IBM-Sun: Part cheap, part fearful

IBM is bracing for impact. The tech conglomerate is pondering a bid for Sun Microsystems. Sure, combining the two big producers of computer servers promises substantial cost cuts. And Sun’s depressed valuation and substantial cash pile are no doubt tempting for the blue-chip IBM. But Cisco’s entrance into the already crowded server market is probably the key - especially for Sun.

First the cheap part, for IBM at least. Prior to the technology giant's interest leaking, Sun had lost about 70% of its market capitalisation over the course of a year.

Assuming IBM paid a premium to Sun's undisturbed price of around 100%, as news reports suggest, IBM would be paying an extra $3.7bn for control.

That should pale beside potential synergies. If IBM could cut 10% of Sun’s bloated cost base, it would save $1.25bn a year. The value of these savings today should be more than double that premium. That suggests a deal could look like a bargain - as long as Sun’s decline doesn’t accelerate.

Then there's the defensive aspect. Servers already bring in low margins for producers, and they keep falling. Virtualisation software means one server can now do the job of many. Users are also switching to cheap off-the-shelf hardware instead of more expensive – and profitable - specialised kit.

This last trend has particularly hurt Sun. The worldwide server market declined 3% in 2008, according to research outfit IDC, while Sun’s hardware sales fell 7%. Luckily for Sun, its smaller services business is steadier. But with hardware sales stagnating almost across the board in major markets, a deal with IBM could stop Sun disappearing over the horizon.

The market shifts won't be lost on IBM, either. Aside from anything else, Cisco has now entered the server market. For the four firms that dominate the market - IBM, HP, Sun and Dell - that means a tough business is about to get tougher. Hooking up with Sun - especially at a modest price - is one way to take on a new rival