Sun Carbon Copies Another Transitional Quarter, Year

by Timothy Prickett Morgan

Server maker Sun Microsystems reported its fourth quarter and year-end results for its fiscal 2005 this week, and while the company has made layoffs, restructurings, acquisitions, and substantial changes in its portfolio of products in the past year, the company is still seeing slight revenue declines when measured in aggregate even as it is getting traction in new markets. Sales in fiscal 2005 were $11.07 billion, down 1 percent compared to the prior year, which was also a challenging 52 weeks, too. Profits for the fiscal 2005 year improved in as much as Sun was at nearly breakeven, with an $11 million loss compared to a $388 million loss in fiscal 2004.

For the fiscal fourth quarter ended June 30, Sun's product revenues, which include servers, storage, software and a smattering of workstations, tallied up to $1.928 billion, down 6.7 percent, while services sales were up a smidgen to $1.047 billion. Overall sales in the quarter were $2.975 billion, down 4.3 percent compared to the prior year. Sun brought $121 million to the bottom line in Q4 of fiscal 2005, a lot lower than the $783 million of fiscal 2004's final quarter, but then again, that quarter included nearly $1.6 billion in Microsoft monopoly money, which means Sun was in the red big time this time last year. However, that fiscal 2005 Q4 also included a $190 million benefit over two fights Sun won regarding taxes against the governments of the world. So maybe Sun really didn't profit in the quarter from its products and services this time around, just like it didn't this time last year. That $190 million was money Sun made a long time ago. It just got to book it now.

The very fact that we are talking about Sun--the former server powerhouse that was once projected to have the dominant revenue share in the server market by 2002 and which used to have a market capitalization that rivaled General Motors and Wal-Mart--in four significant digits to talk about its trends speaks volumes. Dissecting Sun's financials these days because of the reorganizations, big payments from Microsoft or Uncle Sam, charges and exceptions for this and that, and soon the acquisitions of middleware software maker SeeBeyond and tape storage specialist StorageTek, is about as difficult as parsing IBM's financial results (which have seen reorganizations and big payments from Microsoft, too, as well as big checks from Hitachi, which bought Big Blue's disk business, and Lenovo Group, which bought its PC business). Sun and IBM have both been helped by some pretty happy coincidences in terms of settlement money, and while they offer some means of trying to assess the underlying business absent these charges and benefits, at some point the business has to stabilize such that non-GAAP analysis is unnecessary.

Sun has to get traction at some point, and the company's top brass have said calmly and correctly for many, many quarters that they are in the IT racket for the long haul, they will invest billions of dollars in research and development a year, and they will ride out the many transitions that Sun is in the middle of--open source products and moving to a services or per-employee pricing model for software, developing Opteron server products that compete against its own Sparc machines as well as those from other vendors, and creating a grid computing utility, just to name three. All of which will take an undetermined amount of time. If this is frustrating for Sun's customers and investors, it has to be worse for Sun's employees.

So instead of focusing on the revenue and profit numbers now, which may or may not meet a Wall Street consensus that investors may or may not care about any longer, Sun's top executives are looking at the leading indicators: how many Solaris 10 downloads there are (over 2 million now), how quickly the X64 server business is ramping up (nearly 50,000 in fiscal 2005, up 117 percent), how many seats of the Java Enterprise System middleware stack have shipped (619,000 seats, up 43 percent in the quarter and not including a big JES on Solaris deal that General Motors will announce this week), and so forth. To Sun's credit, it has managed a difficult four years and is still cash-flow positive. But Wall Street has long memories of big Sun profits, and they want them to return just as much as Sun's own employees do.

It is a challenge, to say the least. Steve McGowan, Sun's chief financial officer, said in a conference call this week that Sun's overall server shipments were up 7 percent in fiscal 2005, to over 331,000 units. That it pushed out nearly 50,000 X86 and X64 servers in fiscal 2005, more than doubling its shipments, is a big number, but that also means Sun's Sparc sales are declining.

The revenue mix and product mix shifts, which McGowan revealed this week in his presentation, are dramatic. In fiscal 2001, when Sun was at the top of its game, 82 percent of its revenue came from product sales, while 18 percent was from services. In fiscal 2002, when the bottom dropped out of the server market, the mix shifted to 73 percent products, 27 percent services. And the services component has gradually crept up, with fiscal 2005 having 64 percent of sales coming from products and 36 percent coming from services. What accounts for most of this shift? The move away from midrange and big Unix iron from circa 2001 to equally capable and equally powerful entry and midrange servers circa 2005. In fiscal 2001, Sun 55 percent of Sun's server revenues came from enterprise and datacenter servers, by which Sun means a machine with more than 8 processors, with a large number of pizza box servers snapped up by telecom and dot-com companies accounting for 45 percent of sales. (This 45 percent is represented by servers with 1 to 8 processors in McGowan's comparison.) All of these machines in the 2001 era were based on Sun's own Sparc processors. That server mix held in fiscal 2002, but in fiscal 2003 and 2004, these entry servers, which had lots more oomph than prior generations of machines because they were based on the new UltraSparc-III processors, attained about 55 percent of server revenues. And in fiscal 2005, thanks to Sun's aggressive marketing of both Opteron-based V20z and V40z servers and other entry Sun Fire servers based on the single-core UltraSparc-IIIi and dual-core UltraSparc-VI processors, the mix continued to trend down toward entry machines. In fact, in fiscal 2005, the entry servers comprised 65 percent of Sun's server revenues. The good news for Sun is that its server gross margins in fiscal 2005 improved by 1.6 percent to 42 percent even as that mix shift was going on.

As Sun exited the fourth fiscal quarter, Scott McNealy, Sun's chairman and CEO, said, as he has said many times, that he was happy with Sun's positioning in the IT market and its progress in creating new business models and getting costs in line with expenses. McGowan said that while product sales were down nearly 7 percent in the fourth quarter--with computer systems down 4 percent and network storage down 18 percent--X64 servers, Sparc machines with 4 to 8 processors, midrange storage, and software sales were all up. And while overall sales (hardware, software, and services) in Sun's key United States market were down 13 percent for the quarter, McGowan said that demand generation indicators stabilized in the U.S. in the quarter and product backlogs and deferred revenues were up significantly. Sales in Europe were also up 4 percent in the quarter, while sales in Japan were down 11 percent. The decline in Japan was blamed mostly on Sun's partnership with Fujitsu to jointly develop and market Sparc-based servers; Fujitsu is getting more of the revenue in Japan, but Sun is getting to extract more profits from these sales than it would have made competing against Fujitsu. (If this isn't the case, why bother?) Sales in other parts of the world were up 5 percent in the quarter, driven by demand from China, Singapore, Russia, India, and Canada. Significantly, McNealy said after some pampering and attention starting earlier in the year, Sun has been able to increase its sales in the financial services area. "This shows that when we focus, we can execute on the new strategies," he said. However, Sun's sales in the telecommunications and government sectors faltered; the latter is why Sun has re-established its Federal Systems business unit. It wants focus there, too.