Sun Profits Nicely in Q4, Thanks to Microsoft Settlement

by Timothy Prickett Morgan

When Sun Microsystems said it wanted to be profitable by the end of fiscal 2004, no one could have predicted the way in which it would happen. Sun did indeed report a profit of $795 million for the fourth quarter, after booking $1.6 billion of its $1.95 billion settlement with Microsoft. But the company is still in the midst of a number of product transitions, and it prospects for profits and revenue growth in fiscal 2005 are a big question mark.

This is the sort of thing that makes investors uncomfortable, but Sun is not as worried about investors as it is about customers these days--and rightly so. The subscription-based pricing model being championed by new president and chief operating officer Jonathan Schwartz does offer Sun a chance to differentiate itself from the pack in the IT market. Heaven only knows what effect Sun's transitioning from product sales on a quarterly basis to subscriptions spread out over the course of a year or more will have on sales or profits, but what seems clear is that Sun wants Wall Street to keep its eye on the amount of deferred revenue the company has booked. This is exactly the trick that former chairman Lou Gerstner did when he took over IBM more than a decade ago and got everyone to focus on the Global Services business and its quarterly bookings and growing backlog of orders, as sales for servers and other products moved a bit chaotically.

In the fiscal fourth quarter, which ended June 30, Sun's total sales were $3.11 billion, up 4.2 percent. Steve McGowan, the company's chief financial officer, said that Sun had product sales of $2.07 billion in the quarter, up 3.1 percent from the same quarter a year ago. Sun said that $1.64 billion of that came from computer product sales, and that $427 million of that came from Network Systems, which is what Sun calls entry servers, based on its Sparc and X86 architectures.

McGowan said that Sun's sales across entry, midrange, and enterprise Sparc server lines were all up, and that machines using its new dual-core UltraSparc-IV processors comprised 30 percent of Sparc server sales in the quarter. As the transition to these new chips continues, McGowan said, Sun expects the UltraSparc-IV processors to account for about half of server sales in the first quarter of fiscal 2005. This, he said, was slightly ahead of plan. He also said that while Sun's fledgling X86 server business, which is dominated by its Opteron-based Sun Fire V20z server, does not yet represent a measurable revenue stream, sales more than doubled in the quarter.

Scott McNealy, Sun's chairman and CEO, reiterated that the company is focused on driving unit volumes, which have traditionally been the forerunner of profits for Sun. "This is a company that is in control," he said in a conference call with Wall Street analysts. "Volume is a leading economic indicator, and it is what will drive future revenue at the company." To that end, Sun pushed up X86 server sales by 327 percent in the quarter, and overall shipments (including both X86 and Sparc servers) were up 46 percent in the quarter.

All of Sun's executives were excited that the company booked its first quarter of services sales of more than $1 billion, with $1.044 billion in sales. McGowan said that Sun had some 771,000 systems under maintenance, which represented about 48 percent of the Sun installed base, an increase in 8 percent in the past year. The Sun executive team was similarly thrilled to report that subscriptions to the Java Enterprise System software stack grew by 74 percent sequentially in the quarter, and that the company now has 303,100 users licensed for the software stack, which includes Solaris and a whole slew of middleware. While these are great growth numbers, Sun needs an installed seat count that is two orders of magnitude larger to be a player. That said, this is a start, and such growth could, as McNealy is fond of saying, create a positive feedback loop. Such a loop is, after all, how Sun came to dominate the Internet and then the dot-com era.

Sun has deferred another $350 million payment from Microsoft as it awaits some advice from the Securities and Exchange Commission on how to treat it. Sun's CFO could be confused because the Microsoft settlement is complicated, or it could be that Sun has decided to be cautious about how it books this money, so it can cleverly save that unearned revenue to apply in a quarter with a rainy day or two. By booking the $1.6 billion in the fiscal fourth quarter, Sun was able to book a $795 million profit, and that was enough of a contrast with the $1.04 billion loss it had in last year's fourth quarter to make Wall Street happy. But without the Microsoft money, Sun only generated $276 million in positive cash flow and would very likely not have booked a profit in the quarter.

For the full fiscal year, Sun's sales were $11.185 billion, down 2.1 percent. Product sales were $7.355 billion, down 5.6 percent. Services revenues for fiscal 2004 were $3.83 billion, up 5.2 percent. Sun booked a loss of $376 million for the full year (and that extra $350 million would not have wiped it out), which was a lot better than the $3.43 billion loss it booked in fiscal 2003.

Sun's executive team did not provide any guidance on what fiscal 2005 will be, except to say that the company will make modest cuts in R&D spending and continue to drive out sales and other costs. McNealy said that the company's compensation and bonus plan for fiscal 2005 is oriented on the basis that Sun will have revenue growth, strong cash flow from operations, and profits. Exactly what they might be, McNealy and his team are just not going to say. Given the tumult Sun has been through, however, this is perhaps the wisest course of action.