Sun Grows Sales and Profits Despite Product Transitions

Published: April 26, 2007

by Timothy Prickett Morgan

The majority of the revenues and most likely the lion's share of the profits of Sun Microsystems still come from servers, their associated storage, and operating systems. And considering the number of product transitions underway at Sun, it is something of an accomplishment that the company was able to boost its sales by 3.3 percent to hit $3.3 billion in sales in its third quarter of fiscal 2007, which ended April 1. The company even managed to bring some dough to the bottom line.

In the quarter, Sun had product sales of $2.06 billion, up a meager 1 percent from the year ago quarter, while services sales fared a little better at $1.22 billion, up 7 percent. Sun is never terribly precise about how its different hardware and software product lines do in terms of sales, which makes it more like IBM and less like Hewlett-Packard. But in a conference call with Wall Street analysts this week, Jonathan Schwartz, Sun's president and chief executive officer, and Michael Lehman, the company's chief financial officer, gave some insight into what went right and wrong in the quarter.

As in past quarters, the resurgence of the high end of the Unix market is helping to buoy Sun, much as it has IBM, in the latest fiscal quarter. Sun normally calls out what parts of the Sparc line are doing well in its presentations, but didn't say much this time around. Total server units at Sun declined by 9 percent in the quarter; Sun does not give out a precise number in its presentation to Wall Street, but what is clear from the chart is that server shipments are in the middle 70,000s and are lower than they were in the first two quarters of fiscal 2007. In fact, they are at the lowest levels that Sun shows on the chart, which spans from 2Q fiscal 2005 to 3Q fiscal 2007.

Shipments of the "Galaxy" line of X64-based servers were up 12 percent in the quarter, up a few thousand from last quarter and about 5,000 units higher than the first quarter of fiscal 2007. But Sun's growth in this market has clearly slowed. In fiscal 2005, the X64 server line was more doubling each quarter, then in fiscal 2006, it started slowing to high double-digit growth and through fiscal 2007, it has decelerated all the way down to low double digits. The Galaxy line is still, according to Lehman, pegged at an annual run rate of about $600 million, with perhaps some upside. And the "Niagara" Sparc T1 server line is still pegged at somewhere between $500 million and $600 million in annualized sales for fiscal 2007.

If you do the math and make some guesses about the numbers behind Sun's chart, it looks like Sparc server shipments fell by around 17 percent to somewhere around 48,500 units. If you assume Niagara units are strong and that high-end shipments were good (and generating a lot of revenue), then you have to assume that the remaining entry Sparc product lines have declined substantially. And if you want to know why Sun is in the X64 server business, it is because at least until Niagara has more oomph and "Rock" comes online, a lot of customers will choose Opteron-based Solaris boxes over Sparc boxes so long as their applications can make the jump. The price/performance is just that much better.

But, that doesn't mean the X64 server business doesn't have its problems, and Schwartz is a bit defensive about those declining growth numbers. "We're going to continue to build as compelling a low-end product line as we can," Schwartz said in the call, explaining that this is where the next wave of innovation is in the server space and that this is where customers buy gear first. "Our growth is a multiple of the industry average, so by every measure, we are gaining share."

He reminded everyone that the first Xeon-based server products, made in partnership with Intel, would be added to the Galaxy line in June, and did not blame Advanced Micro Devices for some of the Galaxy line's woes. It could be argued that Intel's quasi quad-core "Clovertown" is getting some traction, and AMD's real quad-core "Barcelona" Opteron is not expected until June or July. The current dual-core Opterons are competitive on every front with the dual-core "Woodcrest" Xeons, but the Opterons do not have the huge edge in performance and performance per watt that Sun used to its advantage in prior years.

While high-end Sparc systems and archive and tape drives did decently in the quarter, Lehman said that Sun saw weakness in its systems business in the United States and in the United Kingdom. The key verticals that Sun plays in--financial services and telecommunications--held up well in the quarter, but other verticals did not. And Sun's channel did not perform as well as the direct sales force did in terms of generating top-line revenue growth. Sun's overall sales in the U.S. fell by 6 percent, while Europe overall was up 9 percent. The International Americas sector saw 5 percent sales growth in the quarter, while Asia/Pacific rose by 14 percent. Lehman would not give any guidance on how much of these increases were driven by currency effects, as IBM always does. Based on currency exchange rates, the number is probably significant. And Sun's argument is that it all spends as dollars once it gets back to California is equally legit to reckoning things in constant currency.

While Sun hinted that Sparc server sales might have been adversely affected by the impending launch of the Sparc Enterprise servers, which were jointly launched by Sun and Fujitsu last week, it is hard to say what kind of appetite Sun's customers will have for these Sparc64 VI-based servers when they know Sun can deliver its own UltraSparc-IV+ chips at reasonably high clock speeds, when entry Niagara-2 chips are coming this year, and when Rock is coming next year. Sun nonetheless says that there was some hesitation in fiscal Q3 as customers were trying to sort their buying plans out.

"A lot of customers said that they have made their choices, but they want to cut the purchase order next quarter," said Schwartz in explaining the situation. He also said that people who were hesitant to make decisions in this quarter were saying that they wanted to talk now--which is also when Sun is eager to have a big final finish to its fiscal year. "The roadmap is on our side, but the economy is always a big question mark for everybody," he said.

Sun's deferred revenue increased by 15 percent to $2.5 billion. Product support services grew by 5 percent to $954 million, and professional and education services grew by 15 percent to $269 million. Sun added a few hundred thousand subscribers to its Java Enterprise Server System middleware products, breaking above 1.5 million cumulative seats worldwide, and independent software vendors have over 6,000 applications running on Solaris 10 (some are in transit at the moment toward certification).

Even with the top-line revenue growth in the quarter, Sun booked an operating loss of $45 million. After some tax benefits and $54 million in lawsuit settlement income from Microsoft, Sun was able to post a net income of $67 million, compared to a loss of $217 million a year ago.

Looking ahead to the final quarter, Lehman said that Sun expected to have sales growth in the fourth quarter that would be 15 percent to 18 percent higher than the third quarter. Which works out to $3.80 billion to $3.89 billion in sales. Unless something weird happens, a lot of that incremental dough should drop to the bottom line.

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