Sun Profits in Fiscal Q2, Gets $700 Million Equity Injection from KKR

Published: January 25, 2007

by Timothy Prickett Morgan

Server and operating system maker Sun Microsystems reported its first significant--albeit still small--profit in a long time with its second fiscal quarter of 2007 results this week, and the top brass at the company--office mates Jonathan Schwartz, president and chief executive officer, and Michael Lehman, chief financial officer, were clearly happy about that. Sun also announced that it has negotiated a $700 million equity investment from KKR Private Equity Investors, the publicly traded equity arm of takeover specialist Kohlberg Kravis Roberts.

Before anyone goes jumping to any conclusions, the KKR equity investment does not appear to be the prelude to a hostile takeover--or a friendly one, for that matter. But it was a bit surprising to the Wall Street analysts on the conference call that followed the announcement of Q2 results and the KKR investment.

KKR Private Equity, which is traded on the Euronext exchange, has agreed to kick in two sets of convertible senior notes, each worth $350 million and coming due in 2012 and 2014, respectively. Once the cash is in Sun's hands for these notes, KKR will get a seat on the Sun board of directors. Sun exited the second fiscal quarter ended December 31 with $4.8 billion in cash and equivalents, and seems to want to build a bigger war chest for marketing for internal growth and to position itself for acquisitions. KKR is obviously keen to help.

"This is a strong endorsement of our strategy and of our management team," explained Schwartz on the call. And when he kept getting questions about the cash injection, Schwartz said that Sun was keen on getting KKR's expertise in mergers and acquisitions and its access to funds to support such deals. "We don't need the money," said Schwartz, "but this is an opportunistic transaction." Schwartz said that Sun would use the money to fuel its growth and count on KKR's expertise to help it with acquisitions--and he did not elaborate further.

KKR, of course, has done some of the biggest takeover deals in history, and in the IT field, it has been part of the acquisitions of NXP (formerly chip maker Philips Semiconductor), SunGard Data Systems (financial services software and disaster recovery solutions), and Avago (a $1.7 billion privately held semiconductor maker). KKR was not on the call with Sun, but George Roberts, one of the founding members of KKR, did release a glowing statement, exactly what you would expect from a big investor.

"Sun Microsystems is a leader and innovator in the global technology marketplace," said Roberts. "Jonathan Schwartz and his team have demonstrated remarkable vision and strong discipline in executing its turnaround strategy. This leadership, coupled with the world-class products and services for which Sun has always been known, underscores the company's ability to sustain its recent momentum and the gains it has made in the marketplace. We are pleased to have the opportunity to pursue this investment through KKR Private Equity Investors in order to help Sun to best capitalize on its substantial growth potential."

It is unlikely that the investment was tied specifically to yesterday's announcement of a joint server and workstation development effort by Sun and chip maker Intel as well as Intel's endorsement of the Solaris Unix variant as a tier-one operating system on the Xeon processor. But the timing of these two announcements was clearly engineered as much as is humanly possible to coincide with Sun's return to profitability in the second fiscal quarter to give the impression of a lot of momentum. What Sun has is a revitalized product line that faces cut-throat competition, which it is able to withstand because it has removed 3,700 people from its payroll since it announced layoffs last year. Some 1,600 employees were removed from the Sun payroll in fiscal Q2, and Sun is on track for its projected 4,000 layoffs.

Lehman said that Sun exceeded its own expectations on system product sales in the quarter, and also did better on cutting costs and boosting gross margins than it expected, which is why the company was able to boost a small $126 million profit against sales of $3.6 billion. Overall revenues were also helped by a favorable foreign exchange rate to a certain extent, since more sales came from overseas this quarter than the same quarter from the year-ago period. Sun's sales in Q2 grew by 7 percent from $3.3 billion a year ago. Product sales--including hardware and software--rose by 7 percent to $2.26 billion, while services revenues rose by the same 7 percent to $1.3 billion. In the year-ago quarter, Sun lost $226 million.

"It is great to be profitable again, and to be adding customers and gaining share," said Schwartz.

System sales rose across all product categories, according to Lehman. Sun's "Thumper" X4500 hybrid storage server, which is based on its "Galaxy" Opteron server line and which includes 24 TB of disk capacity as well as moderate computing capacity, started shipping in volume in December. The Thumper arrays contributed $20 million in product sales during the quarter, and are expected to ramp up significantly in calendar 2007. Lehman added that entry, midrange, and high-end servers all saw revenue growth from both the Q2 fiscal 2007 and from Q2 fiscal 2006. Midrange machines were strong, and average selling prices seem to be on the rise.

Sun's X64-based server line saw 46 percent revenue growth against a 21 percent shipment growth. (Sun was not specific on revenues, but it looks like Sun shipped around 25,000 boxes in the quarter.) Total server shipments were up only 1 percent in the quarter, to what looks like in the Sun charts as a little over 80,000 units, which means Sparc server unit shipments fell considerably. The fact that Sparc server revenues were up shows that Sun is getting some traction on bigger boxes, which would seem to imply that at least some of Sun's installed base are upgrading to new UltraSparc-IV+ machines as well as buying servers that use the "Niagara" Sparc T1 multithreaded processors.

And just in case anyone might get too excited about new Galaxy servers based on Intel Xeon chips, Lehman said that the first of these machines--a two-socket box supporting Intel's dual-core "Woodcrest" Xeon 5100 and quad-core "Clovertown" Xeon 5300 chips--would not ship in volume until the first quarter of fiscal 2008, which means after June 30 of this year. At the Intel-Sun alliance announcement, Schwartz put John Fowler, general manager of the Systems Group at Sun, on the spot and he said these machines would ship late in the first half of calendar 2007, which should have meant May or June of this year.

Lehman said that Sun is actually trying to reduce the amount of its gear that is out in its channel, and intentionally cut back on $40 million in sales during the quarter--half of that in the United States. Sun had about four weeks of inventory in its channel as it exited fiscal Q2, and it has a goal of reducing that to one week of inventory over the next several quarters.

Sun did not break out its software sales separately from computer system sales, as it traditionally has, but said that software revenues were up by 2 percent in the quarter. And while Sun has attained a big base of 6.8 million downloads of Solaris 10 through December 2006, it is unclear how much money this big base is bringing in. But Schwartz knows it has to do this, sooner rather than later. "It is all well and good to be popular, but we want to be successful, too," said Schwartz. And success means sales and profits for a public company.

On a geographic basis, Sun's sales in the United States were down 4 percent, to $1.32 billion. Sales in the Europe/Middle East/Africa region climbed by 9 percent, to $1.36 billion, marking one of the few times in Sun's recent history when sales in Europe came in ahead of those in the United States. During Q2, sales in the Asia/Pacific region were up 20 percent, to $642 million, while sales in the Americas region not including the U.S. rose by 34 percent, to $250 million.

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