Openomics: innovation drives value

With the interview of Pr. Simon Parienté on page 6 in this month's (March 2009) issue of Linéaires, a leading French magazine targeted at grocery retail professionals, about his (corporate finance) work in the Retail industry, I would like to acknowledge an interesting study I had the opportunity to participate in and come back on some of its findings. The study (#200806), published last October, is sponsored by ILEC, a French association representing the largest branded food, beverage and consumer-product manufacturers. It seeks to do a comparative analysis of the financial performance of retail stores and consumer-product manufacturers.

Here is an excerpt of the results.

1. Overall, retailers outperform manufacturers. (...)
   
   
2. Large manufacturers are much more profitable than SMB. (...)
   
   
3. For both retailers and manufacturers, margins yield a better profitability and more value creation than volumes. (...)
   

The quest for margins have thus led manufacturers and retailers to invest in product innovation, branding and advertizing…

[Read More]

Sun's Q1FY09 earnings release 3 weeks ago was a historic moment with the disclosure of revenue per lines of business. This is giving a unique insight into whether Sun's strategy and investments are working out and how. Is Sun's open innovation paying off? Is it creating value for Sun? Interestingly, the Q1FY09 earnings also contained a piece of news about goodwill, a goodwill impairement though. How does all this come together then?

In today's post, I am making an attempt to connect the dots and make sense in all this. Let me start with a disclaimer though. I have no access to sensitive company information, all of the information used in the analysis thereafter is public data, don't look for insider's knowledge here. Also I am not a professional financial analyst, comments below are my own (naive) speculations, don't look for any experienced guidance here.

Known as early as Preinreich (1936), a firm's goodwill can be expressed as follow :

Goodwill (t) =  P(t)  −   BV(t)  =

∞ ∑ t = 1

E[x(t) − R · BV(t-1)] _______________ (1+R)t

where

P(t) denotes the market value of the firm's equity at year t, BV() the book value, x() the net earnings, E[ ] the expectation operator, R the discount rate (return on equity).

Note that ax(t) = x(t) − R · BV(t-1) is known as residual income in corporate finance litterature. Similar to the Net Present Value concept, residual income is a measure of how much value a firm creates (or destroys). In a simple perpetual growth model, goodwill becomes :

Goodwill (t) =

E[ax(t+1)] ________ R − g

where g denotes the growth rate of income. Goodwill is thus a function increasing in ax(t) --the current profitability-- and in growth g --fueled by the firm's innovation. See here for more details on how the above 2 equations are connected.

From innovation to growth

I am extracting the following revenue data directly from Slide 6 of the Q1FY09 Earnings presentation. FY06 revenue is calculated based on the year-over-year FY07 growth rates provided on the slide. I have grouped OpenStorage with x64 Servers as OpenStorage revenue seems to be primarily attributed to Thumper, which was built off common x64 intellectual property obtained through the Kealia acquisition. Data is ranked based on the Q1FY09 year-over-year growth rates.

Table 1 - Billings per Business Unit

	FY06	FY07	FY08	CAGR 06-08	Q1FY09 Y/Y
Solaris SPARC CMT Servers	180	609	1119	149%	83%
MySQL / Infrastructure	138	199	208	23%	50%
Solaris, Management and Virtualization	197	222	216	5%	21%
Java	194	219	219	6%	18%
X64 Servers + Open Storage	475	733	798	30%	13%
Disks & Storage Arrays	1398	1412	1527	5%	3%
Tape	1076	989	952	-6%	-4%
Other Storage	42	38	59	18%	-16%
Solaris SPARC Enterprise Servers	3322	3388	3412	1%	-27%
Other Systems Products	2144	1737	1291	-22%	-56%

In the top half of Table 1, we find all of the most recent strategic moves of Sun, into Software and Volume Servers (inc. the hydrid data servers of OpenStorage). I find this very encouraging and an evidence that Sun's open-innovation strategy is working. Sun is able to expand outside of its historical high-end Enterprise IT market and earn marketshare for its differentiated products alongside the commodity platforms (Lintel, Wintel). Because of such good fundamentals, I believe Sun can come out strong of the transition period it is in, of adjusting its cost structure and profitability ratio.

