Sun Can't Buy Cutting Edge

Sun Microsystems(SUNW Quote) has tapped its piggy bank to buy a company with a huge installed base and a steady stream of recurring revenue -- and a core technology that has seen better days.

Sun and StorageTek(STK Quote) are billing their $4.1 billion cash combination as a way to match Storage Technology's tape backup products with Sun's high-end server and storage lines.

Because StorageTek has about $1 billion in cash on the books, the acquisition will actually cost Sun $3.1 billion. That will reduce its reserve by 42% and likely end speculation that CEO Scott McNealy is planning to take his company private or to agree to a huge share buyback. (Sun had $7.4 billion in cash and marketable debt securities on hand at the end of the March quarter.)

In the short run, StorageTek will certainly give Sun a quick revenue infusion. Last year, StorageTek earned $191 million, or $1.75 a share, on sales of $2.2 billion, including $917 million in service revenue. Sun sees the transaction as adding to non-GAAP earnings in the first 12 months after closing, which is expected to occur in the late summer or early fall.

It's worth noting, however, that StorageTek's top line has been growing very slowly, increasing by just 8% since 2000 and 1.9% since 2003. The reason isn't hard to fathom: Tape backup is an old technology that is likely to be slowly phased out as faster, disk-based solutions come down in price. And that worries some on Wall Street. Sun shares had recently fallen 13 cents, or 3.3%, to $3.77, in Thursday trading.

"We question why Sun would buy a slow-growth tape company, instead of a more rapidly growing software company, particularly since Sun's management has not been aggressive on cutting costs to drive EPS," wrote Bank of America analyst Keith Bachman. "The opportunity cost of $3 billion to buy STK seems high to us." BofA has done investment banking for Sun.

What's more, a significant portion of StorageTek's customer base, which has been known as exceptionally loyal to the storage vendor, appears ready to switch to newer technologies, says Brian Babineau, a storage analyst with the Enterprise Strategy Group. According to a study that the Massachusetts-based consultancy conducted in March, 22% of StorageTek's customers have already moved some of their archival storage libraries to disk and another 58% said they were considering such a move.

That trend was not lost on StorageTek management, of course, and the combination with Sun could provide the R&D muscle to develop newer backup technologies that will help the combined companies hold on to customers, said Babineau.