KKR To Invest $700 Million in Sun Microsystems

Includes: JAVA, KPEQF
by: Eric Savitz

Yesterday afternoon, Sun Microsystems (NASDAQ:SUNW) reported solid results for the fiscal second quarter ended December 31 - but that is not the big news. The company also announced that KKR Private Equity Investors (OTC:KPEQF), a publicly traded affiliate of Kohlberg Kravis Roberts, will invest $700 million in Sun via $350 million each in two series of convertible senior notes, one due in 2012 and the other in 2014. KKR will get a seat on the Sun board.

In a statement, Sun CEO Jonathan Schwartz said the company will use the proceeds “to pursue strategic opportunities for growth,” and will leverage KKR’s “expertise, assets, global reach and relationships.”

KKR is not doing this for the income; the 2012 notes pay 0.625% interest annually, the 2014 notes 0.75%. The notes will have a conversion price of $7.21.

According to the announcement, half of the purchase price of the notes was funded by a bank loan. Sun will use part of the proceeds to fund “convertible note hedge transactions…intended to offset the dilution to Sun’s common stock resulting from potential future conversion of the notes.” As part of the hedging transaction, the company will issue warrants in two series to an investment bank: 2012 warrants which will have an exercise price of a 60% premium to the price of Sun shares as of Monday’s closing price of $5.75, which would be about $9.20; and 2014 warrants with an exercise price 75% above yesterday’s closing price, or about $10.06. Details on the hedging transaction including the warrants should be filed in an 8-K with the SEC soon, according to a Sun spokesperson. (NOTE: The warrants were not issued to KKR, as I had previously reported incorrectly.)

Oh, and as for the quarter: revenues totaled $3.566 billion, slightly above the Street consensus of $3.52 billion; the company earned 3 cents a share on a GAAP basis, which reflects 2 cents a share in expenses related to stock-based compensation, restructuring and asset impairment charges and a tax benefit. The Street had expected a loss of a penny a share.

As of the end of the quarter, the company had $3.4 billion in cash and short term investments; long-term debt stood at $579 million.

Put it all together, and you have a very nice afternoon for Sun; the stock was up 39 cents after hours to $6.05.

You also get an interesting model for private equity investors looking to put some money to work in the tech sector: buy a piece of a company, rather than the whole thing. No need to hire new management, no need to worry about future liquidity events; With the relatively modest conversion premium on the notes, and a leveraged investment with half the money coming from a bank, KKR has the potential to get a huge score on its investment if Sun can figure out a viable long-term strategy, and Sun gets, well, some cash and the endorsement of a high-profile investor.

Dow Jones Newswires reporter Mark Boslet, listening to the Sun conference call in the office next door, tells me that Sun told analysts it expects a seasonally challenging fiscal third quarter with revenue down sequentially 3% to 5%, which implies $3.388 billion to $3.459 billion, in either case above the Street consensus at $3.32 billion. Mark says the company also said it was on track to reach a 4% operating margin by the fiscal fourth quarter.

NOTE TO READERS: This item was corrected January 25, 2007, to change the details concerning the warrants. I regret any confusion that resulted from the error.