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Executives

Ken Bond – VP, IR

Jeff Epstein – EVP and CFO

Analysts

Sarah Friar – Goldman Sachs

Adam Holt – Morgan Stanley

Heather Bellini – ISI Group

Peter Goldmacher – Cowen & Co.

Kash Rangan – Merrill Lynch

Brent Thill – UBS

Michael Turits – Raymond James & Associates

Brendan Barnicle – Pacific Crest Securities

Margaret [ph]

Sun Microsystems Inc. (JAVA) Oracle + Sun Strategy Update Financial Analyst Call Transcript January 27, 2010 5:00 PM ET

Operator

Good day. And welcome to today's financial analysts breakout. Today's call is being recorded. I would now like to turn the call over to Michael Meyer [ph].

Ken Bond

While these forward-looking statements represent our current judgment, what the future holds, these statements are subject to risks and uncertainties that may cause actual results to differ materially from statements made today. Throughout today's discussion, we'll attempt to present some important factors relating to our business, which may potentially affect those forward-looking statements. As a result, we caution against putting undue reliance on these forward-looking statements, which reflect our opinion only as of today.

And as a reminder, we're not obligating ourselves to revise or publicly release the results of any revisions to these forward-looking statements in light of new information or future events. And finally, we would encourage you to review our most recent reports on forms 10-K and 10-Q and any applicable amendments for a complete discussion of these factors and other risks, which may affect our future results for the market price of our stock.

So with that out, I move now out of the way, let me go ahead and introduce Jeff. Jeff Epstein, our Chief Financial Officer.

Jeff Epstein

Thank you very much. And for those of you who didn't know, it's Ken Bond, our Vice President of Investor Relations. And we also have in the front of the room Paul Ziats from Sun joining us now and someone who if you don't know you should get to know because he knows a lot about, probably more about Sun than I do at this point, I'm looking forward to learning a lot more. And in the back of the room, we have two of our distinguished members of our Board of Directors, Don Lucas and Bruce Chizen.

So let's start. We are looking for with the Sun-Oracle combination, we believe we'll have both significant cost savings and revenue opportunities leading to higher operating profits. And I'm going to start describing our philosophy which some of you've seen before, but since many of the people on this call may not have seen this, I think it's worthwhile to give a general review and then get specific.

We have an approach to Oracle business processes, which we call business engineering, it's taking an engineer's mindset to our systems and processes and trying to do things better. And there's four parts to this. The first is, simplify. So let's take a look at how Sun is doing a process today for whatever historic reasons they're doing it and say, that the best way to do it, but if it's not, we'll change it.

Turns out over the last nine months through hundreds of meetings with literally thousands of Sun employees and Oracle employees, we've looked and mapped every Sun process, we have what we call playbooks, written playbooks that says on this date, this is what we're going to do on this date, this is what we're going to do. And there are well over 100 processes that will change from whatever Sun is doing to the way Oracle's doing it. So we're going to go from the old way of doing it to the best way of doing it.

We're standardizing. Sun fundamentally has -- is not a centralized company, it's been decentralized and does many things in different ways. So we're going to go from many different ways of doing it to the one best way of doing that process. And then in keeping also with centralization, geographically trying to do it instead of in every country in the world and every location doing the process in fewer shared service center locations where you can get economies of scale.

And then finally, there's still a number of manual processes and being a technology company, we would like to automate those technologies with Oracle software. And Sun already is using an older version of Oracle e-Business Suite, so that involves upgrading to Oracle e-Business Suite 12 and moving the Sun supply chain systems onto the Oracle supply chain module.

So we have a lot of work to do. We've been spending, we've had more time than we've ever had before to plan in detail all of these changes that we're making in the systems and processes. And we're very excited about being at the starting gate today and getting a chance to implement these changes.

Let me get going to a little further detail on some of the things you heard earlier today from (inaudible) for instance in supply chain. And so one of the major areas that we're going to making some changes is supply chain. And I think there was a misunderstanding among some analysts of cutting costs equals cutting headcount. And that's the reason that that's not the case here is because the largest cost at Sun is cost of goods sold, is the product cost and so the way to save money is by figuring out a better way to produce products at lower costs. And obviously the back office type of things and labor costs are an important component, but actually much smaller than cost of goods sold. So supply chain is extremely essential to our financial plan.

So what are we going to do? The same philosophy I talked about in terms of our back office processes, simplify, standardize, centralize and automate applies to supply chain as well. So we went in and we talked with Cindi [ph] and the rest of her team and said, how many different parts do you have, how many different combinations of parts do you have and the answer was tens of thousands and so why do you have so many? And they said well, every time a salesman says I want a unique combination for a customer, we say yes. And that's what we find at many companies we acquire, which is Oracle is very good at saying no.

And companies we acquire aren't so good. And so we say we're going to do what makes sense for us. We're going to produce fewer products, fewer combinations of products. And then our salespeople are going to go out and sell those. And if every single customer doesn't get exactly what they want, maybe not every customer's going to buy that product but we don't want to sell products that we lose money on. So if the cost of supplying tens of thousands of combinations means we can't make money, why should we be in that business?

