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Can Sun Get Hot Again?

By David Shook For Sun Microsystems and its shareholders, these are trying times. It isn't just the weak demand for its powerful corporate servers, or that the company has been unprofitable. Sun also is confronting increased competition from the likes of IBM, Microsoft, Hewlett-Packard, and Dell Computer.

Sun's revenues plummeted to $2.7 billion in the most recent quarter, a 20% sequential drop and 7% below the same period a year ago -- and almost 50% below the $5 billion-plus it posted for three consecutive quarters at the peak of the dot-com era. As a result, Sun's stock has fallen from a split-adjusted high of $64 in late 1999 to a shockingly low $3, near where it was trading in the mid '90s.

While the stock likely won't continue falling -- barring unforeseen circumstances -- analysts doubt there will be a catalyst to lift it this year. Still, investors might want to keep a watchful eye on a diversification strategy that could push Sun (SUNW) higher in 2003 (see BW Online, 10/24/02, "Sun's Tolliver: 'It's Brutally Competitive'").

SMALLER, CHEAPER. With sales of Sun's big machines harder to come by, the Santa Clara (Calif.) company is looking to move into new markets, sell new products, and boost revenues from consulting and services and support. It has traditionally relied on sales of its midprice and high-end servers. These workhorses, which sell for upward of $100,000 a pop -- and in many cases more than $1 million -- are powered by Sun's Solaris operating software and UltraSPARC III processors. In these lean times, many corporations have opted instead for racks of smaller, cheaper servers powered by Intel processors and Windows software.

Given that the entire server market was down 16% in the second quarter, vs. a year ago, diversification is a smart move, says Jean Bozman, research vice-president for IDC. Sun's bread-and-butter hardware sales to the telecom and Internet industries are all but gone. Competition for customers is so fierce, all the players have been dropping prices. "Every deal is being fought and battled for," says Steve McGowan, Sun's chief financial officer.

That's why Sun is looking to be a bigger player in such areas as data-storage equipment, Linux-based servers and workstations, and even servers that are powered by Intel microprocessors, which Sun has long shunned in favor of machines powered by its own chips. A respectable launch into the Linux market, which Sun had long neglected, could act as a hedge against declines in its more traditional server sales. It's also looking to make strides in industries where it hasn't been much of a factor, such as biotechnology, hospitals, and retail.

SERVICES AND LAYOFFS. In addition to fresh hardware and software and new industries to tap for sales, McGowan says Sun will seek to generate more revenue from selling support services -- similar to what IBM has done in pushing technology consulting. While services accounted for 20% to 25% of Sun's sales in recent quarters, they could reach 30% or more in the future, analysts believe.

Sun is also taking more traditional steps to stanch the losses in the server market and keep its competitive edge. On Oct. 17, it announced an 11% workforce reduction -- on top of a 9% cutback in 2001. The drastic job cuts will probably ease Sun's return to profitability by the second-half of fiscal 2003, which is management's stated goal.

Despite its losses, one area where Sun is resisting the urge to cut spending is research and product development. In the first quarter of fiscal 2003, which ended Sept. 29, Sun had a net loss of $111 million (4 cents a share), vs. a loss of $180 million (6 cents a share) a year earlier. But Chief Executive Scott McNealy has pledged to keep R&D spending at about $1.8 billion in 2003 -- the same as this year (for an extensive Q&A with McNealy, see BW Online's Video Views). And, finally, sales of Sun's high-end servers, its bread-and-butter product, could lift prospects if more corporations upgrade or expand their aging systems.

LOTS OF CASH. A big plus for Sun is its healthy balance sheet: It still boasts $5.2 billion in cash. During the Oct. 17 earnings conference call, McNealy seemed confident that Sun could continue to buy back stock and reduce its $1.5 billion in debt without sacrificing the positive operating cash flow it has maintained for 32 straight quarters. McNealy told investors: "Tough times require tough decisions, and everyone at Sun is dedicated to returning the company to profitability as soon as possible."

Certainly, soft tech spending has bitten every computer maker hard. But at some point, the tech industry will recover. What critics of Sun worry about is whether it risks becoming an also-ran in the corporate computer market. "In the long term, Sun's rivals concern me more than the economy," says Merrill Lynch tech strategy analyst Steve Milunovich.

Indeed, more corporations could move away from Sun's expensive proprietary operating system and microprocessors, instead adopting the commodity Windows/Intel server platforms that now run much of the computer world. They might even opt for Linux, the dirt-cheap "open source" operating system known for being easily customized. In the Linux market, IBM, HP, and Dell are seen as better positioned than late-to-the-game Sun.

RUMORS AND TRENDS. Other analysts don't seem too worried about Sun's ability to remain a key player. "I know there have been a lot of stories about rival companies displacing Sun equipment at major corporations, but that's anecdotal," says IDC's Bozman. "What's really important is looking at the quarterly trend lines on overall server market share. Sun remains the third-largest server player in the industry [behind IBM and Hewlett-Packard.] We think Sun will remain one of the major server players in the world."

Sun isn't likely to find any spark to ignite its stock this year -- other than the outside chance that tech stocks as a group find favor in coming months. For investors who want to get back into tech at some point, Sun is worth watching. It has a solid management team that knows what must be done. If Sun can produce evidence that its diversification strategy is paying off, the stock will look much more appealing in the next few quarters. Shook is a reporter for BusinessWeek Online in New York

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