65B

Current market value of $92.94B looks too low to issue new stocks. If they do, they’ll

loose money:

If they cancel this acquisition,

Value of Equity for insiders = $7.4 + $130.65 = $138.05B

If they go ahead and issue the stock,

Value of Equity for insiders = $7.4 + ($130.65+$8.19)* 92.683% = $136.08B

Loss of acquiring Sun, and issuing stock = 136.08-138.05= -$1.97B

Loss of $1.97B = NPV of acquisition + Loss of issuing under-valued equities

= $0.79 + 7.317% * (92.94-130.65)

• For Bearish Managers: E=61.89B

Current market value of $92.94B looks attractive to issue new stocks. If they go ahead,

Value of Equity for insiders = $7.4 + ($61.89+$8.19)* 92.683% = $72.35B

If they cancel this acquisition,

Value of Equity for insiders = $7.4 + $61.89 = $69.29B

Gain from acquiring Sun, and issuing stock = 72.35-69.29= $3.06B

Gain $3.06B = NPV of acquisition + benefit of over-valued equities

= $0.79 + 7.317% * (92.94-61.89)

From above calculations, we know if Managers decide to issue equity, outsiders would

know Oracle is the “Bearish managers” case. The market will for sure punish Oracle’s

Amount Raised $7.4B = = 7.317% Maket Value ($92.94+$8.19)


stock price by dumping its stock. Since managers decided to pay cash in the 1st place to

signal to the market that they thought Oracle’s stock was undervalued, they should keep

the signal consistent. At current situation, when Oracle investors don’t like the merging

of Sun, issuing stock is not a good decision.

Option 3, Leverage Up, Borrow more

Current return on assets for Oracle is 10.25% and for Sun is 16.4%. Although Oracle can

borrow at 5% today, it doesn’t mean it can borrow at this rate because Sun’s asset is

riskier. Assume Oracle can borrow the new debt at grade A bond rate =6.4%, Oracle can

lower its WACC compared to equity financing. Exhibit 7 shows the difference in capital

structure for Equity finance and Debt finance, and WACC for these 2 cases. Using equity,

the new company will have a WACC of 10.70% (which is higher than current Oracle

WACC). By increasing leverage, thanks to the lower debt rate, WACC can be lowered to

10.18%. The cost of Equity for Equity financing will be raised to 11.43%, while Debt

option is 11.04%.

Another benefit for debt is the tax shield. Oracle today has Debt/Equity Ratio 1:9. The

Current EBT is too high, implying Oracle doesn’t take as much as tax shield as it should.

By leveraging up, Oracle can benefit from lower WACC (because bank is more senior in

capital structure and thus less risky), lower cost of equity, and lower tax because of

paying more interest. In Exhibit 8 I calculated the effect of tax benefit and lower cost of

equity compared to Equity financing. After lowering tax, the net income and cashflow is

reduced. I used discounted cashflow approach to calculate the expected value of equity

for Oracle. The existing share holder’s value is raised due to lower discount rate. Added

debt and present values of acquisition, the value of the new firm (Oracle+Sun) is higher if

they use debt financing.

Conclusion

By giving out Dividend, Oracle management did a good job on rising market

expectations of Oracle stock before they announce the acquisition. Paying cash in the

acquisition deal gave the market a good signal about Oracle’s insider view about its own


stock price. This made the Oracle stock price held pretty well even in this unpopular

M&A deal. Otherwise the Oracle stock will have been worse. Outside Equity should not

be used now because it will send a weak signal to the market and will punish its stock

price. I recommend Oracle to finance this $7.4B acquisition using Debt. Using higher

leverage, Oracle can benefit from cheaper cost of capital because debt is less risky.

Interest payment can also provide tax shields that gives the firm a higher value. Share

holders will capture this value and enjoy higher growth.


Exhibit 1 ORCL Abnormal return of at announcement of dividend

Exhibit 2 ORCL performance after Dividend announced, through ex-dividend

Exhibit 3 Oracle and Sun stock performance after announcement of merger Oracle =ORCL Sun =JAVA

4/18/09 Announcement of dividend

4/19/09 Abnormal return 12.78%

Announcement of dividend

1st Dividend payout


Exhibit 4 WACC for Oracle and Sun

Company: Oracle

• Cost of Debt: 5% (using Moody’s A2 bond rating5)

• Corporate Tax rate: 30% (back calculated from Oracle’s income statement)

• Equity Beta = 1.07 (from Google Finance )

• Equity Value today = $18.65 share price * 4.983B shares = $92.93B

• Value of Debt = $10.3B (from Balance sheet)

• Risk free rate (10 year Treasury –note) = 3.45%

• Market risk Premium =7%

Cost of Debt after tax = 5% (1-30%) = 3.5%

Cost of Equity = 3.45% + 1.07 * 7% = 11%

Debt Ratio D/(D+E) = 10.3/(10.3+92.93) = 10%

Equity Ratio E/(D+E) = 92.93/(10.3+92.93) = 90%

WACC for Oracle = 3.5% * 0.1 + 11% * 0.9 = 10.25%

Company: Sun

• Equity Beta = 1.85 (from Google Finance )

• Equity Value today = $9.00 share price * 746.25M shares = $6.716B

• Sun is all Equity (from Income statement & Balance sheet), zero interest expense.