So what we're doing is we are taking the Sun footprint. And we're focusing it on the highest value products, the most popular combinations of products. And then we're modularizing them because every product is made of components to how many core, storage and servers and so you can by having common components and then building a limited set of products, we can dramatically lower our costs in terms of manufacturing and supply chain. So that's what the first item is.

The second item which Cindi mentioned was move from build to stock to build to order. This is a major change in the philosophy of the company. A customer says I want to buy something. And I want it to be inventoried today. I need it shipped to me this afternoon. We may not have it in stock for them tomorrow. Sun built their business and tried to do that. We think the value added is in the product and the engineering. The value added is not in the logistics. And that's what we have partners for.

So you heard today about how we're going to go direct to our largest customers, but we'll work extensively with value-added partners. And those value-added partners I'm sure will stock inventory. They'll place orders in advance. And so in effect, we're letting these very large companies with enormous logistics investments take advantage of their infrastructure so we don't have to build warehouses and maintain warehouses and maintain inventory everywhere.

So we're going to see substantial decreases in inventory, substantial improvements in our -- again, manufacturing and logistics costs because we will focus on large volumes of the products that we think we can do well at and let outside partners and logistics operators handle the inventory and carrying costs.

An example of that would be plug; I got some direct ship in a minute. So let me talk about centralized supply chain with fewer build locations. There's a philosophy of -- we want to have multiple manufacturers for multiple products because we like the idea of getting people to bid against each other. We don't think that's necessary. We think we're big enough on our own that if we can negotiate attractive deals. And if for whatever reason a vendor, an outsource manufacturer says that they're going to raise the price on us we just won't use them again for the next product.

So we will have many fewer producers in terms of outsourced manufacturing that Sun currently has today. And we'll get volume discounts, lower costs, higher volumes with more focused purchasing. So we'll have fewer vendors with lower cost. And then also we talked about how fewer parts, less supply chain fragmentation means that we'll have lower cost in the distribution chain and then implement 100% direct ship for all products.

Sun had been having consolidated shipping. So if they were, someone ordered ten different products, they would have ten products shipped to a Sun location, they'd wait to assemble it all together and then reship it. So you would have examples of things where a customer in Asia would order a product which was manufactured in Asia but was shipped from the United States. So the manufacturer shipped it to a warehouse in the United States would've been shipped back to Asia. And we looked at that and we said, why are you doing this? And they said well, because we want to have this terrific, we have these warehouses. And we want to consolidate a shipment. We said, we don't think you're getting value for that. We don't think that's really what customers are paying for, they're paying for the product. And so we're going to go to 100% direct ship.

Now if, again if we have customers who for whatever reason feel they need the inventory faster, that's where the partners will provide the value. So essentially, what we're able to do is we're going to focus on the engineering. And we're going to, we've already -- Sun has already outsourced manufacturing and in a way, we're going to work with our partners to not invest a lot of time and effort and cost in the shipping inventory and logistics and warehousing.

And then finally, optimized sale, Sun sales qualification policies, this comes back to just saying no. Sun from time to time will take orders, manufacture products, but customers who said they're interested in a product but just haven't made up the purchase order yet, so please will you make it for us and then or by the way, maybe we decided changed our mind. We don't need it. Then Sun is stuck with the inventory. And he'd have to scrap it or has to remanufacture it. And that's not our way of doing business. So we're going to not manufacture until we get an order to be signed, order where there's a commitment on the part of the customer.

So there's a whole series of activities where for various historical reasons, Sun felt compelled to have a number of practices which is not in keeping it the way Oracle has done business. And we're changing those starting today. So we are very excited about the opportunities. We think our customers will appreciate the fact that we're taking costs out of the system. So they're going to get value because they're going to get highly engineered products which are differentiated, which are very effective for them, they'll be able to get the kind of quick delivery and turnaround time they need from their partners if that's important for them. But if it's not important for them, they're not paying for it. And we've eliminated cost from the system.

Let me turn to a quick overview of an elaboration of what Cindi talked about in terms of the improvements in supply chain. And in terms of dollar terms, this is a very significant number. It's a large difference in Sun's cost structure compared to Oracle's cost structure. Let me talk about customer services. Juergen Rottler who runs Oracle's customer services, talked earlier about the plan and he talked about My Oracle Support. Sun today has multiple levels of support. So there's multiple quality levels, different country levels, different turnaround times. We think there's unnecessary complexity in there. And we just want to have one very high level of support for everybody. We think it simplifies everything; the cost of delivering the support is much more streamlined and lower cost for us. And it can be higher value for the customer.

And in fact, there's a history here because we had a similar type of thing happen in software support, where many years ago we had multiple software combinations. And we just went to one level of software support at 22% of the purchase price. Everyone gets the same high quality level of software support and it's worked very well. And we think that this will work well as well.

And then we're going to combine the support delivery mechanism into the My Oracle Support portal. So when a customer has a problem with hardware, they will go to the same place they go to with when they have a software problem. Today, 75% of Sun's support inquiries are by the telephone, which means Sun has to have a lot of people answering the telephone to find out what's going on. Oracle has less than 5% of our support inquiries by telephone. Almost, all are through the internet.

