Sun Micro Gets the Cold Shoulder

Shares slumped Wednesday after the IT outfit reported a quarterly profit, as investors fretted that it faces increasing competition

Sun Microsystems (SUNW) managed to post a second consecutive quarterly profit, after having only recently persuaded more customers to buy improved versions of the computer hardware they had avoided since 2002. But investors sold the Santa Clara technology outfit's stock nonetheless on Apr. 25, worried that disappointing sales might herald a short-lived turnaround in the face of looming rivals.

Sun's net income during its fiscal third quarter amounted to $67 million, compared with a net loss of $217 million in the year-earlier period. "With another quarter of profitability, we're seeing continued progress operationally, strategically and financially," CEO Jonathan Schwartz said in a press release late Apr. 24.

The profit amounted to 2 cents per share during the quarter, including a net 2 cent reduction related to items such as stock-based compensation, restructuring costs, losses on assets, and taxes. While Sun's earnings per share came out mostly in line with analyst forecasts, its sales rose 3.3% year over year to $3.283 billion during the April quarter. Analysts surveyed by Thomson Financial had expected $3.421 billion.

Investors sold the stock 12.1% to $5.22 per share in early New York afternoon trading on the Nasdaq.

"We are encouraged by SUNW's second consecutive quarter of profitability and by Mar-Q cash from operations, but we are somewhat concerned by increasing competition," Standard & Poor's equity analyst Jay Hingorani said in a research note. (S&P, like, is owned by The McGraw-Hill Companies.) "We also see a softening economy and lower enterprise spending impacting June-Q revenues."

Since taking the helm in April, Schwartz has brought in new Niagara computer servers, designed to save customers money by yielding more processing power for the buck. And Sun's Solaris operating system distributes an open-source version that tempts customers with free software packages, in the hopes that they'll also buy Solaris licenses and switch to Sun hardware. As such efforts begin to bring back buyers who had seen Sun products as expensive, the company finally swung to profitability during the December quarter.

So far much of Sun's recent growth has come in inexpensive servers powered by Advanced Micro Devices' (AMD) Opteron chip, and it's tough to improve profits in that business. Sun's total gross margin as a percent of revenues was 44.5% during the third quarter, an increase of 1.5 percentage points year over year.

Schwartz has taken hardball steps to cut costs. In May, for example, the company announced a "growth" plan that included downsizing the company's 37,500 staff by about 4,000 to 5,000 people within six months. Sun also said it is selling its Newark campus and exiting leased facilities in Sunnyvale, Ca. The company has incurred nearly $1.5 billion in charges since 2002, eliminating one fourth of its workforce and closing facilities, according to Morningstar. The firm recently announced another 5,000 job cuts and more facility closures, with the goal of delivering a 4% operating margin by the end of fiscal 2007.

Meanwhile Schwartz is facing tough competition. For example, the technology giants IBM (IBM) and Hewlett-Packard (HPQ) offer comparable server platforms on the high end, but with superior service organizations that help companies design, deploy, and maintain their technology infrastructure investments, according to Morningstar. "We expect this weakness in [Sun] servers to continue as companies adopt industry-standard x86 servers in lieu of Sun's higher-end systems," Morningstar analyst Rick Hanna cautioned. Giving the rising competition, Hanna doubts Sun can reach its profit operating margin target of 10% by 2009.

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