Five reasons Sun won't be acquired

Sun Microsystems last week launched its second major restructuring for the year--with good reason.

The company posted a sizable $1.68 billion net loss in its fiscal first quarter last month, amid a 7 percent decline in revenue, as its traditional business of high- to midrange servers running on Sparc processors took a hit. Add to that a steep sell-off of its stock over the past 12 months, falling from about $25 a share earlier in the year to close at $3.02 a share on Friday.

For the embattled tech titan that's lost its allure over the years, a dramatic restructuring is virtually the only option to make good for Sun's investors--given prospective buyers aren't around, say some investment bankers and private equity players.

Here are five reasons why Sun won't be acquired, even if its stock is trading at dramatically low prices:

1. Market turmoil and tightening credit markets dish up a double whammy for Sun.

Prospective buyers hoping to use their stock as currency to buy Sun are facing a market that is dramatically undermining the value of that currency. As a result, that leaves prospective buyers with the prospect of using cash--a precious commodity in light of the credit crunch that has enveloped corporate America and beyond.

2. Sun's parts aren't greater than its whole.

The company's software offerings have yet to offset the losses on its traditional business lines, even though it's banking on open source as paving the way to profitability for the company and its high-end Sparc servers. Products from the StorageTek acquisition and legacy storage products are rather long-in-the tooth, said one major private equity player.

And this source noted that any likely buyer that would snap up various parts of Sun (like IBM, Hewlett-Packard, EMC, and Microsoft) is already in the market and taking share. That begs the question of why it would want to buy its competitor's business units when it's already making progress in the market.

Nonetheless, it could still be an attractive proposition. Analyst Toni Sacconaghi of Sanford C. Bernstein said in a research note last week:

We believe a controlling shareholder could also realize meaningful value by selectively selling, harvesting, or growing specific business lines within Sun. We believe such a strategy could drive $7 to $8 per share or more in value, though the value-creation potential is difficult to quantify precisely.

He pointed to Sun's MySQL, Java, and other software assets as potential sale items, as well as letting some of its slow-growth lines of business--such as its high-end Sparc servers, StorageTek, and legacy storage products--die a slow death by scaling back research and development investments, direct sales teams, and support.

Sacconaghi, however, notes such a strategy carries some risks:

The harvest opportunity at Sun carries significant risks for shareholders, however, including uncertainty around what buyers would pay for Sun's assets (and indeed, if any buyers can even be found) and the risk that public equity investors will not ascribe appropriate value to a declining business. Given this, and the relatively limited upside potential available, we continue to believe aggressive cost-cutting is the most viable strategy for Sun to regain profitability.

3. Lack of debt financing makes so-called leveraged buyout companies, which have had turnaround successes with tech companies such as Seagate Technology, a tough go to take the company private.

"There is no debt financing available today, which makes LBOs (leveraged buyouts) a nonstarter in every category, not just tech," Roger McNamee, a managing director with private equity firm Elevation Partners, said in an e-mail interview.

He added it will take both availability of money and a significant easing of rules that regulate LBOs, before there is a sizable increase in the number of technology buyouts. As a result, McNamee does not expect to see any transactions this year involving companies going private.

McNamee added there were a fair number of private equity transactions in tech over the past five years, since the Seagate IPO, but most were transactions where most of the return came from leverage and cost cutting, rather than growth.

"My view is that the better way to do private equity in technology is acquire a large stake and partner with management to transform the company," McNamee noted. "Being public creates hassles during the transformation, but at least you don't have to worry about getting public again."

4. Lack of earnings growth potential and company mismanagement.

A management-led leverage buyout with support from private equity players is not a likely option for Sun, even when the choke hold on debt financing lessens, said another source, who comes from a major private equity firm.

Sun's problems are multifaceted--an inability to deliver a successful strategy, an ineffective management team in CEO Jonathan Schwartz and founder Chairman Scott McNealy, and a lack in its ability to execute, said this private equity source.

As a result, cheap stock or not, it would take demonstrated earnings growth potential to seal a deal.

And one investment banker noted: "They have a great installed base, but their lack of product innovation is hurting them. They need to solve their product position first, otherwise it's like catching a falling knife."

5. There are other investor concerns.

Last May, Southeastern Asset Management, an investor that seeks out downtrodden stocks that show potential, took a 10 percent stake in the company and steadily increased its position through the fall to 21.2 percent.

But late last month, it became apparent this investor was not a happy camper. In a filing with the Securities and Exchange Commission, Southeastern Asset Management went from being a passive investor to an active one, in which it wants the flexibility to hold talks with Sun's management and also third parties.

Southeastern has previously declined to comment on its investments in Sun.

And KKR Private Equity Investors, which last year invested $700 million in the company in exchange for two interest-bearing senior notes, will likely want its principle paid back in cash and not Sun stock, when the notes come due in 2012 and 2014.

Sun's shares are currently trading substantially below the $7.21 a share value that would be assigned to its stock if KKR wanted its $700 million principle in Sun shares and not cash.

KKR declined to comment on its Sun investment, but one private equity investor noted Sun's shares are underwater in relation to the $7.21 a share price. So it makes more sense for KKR to take the money, rather than to become a sizable equity holder in the company.

Sun was not immediately available for comment.

Sun also may be less attractive to private equity players because its $2.6 billion in cash and short-term securities is not as sizable as it may seem. When adding in the $700 million in senior debt that Sun will likely have to pay out in cash, that reduces its net cash and short-term securities by roughly a third.

As a result of these factors, a white knight buyer is unlikely to appear on the horizon anytime soon, despite Sun's cheap stock price, which is down 85 percent from its 52-week high, and substantially lower value in comparison to its competitors IBM, HP, and Microsoft.

It's a "screaming deal," said the investment banker. That is, if you don't look at all those other factors.