Most engineers who are the people who are submitting these support inquiries would rather go on the internet just the way that when I buy a book, I'd rather buy it on Amazon online than call up someone and talk to a human being to order a book if it's long distance, so it's just a more efficient way of doing it. And it's one of those things that Sun wanted to get around to. For whatever reason, they didn't. We're going to have this launched in the near future, where we'll move the Sun support base onto My Oracle Support.

Optimized after market repair and logistics cost, we talked already about how from a supply chain point of view, we're going to have fewer parts. And that will reduce also the support cost because it'll simplify things there. We're going to streamline the number of depots. Sun felt that they had to have inventory in every city around the world or a large number of cities around the world. And that meant enormous extra inventory cost because you had to have small amounts of inventory everywhere instead of fewer, larger amounts of inventory and then use shipping or use your partners for people who have critical applications.

And then the support third party providers Sun did not have as comprehensive an offering of support services by Sun employees. They had a lot of non-Sun employees providing support, a lot of partners supplying support. And our view is, certainly for the major customers in the major countries, those will all be Oracle employees providing that service. And we'll get the value for that. And then finally, we talked about the automated self-service system support plans based on My Oracle Support.

So customer service is the secondary after supply chain. And then finally, the area that is probably more familiar with everyone here because it's similar to the software side of it, which is the back office infrastructure, we have a very effective and efficient global infrastructure in all of our back office operations. We have the capacity to handle incremental volume at low marginal costs. We're talking about the financial operations, legal operations, marketing which I'll come back to in a minute, HR and procurement is obviously the combined benefit of having the two companies together. We can get better prices and more focused buying. We talked about the supply chain procurement, where we're going to have concentrated buying with fewer vendors, but then all the non-supply chain procurement we're going to have enormous economies of scale.

Facilities, we have a lot of ops buildings, they have a lot of ops buildings. We can consolidate space. Sun already has a lot of empty space that they weren't using because their headcount today is much lower than it was a few years ago. So I think we're going to be pretty good at combining the offices of Oracle and Sun city-by-city and over time dramatically reducing the number of square feet that we need.

And then IT is going to be very substantial savings because we have a very efficient datacenter operation fundamentally, virtually all of Oracle's computing is done in our Austin datacenter. So instead of having multiple datacenters and multiple development labs all over the world, we have fewer much more cost efficient centers. And we've done a great job of lowering our cost of IT. And there's a lot of opportunity at Sun.

Let me come back to marketing. Sun for -- I think many years now has devoted a fair amount of effort in marketing to non-revenue related marketing. Their marketing people were evaluated for instance, on a cost per download type of metric. And our marketing is based on cost per lead or cost per converted lead type of metric. So we're going to see a big shift in marketing. It's a large dollar amount. And we will continue to spend a fair amount of dollars in the aggregate. But most of those dollars will be spent on media and on measurable media which have a direct result of supporting sales as opposed to just generally getting awareness and getting people who are not customers, who are not paying customers to use the products.

So there's a whole series of ways in the non-product area where we think we can save costs. And then all the systems will run on the Oracle global single instance. We showed this slide earlier today that the key difference between this acquisition and our other 60-plus acquisitions is there's a supply chain element. Fortunately, the supply chain that's required is the Oracle e-Business Suite supply chain, which we happen to know a lot about rest as the slide says, we've done thousands of implementations of this product. We have our own development team, who wrote the code, who can help us implement it. So while it'll take a little longer than a smaller company acquisitions because of the scale of Sun, we're very confident we can implement the Oracle e-Business Suite supply chain modules very effectively and then run on a single global instance on the Oracle IT structure.

Beyond that, everything else is comparable to other acquisitions we've done. 99% of Sun employees work in areas that are comparable to Oracle departments. Fewer than 1% of Sun employees work in manufacturing and supply chain. So who are all the Sun employees? They're engineers. They're salespeople. There's education, training, consultants, support, back office, so we understand those functions. And we've done 60 acquisition integrations. So we have detailed written playbooks and we're highly confident we can be effective and timely in getting those integrations done.

So we've talked mostly about cost. And I'd like to talk about revenue, because revenue, as Larry said, is an important part of this equation. There's going to be some transition period because there's some revenue that Sun generates today that they don't make money on. And so the simplest thing to do is to stop is to sell less of things that you're losing money on, which will tend to decrease revenue and then sell more of the things you do make money on, which will increase revenue. They'll both be happening at the same time over the course of the next 18 months. So the aggregate revenue may not grow that much, but you're going to see these underlying trends. And then, of course, once the declining stops, the products that are growing will come out, as you'll see in 2012.

So what are the things that we'll do less of? Sun sells third party products today, where they're essentially just a distributor of other companies products. And the salespeople are paid on revenue. So even though Sun makes a very small gross margin and in some cases they lose money on an operating margin basis when costs are fully allocated, the salesperson still makes money. So if I can sell a $1 million worth of a third party product or I can sell a $1 million of a Sun software product, where I have 100% margin, the customer, the salesperson makes the same sales commission. So we're going to change that. And we're going to compensate our salespeople based on the margin they contribute, which will have the effect of reducing the amount of third party low-margin sales that they make so that revenue side will go down.