From growth to goodwill

The Q1FY08 earnings release also announced a $1.445B goodwill impairment. Early on, analysts attributed it either to the StorageTek or MySQL acquisitions. The amount of the write-off led to conclude however that MySQL was probably not to blame. If confirmed, this result would be consistent with the growth rates from Table 1; the rate of growth for the Software business is accelerating in Q1FY09 compared to its past trend so, if goodwill should change in any direction for the Software business unit, it should be upwards.

From Sun's SEC filings, I was able to gather the following data, that summarizes Sun's acquisition activity up to the previous major goodwill impairment in 2003, which resetted the goodwill balance close to zero --if we fully attribute the $2B goodwill impairment in 2003 to pre-2003 acquisitions, Sun started the 2003-2008 period with a little $155M net goodwill. I have categorized, to the best of my understanding, the acquired companies using the product categories listed in the Q1FY09 earnings slides (Note: xVM is short for Virtualization and Management; Volume Servers include Sparc CMT and x64 systems).

Table 2 - Business Combinaisons 2003-2008

Acquisition	Fiscal Year	Total Price ($M)	Goodwill ($M)	Business Unit	Category
Pirus Networks	2003	167	143	Storage	Other Storage
Terraspring	2003	30	27	Software	xVM
Afara	2003	28	0	Systems	Sparc CMT
Pixo	2004	23	17	Software	Java
CenterRun	2004	65	46	Software	xVM
Waveset	2004	136	77	Software	Infrastructure
Nauticus	2004	12	4	Systems	Other Systems
Kealia	2004	93	0	Systems	x64 Servers
SevenSpace	2005	48	37	Services	Services
Procom	2005	52	0	Systems	Other Storage
Aduva	2006	13	12	Software	xVM
StorageTek	2006	4082	1886	Storage	Storage
SeeBeyond	2006	375	252	Software	Infrastructure
Tarantella	2006	26	19	Software	xVM
Neogent	2007	24	7	Services	Services
SavaJe	2007			Software	Java
MySQL	2008	904	711	Software	MySQL
Innotek	2008	163	103	Software	xVM
Cluster FS	2008			Software	Solaris
Vauu	2008			Software	Infrastructure

Business Unit Goodwill ($M) Software 1264 Services 44 Storage 2029 Volume Systems 0 Enterprise Systems 4 Total 3341 Table 3 - 2003-2008 Goodwill per Business Unit

Fiscal Year New Goodwill Impairment Balance 2002 - - 2182 2003 171 (2027) 326 2004 144 (64) 406 2005 37 (2) 441 2006 2169 2610 2007 7 (103) 2514 2008 814 (113) 3215 Table 4 - Total Goodwill Balance

This closer look at Sun's annual reports confirms that goodwill is concentrated in the Software and Storage lines of business. It also confirms that only the Storage goodwill is as big as the write-off so the Storage goodwill has necessarily been impaired. If we discard Software altogether based on the growth rate analysis, we also conclude that the bulk of the goodwill impairment can be attributed to the StorageTek acquisition.

Is this write-off bad news? Long-term, I think the rationale for buying StorageTek continues to make sense, i.e. offering the complete range of products, services and solutions to Sun's traditional high-end customers --the needs of mission-critical data and vertically-scalable applications are not today and may not ever fully be addressed by commodity platforms. When these customers (e.g. Wall Street, Manufacturing) come out of recession, Sun will remain a vendor of choice and may in fact gain marketshare. Because Sun uses the same underlying technology innovation in its emerging business lines --OpenStorage is OpenSolaris, Sparc CMT is OpenSparc--, the Enterprise Solaris Sparc platform should gain in credibility and popularity throughout the economic downturn, unlike other Unix/RISC alternatives, I predict.