WACC for Sun = Cost of Equity = 3.45% + 1.85 * 7% = 16.4%

Exhibit 5 NPV of the Sun Acquisition project

• Cost= $7.4B Cash

• Cash flow: Oracle clams Sun can bring in 1.5B annually. I am using 1.34B from

Sun’s cash flow data of year 2008

Sun Micro (Java) Jun-08 Jun-07 Jun-06 Jun-05 Cashflow from Operations (Million) 1329 958 567 279

• Discount Rate = 16.4% using Sun’s WACC

Present Value of Cashflow = $1.34B/0.164 = $8.19B

• NPV for project = 8.19 – 7.4 = $0.79B


Exhibit 6 Insider’s view of Oracle:

Oracle (ORCL) May-08 May-07 May-06 May-05 Net Cash from Operating Activities (in Millions) 7,402.00 5,520.00 4,541.00 3,552.00

Bearish Managers:

If managers views Oracle keeps having $7.4B cash flow with no growth,

Value for Oracle will be 7.4B/0.1025 = $72.19B

Value of Equity = $72.19 - $10.3B debt = $61.89B

Bullish Managers:

If managers believe Oracle can grow 5% per year in cash flow

Value for Oracle will be 7.4B/(0.1025-0.05) = $104.95B

Value of Equity = $104.95 - $10.3B debt = $130.65B

Exhibit 7 Capital Structure Options for the new company

Option 1 and 2, Equity Financing

Option 3 Debt, Financing at grade A bond

D =10.3 5% D =10.3 5%A=103.23 10.25% A=103.23 10.25% New D=7.4 6.40% E=92.93 11% E=92.93 11%A = 8.19 16.40% NPV=0.79 16.40% A = 8.19 New E=7.4 16.40% NPV=0.79 16.40%WACC = 10.70% Re=11.43% WACC = 10.18% Re=11.04%


Exhibit 8 Tax benefit of Debt Financing

Equity Financing Debt Financing Market value Equity $18.65 Debt amount 7.4 Shares outstanding 4.983 Interst rate 10 yrs A rated bond 6.36% Market cap $92.93 Interst expense 0.47064 Income and Cashflow Effect Income and Cashflow Effect Operating Earning 8.2880 Operating Earning 8.2880 Interest Expense (existing) 0.3940 Interest Expense (existing) 0.3940 Interst expense (New Debt) 0.47064 Income Before Tax (EBT) 7.8940 EBT 7.4234 Income Taxes 30% 2.3682 Income Tax 30% 2.227008 Net income 5.5258 Net income 5.1964 Depreciation and WC adjustments 1.8742 Depreciation and WC adjustments 1.8742 Cahsflow from Operation 7.4000 Cahsflow from Operation 7.0706 Banance sheet Effect Banance sheet Effect Cost of Equity 11.43% Cost of Equity 11.04% Annual growth rate 3.47% Annual growth rate 3.47% Existing Value of Oracle Equity $92.9300 Existing Value of Oracle Equity $93.3655 Existing Debt 10.3 Existing + New Debt $17.7000 PV of Acquiring SUN 8.19 NPV of Acquiring SUN 0.79 Value of Firm Oracle+Sun $111.4200 Value of Firm Oracle+Sun $111.8555 Value of Equity, Oracle+Sun $101.1200 Value of Equity, Oracle+Sun $94.1555


Exhibit 9 Oracle Balance Sheet and Income Statement

Oracle Balance Sheet Oracle Income Statement 2009-02-28 2008 Assets Operating Revenue 22,430.00 Cash and Equivalents 8,211.00 Total Revenue 22,430.00 Marketable Securities 3,083.00 Adjustment to Revenue 0 Accounts Receivable 3,025.00 Cost of Sales 4,713.00 Receivables 3,025.00 Cost of Sales with Depreciation 4,981.00 Prepaid Expenses 657 Gross Operating Profit 17,717.00 Current Deferred Income Taxes 635 R&D 2,741.00 Total Current Assets 15,611.00 SG&A 5,487.00 Gross Fixed Assets (Plant, Prop. & Equip.) 3,866.00 Operating Profit 7,844.00

Accumulated Depreciation & Depletion 1,952.00 Operating Profit before Depreciation (EBITDA) 9,489.00

Net Fixed Assets 1,914.00 Depreciation 1,480.00 Intangibles 7,704.00 Amortization of Intangibles 1,212.00 Cost in Excess 18,642.00 Operating Income After Depreciation 8,009.00 Non-Current Deferred Income Taxes 0 Interest Income 337 Other Non-Current Assets 1,078.00 Other Income, Net 107 Total Non Current Assets 29,338.00 Income Acquired in Process R&D 0 Total Assets 44,949.00 Interest Restructuring and M&A -165