And then if you look at the Sun product line and you see there are some high margin products and low margin products, when we compensate our salespeople based on margin, they're going to figure it out pretty quickly. We've worked with salespeople for a long time and it just turns out they figure it out in about a day, what products are the ones to sell. And we think they're going to sell a lot more of the high margin products and many fewer of the lower margin products. And that will dramatically change the revenue profile overall.

So let's start with at the top of the slide, engineering. We're going to also shift our engineering focus to invest heavily in the high value, differentiated products and have increased investment in those areas. And in addition, having these database appliances or appliances where the hardware and the software are engineered together (inaudible) being the first one, we'll have a series of new products, we're investing heavily in engineering to make great products that are differentiated that are multiple times better, order of magnitude times better than competing products.

Customer services, we've talked about how important that is. Renewing and upselling existing hardware support and increasing attach rates, virtually every customer who buys and Oracle product today buys support, that's not the case with Sun. Some customers are not buying support at all. Some customers are getting support from partners. Some customers may be getting the support, but they're not paying for it. And we have a disciplined approach to all this. And we think that our policies and our value added, so we'll start with giving really high quality support, which is essential. But then also through our policies and through our working with our customers who we already have relationships with we think we can dramatically increase the attach rate and increase the support revenue.

And then the field changes are going to be very significant. So we talked before about having high margin revenue going direct. So the largest 4,000 customers, we will sell direct to. We will make a higher profit margin on that revenue than we are today through that Sun is through partners. And yet we'll still continue these partners for the other tens of thousands of customers. And where there are value-added partners in particular segments like telecommunications, even for the large customers, we'll work with partners, but the question there is, is the partner adding value? Is it doing more than just taking the order and arranging for the shipping? And we value the direct relationship with these 4,000 large customers.

Second is compensation. We're changing the compensation system immediately in the countries where we're legally allowed to and as soon as we can in the countries where there's going to be some delay, but you're going to see dramatic changes in the sales compensation, which is well aligned with how Oracle compensates sales executives, which is it's the revenue minus the controllable costs. In Oracle's case, the controllable costs include the sales expense and T&E, some direct cost for the office space that the sales manager's responsible for and of course, in Sun's case, it's also going to include the cost of the products. So it's the philosophy, the Oracle philosophy applied to a hardware business. And we've already seen at Oracle how that dramatically changes sales behavior. And we're very excited about that change.

And then finally, this last point is very important. Oracle's to detect Oracle's sales strategy today for support is that when an Oracle sales executive sells software; they also sell the first year of support because it's sort of combined with that initial sale. Then the second year of support, which is the renewal, which is much easier because the customer's already using the product, presumably happy with it that's the renewal is handled by the support sales organization. So that was not the case at Sun, so we're going to move Sun where the hardware salesperson at Sun is also going to be incented to sell the first year of hardware support. And we think that will have a dramatic increase in the support attach rate, so a number of different opportunities.

And to try to summarize the financial strategy, there is, I do need to highlight this, as I said before, there's literally over 100 types of changes like this that we're doing in terms of policies and procedures and processes. And these are in my view what the most important ones, in terms of cost savings, optimizing the supply chain because that's the biggest cost element for a product company; simplifying and standardizing customer support, which can help reduce our cost while we're increasing the value of support and streamlining the back office and marketing and having substantial savings and economies of scale there.

At the same time, we're going to grow revenue in the areas of the high margin products and drive profitable revenue by focusing in engineering and sales on the highly differentiated, high value technologies by going direct to our 4,000 largest customers by compensating our sales teams on margin, not on revenue and by improving the support attach rates, which as you know from Oracle is an extremely important part of our profit model.

So the numbers, we expect Sun in the first full year of ownership, which is fiscal 2011 to have $9.6 billion of revenue. And we expect, as we've already previously stated, $1.5 billion of operating income, which translates to $0.15 per share or more depending on how you allocate the interest expense and the cost of capital and all those things, so rather than get into that, we're focusing on the operating income line. And then in fiscal 2012, we believe we can continue increasing our profitability. Some of the programs that I've talked about in changing won't be able to happen; we'll do them as quickly as we can. But they won't all have an impact for the full year fiscal 2011. And so some of that impact, we'll get the benefit as well in fiscal 2012. And we expect $2 billion of incremental operating income in 2012.

So can we do it? I've outlined what we expect to do. And now the question you all have to decide is, can we execute? And from my point of view, I'm just continue to be very excited about the quality of our internal teams at Oracle, the quality of the cooperation we're getting from the Sun teams, the enthusiasm from the Sun people in working with us because I think they've been frustrated at working with a company that's been losing money for a number of years and has revenue declining, they want to be on a winning team. They see what Oracle's talked about. And they are onboard.

And so what we've done in the past is when we've made these acquisitions, we've typically bought companies with lower operating margins. And as I showed this slide earlier, just simply the arithmetic average of our margin back in 2004, 39%, plus the companies we acquired would've meant our overall margin of decline and factor of our margin grew which demonstrates our ability both at the Oracle base and the acquired revenues to use these techniques, both in terms of things like high quality support at fair prices, things like sales compensation, which align sales incentives with shareholder incentives and things like back office efficiency to increase our profitability margins.

