Sun Exceeds Margin Goals in Q4 on Flat Sales

Published: August 2, 2007

by Timothy Prickett Morgan

Server and software maker Sun Microsystems closed out its fiscal 2007 at the end of June, and according to a report Sun's top brass made to Wall Street this week, the profit picture was better than expected even though overall sales were flat compared to the same quarter in fiscal 2006. Specifically, Sun had $3.84 billion in sales in what is usually its strongest quarter, up a tiny 0.2 percent. But gross margins rose by 4.4 percent to 47.2 percent, and net income was $329 million, a big change from the $301 million loss a year ago.

Sun said that it sold just under $2.5 billion in products in the fiscal fourth quarter, which actually represented a 1 percent decline in sales of servers, workstations, storage, and various software products that are still distributed under licenses. Sales of computer products, which basically means hardware, were up 2.3 percent to $1.85 billion, despite weakness in the United States--the second time in fiscal 2007 that has happened to Sun. But the real weakness for Sun appears to be in the storage side of its products business, where in the fourth quarter sales fell by 10.4 percent to $639 million.

Sun's services business did well in the quarter, with sales up 3 percent to $1.34 billion, and the brightest spot in the quarter was Sun's product support services, which had sales of $1.02 billion, up 4 percent. Sun's professional services and training unit, which has been growing well throughout fiscal 2007, came in with only 0.3 percent growth, hitting $319 million in sales.

While Sun did not say so, the transition of Solaris 10 to a licensed product that comes in on the product side of the Sun product revenue sheet to a free product that Sun hopes customers pay to support, much as enterprises do for Linux and other open source programs, may be affecting the revenue shift. Sun has been tight-lipped about what the conversion rate for Solaris shipments to Solaris paid support contracts is, but if the number was high, you can bet Sun would say something. That said, with nearly 9 million licenses now distributed in two and a half years, even a fairly small conversion rate can generate hundreds of million of dollars. And Sun can allocate revenues on its Sparc-based servers, which have Solaris bundled on them, as it sees fit.

Jonathan Schwartz, Sun's president and chief executive officer, highlighted the fast-growing segments of Sun's product line, but the somewhat sparse details on what was selling in the quarter was equally telling. Schwartz singled out the Sparc T1-based "Niagara" server line, which accounted for $200 million in sales in the fourth quarter and which grew by 225 percent in fiscal 2007, breaking $550 million in sales, for particular acclaim. Sun's "Thumper" storage servers, which cram 48 SATA disks on a two-socket Opteron server running Solaris 10 and the ZFS file system, was also singled out, and Schwartz said that this machine, also known as the "Galaxy" X4500 server, has attained an annual run rate of $100 million. Sun's new blade server line is at a run rate of $55 million annually now, and the Netra telecom server line, based on both Sparc chips and Opterons, had 38 percent revenue growth in the fiscal year. In total, Sun's X64-based Galaxy server line (including Thumper arrays, presumably) showed 39 percent revenue growth.

While these growth numbers are pretty good, especially considering the competitiveness of the IT market where Sun plays and the choppiness of the U.S. economy in certain sectors, Sun did not say that UltraSparc-IV+ servers were selling well, or that machines with two to eight processors were strong, as it has said in past quarters. Schwartz said that there was some weakness in "certain legacy systems" and that there was a weakness in storage in the U.S. He also added that on the storage front, Sun was committed to transitioning its non-tape storage products to the approach taken by Thumper, which is to tweak server designs running Solaris to create storage products, and he characterized this as "a difficult transition." In speaking to Wall Street analysts, he gave the impression that the former StorageTek tape and library business was not the problem, but did not elaborate on exactly what Sun's storage business was faltering.

The conversation that Schwartz and Mike Lehman, Sun's chief financial officer, had with the Wall Street analysts turned again and again to the topic of server virtualization. And for good reason. While Sun's computer product sales rose by 2.3 percent in the fourth quarter, unit shipments for X64-based servers fell by 4 percent in the fourth quarter after cooling throughout fiscal 2007. Sun does not provide the number, but it looks from its charts that Sun sold maybe 26,500 Galaxy servers in the quarter, and total server sales (including Sparc and X64 machines) fell by 15 percent in the quarter, to around 90,000 units.

Schwartz contends that having highly virtualizable machines, as Sun does, plays in its favor as companies seek to consolidate server footprints and to increase server utilization rates. Virtualization, which tends to result in fewer footprints but richer configurations that are more profitable for big vendors that get components cheaper than smaller players, can cut both ways financially for the vendors who push it.

"As we sell virtualized systems, people tend to buy integrated racks, not piecemeal parts that they then integrate. This just gives us more bites at more apples," Schwartz said to explain way the virtualization effect. "When we double the scale of our computers, people don't cut in half what they buy."

Of course, there is a first time for everything, and it may take years for the effect to take place as companies roll through their data centers, replacing racks and towers that cannot be easily virtualized with ones that can.

Whatever is going on, Sun's X64 server business is not growing, and it could be that virtualization on Opteron-based servers is aggressive, or that Advanced Micro Devices's delays in deliver quad-core "Barcelona" Opterons has left Sun with the wrong products to sell. In a market that consumes a few million servers a quarter, something north of 25,000 units is not cutting it. Sun needs to get Barcelona boxes out the door ASAP, and it needed to get Galaxy machines based on Intel's "Clovertown" quad-core chips out the door at the beginning of calendar 2007 to catch the Clovertown wave that has buoyed Hewlett-Packard, Dell, IBM, and Fujitsu-Siemens.

On a geographical basis, Sun sold $1.57 billion in products and services in the United States, down 2 percent. Sales in the Americas region (including Canada but not the United States) came to $230 million in the fiscal fourth quarter, flat compared to a year ago. Sun sold $1.38 billion in products in EMEA in the quarter, up 2 percent, and in the Asia/Pacific region, Sun's sales were up 2 percent to $652 million.

For the full year, Sun's sales were up 6 percent to $13.9 billion, and it had a profit of $473 million, which is a lot better than the $864 million loss it had in fiscal 2006 on sales of $13.1 billion.

Sun had been targeting an operating margin of at least 4 percent as it exited the fourth quarter of this year, and it hit 8.5 percent. Sun's goal looking ahead, said Lehman, is to hit at least 8 percent in the fourth quarter of fiscal 2008 with low-to-middle single-digit revenue growth, and to have at least 10 percent operating margins for all of fiscal 2009. "We recognize that we still have to reduce our cost structure, and we are working to do this," said Lehman. He also warned Wall Street that given product transitions coming up in its Sparc and X64 product lines, Sun expected revenue growth to be higher in the second half of fiscal 2008.

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