Sun Books Tiny Loss as Sales Decline 1 Percent in Q3

by Timothy Prickett Morgan

Sun Microsystems continued to have difficulty growing its sales in its third quarter of fiscal 2005, and actually saw sales decline by 1 percent in the quarter to $2.63 billion. Continuing reductions in cost and a $54 million payment for potential patent liabilities from Microsoft in the past year (part of its decade-long settlement with that company) were not enough to make Sun profitable in the quarter, and the company booked a loss of $9 million when all the math was done.

This was not entirely a surprise, and it is clear that Sun and its investors would like the company to be a lot more profitable, but that loss was a big improvement over the $760 million loss that Sun had in the fiscal 2004 third quarter. "Break even is much better than things were a year ago," said Scott McNealy, Sun's chairman and CEO, in a conference call with Wall Street analysts. He said that over the nine months of fiscal 2005, revenue was up, cash flow from operations was up, and so were recurring revenue and deferred revenue. "All of this is moving the company in the right direction," said McNealy, adding that Sun would be working on trying to make its cost structure lower and more flexible. To that end, Sun will be outsourcing its own global IT operations to Computer Sciences, and doing IT projects for its business with long-time partner Electronic Data Systems. "We have to get the revenue moving now that we have the cost structure in line. We want to have revenue momentum to drive earnings momentum," he said, adding that customers have gone from asking "Are you going to make it?" to "What have you got?"

With the "Galaxy" Opteron-based systems probably not shipping in the fiscal fourth quarter--all McNealy would say is that Sun would be shipping 16-core Opteron servers in the "near future"--and the kicker UltraSparc-IV+ "Panther" processors not due until mid-2005 after being expected perhaps a few months earlier this time last year, Sun could be looking at a pretty tough quarter coming up. McNealy and chief financial officer, Steve McGowan, said that Sun's sales were impacted by a shift from data center-class Sparc servers toward powerful entry and midrange machines based on Sparc and Opteron servers.

While Sun's aggregate product sales for the quarter were down 2 percent to $1.68 billion, McGowan said that sales of computer systems (meaning servers and workstations) were up 2 percent in the quarter. However, Sun's storage sales took a 16 percent dive, which McGowan attributed to the decline in high-end server sales, which also had an adverse affect in the overall storage attach rates on Sun's own servers. Sun's president and chief operating officer, Jonathan Schwartz, said that server volumes were up 8 percent in the quarter and that X86 server sales, mostly represented by Sun's Opteron-based Sun Fire V20z and V40z servers, were up 197 percent. Attach rates for Solaris on its X86 boxes are 20 percent, and growing, but a lot of the iron goes out bare as well since customers have their own site licenses for operating systems. The X86 sales growth in fiscal Q3 represented a significant acceleration of sales from the 160 percent rate in the second fiscal quarter, but still well below the 475 percent growth rate Sun had this time last year in the X86 market. Sun is still growing from a very small X86 installed base, and is seeing a 69 percent return rate for X86 server buyers (up from 55 percent from the prior quarter), but it probably needs to sustain triple-digit growth rates for quite some time to be an X86 player that can produce profits. The good news is that of the 1.1 million Solaris 10 downloads thus far, only 25 percent are for Sparc machines, and the remaining 75 percent have been installed mostly on competitors' X86 machines. This is a vast installed base of potential paying Solaris customers, and one that Sun has been able to create in about six weeks.

Sales of Sun's Java Enterprise System middleware stack were somewhat disappointing, with only 15,000 new licenses in the quarter, boosting cumulative sales to 433,000 licenses to date. While Sun has now seen 1.1 million downloads of its Solaris 10 operating system, which is a stunning feat, these downloads have yet to turn into product sales, which many of them probably will as companies are evaluating Solaris 10 on existing X86 iron and will only begin paying for Sun support and maybe Sun X86 servers when they decide to roll Solaris 10 into production. Sun is doing the right thing with Solaris 10, but it is very hard for Wall Street to be patient about making money. Sun's services sales were $944 million in the quarter, up a smidgen.

In terms markets, McGowan said that Sun's appeal in the financial markets that were key to its establishment and growth as a company over the past two decades was improving, and the telecommunications market was also improving. However, sales into local, state, and federal governments were down in the quarter. In terms of geography, sales in the United States were down 5 percent, and in Europe, sales were flat; sales in Japan were down 5 percent. In the rest of the world, sales were up 9 percent, with sales in other Asian countries, Eastern Europe, and in established European countries such as Germany, Italy, Switzerland, and Belgium.

McGowan said that the $54 million in extra money from Microsoft was part of its antitrust settlement with the software maker last year, which had a provision that allowed Microsoft to pay Sun for potential intellectual property and patent infringements by Microsoft products against Sun's patent portfolio based on an annual schedule. This payment covered IP and patent issues from April 4, 2004 to March 31, 2005. McGowan also warned Wall Street that beginning in July 2005, when its fiscal 2006 year begins, Sun would start expensing the unvested portions of stock option grants and any new stock grants it makes. Later in the call, McGowan noted that a lot of customers with stock options are underwater because Sun's stock has taken a pounding in the past five years, and that Sun would obviously have to pick a number to value these stocks that is higher than the current street price. How much higher, he would not say.