By Megan Graham-Hackett Over the past year, Sun Microsystems (SUNW) has been on the defensive, as Wall Street questioned its market position, financial outlook, and overall strategy. But Sun's annual analysts meeting (held Feb. 6-8) told a different story. Company officials seemed more upbeat and were able once more to joke and laugh with analysts. The improved tone was evident as the company detailed its strategy for the coming year, especially how it intends to beef up its competitive position and improve its customer service. Sun also launched new products, outlined new selling strategies, and set new financial goals.
No, Sun didn't raise its earnings forecasts, but we at Standard & Poor's believe the company's momentum has changed for the better. We were pleased to see that Sun was more focused on its customers, new market opportunities, and financial goals -- and no longer seemed distracted by what was happening to the overall economy.
The company announced its plan to return operating profit margins to double-digit rates. Sun didn't say exactly when that would happen, and we don't expect it to reach this goal by the end of fiscal 2003 (June). Sun has said with revenue of $4.5 billion per quarter, it could achieve gross margins of 45%. With an operating expenses including research and development at 10% of revenues, and selling, general, and administrative expenses (SGA) at 25%, it could achieve 10% operating margins.
E-BIZ PROGRAMS. Our current earnings model estimates that Sun could close in on this target by the end of calendar 2003. But our forecast may prove too conservative, given the leverage Sun has built into its business model by adding efficiency to its organization.
How will it reach its goal? Sun has implemented new e-business programs that have streamlined its worldwide operations in procurement, supply-chain management, and other business functions. Meanwhile, top-line growth is expected to come as Sun penetrates new markets through a combination of new products and selling strategies.
Sun has launched two new storage products, the StorEdge 3900 and 6900. Both build on Sun's established T3 storage offerings but boast improved features such as remote diagnostics and "phone home" capability, which means in the event of a failure -- or potential failure -- the system can contact Sun's service center, and engineers can solve the problem remotely. Also, Sun announced its new Storage Resource Management software offering, which is aimed at making sprawling data centers more manageable.
OVERBLOWN FEARS. The company also detailed its strategy for the Linux operating system. Sun intends to better support Linux within its current product offerings. What's more, it will offer a new low-end server running on Linux (to be released mid-2002). The company's response to the emergence of Linux has been a real concern for investors. The belief has been that Linux, since it's similar to Unix -- and much lower in cost -- could take market share from Sun's significant Unix-based server business.
Linux was indeed a threat at the low end of Sun's line, but we think fears of Linux taking over the entire Unix market are overblown. Most industry participants concede that for large, mission-critical systems -- particularly the core computing architecture for data centers -- Unix will remain dominant. But a market does exist at the edge of the network in which low-end servers are used for single software applications in which Linux has been a significant player for some time. Now Sun can better participate in this market, which has been growing faster than the high-end server market during the economic downturn.
Sun can also gain a foothold in the growing service and support industry springing up around Linux. Market research firm International Data Corp. estimates that the market for service and support of Linux-based systems was $7 million in 1999 but is expected to jump to more than $3 billion in 2002 and exceed $10 billion by 2006.
STRATEGIC MOVES. We believe Sun has stepped up its commitment to its "Six Sigma" customer-advocacy program, aimed at improving its response to clients' needs and anticipating those needs. That may be a reflection of the program's maturation within Sun or the company's response to the economic realities in the market today. Probably both. The company spelled out two programs along these lines: pre-integration (integrating customers' software and hardware choices for them before they are shipped) and Floor Tile Ready (FTR), to enable its clients to deploy a high-quality, reliable configuration faster within their existing computing environment.
These new products and strategies reflect the different computing environments into which Sun is selling. It's now focusing sales efforts on health-care, retail, and government customers. These industries have substantial legacy computing environments, unlike the dot-com companies that accounted for such a large portion of Sun's sales in the past few years.
This means Sun has had to adjust its strategy to make sure its offerings work with other vendors' computing systems. It also means it has had to build better relationships with systems integrators to better coordinate its equipment with existing environments and that the additional capacity has to be economically and efficiently deployed. In short, Sun is now focused on solving problems, instead of just adding computing capacity for its customers.
DEALS AHEAD? The change in strategy is obviously also driven by what's happening in the overall economy. Sun is now embracing "horizontal computing" (when capacity is added by joining together low-end servers) to a larger degree. While this market has been around for awhile, it has taken on a new urgency as sales for Sun's high-end servers (which can fetch $1 million each) have been dramatically reduced. Why the drop? Companies are watching their spending on information technology -- and large IT project roll-outs -- more closely. And since much higher levels of management must now sign off on such expenditures, the sales cycle gets stretched out further.
One other wrinkle in Sun's strategy: It appeared to talk more about acquisitions. Our guess is that Sun would likely make a small to midsize acquisition to better position itself in horizontal computing. And more deals may be coming in the storage business.
Sun's shares, which carry S&P's highest investment ranking of 5 STARS (buy), have been under considerable pressure of late, after a strong start in the early weeks of the year. We believe this presents a compelling opportunity for investors. We think the shares are undervalued both on a price-to-sales basis (Sun trades at a discount to its historic average and below many of its peers) and as compared to its instrinsic value, which we place at $16 a share, based on our discounted cash flow analysis. Graham-Hackett is a technology analyst who follows computer hardware stocks for Standard & Poor's