Sun Ekes Out Slim Profit in Fiscal Q3

by Timothy Prickett Morgan

Sun Microsystems today said that it eked out a skinny profit in its fiscal third quarter ended March 31, even though the middle of the quarter was weaker than expected. Total worldwide sales for the quarter were $2.8 billion, a decline of 10.2 percent compared to last year's third quarter and down 4 percent sequentially compared to the quarter ended December 31, 2001, which is Sun's second fiscal quarter. Net income was $4 million--not even a penny a share--compared to a net loss of $37 million or a penny a share a year ago.

Steve McGowan, Sun's chief financial officer, said in a conference call with Wall Street analysts that the first few weeks of the thirteen-week quarter were good, but that the company saw weakness starting in week five; this weakness carried through until week 11, and then a certain amount of momentum returned. McGowan said that the softness in sales that began in early February and which stretched through mid-March was most pronounced in the US, UK, and Asia/Pacific markets; he added that sales in Germany, Spain, India, and China were up.

In typical fashion, Scott McNealy, Sun's chairman and CEO, pulled no punches about the numbers. "We want credit for not blaming SARS or the war," he quipped, explaining that there were easy ways for Sun to return to strong profitability by deeply cutting costs--particularly research and development expenses. But he said that Sun was looking ahead to "inflection points" in the IT industry and using R&D to position itself to take advantage of those points over the long haul, presumably so it could extract greater profits from the market. He said that cutting costs to boost profits in the short term was the wrong strategy for Sun, saying that the investments it was making in its N1 virtualization technologies would help differentiate Sun from the competition. "There's some good news-bad news here. This stuff is hard to do, but luckily few people can do it. It's expensive, and there's some risk involved. We could cut back, but that would be a shame since we are 34 quarters of cash flow positive and all it will take is a revenue uptick to bring money to the bottom line."

In Sun's core Unix server market, here's how McNealy characterized the situation: "I wish we were growing share like we did a couple three years ago, but we are holding our own." Sun presented some IDC data that showed this as part of the conference call. "It's starting to look like its coming down to Sun and IBM taking share from HP." This is a characterization that Hewlett-Packard would undoubtedly dispute.

Sun's increased sales in Germany were noteworthy in that the sales level Sun has is almost at the high-water mark it hit in 2000 and 2001 despite the fact that the German economy is one of the weakest in the Western democracies. Robert Youngjohns, executive vice president of Sun's global sales, said that the company had rolled out a new solutions-based selling method in Germany and other regions, and he attributed the good growth in large measure to this new approach by Sun. He said further that Sun was helped by the stirring of some life in the telecommunications market, which is one of the two areas (financial services being the other) that put Sun on the map and that helped Sun grow so fast and furious during the dot-com boom. Sun, like other IT suppliers, is benefiting from an uptick in spending as governments spend big bucks on security and defense, but he said that the new sales approach was getting Sun into retail, healthcare, and retail banking accounts, too.

McGowan said that Sun had $2.69 billion in bookings in the quarter, and that the third quarter had a book-to-bill ratio of less than one for the past six years, and this one was no exception. He also said that enterprise sales were flat year-to-year and up quarter-to-quarter, driven by the new 12-way V1280 server, and that services revenues were up 7 percent. Later in the call, McGowan said that recurring revenue streams from services and other annuity-like products now accounted for 30 percent of Sun's sales, and that the company would be increasing that percentage.

On a geographical basis, sales in the US comprised 43 percent of Sun's $2.8 billion in sales during the quarter. Sales in Europe accounted for 32 percent of sales, while sales in Japan accounted for 9 percent and the rest of the world for the remaining 16 percent. Sales outside of the US were artificially raised by the weak dollar to the tune of about 5 percent. The US share was lower than the quarterly trend for the past two years. What seems clear is that Sun is gearing up for a revenue increase to return it to profitability in fiscal Q4. But McGowan didn't take the bait when Wall Street pressed him for some guidance on what Sun was expecting. And given how Q3 went, that was probably the wise thing to do even if it was not helpful. "We expect some growth in Q4, but we'll let you guys take a whack at it." Sun had a 10 percent increase in sales in Q4 last fiscal year, and if it can pull that off again, it can probably break $3 billion in sales and bring several hundred million bucks to the bottom line.