Can Oracle really generate a $1.5B profit from Sun?

My analysis leads me to question Oracle's target of generating over $1.5B in operating profit from Sun in the first year after the acquisition

This post is not a commentary on the impact of Oracle's profit target for Sun on Sun and Oracle employees. I don't want to make light of any potential cuts that may result. I simply want to understand what it will take for Oracle to hit the $1.5B profit target for Sun:

"We estimate that the acquired business will contribute over $1.5 billion to Oracle's non-GAAP operating profit in the first year, increasing to over $2 billion in the second year. This would make the Sun acquisition more profitable in per share contribution in the first year than we had planned for the acquisitions of BEA, PeopleSoft, and Siebel combined," said Oracle President Safra Catz.

[ For all news related to the acquisition, visit InfoWorld's special report: Oracle buys Sun for $7.4 billion ]

I started with Sun's fiscal 2009 results. Revenue from the first two quarters of fiscal 2009 is currently available. Going back to fiscal 2008, Sun's revenue appears to be fairly consistent, at approximately 25 percent per quarter (see page 92 of 172). I assumed we could double the first half of fiscal 2009 results to get a full-year fiscal 2009 view. You can see this in the "Est. Full Year @ Run Rate" column. Next, I estimated "Sun's Yr 1 as part of ORCL" column based on the assumptions below.

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First, I assumed that product and services revenue would decline 12 percent and 4 percent, respectively, in the first year. These figures are the reported year-to-year declines for Sun's product and service revenue in the first half of fiscal 2009 versus first half of fiscal 2008.

Second, I estimated that Sun/Oracle will be able to reduce the cost of goods sold. I assumed that a 10 percent decline in "Cost of sales-products" would be doable as Sun/Oracle could squeeze their manufacturing suppliers. Next, I estimated a 10 percent decline in "Cost of sales-services." I assumed that Oracle would leverage its current maintenance and support teams to help curtail costs. However, since software accounts for less than 15 percent of Sun's revenues, one could argue that Oracle doesn't have the skills to provide the support and services to Sun's systems products. For perspective, Sun decreased its cost of products sold by 3 percent and its cost of services sold by 1.2 percent from fiscal 2007 to fiscal 2008. My estimates are significantly higher. However, Sun has been in cost cutting mode this year, and I expect Oracle to continue the effort.

Next, I assumed restructuring costs would remain flat at $570 million for the full year.

Now, let's consider Sun's R&D budget. Yes, Sun's software portfolio overlaps with Oracle's portfolio. The extreme argument is that Oracle will reduce the majority of Sun's software-related R&D. However, Sun's software revenue is estimated at less than 15 percent of overall revenue. So if R&D spending is aligned with revenue, a maximum of 15 percent of Sun's R&D would be at risk of being cut. I estimate a 20 percent reduction spread 5 to 10 percent in the software division and 10 to 15 percent in the hardware division.

The final operating expense category is "Selling, general & administrative."

If we use the above estimates, then the Sun "division" would report an approximate $800 million operating loss in its first year with Oracle. Since negative $800 million is not equal to $1.5 billion profit, Oracle will look for SG&A cost reduction from Sun.

A 63 percent reduction in SG&A:
Working backward with a $1.5B operating profit as the goal and the above assumption, I calculate that a 63 percent reduction in SG&A would be required. Wow. That is a big number, representing more than $2.3B in cost reductions. It's hard to imagine this large a reduction in just one year. Yes, there is overlap in SG&A functions between Sun and Oracle. But 60-odd percent overlap? I find that hard to believe. Maybe Oracle will reduce Sun's advertising budget, curtail JavaOne spending or CHQ-level roles like strategy teams. But these are minor elements of a multi-billion-dollar expense.

If 85 percent of Sun's revenue and approximately the same level of SG&A spending is linked to Sun's hardware business, can Oracle really find 63 percent of overlap or reduction in SG&A spending? Oracle doesn't have any hardware-related SG&A spending today. So where will the cost efficiencies of this magnitude come from? At an extreme, one could argue that Oracle will reduce software-related SG&A spending. But this is closer to 15 percent of SG&A than 63 percent of SG&A spending.

For completeness, if Oracle can maintain flat Sun revenue, versus a 12 percent and 4 percent decline in product and service sales, a 33 percent reduction in SG&A would be required to meet the $1.5B operating profit target. Yes, 33 percent is more realistic than 63 percent. But even a 33 percent reduction is difficult to see considering that approximately 85 percent of the current SG&A spending is linked to business lines that don't overlap with Oracle's current spending or staffing.

What do you think? Is the $1.5B Sun operating profit target achievable?

Follow me on Twitter at: SavioRodrigues

p.s.: I should state: "The postings on this site are my own and don't necessarily represent IBM's positions, strategies, or opinions."

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