Here comes the sun, here comes the sun, and I say it's all right.
-- The Beatles
It's tough to find a more hated stock on Wall Street than
. It's not hard to imagine why. A lot of people lost some serious scratch on Sun. The stock traded as high as $64.65 in September 2000, only to lose 96% of its value before bottoming out at $2.34 in October 2002. The stock has nearly doubled since then, but is still off a heart-stopping 93% from those lofty levels of 2000.
Furthermore, Sun has been profitable in just five of the past 20 quarters and cash flow positive in just four of the past 20 (in fairness, cash flow from operating activities has been positive for eight consecutive quarters). The company's cost structure is too high and it is giving away its software. Not exactly the stuff upgrades are made of.
In fact, only three sell-side analysts rate the stock buy, compared with 13 holds and seven sells.
The Consensus Story
: The Street is concerned about margins -- especially considering that Sun's software is now free to download. Sun's software strategy is a move to support open source, reflected in the company's announcement it will provide technical support to help programmers adapt Linux or other open source software systems for new servers that use Sun's Sparc chips.
Management hopes that by offering its software for free, it will attract more customers who will sign up for service contracts. Organic revenue is declining as is Sun's core server business. Analysts are taking a wait-and-see attitude before supporting the stock.
The Real Story
: Value investors have been quietly amassing shares of Sun. The company is in the midst of an overhaul of its business. The recently acquired StorageTek should boost margins and fit in well with Sun's product portfolio. The company is beginning to see some traction in its core business.
What made me really take notice of Sun is the fact that in the past few quarters, several big value players have been accumulating shares.
Dodge & Cox
, known as a deep value player, picked up more than 137 million shares in the third quarter and another 115 million in the fourth, giving the firm a 7% stake in Sun.
Brandes Investment Partners
, another value investor, added 46 million shares to its existing 57 million-share stash in the third quarter. The
Merrill Lynch Basic Value Fund
(MDBAX) also purchased 7.5 million shares to bring its third-quarter total to 22.9 million.
Merrill Lynch Basic Value portfolio manager Bob Martorelli, who considers himself a contrarian, acknowledged that Sun's is not a perfect story. "We hope they find some religion on the cost side," he says. "Most of the companies that we look at underperform on margins and we hope they'll return to historical levels."
Sun's operating margin for fiscal 2005 was negative 1.04% compared with its 10-year average of 5.82%. Net margin was negative 0.97% compared with the 10-year average of 1%. Martorelli is further emboldened by Sun's balance sheet, which includes $2.5 billion in cash and just $1.1 billion in debt.
He believes the company can eventually earn 40 cents per share and trade at a 15 multiple, or $6 per share. On Tuesday, Sun shares rose 1.4% to $4.39.
Get a Leg Up
Fund managers like Martorelli are banking on some of Sun's new initiatives such as its so-called Niagara-based servers to drive revenue, which it is hoped will flow to the bottom line. Niagara is a new processor that uses less energy and costs less to operate than traditional processors. The servers have received very good reviews for performance and power consumption.
Even some sell-siders acknowledge that the new processor has a leg up on the competition. "With Sun and
the only two significant server vendors really addressing these customer concerns in a serious way at this point, there could be market share shifts toward those players coming in the low-end server space," says Thomas Weisel Partners analyst Kevin Hunt, who owns shares of Sun. (Thomas Weisel Partners has an investment banking relationship with the company and makes a market in the stock.)
Despite having the equivalent of a hold rating on Sun, the analyst believes there are some positives: "It appears clear that Sun is in a better product and cost position than it has been in the past few years, which seems to suggest that some kind of financial recovery lies ahead."
However, Hunt, like most of his contemporaries, wants to see more proof that Sun has turned things around before recommending the stock.
As I've stated before, the sell side is often reluctant to stick its neck out. The buy side on the other hand is always in search of market-beating returns and is more inclined to take risks, albeit calculated ones. Institutions don't often take big positions without doing their own research. When firms such as Dodge & Cox back up the truck on a beaten-down stock like Sun, it pays to take notice.
Based on the aforementioned institutional interest, chart watchers shouldn't be surprised that Sun is showing some technical improvement.
The four-year weekly chart of Sun below shows the stock has engaged in similar behavior three times since bottoming in 2002. The stock formed a base below $4 and then rallied up to roughly $6 on increasing volume before falling back to previous levels. Beginning in late 2005, Sun once again emerged from a base on stronger volume. The most recent base was longer than the others and could indicate this rally will be sustainable.
It's hard to say where the institutions that have been buyers would start cashing in. But I believe Martorelli's $6 price target is a good one, especially taking the technicals into consideration. And should Sun start to make real progress in turning its business around, the sell siders will pile on with upgrades, which should boost the stock even more.
Is it risky to own a stock of a company that has yet to prove it can return its business to profitability? Absolutely. But I like following smart investors -- more especially when they find value in stocks at which the rest of the Street thumbs its collective nose.
The Sun Also Rises
As originally published, this story contained an error. Please see
Corrections and Clarifications.
In keeping with TSC's editorial policy, Lichtenfeld doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.
Marc Lichtenfeld was previously an analyst at Avalon Research Group and The Weiss Group and a trader at Carlin Equities. He holds NASD 86,87, 7 and 63 licenses. His prior journalism experience includes being a reporter/anchor for On24 in San Francisco and a managing editor of InvestorsObserver, a personal finance Web site. He is a graduate of the State University of New York at Albany. He appreciates your feedback;
to send him an email.