Oracle buys Sun, what should Oracle do?

Oracle: Why pay dividend &
How to Finance the Acquisition of Sun

By:Eric Li

Evening MBA 09

UNC Kenan-Flagler Business School

Oracle Sun Merger 0 Eric Li

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.


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


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

4/19/09
Abnormal
4/18/09 return
Announcem 12.78%
ent of
dividend

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

1st Dividend payout

Announcement of
dividend

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


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
Operating Profit before Depreciation
Accumulated Depreciation & Depletion 1,952.00 (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
Total Income Avail for Interest
Liabilities 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. & Operating Profit before Depreciation
Equip.) 4,788.00 (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
Total Income Avail for Interest
Deferred Revenues 2,190.00 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?

More Related Content

Viewers also liked

Oracle buys Sun, what should Oracle do?