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What's That Glow around Sun's Stock? The Internet

And every investor knows what that means

Sun Microsystems (SUNW) has been hitting on all cylinders lately. Last fall brought a stream of good news, including a groundbreaking strategic partnership with America Online (AOL), soaring sales of its high-end servers, significant improvements to its Java software technology, and a court victory over Microsoft (MSFT) in a dispute involving the software king's use of Sun's Java programming language. Sun's new status in the top tier of computer companies is triggering a revaluation of its stock by investors.

Which raises the question: Is Sun rising too fast? After stalling in the low 40s for much of 1998, the stock took off in early October and vaulted to a 52-week high of 94 5/8 on Jan. 6. Sun is now trading about 80% higher than its 150-day moving average. Its current p-e is 46, up from its historical range in the low teens to the high 20s during most of the 90s.

Many analysts believe that this "multiple expansion," as they call it, may be warranted. "Right now the p-e looks high, because earnings estimates are probably too low," says Megan Graham-Hackett, an analyst with Standard & Poor's equity research group. Referring to the potential profit boost from Sun's AOL deal, she adds: "It's very hard for analysts to quantify something like this. So right now, I think the market is reacting to a positive opportunity." She expects analysts to ratchet up their 1999 earnings estimates after the company reports its second-quarter fiscal 1999 earnings on Jan 21.

Add it all up and what do you get? Sun is emerging as an Internet play. And as any investor who has been following the staggering runups of Web stocks in the past year knows, current earnings are of little importance when it comes to stock valuations. What matters most is a company's potential to be a key player as the Internet becomes a mass medium.

"DOT.COM-ING THE WORLD." Sun is starting to prove it deserves that kind of status. Chief Executive Officer Scott McNealy's grand vision is a day when PCs are obsolete and consumers are armed with a range of personal electronic devices that grab data and software applications directly from the Internet. (Of course, these will be programs written in Java and data stored on Sun servers. Sun's advertising boasts of "dot com-ing" the world, and McNealy plans for Sun to provide "Web tone," or the Internet's equivalent of a dial tone.

Investors started to believe that McNealy's grand vision made some sense when AOL announced last November a partnership with Sun as a key feature in its deal to acquire Netscape Communications. The deal is a big win for Sun, which not only gets to sell about $350 million in systems and services to AOL over the next three years but also finds itself in possession of a strategy for packaging and selling a complete E-commerce solution -- from Web-site development to back-office database systems -- to its business customers.

The deal also amounted to a thumb's up for Java, Sun's increasingly popular programming language. In a still-fuzzy part of the arrangement, Sun will also help AOL develop low-cost "network appliances" using Java that will let AOL members log onto the service from new kinds of electronic devices. "[Sun] probably made the best partnership they could to benefit from the E-commerce wave," says Graham-Hackett.

Indeed, the more gizmos that reach the Net, the more servers Sun can sell. To date, many investors have embraced networking giant Cisco Systems (CSCO) as the Internet "plumbing" play, since it provides the routers and switches that move data across the Web's infrastructure. Now, Morgan Stanley analyst Thomas Kraemer calls Sun "the Cisco of servers." His analogy is that while Cisco is providing the Internet's railroad ties, Sun is selling the railroad cars "that carry the networked applications and services to the next technology gold rush." So wrote Kraemer in a recent report.

PARTLY CLOUDY. He rates Sun a "strong buy" and calculates a fair value for the stock based on the company's break-up price of between $109 and $113. Merrill Lynch analyst Steven Milunovich explains simply that while Cisco is making all that data move across the Internet, companies need more Sun servers to manage the data. On Jan. 4, Milunovich raised his price target on Sun to $103, or 36 times his 1999 earnings estimate.

To be sure, a few possible clouds are on the horizon for Sun -- so analysts are eagerly awaiting the company's next earnings announcement. Milunovich expects it to report earnings of 66 cents a share, up from 57 cents a year ago, on revenues of about $2.9 billion. Both he and Sun Chief Operating Officer Edward J. Zander have ominously referred to the quarter as a "nail biter" in recent weeks, mainly because Sun installed a new internal computer system in the quarter, prompting some of its big customers to place orders early to avoid any possible snafus.

Still, Milunovich notes that server demand has been strong lately. "I can't guarantee that they might not come in below [expectations], but I don't think that is likely," he says. "Even if that did happen I don't think it would affect the stock much."

Analysts are also somewhat concerned that Sun's earnings release will hint at slowing demand in the second half of 1999, perhaps related to companies hunkering down to deal with Y2K issues instead of adding new servers. But analyst Doug van Dorsten of Hambrecht & Quist points to Sun's strong sales momentum. "Many people who thought they could go with all-Microsoft for a Year 2000 solution are finding they cannot," he says. "That has benefited Sun."

Those who don't share McNealy's long-term vision for Internet-based computing might want to take profits sometime soon. But Kraemer exhorted investors to stick around in a surprisingly insistent December report. "You've got to have religion, you've got to believe, and you've got to see the vision thing," he wrote. It's an understatement to say Wall Street has heaped high praise on Sun in the past few months. It's also true that its share price can't continue to rise at the current pace forever. But for long-term investors, this high point hardly seems the time to bail out.

By Amey Stone in New York, with Robert D. Hof in San Mateo, Calif.

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Updated Jan. 7, 1999 by bwwebmaster
Copyright 1999, Bloomberg L.P.
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