Sun Wrings Profits from a Flat Fiscal First Quarter

Published: November 6, 2007

by Timothy Prickett Morgan

Server and software maker Sun Microsystems continues to struggle to grow its revenues as it undergoes product transitions in conjunction with changes in the IT market. But, because of tight cost controls, Sun has been able to boost its gross margins in the fiscal 2008 first quarter ended September 30 to a seven-year high, and that means it was able to book a slight profit. This is the fourth quarter in a row that Sun has brought some black ink to the bottom line, albeit a small smear of black ink at that.

For the fiscal first quarter, which is one of the company's seasonally softest quarters, Sun had total revenues of $3.2 billion, up 1 percent, and gross margins rose by five points to 48.5 percent of sales. Sun booked $113 million in restructuring charges in the quarter and was nonetheless able to still bring $89 million, or 3 cents per share, to the bottom line. This was obviously somewhat better than the $56 million net loss that Sun had in the year-ago quarter, which worked out to a 2 cents per share net loss. Sun generated $574 million in cash from operations in the quarter, and exited the three-month period with just under $5.2 billion in cash and marketable securities. That cash pile was diminished in the quarter by $1.25 billion, as Sun acquired 244.6 million of its shares from Wall Street, which obviously helped boost per-share earnings for the quarter. Sun has another $3.75 billion of stock buybacks still authorized by its board of directors.

"Q1 was seasonally challenging, as expected, and top-line growth is still an area of focus," explained Jonathan Schwartz, Sun's president and chief executive officer, on a conference call with Wall Street analysts. "Clearly, we are bullish about our longer-term prospects, as evidenced by our aggressive share repurchases in Q1."

As if share repurchases were anything more than financial engineering. The only reasons to buy such large tracts of shares are to give some to employees or to hope to sell it back some day at a much higher price. Well, there is another reason. If you want to try to take yourself private--something that would probably do Sun a lot of good, in fact.

Sun's hardware products accounted for $1.98 billion in sales in fiscal Q1, up 1.1 percent, with computer systems coming in at $1.48 billion, up 0.5 percent, and storage up 2.9 percent to $505 million. Schwartz said that tape sales were weaker than expected, and that midrange disk array sales were up and high-end array sales were stable; he also said that "Thumper" disk arrays, which are based on Sun's "Galaxy" X64 servers and its Zettabyte File System for Solaris, were seasonally down. On the services front, sales were up 0.7 percent to $1.24 billion, with support revenues actually down nearly 1 percent to $979 million and professional services and education up 7 percent to $260 million.

Based on the presentation that Sun handed out as part of the call with analysts, it looks like the company shipped around 78,000 servers in the first fiscal quarter of 2008, down 2 percent; the company sold about 23,000 X64-based machines in the quarter, rising 7 percent compared to shipments a year ago. When you do the math that means Sparc-based server shipments dropped by 5 percent or so. (Sun does not provide precise shipment numbers in the presentation, so it is hard to be precise on how much shipments fell.) Schwartz said that Sun's sales of high-end systems based on Sparc designs did well in the quarter, and also helped to bolster revenue that would be deferred into the second quarter. He did not give out revenue figures by product line, but did talk about billings growth in the quarter, saying that billings for CMT systems (presumably this means Sparc T1 and T2 machines) were up by 70 percent, that billings for enterprise systems rose by 23 percent (presumably meaning both UltraSparc-IV+ and Sparc64 VI machines), and that X64-based machines rose by 10 percent. Sun exited the quarter with $2.6 billion in deferred revenues, up 14 percent from a year ago.

Schwartz once again said that Sun was not concerned about shipment declines and was focusing on growing revenues for the machines. This is because companies are trying to consolidate their large numbers of small rack servers into smaller numbers of larger machines that have been virtualized. This lowers operational and acquisition costs and also increases the manageability of the server platform. The tendency to consolidate servers may also be having an effect on support sales, which Sun saw a decline for in the quarter.

Sun has not, as yet, finished breaking out its software business, but Schwartz said that the company was working on this and was committed to transparency in all of its business units. The question, of course, is how to allocate Solaris and support revenues on systems that come with these bundled into the hardware price. If Sun takes out the software and services, it will make its hardware sales look smaller. It's a bit tricky, and there are undoubtedly some heated discussions within Sun concerning how to go about this, particularly now that Solaris 10 has been freely distributed for nearly three years.

On a geographical basis, Sun's sales were down in the United States by 4 percent to $1.32 billion, while sales in the International Americas region rose by 6 percent to $193 million. Sales in the EMEA region were up 5 percent to $1.16 billion, and sales in the Asia/Pacific region rose by 6 percent to $547 million. Schwartz cited sales in EMEA and AP as strong, with particular strength in China and India and sluggishness in both Japan and the United States.

Like IBM in its third quarter ended September 30, Sun also saw a slowdown in the financial services sector in the United States. "We have certainly see some slowing in the financial services companies, especially among those that were more exposed by subprime mortgage issues," Schwartz said. "Broadly, retail banking, commercial banking, and the capital markets are up and otherwise strong as these companies continue to look at technology from both Sun and others as a vehicle to grow. Telecommunications we also see as being reasonably strong," he said, but "most traditional industries are slow and frankly have been for a while. Beyond that, we'll see as time goes forward."

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