Acquisitions Cut Both Ways for Sun in Third Fiscal Quarter

Published: April 27, 2006

by Timothy Prickett Morgan

Struggling Unix server maker Sun Microsystems continues to be helped by and hurt by its recent acquisitions, with revenues up by 21 percent to $3.18 billion in the third fiscal quarter ended, but acquisition and restructuring costs pushed Sun to a net loss of $217 million, compared to a loss of $28 million in the year ago quarter. Sun just missed out on meeting Wall Street expectations on the revenue side, and had about the loss that the street expected, too.

Sun's returning chief financial officer, Michael Lehman, ran down the numbers in a conference call with Wall Street analysts this week, and as he was finishing his comment, Sun's chairman and chief executive officer, Scott McNealy, dropped the bomb that he was stepping down as CEO. McNealy is one of Sun's four founders, has been chairman and CEO since 1984, shortly after the company was founded; he has been criticized for the past several years for not cutting costs enough to make Sun a profitable company. Like many founders of technology companies, McNealy has tried to ride out downturns and hold on to as many people and products as his company would allow. It will be interesting to see what Jonathan Schwartz, who has been Sun's chief operating officer and president and who has been named by the Sun board to be its new CEO, will do differently--if anything. McNealy and Schwartz may be very different people, but they seem to agree on how to run Sun. (See separate story for more on the executive changes at Sun.)

Sun posted product sales of $2.035 billion in the fiscal third quarter, up 21 percent, and services sales of $1.142 billion, also up 21 percent. Gross margins grew a little bit more, up 26 percent to $1.367 billion, but restructuring charges of $36 million, $87 million in amortization of acquired assets from the StorageTek and SeeBeyond acquisitions, and $57 million in stock-based compensation charges helped push Sun to that $217 million loss.

Sun's product revenues were helped by a backlog of UltraSparc-IV+ servers as it exited the second fiscal quarter, which the company said three months ago was due to its own skepticism about where UltraSparc-IV+ orders would be, and McNealy made it a resolution to never do that again.

Lehman said that Sun hit its target of combined R&D and SG&A spending in the quarter, at $1.6 billion, which seems to suggest that Sun was hoping revenue would be up by a few hundred million more bucks so it would not have posted a loss at all. Sun's server shipments were flat compared to the prior quarter at around 80,000 units, but up 6 percent compared to the third quarter of fiscal 2005. Sun's X64-based server shipments were up 81 percent in the quarter, with nearly 24,000 units shipped. As has been the case in prior quarters, Sparc-based server volumes are continuing to decline, and the introduction "Galaxy" Opteron servers have helped offset those volume declines; new "Niagara" Sparc T1 processors and their associated T1000 and T2000 servers are just getting going, but Sun is hoping to get decent volumes akin to what it used to get with entry Sparc servers even a few years ago.

Schwartz said that Sun's "try and buy" program that lets customers play with a Sparc T1 server before buying it has yielded over a 50 percent success rate in turn the tries into buys. "The numbers are pretty encouraging," said Schwartz in the call. "This is the moral equivalent of a free software download, but done in hardware." That is why Sun is extending this program to its Galaxy Opteron servers.

Lehman said Sun's four-way to eight-way Sparc servers, Galaxy machines, and midrange and high-end storage arrays were particularly strong revenue drivers in the quarter.

On the software front, the Java Enterprise System increased its subscriber base by 14 percent to 1.12 million seats, and the number of registered downloads of the Solaris 10 operating system increased to neatly 5 million units. Schwartz said that this was an order of magnitude higher than the company's expectations a year ago when the company decided to freely distribute and then open source the Unix variant. Solaris has 1,750 applications certified on Solaris 10, and another 500 that are working on it right now.

On a geographic basis, Sun's sales in the United States increased by 35 percent to $1.33 billion, with sales in the EMEA region up 11 percent to $1.11 billion. Sun's sales in the Asia/Pacific region grew only by 7 percent to $540 million, while sales in the International Americas region (Canada plus Central America plus Latin America) grew by a stunning 44 percent, but only came to about $190 million in sales.

When pressed by Wall Street analysts, Lehman would not break out the revenues separately from the StorageTek and SeeBeyond acquisitions, and Schwartz said that the people and products that come from these formerly separate companies are now woven into Sun and it was not going to keep track of it that way any more.

After McNealy came on the call and dropped the bomb that he was moving up to the boardroom permanently, everyone piled on to try to get Schwartz and Lehman to divulge whatever plans they might have to reduce Sun's operating expenses to get profitable. Many on the Street have been asking for Sun to cut as much as 10 to 20 percent of its workforce to get consistently and solidly profitable, but neither Schwartz nor Lehman seemed inclined to give anyone the impression that such large cuts were looming. "We expect to take costs down," said Lehman, "but it is too early to say where."

Sun has just entered its annual budgeting cycle, and it looks like McNealy handed Schwartz the reins so he could steer that process and make the decisions along with Lehman to get Sun profitable. Schwartz cited one analyst, who said such draconian cuts would undermine the business. "I don't think we're interested in undermining the business," Schwartz explained--not when the company, despite its loss, is seeing revenue growth in most product lines and has become a champion of open source and eco-responsibility. "There are two ways to hit it," said Schwartz. "Reduce costs or increase revenues. There is no plan for a cut of that magnitude."

Lehman also stepped on the idea that Sun might spend some of its $4.4 billion in cash on share buybacks. "We are not interested in buybacks. We are principally interested in growing the business," he said.

Schwartz said that the innovation on its T1 and Opteron servers have given it a foot in the door at many companies, and that the increased volumes with these products will eventually have a positive feedback loop, helping Sun sell even bigger UltraSparc-IV+ systems. He explained that eventually, all horizontal server architectures eventually scale up, and as far as Sun was concerned, only two companies have the complete software stack to deploy big vertically scaled systems: IBM and Sun.