Sun Sees Sales Accelerate in Fiscal Q4, Still Loses Money

Published: July 27, 2006

by Timothy Prickett Morgan

Unlike many of the giants of the IT industry, who saw their sales soften as the end of the second quarter rolled around, Sun Microsystems is telling Wall Street that it actually saw sales accelerating as the quarter ended on June 30, helping to push (as did acquisitions last year) Sun's sales up 29 percent to over $3.8 billion. Still, because of increased research and development costs, restructurings due to layoffs and office closings, and higher compensation driven by the boost in sales, Sun nonetheless is still losing money, and booked a net loss of $301 million in the quarter.

The revenue uptick was expected, of course, but by no means inevitable. Sun has unleashed a new array of Sparc and Opteron systems, which are well-regarded for their technical features. The "Niagara" T1 Sparc and "Galaxy" Opteron server lines are second to none when it comes to intelligent design, compactness, and power-saving. After years of pre-marketing, marketing, launching, and then finally sales of these products, eventually you would expect them to take off. And, Jonathan Schwartz, Sun's chief executive officer, said in a conference call with Wall Street analysts that the Niagara T1000 and T2000 systems accounted for more than $100 million in sales in the fiscal fourth quarter, and that the Galaxy servers are now clipping along at a $500 million annual run rate. (That is another way of saying that Sun is almost generating as much revenues from Niagara servers as it is from Galaxy boxes.)

One reason to expect Sun's product sales to increase, particularly after the rollout of these products is simply that it is the end of Sun's fiscal year, and employees are motivated to keep their jobs, especially in an environment where their employer is trying to find 4,000 to 5,000 employees to eliminate. Moreover, this was the first quarter under the new management team put together by Schwartz, who was named to the CEO position at Sun at the end of the third fiscal quarter. You can bet that Schwartz and his team were motivated to post the best numbers possible. And you can also bet that the timing of his ascension back at the end of April was such that this would be exactly what Wall Street and investors would be thinking here at the end of July. With Sun predicting a revenue decline of around 20 percent in the first fiscal quarter of 2007, which ends on September 30, you can bet that would not be a good time to be a new CEO.

Anyway, Sun's numbers were, in many respects, pretty good. The company's hardware and software product sales were up 31 percent to $2.5 billion in the quarter, with computer systems up 15 percent in the quarter to $1.8 billion. Sun's total server shipments in the fourth quarter rose by 14 percent (Sun refused to be specific about the number, which is ridiculous since it was in its charts); to my eye, it looks like about 105,000 units, and the company pushed unit sales of its Opteron-based machines up 53 percent (to what looks like about to 28,000 units) over the prior year's shipments.

Sun had been doubling or just about doubling its shipments in the past six quarters in this market, and it is not clear why Sun was not able to do better with its Galaxy server line than it did, but Michael Lehman, Sun's chief financial officer, said that none of the company's products were supply constrained in the quarter, as was the case with Sun Fire servers using the UltraSparc-IV+ chips two quarters ago. It could be that the impending Rev F Opteron launch from AMD, which was slated for July, then August 1, and now maybe August 15, is putting a damper on sales. Once again, Sun singled out its Opteron products and Sparc servers with one to eight processors as being the revenue drivers for the quarter, with the latter increasing sales by 21 percent. Data products--which means storage and related software--more than doubled to $173 million (thanks largely to the StorageTek acquisition, but Sun didn't break out how much of that growth came from STK). Sun's software sales declined by 8 percent, reflecting Sun's shift toward subscription-based licensing, but OEM sales (predominantly Java and Solaris) rose by 23 percent. Sun finished the quarter with a $1.09 billion product backlog, up $119 million sequentially, which should help in the first quarter a bit.

Sun's services revenues in fiscal Q4 were up 25 percent to $1.3 billion. Training and education services accounted for $318 million, up 18 percent, while other services (including systems integration, product support, subscription-based licenses for products, and so on) accounted for $986 million, up 27 percent. Lehman said that without StorageTek, the Sun-only part of the services business would have had a sales increase of about 1 percent in the quarter.

Looking ahead, Schwartz said that starting in the first fiscal quarter of 2007, the company would provide a more detailed breakdown of financial results, with a breakout for systems, storage, software, and services as separate items.

On a geographical basis, Sun's operation in the United States had sales of $1.5 billion, up 30 percent, with sales in the EMEA region up 21 percent to just under $1.4 billion. Sales in the Asia/Pacific region grew by 33 percent to $657 million, and sales in the non-U.S. Americas region exploded by 60 percent to hit $273 million. Lehman said that in the 15 sub-geographies where Sun operates, eight of them had double-digit growth in the quarter for Sun products that did not include the StorageTek or SeeBeyond products that the company acquired last year.

Schwartz may not be as funny as Sun founder and chairman Scott McNealy--he may not be funny at all, at least not while Sun is trying to get profitable again and keep from having to lay off even more employees--but he is very serious about the job he has, how he is doing, and where he wants to go. "This quarter's performance was an important step toward our long-term goal of 10 percent operating margins," he said. He also put another target in front of himself, committing to Sun having an operating margin of 4 percent by the fourth quarter of fiscal 2007. Sun would like to grow its way out of its problems, and Schwartz clearly believes this is the best strategy, as he has said time and again. "Growth is the best way of delivering operating margin. Just cutting costs is a pretty short runway."

Because of prototyping and other expenses, Sun's R&D costs rose by 15 percent to $543 million in the quarter, even as the company is cutting back on some projects. SG&A expenses exploded by 44 percent to $1.1 billion, driven by higher compensation (bonuses from higher sales) and stock-based compensation. Throw on another $228 million in restructuring charges, a bunch of other items, and that gave Sun an operating loss of $335 million in the quarter and after taxes and other items a net loss of $301 million, or 9 cents per share. Sun had a net profit of $50 million or 1 cent a share a year ago, on substantially smaller revenues. Change is not only difficult, it is expensive, too.

During the quarter, Sun repatriated $2 billion in offshore profits to the United States, which will give the company some breathing room, and because of a generous policy of Uncle Sam, Sun only had to pay $58 million in taxes on that dough. This generosity just ran out, and Uncle Sam is charging real taxes on profits again. Sun now has nearly $3.6 billion in cash and another $1.3 billion in short-term and long-term investments.