How Will Sun Weather the Downturn?
By Amey Stone
As the music dies down from Sun Microsystems' (SUNW ) three-day meeting with analysts (Merrill Lynch refers to it as the company's "annual love fest"), a nagging main question looms over the stock: How fast can Sun, which makes hardware and software and sells services for building and maintaining computer networks, grow in a struggling economy?
On Feb. 6, Sun execs forecast sales growth in the 20% to 35% range for the next three years, which is strong but a rather broad spread. "In our view, 20% would suggest the stock is somewhat fairly valued," Merrill Lynch analyst Tom Kraemer wrote in a note to investors that day. "We expect the stock to mark time near term until there is more visibility," he added.
Referring to executives' "somewhat sobering comments about January spending levels" on Sun equipment, Sanford Bernstein analyst Toni Sacconaghi predicted in a Feb. 7 note that there will likely be "little opportunity for short-term appreciation" in the stock. He expects the company to earn 68 cents per share in 2001, up from 51 cents a share the previous year.
The fact that Sun apparently wasn't able to rekindle Wall Street's conviction in its near-term growth rate -- and enthusiasm for the stock -- isn't good news for current investors. But analysts' concerns are near-term and tied to the slowing economy. For long-term investors who remain convinced that Sun will remain one of the key enablers of Internet business, the expected lull in the stock the next few months could provide a buying opportunity.
Now priced only in the mid-20s, from a September high of 65, "the stock begins to become more attractively valued," Sacconaghi admitted in his note. That's hardly the fanfare Sun executives were likely hoping for following three days of putting their best foot forward, but it will have to do for now.
The fact is, the economy is slowing, dot-coms are failing right and left, telecommunications companies are cutting back, and even large global corporations may be lowering their spending on Internet initiatives. In this light, it is no surprise that the growth of Sun's sales -- 75% of which are tied to Unix servers, the dominant hardware used on the Internet -- is slowing dramatically.
Growth was an astonishing 60% year-over-year for the quarter ended Oct. 1, 1999. But in its last quarter, reported Jan. 18, revenue grew 44% over the prior year. That's still pretty fabulous -- especially given that sales were more than $5 billion. But analysts weren't cheered. Some were anticipating 45% sales growth, and a wave of downgrades ensued. Analysts from at least eight firms have downgraded the stock since last fall.
Despite its 60% drop in share price, Sun's stock could still fall further, some bearish analysts warn. What we've seen so far "is just the correction of the extreme overvaluation," says Michael J. Davey, technology analyst with Investec Ernst & Co. Still pricey by most measures, Sun trades at a forward price-to-earnings (p-e) ratio of 41, in contrast to a p-e ratio of 24 for the Standard & Poor's 500-stock index.
Meantime, Sun, which has about 50% of the Unix server market, is facing an increasingly competitive environment. Chief adversary Microsoft is homing in on the same fledgling market for Web services and software. And other hardware makers at both the high and low ends are going after Sun's server sales. Already, Davey believes, pricing pressure on the hardware side has crimped Sun's profit margins. "I don't think the stock reflects all the problems [Sun] will encounter trying to be all things to all people," he says.
"Sun is now under pressure in a way that it just wasn't," concurs James Governor, an industry analyst with information-technology consulting firm Illuminata. "It has had a free ride over the last couple of years."
Governor was unimpressed with the main news of the conference -- Sun's launch of the Sun Open Net Environment (Sun ONE) strategy, a suite of advanced Web software and services. "The problem is, it just isn't that compelling," he says. "There was nothing really new. It was a repackaging and rebranding exercise." IBM, Oracle, and Microsoft are all pushing similar offerings, he says.
Another concern: Merrill's Kraemer has noted with disappointment that Sun didn't introduce the midrange of its server product line, the UltraSparc III, at the meeting. Kraemer is hoping it will alleviate some pricing pressure from IBM. Sacconagi, also eyeing the new product rollout, called Sun's plan "non-confidence inspiring."
Sun did put across a major point at the analyst meetings -- showing Wall Street that it has the long-term vision and focus on its customers that will allow this dominant player in the networking industry to continue to gain market share. At the current stock price, any signs that Sun isn't executing flawlessly on its plan or isn't making the market-share gains anticipated leave room for downside moves. That, of course, may be just what long-term investors are looking for.
Stone is an associate editor of BusinessWeek Online and covers the markets in our daily Street Wise column.
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Edited by Beth Belton