On Mar. 5, Standard & Poor's Ratings Services lowered its corporate credit rating on Sun Microsystems (SUNW ) to 'BB+', below investment grade, from 'BBB'. The downgrade reflects weak and inconsistent profitability, and Standard & Poor's expectation that Sun will be challenged to profitably expand its market presence, says analyst Martha Toll-Reed.
The ratings were removed from CreditWatch, where they were placed with negative implications on Oct. 17, 2003. The outlook is stable. As of Dec. 28, 2003, Sun had total debt outstanding of about $1.3 billion.
The ratings on Santa Clara, Calif.-based Sun Microsystems reflect a good but not leading position (based on all operating systems) in the highly competitive global server market, a relatively narrow revenue base -- particularly in comparison to major competitors -- and inconsistent profitability. These factors are partly offset by moderate debt levels and ample liquidity.
During the late 1990s, rapid growth in Unix-based network servers, and related storage and software products, combined with Sun's strong technology and product development skills, bolstered the company's business position. However, the 2001-2003 downturn in technology spending led to a significant decline in Sun's revenue and profitability levels. In addition, recent growth has occurred in lower-cost Windows- and Linux-based segments, in which Sun has not historically had a strong position. Although Sun has also shifted its strategic product and market emphasis to include recurring software sales, the current rating does not incorporate the potential success of that initiative.
Ongoing cost-reduction efforts have enabled Sun to maintain largely positive EBITDA, despite continuing year-over-year revenue declines. Nevertheless, given fierce industry price competition and Sun's high R&D investment rate, Standard & Poor's does not expect profitability levels to return to historical levels in the near-to-intermediate term.
The company reported revenues of $2.9 billion in the quarter ended Dec. 28, and a net loss of $125 million. Quarterly EBITDA margins (adjusted for capitalized operating leases) have varied between 0% and 10% over the past two years. As a result, total debt (including capitalized operating leases) to EBITDA has also fluctuated widely -– from 1 times to 6 times -- over the past several years.
While near-term free operating cash flow (after capital expenditures) is expected to be weak, more than $5 billion in cash and marketable securities provide ample liquidity. Although Sun does not maintain a committed credit facility, funded debt levels are moderate, and cash balances provide sufficient cushion for expected cash operational requirements.
The only near-term debt maturity -- $250 million due Aug. 15, 2004 –- is expected to be paid from existing cash balances. The current ratings also incorporate the expectation that Sun will maintain cash and marketable securities in excess of $3 billion.
The outlook is stable. At the current rating level, a strong liquidity position, emphasis on cost reductions, and Sun's technology and product development skills are expected to offset highly competitive market conditions and increasing market acceptance of lower-cost Windows and Linux systems.
From Standard & Poor's Ratings Direct