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Sun's Surprising Tale of the Tape

By Peter Burrows Anyone who knows Sun Microsystems (SUNW) Chief Executive Scott McNealy realizes that he isn't afraid of taking big risks. Over the years, McNealy has invested billions of dollars to develop Sun's own Sparc chips and Solaris operating system, rather than simply resell products offered by Intel (INTC) and Microsoft (MSFT). McNealy even offered to give away Sun's Java software as a way to spark demand for Internet servers, long before Linus Torvalds and the Linux crowd began making headlines with their open-source revolution.

But McNealy has always steered clear of another type of risk: the operational kind that come with big mergers. That's why so many observers were shocked on June 2 when Sun announced the $4.1 billion acquisition of tape-storage systems kingpin Storage Technology (STK). While Sun has bought tech startups in recent years, this is by far the biggest deal it has done -- twice the value of its purchase of server-appliance maker Cobalt Networks in 2000.

It's not just the deal's size that has Sun watchers scratching their heads. Given Sun's repeated failures in the fast-growing storage segment, many expected McNealy to spend his $7.4 billion cash horde to turbocharge efforts to bulk up in software.

STUMPED ON THE STREET. While the $65 billion storage market may be one of the few hardware segments with heady growth rates, StorageTek presides over a decades-old tape-storage business that has been slowly shrinking. With sales of $2.2 billion in 2004, it's especially strong with large corporate customers that need massive tape libraries to go with their mainframe computers. But many of those buyers are moving to faster disk-based systems, given the rapid drop in prices over the years.

Many analysts and industry execs think Sun has bigger problems to solve. It posted a $61 million loss in its most recent quarter and suffered continued market-share losses in its core server business. "I'm not sure what [this deal] gets them," says Mark Hudson, Hewlett-Packard's (HPQ) server and storage marketing chief. "To spend half their cash on this deal seems strange, given where we thought they were going."

Investors shared Hudson's view: Sun shares fell almost 3%, to $3.79, on news of the deal.

OPENING DOORS? Ever the contrarian, McNealy says people are missing the point (see BW Online, 6/3/05, "I'm a Believer in Quality"). Tape drives may be the least glamorous segment of storage, but Sun is betting that customers will continue to use this low-cost technology for years to come -- especially since new federal regulations require medical information and corporate e-mail to be stored for years. Far more important, McNealy says, is the ability of StorageTek's salespeople and service reps to help Sun sell other gear to StorageTek's 17,000 corporate customers.

That expert sales corps is crucial. Analysts say Sun has had competitive storage products at various points in its history, but its sales force has never been able to effectively hawk them. "These folks can help us move our products into [storage industry leader] EMC's customer base," says McNealy. "In recent years, those customers haven't wanted us at the table, even though we have some products that are superior to EMC's. Now they may listen."

The deal will certainly bolster Sun's financial prospects in the short term. StorageTek survived a bout with bankruptcy and languished until CEO Patrick Martin led a recovery after arriving from Xerox (XRX) in 2000. Now, the company is profitable, with gross margins of 47.6% over the past 12 months, vs. 41% for Sun, says First Albany Capital analyst Joel Wagonfeld.

ONGOING STRUGGLE. StorageTek also brings in more than $1 billion a year in storage-related services -- a nice, reliable revenue stream for a company like Sun, which has been more dependant on big server sales than its rivals, particularly IBM (IBM). And even after paying an 18% premium to StorageTeks' investors, the deal should be accretive to Sun's earnings.

Still, McNealy faces an uphill climb to make this acquisition a winner. For starters, he's fighting a storage industry megatrend. Over the past 10 years, pure-play outfits including EMC (EMC) and Network Appliance (NTAP) have taken gobs of market share from server makers such as Sun, HP, and IBM .

The reason? It's the same one that explains why these big computermakers lost out to Microsoft in operating systems, Intel in chips, and Oracle (ORCL) in database software: Customers want a best-of-breed product -- one that works on many brands of computers so they're not locked into a proprietary offering. "The server vendors will continue to struggle in this market," predicts Network Appliance CEO Dan Warmenhoven, whose saw his business leap 34% in its most recent quarter.

"GRAY-HAIRED DUDES." What's more, Sun has had the poorest performance in storage of the top server makers over the years, although HP has been struggling mightily of late as well. According to IDC, Sun's storage sales fell 12.8% in the first quarter, in a market that grew 6%. And while most computermakers supply the accompanying storage gear on more than 50% of their server sales, Sun's so-called "attach rate" is less than 25%, says Steven Duplessie, a senior analyst with market researcher Enterprise Strategy Group. He says Sun's overall storage sales fell from $953 million in 2002 to $873 million in 2004 -- and that almost all of those sales were from products made by Sun partners including Hitachi Data Systems and Dot Hill Systems.

Sun has been trying to move in new directions. Duplessie says as the result of its acquisition of startup Pirus Networks, Sun has developed an impressive new virtualization product that lets customers manage different brands of storage gear as if they were from one supplier. Even so, it's no slam-dunk that StorageTek's 1,500-odd salespeople will be able to sell such newfangled products.

"There are a lot of gray-haired dudes in that sales force, and they work their accounts brilliantly to get them to buy more of what they sold them last year," says Duplessie. But just as Sun's salespeople have struggled to move beyond selling servers, he fears StorageTek's sales force may also be a one-trick pony -- able to sell those tape drives, but little else.

WAITING TO BE CONVINCED. Take StorageTek's push into the much-hyped "information life-cycle" software market. The idea is for companies to save big bucks by efficiently moving data to the most cost-effective storage -- say, from the drive on a CEO's laptop, to a corporate server, and finally to cheaper tape drives. McNealy is clearly betting that StorageTek's offerings in this market can help Sun provide more of a soup-to-nuts solution to big customers.

But rivals say StorageTek has yet to distinguish itself in this market. "I don't think StorageTek has a strong position in the whole life-cycle discussion," says Network Appliance's Warmenhoven, who thinks the whole concept is a bit oversold. "I think everybody uses the term to describe whatever it is they have to sell."

Until Sun starts posting profits and regaining lost market share, the naysayers aren't likely to put much stock in McNealy's vision of the future -- at least not as it relates to the StorageTek acquisition. Burrows is Computer editor in BusinessWeek's Silicon Valley bureau

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