And we're going to do this importantly not by cutting R&D. We're going to continue to invest very heavily in R&D. Engineering is the lifeblood at Oracle, it's also very important at Sun. We want to make terrific high quality products, price them fairly and get full value for them and then run the business cost effectively. And so we expect to have $4.3 billion at research and development in fiscal 2011, which is almost triple what Oracle had back when we started the acquisition program.

Thank you very much. And Ken, I'll turn it back to you for questions.

Question-and-Answer Session

Ken Bond

Sure. We're going to go ahead and do a Q&A session. What I want to do is I know there's lots of questions here in the room, but for those folks that are out on the internet webcast, just send a reminder to you all that you do have an opportunity if you're dialed in the webcast to ask questions. So what we'll do is at a later point, Jeff we'll kind of bring back some questions from the internet, but for now why don't we go in the room. So, Sarah do you want to kind of kick it off?

Sarah Friar – Goldman Sachs

Great. Do you want me to grab a mic for the webcast or…

Ken Bond

We've got a one…

Sarah Friar – Goldman Sachs

You can clearly hear me. Thanks very much, Sarah Friar from Goldman Sachs. Jeff, very bear bull in guidance, are you willing to go a little deeper and just give us any sense of even the split between products and services, for example for Sun? So that $9.6 billion, we've kind of estimated something around a 55 product, 45 services split because it helps us think about the margins. And then on the gross margin side, kind of expectations there in terms of can you move the needle on the gross margin for Sun? How do we think about the shift between COGS and OpEx?

Jeff Epstein

Okay. So two questions, first of all, what is our guidance policy going to be? And secondly, what about cost of goods sold in particular? Our guidance policy for a long period of time has been that we've given one quarter guidance out and with a fair amount of information. And we will do the same, so on our next quarterly conference call, when we close Q3, we will give guidance for Q4, including hardware and software. And we will describe what, when I say hardware and software, I mean what we're expecting from incrementally from Sun as opposed to Oracle. And we will continue to do that going forward every quarter. In terms of cost of goods sold, we clearly expect to have substantial cost savings in the supply chain which means we think that the, our gross margin is going to improve.

Sarah Friar – Goldman Sachs

I'm sorry, I just want to clarify. Thank you. That was very helpful. But just on the product service split, what I was asking was more for Sun specifically?

Jeff Epstein

Right.

Sarah Friar – Goldman Sachs

Are you going to give us any gradation between their product and their services line?

Jeff Epstein

We're not giving it now.

Sarah Friar – Goldman Sachs

Okay.

Jeff Epstein

And we'll be evaluating the kind of guidance we're going to give before the next quarterly conference call. And then we'll give -- we're going to come up with something which we will be able to sustain every quarter.

Adam Holt – Morgan Stanley

Hi. It's Adam Holt from Morgan Stanley. If you look at the revenue numbers for fiscal '11, it's a little bit below the run rate we saw in September, but yet you have $1.5 billion in operating income, which implies the additional hiring you talked about today is going to be at least offset, if not more than offset by the cost cuts. I just wanted to think about or to ask you how you're thinking about that balance. Will hiring be based on what you see on the cost saving side or more driven by what you see on the revenue side?

Jeff Epstein

Well, a lot of the hiring is sales. For whatever reason Sun had a philosophy of not going direct, which meant they had few salespeople. And they went through partners. And so we are going to hire a lot of salespeople and particularly in the United States and take that business, direct business. And so the offset is the people we're hiring will be generating revenue day one, in fact, they may even be the same individuals because I think what has happened to some extent is there were Sun salespeople. Sun said let's go to partners, Sun laid off the salespeople. And the partners hired them. And we're going to hire them back.

So what you heard today was a big ad for all of the Sun experienced salespeople who are interested in coming back to Sun to come back. And they're going to take the same accounts with them. So I think the incremental hiring will immediately add revenue and be profitable in terms of that side of that. And then in terms of the other revenue that the decline in revenue we believe will be in a product that’s more profitable anyway. So even though, we I think on a last four quarters basis the 9.6 billion is down about 10%, that's around the kind of volume that we see where you could say take the lowest margin 10% of the business, there's really no operating income associated with that. So you're losing on profitable revenue.

Adam Holt – Morgan Stanley

And if I could just ask a real quick follow up, if you look at the operating income contribution in year two, it's a little over a 30% increase. Do you see that being driven by the revenue starting to reaccelerate? Or do you anticipate further efficiencies on the cost side to drive that increase in operating income?

Jeff Epstein

Well, we're not giving revenue guidance specifically for 2012 now. But clearly, you heard from Larry and from our other executives. We believe that Sun is a growth, a revenue growth opportunity. We think if we can come up with the products that we, we're highly confident we can, which are differentiated, we believe the Sun product line within Oracle will clearly be a revenue growth opportunity for us. We will hold off on giving guidance because we'll end up just giving guidance quarter by quarter. So I don't think we won't be giving fiscal '12 revenue guidance. That'll just come quarter by quarter.

But the second part of your question is, is there some additional cost savings in fiscal '12? There probably is because some of the cost savings that we anticipate we won't be able to implement day one. So it'll some of that will flow through in full year fiscal '12. For instance, there's agreements with content manufacturers that don't expire for a certain amount of time, a whole series of things that we have planned but take time.

