Analysts Criticize Sun Ahead of Financials This Week
by Timothy Prickett Morgan
Sun Microsystems is in the middle of remaking itself as it faces a wildly different market than the one the company was engineered to tackle during the dot-com era. This we all know. But Wall Street and customers do not always exhibit patience with IT vendors. The top brass at Sun have talked so much about how they are turning the company around that it is hard to remember sometimes that Sun is still largely testing out its new-fangled ideas and is still basically a Unix server and operating system company with broader aspirations.
Later today, Sun is going to report financial results for its second fiscal quarter of 2005, which ended December 26, and the consensus on Wall Street is that Sun will earn about a penny a share on about $2.93 billion in sales, compared with a loss of 3 cents a share on sales of $2.89 billion in the same quarter a year ago. Ahead of the numbers, the research departments at the main brokerage houses were all giving their opinions on what Sun would do and what it all means.
Steve Milunovich, who watches the tech stocks for Merrill Lynch, released a report last week that expected Sun would have an "uninspiring quarter." Merrill Lynch has been particularly harsh on both Sun and Hewlett-Packard, which have had very different kinds of transition troubles that came to the same result: relatively poor stock performance. Milunovich wants Sun to forget Unix and buy one of the two main Linux players, Red Hat or Novell, and he wants HP to break itself up into two pieces, creating either a printing and imaging company and an IT company or a consumer IT company and a corporate IT company. The odds of either one of these things happening are very low, and the ideas make sense if you are trying to get in on a merger or spin-off deal or ride up the stock price on one of these pieces of a revamped Sun or HP. But these proposed actions do not make any sense in the context of who Sun and HP are and how they perceive themselves within the IT ecosystem.
While Milunovich's suggestions are not necessarily useful (many of them are, just not these two), his observations about what is going on inside the Sun customer base are very useful. In his report, he says that the second quarter was "unusually linear with a soft close and a modest skew to the midrange and low end." Milunovich's model suggests that Sun will boost server shipments to 99,488 in the quarter, up from 89,079 this time last year, and that average selling prices will rise across entry, midrange, and high-end machines. However, the shift in the sales mix will push overall server sales down a smidgen, to $1.384 billion, from $1.414 billion a year ago. Throwing in workstations, storage, and other hardware sales, and other revenues, and Merrill Lynch expects Sun to book $1.911 billion in product sales, and total sales (including services and software) of $2.913 billion. Milunovich thinks Sun will be able to pull down profits of 2 cents a share, a little higher than consensus. He adds that Opteron-based Sun Fire server sales are picking up, but are still coming off a very small base, and says that since Linux is installed on these Sun machines as much as Solaris, that is a good reason for Sun to buy a Linux distributor.
What Milunovich doesn't seem to believe is that Solaris 10, which will be in production in a few weeks, will change that distribution of Solaris versus Linux on Sun's own X86 boxes. Anyone who believes that Solaris 10 is a better choice than Linux is waiting for Solaris 10. Sun's vast Sparc/Solaris installed base is not going to start buying into the X86 strategy Sun has until Solaris 10 is ready, key ISVs have ported their applications to Solaris 10 for X86, and a more complete Opteron-based Sun Fire line is available. When this all happens, I believe that Linux will be a miniscule part of Sun's operating system distribution on the Opteron machines. And if that turns out to not happen, Milunovich will have been correct, and Sun would have done better to buy a Linux distributor while it had the cash.
"It's an interesting time to debate Sun's investment case," said Mulinovich. "Many classic elements of a phoenix are present. After years of disappointments, the company has made important strategic progress . . . and is midway though an important product cycle. Unfortunately, our surveys show mediocre buying intentions. The run in the stock suggests investors expect a financial turn that isn't yet supported by our checks." Merrill Lynch is holding its rating for Sun at neutral.
The day before Merrill Lynch released its Sun report, Toni Sacconaghi, the IT analyst at Sanford Berstein, released a research report on Sun as well. He noted that Sun's shares were up almost 50 percent since last summer, thanks to the non-stop PR blitz and product repositioning by Jonathan Schartz, Sun's president and chief operating officer, and Scott McNealy, chairman and CEO. But Sacconaghi concurred that the excitement about Sun's renewed hopes had pushed up the stock ahead of its actual performance, and he downgraded Sun's stock to "under-perform" from "market-perform."
Sun's stock was trading at $5.38 per share last Friday before these two analysts released their reports, and the stock had dropped to around $4.50 at press time, a drop of about 18 percent.