Sun: Always Darkest Before the Dawn?


By David Shook For a brief moment, it looked like Sun Microsystems (SUNW), one of the battered bellwethers of the Internet economy, was ripe for a rally. Goldman Sachs analyst Laura Conigliaro put out a research note early on the morning of June 6 suggesting that Sun's worst days could be over. Investors took notice: From $17 at the previous close, the stock opened at $18.35 and traded up to $19.06 -- a quick 12% gain.

Then the rally fizzled as fast at it began. The stock, which hit a 52-week high of $65 last September, closed the day at $17.61, and has slipped even lower since then, to a $16.88 close on June 11. Conigliaro stopped short of eating her words: "All we were trying to suggest is that, in this environment, after seeing a lot of negative data points on Sun, we discovered a couple of not-so-negative points," she says.

Point taken. In the current rocky environment for tech stocks, it's all well and good for short-term traders to seize on one analysts' mildly positive comments. But long-term investors may want to wait until stronger evidence of Sun's turnaround materializes. While $17 may seem like a temptingly low price, Sun's business faces continued risk. And given the company's plummeting earnings, the stock isn't as cheap as it looks.

LOSING GROUND. Fact is, Sun remains on a loose footing as long as the IT-spending slowdown persists. "With all the Sun equipment dumped on the market by dead dot-coms and the huge incremental capacity added by traditional companies [last year], there's quite a bit of excess capacity not likely to be used amid the current economic downturn," says Peter Cohan, an Internet strategy consultant in Marlborough, Mass.

Weakness on the international scene is making matters worse. European tech spending is still softening -- the main reason Sun said in its May 30 mid-quarter conference call that it wouldn't meet its earlier forecast for its fourth-quarter earnings. "Demand in the U.S. is still less than we expected, and demand in parts of Europe and Asia Pacific are now also below our previous expectations," Sun CFO Michael Lehman said during the recent mid-quarter call. Fourth-quarter earnings will be in the range of 2 cents to 4 cents, down from the 8 cents it hoped to achieve. The company derives almost half its revenues internationally.

Meantime, Sun is feeling competition from the likes of IBM (IBM), Microsoft (MSFT), and Intel (INTC) in its bread-and-butter corporate-server market -- about 70% of sales. "It's not a good sign that Sun lost its server market lead to IBM in the first quarter of 2001," Cohan says.

Asked about its market-share gains in the server market, an IBM executive cited several companies that chose Big Blue over Sun. Weather.com is now using IBM servers running a Linux operating system for Web serving, the IBM source said. Other examples: Danish telecom giant Telia replaced dozens of Sun Web servers with a single IBM mainframe running Linux, as did Venezuelan bank Banco Mercantile.

"CHALLENGING ENVIRONMENT." Sun has also tried to break into the storage hardware and software market, where rival tech giant EMC (EMC) remains king. But so far, its efforts haven't amounted to much. "I'm not sure the economy is the only factor affecting Sun. I think competition is affecting the company at many levels," says Bill Shope of ABN Amro.

Sun's Lehman admitted as much in a conference call recently: "Without doubt, it's a challenging environment out there," he said. Lehman added that the company would place a heavier emphasis on its accounts with the largest corporations, where Sun still sees the most opportunity during the economic slowdown.

Such measures, however, don't provide much of an anchor in the face of Sun's steep earnings slide. For the fourth quarter ending June 30, the company's 3 cent forecast compares to earnings of 16 cents per share in the year-earlier period. Fourth-quarter revenues are expected to be $3.8 billion to $4 billion -- a significant drop from $5 billion reported a year ago and $4.1 billion in the third quarter of this year. Between the third quarter of last year and this year, Sun's earnings fell 73%.

IN THE CHIPS? Given these numbers, Sun is still a pricey stock. It sports a price-earnings ratio of around 40 (the S&P 500 has an average p-e of 22) and even though the stock seems to have stabilized around $17, there's still a chance it could fall further if the company can't meet its current targets.

Goldman's Conigliaro believes Sun is holding ground fairly well against rivals and thinks its efforts to branch into new territory, such as storage and services, will help the company defray any losses in its crucial server business. She also points out that Sun recently resolved the chip-supply problems that plagued the rollout of UltraSparc 3, its second-generation, 64-bit server technology designed to support large corporate intranets, high-capacity Web servers, and online transaction processing. That's why she still likes the stock at $17.

She may be right. Sun's price may prove to be attractive -- once there is more evidence of a pick-up in the company's business. But given the questions still surrounding Sun, it's easy to see why long-term buyers now seem reluctant to heed her advice. Shook covers the markets for BusinessWeek Online in New York


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