Heather Bellini – ISI Group

Hi. Thank you. Heather Bellini. Two questions for you Jeff. One, just to help people think about from the cost side of things, what percentage of the cost reductions are going to come from COG versus the percentage that we should expect to come from OpEx just in terms of helping us build out our models? And then also, given Sun had a different geographic footprint then you did the tax rate potential looks like it could go up in fiscal '11. Could you give us a sense for the magnitude you're talking about?

Jeff Epstein

Well, the first question on -- we're not going to give specific guidance on the components of cost. But each of the major components of cost are material. So cost of goods sold is clearly very important. The operating expense is going to be important. Marketing in itself is going to be an important line item. So there -- and then the avoiding of the partner cost. So that's not really on the income statement today. But there is cost in the system of having partner margin, which is outside of the system today, which will come into Oracle. And that's going to be a very significant portion to generate the revenue and margin that today is going to partners. So it's, each of those is material in terms of achieving the $1.5 billion target.

The next question about attach rate is --

Heather Bellini – ISI Group

No, tax rate.

Jeff Epstein

Tax rate. I'm sorry. Well, tax, we are not giving specific guidance on a tax rate yet. But there are a couple things I just want to point out. From an accounting point of view, Sun has very attractive tax loss carry forwards and tax attributes which don't show up in our income statement. Those are all, we get the benefit of that. But it goes onto the balance sheet and then will not affect our income statement going forward. So it's a meaningful amount of money in terms of the value to the company. But it's not going to affect your model.

But then the other thing just to keep in mind is the way international tax planning works is you typically try to have your services, there are companies that have provide services and get service fees. So if a company is low margin, those service fees are a bigger percentage of the total. So ironically, since Oracle is very high margin, we get the benefit of that tax. Sun doesn't -- that tax planning and Sun doesn't. So it's possible that the Sun incremental tax rate could be somewhat higher than the Oracle incremental tax rate. But I think it's too early to say that.

Peter Goldmacher – Cowen & Co.

Hi, Jeff. Peter Goldmacher at Cowen & Co. You guys spent a lot of time in the earlier session and this session talking about how you're changing the supply chain, how you're changing your whole build model and how you're changing your delivery to customer model. And here, you talked a little bit more about how you're changing your customer support model, pushing more support to the web. Maybe you can't get what you want. Maybe you can't, you have to wait a little bit longer for a box. I mean, these are big changes.

I'm not as familiar with the hardware business as I will become I'm sure. But how different are your is your hardware support going to be from people like Dell and HP and IBM? And do you factor that into for some parts of the business that are more commodity oriented, was Sun's support because it was so accommodating, was that a competitive differentiator for a lot of these guys?

Jeff Epstein

Yeah. We're going to give very high-quality support. But customers who need the time-sensitive nature you're talking about will pay for it. So Sun has been providing -- Sun had a high cost structure to serve everybody when only some customers needed it. And so the way to at the end of the day, what will happen is customers that need that immediate turnaround time will have an opportunity to pay us for it or they'll pay a partner for it. So we will have a low cost structure giving customers the option. If they find value, they'll pay.

And we'll -- it's a competitive market out there. I'm sure our support offerings will be competitive. I think one difference is our support I think will be much simpler. The standard out there among hardware providers is to have multiple levels, very complex structure. And we'll have to see if that remains the case. They may find that this is actually a better way to run the business than to have one level of very high-quality support and still give customers what they need.

Peter Goldmacher – Cowen & Co.

Thanks.

Kash Rangan – Merrill Lynch

Thank you very much. Kash Rangan from Merrill Lynch here, Jeff.

Jeff Epstein

Hi. Kash.

Kash Rangan – Merrill Lynch

Back here. A bit of a comment. It looks like based on the operating margin contribution guidance for fiscal '12 that operating margins for the combined company probably go up in fiscal '12 as opposed to going down in fiscal '11. Actually, the first year, I would expect compared to Oracle standalone, margins obviously go down. And my question/clarification is the following year after the acquisition, would margins go back up? It would seem like they do go back up just based on the operating income growth of almost 30% in year two. I just want to make sure that that is indeed the way to look at the business because there's some skepticism among some investors that margins could be going down year after year because the hardware business is a lower-margin business, the faster the growth. And I just wanted to make sure that I'm on the same page with you in terms of the how the operating margins of the combined company look like in year two after the acquisition.

Jeff Epstein

Okay. Well, there's several elements to that. So let's just walk through the model together. Obviously, if you have a high-margin business like Oracle with margins in the 45-plus percent range and you have a lower-margin business like Sun, which just in the sort of 15% range if it's 1.5 billion on 9.6 billion; the weighted average of the combined company is lower than Oracle's. So by the math, it's simply that you have a lower margin to begin with. Then the question is what happens the next year. And the way to think about that is which there's two questions. One is which grows faster, the Sun part of the business or the Oracle part of the business? And then what happens to the Oracle margin? And what happens to the Sun margin? And we've publicly said before and I would reiterate today that we think over time Oracle's core business can continue to grow margin. There's no sort of cap that we're reaching for some reason.

