Can Software Stop Sun's Slide?

The server maker is betting big on it--once again

It's been a rough year for computer server manufacturer Sun Microsystems Inc. (SUNW ) Its free-spending Internet customers have gone the way of the dodo. The soft economy has hurt demand across the board. Most worrisome, it's losing market share to hard-hitting competitors, such as Dell Computer Corp. (DELL ) With its troubles mounting, Sun's stock has plummeted to less than $5, a 92% drop from its $64 peak in 2000.

So how do Sun execs plan to get out of this pickle? In a word, software. While a stronger economy will help sales recover somewhat, the company's top brass think the hardware giant needs to act more like a software company to address its long-term challenges. In a move underscoring the importance of the strategy, Jonathan Schwartz, Sun's chief competitive officer for the past three years, took over the newly created position of executive vice-president for software development on July 1. "Software is right at the center of the future of this company," says Schwartz.

The software strategy, dubbed Sun ONE, for Open Net Environment, is designed to spark sales across the company's product lines, from servers to data-storage gear. The idea is to use software as a Trojan horse to get into big corporate accounts that will then buy more of everything from Sun. The most aggressive move is Sun's decision to give away its entry-level application-server software, a $3,000-and-up product that handles simple e-business tasks like e-commerce transactions and runs the software for more complex e-business functions. Once in the door, Sun figures it will more easily sell additional software for things like controlling employee access to networks. That should allow the company to grab a slice of the $28 billion infrastructure-software market--and sell more hardware. To back up the effort, the company in May set up a 1,000-person sales and service group dedicated to selling software.

No question, Sun needs to do something about its sagging finances. The Palo Alto (Calif.) company's revenues for the fiscal year that ended June 30 are expected to be about $12.4 billion, down 32% from a year ago. The company's gross margins have slipped to an estimated 40% this year, compared with 54% last year. Although it is expected to break even in the June 30 quarter--the first time that has happened in a year-- many analysts question whether the economy alone can spark renewed growth. "Sun has serious, serious technology and strategic problems," says Bill Whyman, an analyst at the Precursor Group, an independent research firm in Washington, D.C.

The company is being squeezed on both sides. Dell is concentrating on sub-$10,000 servers and has boosted its share of the overall market to 7.4% in the first quarter, from 5% in 2000, according to International Data Corp. Meantime, IBM is a strategic threat at the high end because it can offer big corporate customers complete, easy-to-use e-business systems with hardware, software, and everything else they need. The result: Sun's share of the server market has dropped to 14.9% in the first quarter, from 17.0% in 2000, IDC says.

How will Sun's new strategy help? At the moment, software accounts for less than 5% of Sun's overall revenues, according to Whyman, so even doubling software sales would do little for top-line growth. Still, the initiative will give Sun a broader product lineup to compete with IBM, and it could fatten Sun's profits. Business software carries gross margins north of 80%, compared with about 30% for most hardware. Doubling software sales could add about $500 million in gross profit, compared with $200 million for a comparable revenue increase from hardware products. Sun won't specify its targets for software sales or hardware sales driven by software.

For all its grand plans, Sun faces long odds given its track record. As far back as 1993, Sun was promising to beef up its software business. Since then, it has repeatedly tried--and failed--to become a bigger player in the market. "I respect Sun a great deal," says Alfred S. Chuang, CEO of Internet software giant BEA Systems Inc. "But they have never proven they know how to sell software."

The biggest missed opportunity came in 1998. When America Online Inc. (AOL ) acquired Net pioneer Netscape Communications Corp. that year, it handed control over Netscape's software to Sun, giving Sun the two top-selling application servers at the time. Although the market was tiny and fragmented among 40 companies, Sun's $30 million-plus in app-server sales was 10% of the total market, twice that of its nearest competitor.

But Sun blew its lead. It tried to integrate the two application servers, stumbled, and didn't get a new product out the door for nearly two years. Meanwhile, IBM (IBM ) and BEA (BEAS ) introduced upgrades at least once a year. As the app-server market boomed to $2 billion annually, IBM and BEA dominated, together selling more than half the app servers in the world. Sun is expected to slip to a distant third this year, with a 12% share of the market, according to AMR Research Inc. That puts it neck and neck with rival Microsoft and database giant Oracle Corp. (ORCL )

Sun ONE is an attempt to take at least part of that market back. In May, Sun started bundling, for free, its application server with its own Solaris server-operating system. That's only a first step. Later this year, the company will offer the free version of its app-server software for Linux operating systems and other UNIX programs--and, in a move akin to cats living with dogs, for Windows. "We don't think [using Windows] is the wisest move for many reasons," says Schwartz. "But if that's what customers want, we'll make that available to them." Sun says it is more important to give customers options and compete on a product-for-product basis, rather than lock them into a permanent relationship. "Our aim is to win with innovation and quality," says Sun CEO Scott G. McNealy.

And a good sales pitch. McNealy has forced Sun's more than 300 vice-presidents to master Sun's new message. He has had each one trained to explain that Sun can offer complete e-business systems, then videotaped them all giving a three-minute spiel. That should help execs push additional software to go with its application-server product. Sun is selling integration software that ties big computer systems together and works neatly with the application-server software, directory software that controls the identities of people using a computer network, and so-called portal software that makes it easier to share information over a corporate network. Finally, by early next year, Sun will sell two high-end versions of its app server that address specific needs of big corporate customers, such as ensuring the reliability of their networks.

Sun's pitch, that it can offer complete computer systems with hardware and software, is resonating with some customers. They like the idea that one company can respond quickly to any complaint. "You would like to have one throat to choke," says Tim Von Kanel, chief technical officer of Questerra, a Charlottesville (Va.) tech company that buys all of the software and hardware for its network from Sun.

Sun's plans for the future could really get some attention. The company is working on software, called N1, that is similar to the concept of grid computing. Grid would allow a company to collect huge amounts of computing power by using the Net to tap unused computers around the country. Sun's N1 software would enable grid computing so its customers could grab computing resources whenever they needed them. The first version of N1 is expected early next year.

Put it all together, and Sun execs think they can finally compete for big software deals. "Do we wish we could have done this faster? Sure," says McNealy. "But we absolutely have the right offerings at the right place at the right time."

Still, Sun has a tough row to hoe in software. Ask competitors what they think of Sun, and they don't bristle--they scoff. "I think they've lost their window. They had an opportunity to create a software business," says Scott Hebner, director of marketing for IBM's app server, called WebSphere. After years of scuffling, this may be Sun's last shot to prove it can get software right.

By Jim Kerstetter in San Francisco

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