The Shadows Shrouding Sun

With the server giant forced to sell lower-margin Linux machines, earnings are suffering. And its R&D won't pay off for a while

By Jim Kerstetter

Will the real Scott J. McNealy please stand up? Is the chief executive of Sun Microsystems (SUNW ) a pragmatist, partnering with distributors of the low-cost Linux computer operating system in order to make customers happy? Or is he the intractable company man who believes that only Sun's famous research labs can generate the real solution to those customers' problems?

The answer: Probably both. And that's a precarious dual role for McNealy to be playing these days. Sun -- long considered one of the most innovative outfits in high tech -- can't seem to find its way out of the tech slump the same way competitors, such as IBM (IBM ), Dell (DELL ), and Hewlett-Packard (HPQ ), have been doing. In Sun's fourth fiscal quarter, which ended June 30, net income was just $12 million -- breakeven per share -- down from $61 million, or two cents a share, a year ago. Revenue fell 12.9%, from $3.42 billion to $2.98 billion.


  It was a flat coda to what McNealy himself calls a "pretty tough" year. For the full 2003 fiscal year, Sun reported revenues of $11.4 billion, down 8.5% from fiscal 2002. "We're not happy with it, and we've got all our energy focused on growing revenues and generating profits," the CEO says. Just about the only good news was that Sun still managed to generate $1 billion in cash in the fiscal year. Merrill Lynch analyst Steve Milunovich said in a report: "Sun is performing well as a bank -- less impressively as a computer company."

The result: Sun seems to be getting the worst of both worlds. Trading at around $3.70 per share, it's about in the middle of its 52-week range, recovering from the scary $2.34 it hit last September. But after Sun announced its disappointing earnings last month, its stock dropped 19.3%, to $3.85, in one day on July 23.

And the shares have been sliding ever since. Of the 21 research analysts who cover Sun, 16 have it rated as a hold, four say it's a sell, and just one has it rated as buy. Despite the relatively low share price, no one has Sun rated as a strong buy because of its meager earnings.


  The biggest problem may be that servers running on Linux, the inexpensive, open-source operating system, and microprocessors built by Intel (INTC ) are eating into Sun's bread-and-butter business -- servers running its own Solaris operating system. In the first quarter, Sun's share of the overall server market slipped 1.7 percentage points from last year, to 12.8%. During that time, Dell's share, thanks in large part to its hearty adoption of so-called Lintel technology, has increased 1.5 points, to 9.3%, according to research outfit IDC. Sun is "in such a difficult position," says Lindy Lesperance, research director at Technology Business Research in Hampton, N.H. "The market has shifted on them."

Don't expect an overnight fix, either. Gross margins, an important indication of Sun's efficiency, were up 2.4% from a year ago, to 43.7%. But Steve McGowan, Sun's chief financial officer, says the current quarter's gross margins are likely to narrow because of aggressive server pricing among competitors. They've already slipped from the third fiscal quarter, down a little less than a percentage point, because of that price pressure, McGowan adds.

Also, component costs aren't declining as much as Sun execs had anticipated, he says. The upshot: Barring layoffs, Sun has probably wrung as much efficiency as it can out of its business.


  Sun has a well-earned reputation for squeaking out of tough spots, and it has long-term projects -- ranging from software to managing giant networks of computers to a whole new way of designing computer chips called throughput computing -- that could power it out of this pickle. They're the main reason McNealy says Sun has to maintain its $2 billion annual research and development budget, which is one of the biggest in the computer industry.

Analysts, however, fear that the payoff for the long-term projects, intriguing though they may be, is still years away. Until then, all that R&D spending will keep Sun's break-even point high and ultimately translate to meager profits.

So McNealy & Co. are stuck with the balancing act. Sun now sells servers containing Intel chips and a version of Linux distributed by Red Hat (RHAT ) because the Linux server market is the only segment that's still growing. In the first quarter, total server-market revenue was down 3.6% from last year. Linux sales, however, were up 35.1%.


  Sun started selling Linux servers late last year -- a good two years after its competitors -- and has a 0.5% market share, a far cry from HP's 31.7%. Forced to play catch-up, Sun is probably cannibalizing its existing, higher-margin Solaris server business. But if Sun doesn't do it, McNealy points out, someone else will.

Is there good news in any of this? Yes, if you have patience. While analysts estimate fiscal 2004 will be roughly flat from 2003, the consensus estimate for fiscal 2005 has revenues increasing 15.3%. By then, those far-ranging R&D projects should start paying off. But if they don't, McNealy may run out of answers for all the doomsayers who've been predicting Sun's demise for the last two decades.

Kerstetter covers technology from BusinessWeek's Silicon Valley bureau

Edited by Douglas Harbrecht

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