By Krishna Roy, M&A Impact When Netscape Communications Corp fell to internet services giant, America OnLine Inc last month, the implications for AOL’s portal business were obvious. With around 14 million subscribers already, about seven times its closest rivals, AOL was paying $4.2bn for the Netcenter portal and its business traffic, while simultaneously buying into […]
By Krishna Roy, M&A Impact
When Netscape Communications Corp fell to internet services giant, America OnLine Inc last month, the implications for AOL’s portal business were obvious. With around 14 million subscribers already, about seven times its closest rivals, AOL was paying $4.2bn for the Netcenter portal and its business traffic, while simultaneously buying into the founding father of internet computing. What was harder to fathom was Sun’s motivation for joining the party. So far, Sun has agreed a three-year development and marketing agreement with AOL for Netscape’s enterprise server software. In return, AOL will receive $350m in licensing, marketing and advertising fees. AOL has also committed to buy systems and services worth $500m at list price from Sun through 2002. But wouldn’t it have made more sense for AOL or Netscape to sell the enterprise software business to Sun, which has the sales, marketing and development infrastructure to sell to enterprise accounts? Why was the deal cut three ways? Does Sun eventually want to own Netscape’s enterprise server business and is it using a licensing agreement as a precursor to outright purchase?
Netcenter may be the fastest growing piece of Netscape’s business with revenues up 24% on a sequential basis to $48m in the fourth quarter of 1998, but the company’s server side business was still double that size at $114m. The company’s enterprise software business makes for roughly two-thirds of its revenues overall, yet the precise fate of the much larger operation has yet to be determined. Netscape and AOL say they are still in the process of sifting through the combined product portfolio to determine product overlap and future strategy. But it seems odd that more attention had not been paid to a server side strategy, given that both parties had been in discussions for some 4-5 months. Publicly, executives on all sides have tried to distance themselves from any speculation that Netscape’s enterprise business will eventually go to Sun. AOL and Netscape couch Sun’s involvement as evidence of a commitment on its part to build a corporate customer base. The idea is to boost Netscape’s credentials as an enterprise software supplier through Sun’s corporate expertise. There is a commonly held misconception that AOL doesn’t care about the enterprise. That is not true, says John Paul, senior vice president and general manager of Netscape’s server division. But rumors that Sun wanted to buy Netscape have been circulating for some time. Sun CEO Scott McNealey refuted any idea that Sun wanted to purchase Netscape, but did so in terms of not wanting Netcenter. Netscape is very much a traffic and services play, he said, we don’t want to aggravate AOL or any other service provider [by getting into the ISP business.] Yet at the same time he said that Sun wanted to build a platform for e-commerce and would build a tightly integrated product line on Solaris that it would aggressively take to market. It sounded as if another deal with AOL was not out of the question.
The agreement as it stands does not preclude Sun from buying the enterprise software operation at a later date. The business rational would be sound and therefore has not been discounted by the analyst community. Sun has shied away from buying Netscape because the server side of the business as it stands would bring down margins. It wouldn’t help Sun’s bottom line, says Chuck Shih at Gartner Group. Netscape’s failure to penetrate enterprise accounts, as a result of its lack of experience in selling software higher up the value chain, has curtailed growth in this line of its business. But a Sun/AOL combination could spur immediate growth through Sun’s corporate muscle and AOL’s dollars, thereby making it a far more attractive acquisition candidate. In broad terms, the business would accelerate Sun’s e- commerce push by providing it with a set of fairly tightly integrated CommerceXpert servers and an application server (the Netscape Application Ser
ver, bought with its $173.3m acquisition of Kiva Software Corp at the end of 1997 (CI No 3,297). Sun’s application server offering, which it also acquired through the $160m purchase of NetDynamics in September of this year, has been widely criticized for its lack of scalability. Sun’s application server is built on a two-tier architecture and has always had scalability problems. It is only really suitable for departmental use as it does not have the transactional processing power of the Netscape product, says Shih at Gartner. Sun would also get a collection of messaging, email servers and web servers on a platform other than Solaris (like NT, for instance) if it seals a deal with AOL. Although, there would be some product overlap, Netscape’s Application Server would increase its market penetration in the application server market and shore up its market share against Microsoft Corp. Netscape’s software has a larger presence in Fortune 1000 companies that the NetDynamics product, according to figures from Forrester Research, and adding up its 20% share with 13% from NetDynamics would put the combination ahead of Microsoft, which currently has a 27% market share.
In terms of M&A taxation issues, this strategy has further mileage. If Netscape or AOL had split the business apart and sold the server business separately, the sale would have been subject to corporation tax. But by negotiating a separate licensing, marketing and advertising agreement with AOL, Sun will pay a mere $350m over three years for a revenue stream which will not be subject to the same high level of taxation. An SEC filing issued last Wednesday indicates that considerable discussion went into the Sun/AOL part of the deal, and the fact that Sun is believed to have agreed terms only after AOL had sealed its pact with Netscape lends further substance to the theory. AOL may have been reluctant to break up Netscape because it would not have been able to use the pooling of interests accounting method which minimizes the acquisition hit on the corporate bottom line. But if AOL could persuade Sun to buy the enterprise software business it could feel the financial benefits much quicker. Furthermore, there is a key player who resides on both Netscape and Sun’s board that may be anxious to see a transaction between AOL and Sun take place. John Doerr, of venture capitalist Kleiner Perkins, is believed to have played a pivotal role in bringing Sun and Netscape together on the basis that a deal strengthened a coalition against Microsoft, preserved Netscape’s technology and offered Kleiner Perkins a healthy return on its investment. The harder part to figure out is just how much control of the enterprise aspect of Netscape’s business AOL was, is, or will be willing to give up. AOL is anxious to use the software development skills at Netscape to design clients for numerous devices besides the PC. Since the client is the key to attracting and keeping users – and therefore the key to revenue generation – it may well be that AOL wanted to keep some control over those efforts and the efforts to connect those clients back to the servers, says Lise Buyer at Credit Suisse First Boston.