RealMoney Silver - JAVA Brews Up Weak Revenue, Strong Earnings

JAVA Brews Up Weak Revenue, Strong Earnings
By Bob Faulkner
RealMoney Contributor
11/6/2007 8:36 AM EST

Updated from 4:50 p.m. EDT on Nov. 2.

Sun Microsystems (JAVA) reported first-quarter results after close last night that were light on the revenues but pro forma EPS were well above the Street. The company doesn't provide quarterly guidance but I would expect we'll see revenue estimates decline for the December quarter.

Total revenue in the quarter was $3.22 billion (+1% year over year; -16% quarter over quarter), with pro forma EPS of 6 cents (GAAP = 3 cents). The gross margin was 48.5%, up 500 basis points vs. the prior year and 130 basis points quarter over quarter, despite the sequential decline in revenue. The improvement was partially the result of mix, pricing and lower component prices. The operating margin in the first quarter was 2.0% vs. a loss last year but down 650 basis points from the prior quarter in large part due to a restructuring charge. Cash from operations was excellent at about $570 million, up more than $400 million from the prior year. The cash balance declined about $760 million after the repurchase of 244 million shares of stock. Accounts receivable decreased about $700 million, cutting eight days from days sales outstanding (62 days). Inventory increased by about $50 million, pushing days of inventory up 14 days, to 50 days. Channel inventory was said to have declined by about $20 million.

Sun Microsystems' product revenue (62% of total) was up 1% vs. last year but down 21% sequentially. Computing products were up 1% year over year and declined 20% quarter over quarter with the new Niagara servers and x64 servers with very strong year-over-year billings. Storage products rebounded with a 3% year-over-year increase but down 20% sequentially with softness on in the tape business. The services business was 38% of total revenue, up 1% year over year and down 8% quarter over quarter.

Geographically, Europe, Middle East and Africa (EMEA) was up 5% year over year, Asia/Pacific up 5% and Americas International up 4%. The U.S. (41% of total revenue) was down, however, 4% year over year.

The only guidance provided by management is for the fiscal year. Management essentially reiterated most of its prior guidance with the top line should be up in the "low to mid single-digit" range, with the second half stronger than the first. The improvement in the first-quarter gross margin led to a bump up in the range for the year to 44% to 47% (up 1%). Opex should be $5.6 billion to $5.8 billion, and there was a reduction in the expected interest income to $170 million to $200 million. Income taxes are expected to be in the $200 million to $250 million range. The current consensus for 2008 is for revenue of $14.35 billion and EPS of 22 cents. These estimates are consistent with the guidance. With a book-to-bill of 0.98, however, I think the December quarter's revenue consensus of $3.65 billion (+2% year over year; +13% quarter over quarter) will have to come down.

Part of the reason for the first-half 2008 weakness and need for second-quarter revenue reductions is the company's decision (announced last year) to migrate to sell out revenue recognition policy with the distribution channel vs. the prior sell-in approach. This is expected to have a negative impact on revenue in the second quarter of $100 million to $150 million as the program is implemented in the U.S. and Asia. In the second half of 2008, it is expected to have a drag of $40 million to $60 million as it is implemented in EMEA.

As I noted in the preview, Sun Microsystems has always been strong with the financial services industry. Management indicated that it was soft in some of the obvious candidates but saw strength in other areas of the industry. Given the fact that the chickens are just coming home to roost, however, I think it's fair to say the impact has not yet passed.

Sun Microsystems had a solid quarter and managed to eke out a small operating profit, even with the restructuring charge. Cash from operations was very solid. Management has highlighted a number of product lines that are seeing solid double-digit billings growth along with the prediction that the second half will see an acceleration in its business. That point's less that 60 days away, so investors shouldn't have long to wait.

JAVA Preview: In Need of a Jolt

Sun Microsystems (JAVA) will report results for its first quarter after close on Monday with a conference call at 4:30 p.m. EDT. Current consensus is for revenue of $3.26 billion (+2% year over year; -15% quarter over quarter) with EPS of 3 cents.

In the prior quarter, the company reported revenue of $3.84 billion (flat year over year; +17% quarter over quarter) and EPS of 9 cents. The gross margin was 47.2%, up 440 basis points vs. the prior year and 270 basis points quarter over quarter. The company also posted an operating margin of 8.5% vs. losses last year and the prior quarter. Cash generation was a very solid $470 million, with the cash and securities accounts increasing an equivalent level. Accounts receivable increased about $500 million, adding three days to days sales outstanding (70 days). Inventory decreased by about $40 million, with days of inventory declining eight days, to 36 days. Channel inventory was said to be about $250 million, up $10 million from the third quarter vs. an expected decline in the period.

Sun Microsystems' product revenue was $2.49 billion, or 64% of total revenue. Computing products were $1.85 billion, 2% year over year and 24% quarter over quarter, driven by solid growth in the T-series of energy efficient servers as well as the company's Sun Fire servers. Storage products declined 10% year over year but increased 14% sequentially as the new Thumper products gain traction. The product book-to-bill was 1.02 vs. 0.98 last quarter. Services comprised the remaining 36% of revenue, and they increased 3% year over year and 10% quarter over quarter.

There was no specific guidance for the first quarter. Management only indicated that for the full fiscal year, the top line should be up in the "low to mid single-digit" range, with the second half stronger than the first. The gross margin should be in the 43% to 46% range, and opex should be $5.6 billion to $5.8 billion.

There have been a number of cross-currents on the stock. First and foremost, JAVA products have always been popular within the financial services industry, and given the subprime issues, that's been viewed as a drag on business. Some have suggested that the company's done well despite the issues within financials. If JAVA had been reporting very strong numbers, I would worry about this, but it's not.

The storage business has had problems since the company bought StorageTek late last year. While at least one firm is reporting positive channel checks from the tape business, anything that stops the bleeding here would be beneficial.

Despite the sequential decrease in revenue, it would be a psychological positive for the stock if the company is able to show an operating profit in the quarter. It will be close but not out of the question.

CEO Jonathan Schwartz announced on the last call that the company is entering fiscal 2008 with the strongest product line in its history. That's his opinion, and now it's time for him to begin proving it.