We think we can continue to grow our revenues at the rate that we have been growing, given the economy. And we think we can keep our cost growth lower than our revenue growth over cycles, over time. And the Sun business, we think we're starting the advantage of Sun, of course, we're starting from quite a low base. So we think that the Sun portion of that revenue and cost can also grow margin over time. So we expect over a multiyear period for the Sun portion of that business to grow. The question of what happens to Oracle's overall margin depends on the mix.

If all of a sudden we tripled our hardware revenue, even though the hardware margin was growing, it would bring down the overall company margin now. I don't know that we're going to triple our hardware revenue overnight. So my guess is the inherent growth in the margin in the two businesses will outweigh whatever mix shift there is. But it's impossible to see until we see what the relative growth rates of the two businesses are.

There's just one other element I'd like to mention which is, of course, we'll sell increasing number of products, which are both hardware and software. So when we have XTRA data, for instance, the hardware part of XTRA data will be reported as hardware. And the software part of XTRA data will be reported as software.

Kash Rangan – Merrill Lynch

The quick follow up is, on the channel side, you said that you'd be going direct. You seem like you're really comfortable with any risk associated with the change in the channel strategy. It seems like you can identify a lot of the old Sun salespeople, whatnot. How comfortable are you really that simply big change going from an indirect model to a direct model. You've got this revenue forecast for them. I'm just wondering how much of the last nine months have given you more and more comfort that this channel strategy change will not really impact the business?

Jeff Epstein

Well, it's possible there would be risk if we were talking about different customers. But these are our customers. Sun customers are -- Sun has fewer customers than Oracle. But virtually all of Sun's customers are already Oracle customers. So we know the CIO. We're selling to the same datacenter. So we have a high degree of confidence that just the personal relationships we have, the business relationships, the fact that they're still buying Oracle products while they're talking about Sun is something where a salespeople will want to work for Oracle because it's a lot easier job to work for Oracle selling Sun hardware than it was to work for Sun selling Sun hardware.

So we'll get really high-quality people. They'll go into customers where they already have relationships even if they personally don't have relationships, an Oracle institutional relationship. And we've been -- as you said, we've had nine months to work on this, to talk to customers. Our customers have been very involved in these decisions, in these processes. You heard from people at the user groups. You saw customers testify in the EU about how excited they were working with us. And we just think this is really a big win for Sun customers because they're going to have -- I think they want a direct relationship with Oracle. And part of the reason is because they want to be able to have the direct channel. But also, they want to tell us what's wrong. And they want to say here's my list of complaints. Can you fix it? And it's easier to do that if you're a customer when you have a direct relationship.

Brent Thill – UBS

Hey, Jeff. Brent Thill with UBS. Just a follow up to Kash's question on the margin at 15%, not asking you in the near term, but what do you think the long-term margin target is for the Sun business? Is this a business that could be in the 20s?

Jeff Epstein

I wasn't sure that was the end of the question. We're not going to give a long-term margin. But I think that if you would've asked Oracle or any of you 10 years ago what Oracle's software margin was going to be in 2009, I don't know how many people would've said the margin we had. So I think what my observation is we have a pretty good way of running a business. If we can make terrific products that are differentiated and we get fair prices for them and then we can have a simplified, standardized structure of manufacturing, distribution and back office and we can be cost effective, I think we have very high profit margin potential even in the hardware business.

Brent Thill – UBS

And just a quick follow up. We've had a hard time I think collectively just trying to figure out what percent of Sun's business is software versus hardware because they commingle the maintenance with hardware and software. So is there a sense of -- can you give us a sense of what split the net revenue is roughly software versus hardware that you're expecting?

Jeff Epstein

Well, we will probably separate out the support revenue between hardware and software when we publicly disclose our numbers. So we'll give you a sense of that actually once we publish our numbers. Cathy, let's get Larry in the back here.

Brent Thill – UBS

That was actually part of my question is, when you begin reporting with Sun, how much detail are you going to provide so we can kind of monitor the success of the acquisition? And then I assume you did an analysis to derive the revenue target from top down and the bottom up. But if you look at the last two quarters, the run rate of the last two quarters is exactly $9.6 billion, which is depressed and down from almost 14 billion in the '08 year and 11.5 billion the year before. So are you just sort of assuming that this weakness in the whole environment in June and September is sort of the low water mark and a pretty conservative base? Or how did you arrive at the 9.6, which coincidentally is the run rate of the last two quarters?

Jeff Epstein

Right. It's a coincidence that it was the run rate of the last two quarters. We also looked at the last four quarters because there is -- like Oracle, there is quarterly seasonality, where there in a normal economic environment their fourth quarter is the biggest quarter the same way our fourth quarter's the biggest quarter because of the way sales compensation is structured. And so, I'm not sure any two quarters is representative. And also, it's given where the economy's been going and sort of the trend they've been on, I wouldn't put too much emphasis on that.

We did build it up. As you said, we had -- we both took a macro view. We also took product-by-product view in terms of looking at how the businesses were and sales region by sales region. And we wouldn't be giving you a number unless we felt confident that we could achieve it. So our view is the $9.6 billion is our best estimate today of what we could achieve in fiscal 2011. And we could do better. We will report our Q3 in the new format. So we're not going to talk before that. But the actual press release and 10-Q will be in the new reporting format, which we'll continue to use going forward.

Ken Bond

Let me take a question from Michael. Then we'll take one last question after that.