Liabilities Total Income Avail for Interest Expense (EBIT) 8,288.00

Accounts Payable 272 Interest Expense 394 Notes Payable 1,002.00 Income Before Tax (EBT) 7,894.00 Short Term Debt 0 Income Taxes 2,313.00 Accrued Liabilities 1,073.00 Minority Interest 60 Deferred Revenues 3,952.00 Preferred Securities of Subsidiary Trust 0 Current Deferred Income Taxes 0 Net Income from Continuing Operations 5,521.00 Other Current Liabilities 1,673.00 Net Income from Discontinued Ops. 0 Total Current Liabilities 7,972.00 Net Income from Total Operations 5,521.00 Long Term Debt 10,236.00 Deferred Income Taxes 942 Other Non-Current Liabilities 2,722.00 Total Non-Current Liabilities 13,900.00 Total Liabilities 21,872.00 Stockholder's Equity Common Stock Equity 23,077.00 Common Par 12,758.00 Retained Earnings 10,468.00 Other Equity Adjustments -149 Total Equity 23,077.00 Total Capitalization 33,313.00 Total Liabilities & Stock Equity 44,949.00 Additional Data Cash Flow 7,624.00 Working Capital 7,639.00 Free Cash Flow 4,591.00 Invested Capital 33,313.00 Share Data Total Common Shares Outstanding 4,983.00


Exhibit 10 Sun Balance Sheet and Income Statement

Sun Balance Sheet Sun Income Statement Q3-2009 2008 Mar-09 Jun-08 Cash and Equivalents 1,569.00 Operating Revenue 13,880.00 Marketable Securities 1,134.00 Total Revenue 13,880.00 Accounts Receivable 2,265.00 Adjustment to Revenue 0 Receivables 2,265.00 Cost of Sales 6,639.00 Raw Materials 99 Cost of Sales with Depreciation 7,425.00 Work In Progress 61 Gross Margin 6,455.00 Finished Goods 401 Gross Operating Profit 7,241.00 Inventories 561 R&D 1,834.00 Prepaid Expenses 1,036.00 SG&A 3,955.00 Current Deferred Income Taxes 185 Advertising 0 Total Current Assets 6,750.00 Operating Profit 372 Gross Fixed Assets (Plant, Prop. & Equip.) 4,788.00

Operating Profit before Depreciation (EBITDA) 1,452.00

Accumulated Depreciation & Depletion 3,118.00 Depreciation 786 Net Fixed Assets 1,670.00 Depreciation Unreconciled 0 Intangibles 357 Amortization 0 Cost in Excess 1,740.00 Amortization of Intangibles 0 Other Non-Current Assets 745 Operating Income After Depreciation 666 Total Non Current Assets 4,512.00 Interest Income 161 Total Assets 11,262.00 Earnings from Equity Interest 32 Other Income, Net 0 Accounts Payable 1,049.00 Income Acquired in Process R&D -31 Short Term Debt 562 Interest Restructuring and M&A -263 Accrued Liabilities 1,737.00 Other Special Charges 45

Deferred Revenues 2,190.00 Total Income Avail for Interest Expense (EBIT) 610

Other Current Liabilities 160 Interest Expense 0 Total Current Liabilities 5,698.00 Income Before Tax (EBT) 610 Long Term Debt 695 Income Taxes 207 Other Non-Current Liabilities 1,518.00 Minority Interest 0 Total Non-Current Liabilities 2,213.00 Preferred Securities of Subsidiary Trust 0 Total Liabilities 7,911.00 Net Income from Continuing Operations 403 Net Income from Discontinued Ops. 0 Common Stock Equity 3,351.00 Net Income from Total Operations 403 Common Par 7,541.00 Extraordinary Income/Losses 0 Retained Earnings -1,819.00 Income from Cum. Effect of Acct Chg 0 Treasury Stock -2,680.00 Income from Tax Loss Carryforward 0 Other Equity Adjustments 309 Other Gains (Losses) 0 Total Equity 3,351.00 Total Net Income 403 Total Capitalization 4,046.00 Total Liabilities & Stock Equity 11,262.00 Cash Flow -1,246.00 Working Capital 1,052.00 Free Cash Flow -77 Invested Capital 4,046.00 Shares Outstanding Common Class Only 746.25 Total Common Shares Outstanding 746.25 Treasury Shares 155


References

1 http://online.wsj.com/article/SB123740295588874689.html 2 http://www.oracle.com/sun/sun-faq.pdf 3 http://www.reuters.com/article/marketsNews/idINN0641505520081111?rpc=44 4 http://www.oracle.com/sun/index.html 5 http://www.reuters.com/article/bondsNews/idUSN2143121820070321

oracle buys sun, what should oracle do?

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