IBM and Sun: Is it about the hardware or the software?

The Wall Street Journal reports IBM is in acquisition talks with Sun Microsystems. At this point, the companies are refusing to comment on the rumor. If it comes to pass, the acquisition would give IBM a larger share of the high-end server and storage markets and enhanced access to certain customers, especially in the financial services and telecommunications industries. However, the software aspect of the deal might have a larger impact on IBM and the industry as a whole.

Today, IBM is best thought of as a services and software company with a computer hardware division. In 2008, services and software represented 79% of IBM’s revenue and 82% of its pre-tax income. In contrast, hardware represented only 19% of revenue and 9% of pre-tax income. The Sun acquisition would undoubtedly boost IBM hardware revenue and might improve hardware profitability, but the positive impact to IBM’s services and software businesses could easily dwarf these benefits.

Java makes Sun shine for IBM

In addition to its sizeable hardware business, Sun has some strategic software assets, including the Java programming language, the Solaris operating system, and several open source technologies, including the MySQL database management suite. Solaris and the open source technologies are unlikely to make significant contributions to IBM’s software or services revenue, but by owning and guiding Java, the company could create a sustainable competitive advantage over some of its largest services and software competitors.

Java has flourished while Sun hasn’t. Nearly every major middleware and enterprise application vendor (with Microsoft the exception) has built key applications using Java and has plans to build more. By extension, nearly every major corporation relies on Java for some part of its core business processes.

Sun has realized little revenue from all this love for Java. In 2008, the company recognized only $200M from its Java software, an increase of only 0.5% from the year before. As a hardware company, Sun struggled to turn Java into revenue and profit. Unlike Sun, IBM is in a prime position to monetize that asset.

IBM looking to bask in it

IBM is a leading provider of Java-related software and services and could use Java to drive top- and bottom-line growth. The company derives billions of dollars of revenue from Java today. It doesn’t disclose financial results below the divisional level, but AMR Research knows the company’s Java-centric WebSphere business is one of the four pillars of IBM software group’s rapid growth over the last decade. And major portions of IBM’s services business are also tied to Java, including its WebSphere and service-oriented architecture (SOA) practices, as well as parts of its SAP and Oracle applications practices.

By owning and guiding Java, IBM would have a legitimate claim to being the best place to go for Java software and services, which will create a defensible advantage for the company. Unlike Sun, which lacked the channels to sell its Java expertise and software, IBM already blankets the Java market. By owning Java, it could increase its win rate in this massive market and drive billions in additional revenue and profits. Surprisingly, IBM’s software and services divisions could be the primary drivers behind the Sun acquisition as well as the reason for the high price per share discussed in all the rumors.

Acquisition could put Oracle, SAP on the defensive

A larger issue is the impact this will have on the $67B enterprise application software market. While many smaller enterprise software vendors might cheer IBM taking ownership of Java, Oracle and SAP may see this as a strategic threat to their middleware and applications businesses. Java became the dominant language for new enterprise applications thanks in part to Sun’s quasi-open source method of controlling Java’s direction, called the Java Community Process.

No doubt, IBM would be careful to preserve the appearance of Java as a vendor-neutral standard, but SAP and Oracle may not be willing to tie the future of their billion-dollar applications businesses to a language owned by IBM. Sun wasn’t much of a threat to Oracle or SAP, but IBM is a different matter. SAP and Oracle could attempt to block IBM’s acquisition on anti-trust grounds, or splinter the Java standard by building their own versions.

Overall, this acquisition could be a very good financial move for IBM. It promises to boost all of its major businesses and create fear, uncertainty, and doubt in some of its biggest competitors. Ultimately, this may be a masterful play for the enterprise software and services market, not the server and storage market. By controlling Java, IBM may be able to dominate the infrastructure for most of the world’s enterprise applications, making the hardware side of this deal look like an afterthought.