Michael Turits – Raymond James & Associates

Thanks very much. Michael Turits from Raymond James. Larry said that it would be hiring 2,000 in the next few months and cutting less than half of that. Should we think of that as the way the right kind of proportion the year ends up? In other words, is it still a net higher, at least net flat because it seems that if it's not, then if you don't cut heads on a total for the year, it's hard to make OpEx cuts. And if you don't make OpEx cuts, that's 15 points of gross margin improvement, which is a lot.

Jeff Epstein

Right. Well, let me distinguish between laying people off and having fewer people. We have 85,000 people at Oracle. And Sun has over 20,000. So we're talking about 110,000 people as a base. And just through normal attrition, you're talking about many thousands of people leaving a company just through the normal course. And we don't have to replace every person who leaves. So we will get a benefit of cost savings not – through not replacing people, which could end up being a material amount of money.

Michael Turits – Raymond James & Associates

Right. So again, should we think of the -- so the net headcount at Sun as being flat for the year or going down in a meaningful way?

Jeff Epstein

Yeah. I think I'll just leave it at what I said. Clearly, we believe in the potential to be more efficient and have to do more with the number of people who we have. And if people leave and we can rationalize those positions, we'll take advantage of that.

Michael Turits – Raymond James & Associates

Thanks.

Brendan Barnicle – Pacific Crest Securities

Hi. Jeff, Brendan Barnicle from Pacific Crest. I had two. One, Larry was saying that Sun was going to be profitable in February and March, made a big deal out of that. So can we assume that we're going to see accretion in the February quarter and the May quarter? And second, when you think about the top line for the February and the May quarter contribution, should we be working off the same assumption of the sort of $9.6 million run rate that we're using for fiscal '11?

Jeff Epstein

Well, the February quarter is really just one month. And their quarters end in March. So it's not a quarter end month for them. So February is a seasonally slow month for Sun. So I wouldn't get too excited about the month of February. It's not going to -- it's obviously going to have some revenue for us. But it's not going to have a significant amount of profit or loss either way. And then in terms of our Q4, which would include their May year end rather it includes our -- sorry, our May year end the next three months, would be, we'll give guidance on that our next quarterly call.

Ken Bond

Jeff, we had a number of questions on the internet.

Jeff Epstein

Okay.

Ken Bond

A lot of them actually have been asked here in the room. But one that was not is may be if you could just give some color comments about how the acquisition of Sun might affect our balance sheet.

Jeff Epstein

Okay. There are three key elements when I think about the balance sheet separate from well, of course, there's the debt that we borrowed to pay for Sun and the cash and the debt position. We paid $7.4 billion. We're going to get $2 billion of Sun cash back. But the other elements are accounts receivable relative to accounts payable. We think of those as netting each other off. And then there's property, plant and equipment and then there's inventory. So accounts receivable, we've been writing in the mid-50s accounts receivable, they're at 72 days in terms of DSO. So we think that with our processes, our relationship with the same customers as we combine our collections, credit collections efforts. We certainly expect dramatic improvement in Sun's collection success. And we expect to bring the overall company DSO back down closer to the Oracle level. So that's the accounts receivable.

On the inventories, they have on the order of $500 million worth of inventory. And we talked about a number of supply chain changes that we're having here in terms of simplifying the parts, having less inventory, fewer warehouses. And so I think we expect that to decline over time. And then capital expenditures and property, plant and equipment they have a fair amount in real estate facilities, which won't necessarily be needed on a combined basis because we have plenty of real estate facilities as well. And then they have their own internal cost of creating Sun products, which they capitalize and use in their own business. And we're pretty disciplined about capital. So we treat capital investments, particularly for IT and we have very tight controls over that, far tighter than Sun has. So I would expect that to go down over time as well.

Ken Bond

Okay. And then if there's anybody who has not yet – Margaret [ph], why don't we go ahead and let Margaret ask the last question here? No problem.

Margaret

(inaudible)

Ken Bond

Margaret, let's just get the mic for the webcast. Thank you.

Margaret

Just about to that, does that mean that between, it sounds like your cash taxes are going to be lower than your tax rate. And working capital is going to be a source of cash for the next couple years. Does that mean free cash flow growth is going to be faster than earnings growth for the next two years?

Jeff Epstein

Well, I think that's true of taxes that we're going to get the benefit of that. I think in terms of the working capital, I guess I hadn't modeled it out exactly the way you're saying. But that's certainly a reasonable starting assumption. We certainly are very focused on our non-GAAP earnings but we also focus on cash. And I think we have a very disciplined approach at Oracle on our capital expenditures and our use of cash and our balance between receivables and payables. And I think we're going to bring that same discipline to Sun. And we publish our cash conversion ratio of what our net income is and what our free cash flow is. And we think that fundamentally we're in the business of generating free cash flow for our shareholders that we could either reinvest in R&D, we can pay out in dividends or a stock buyback or use for acquisitions. And we'll continue to have that disciplined approach.

Ken Bond

Well, we want to thank you all very much for coming. We know it's a very busy time. We know there's a lot of earnings activities going on right now. So thank you very much for coming today. We appreciate your participation. And we look forward to talk to you again. Thank you.

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