Forget about the good-old days when
traded at $64, on a split-adjusted basis. At this point, investors may find themselves pining for July, the last time the once-mighty networking outfit was worth more than a five-spot.
Like a snowball rolling down a hill, the company's stock has picked up momentum on the descent, since dropping below the ignominious $5 benchmark. Shares of the company closed Thursday at $2.57, unchanged from Wednesday.
Sun has hardly been standing still. By many accounts, the company's been trying to reinvent itself, aiming to boost its revenue from software. But for now it's still squarely tagged as a high-end hardware vendor, a painful designation in a market where cheap standardized products are in vogue. Sun is stuck betwixt and between: relying on hardware sales, it's had no choice but to roll out lower-margin goods. But Wall Street fears the moves will only knock down margins further.
In the meantime, though Sun (barely) met its goal of posting a profit in the June quarter, business has been deteriorating. Sales are expected to drop around 15% sequentially for the current quarter, and Wall Street doesn't expect to see another profit until the first calendar quarter of 2003.
Selling What Customers Don't Want
Not only have IT budgets been cut to the bone, but buyers don't necessarily want what Sun's selling. In September, a Goldman Sachs survey of 100 IT managers found that Unix servers -- Sun's stock-in-trade -- and to a lesser extent, NT-based servers ranked among the areas expected to see the least spending increases over the next 12 months (a dubious privilege shared by mainframes).
In a research note out Tuesday, Goldman analyst Laura Conigliaro said she expects Sun's revenues to grow by only 5% next year, down from earlier expectations for 10% growth. Her verdict: for the near-term, Sun appears stuck in a "slow-growth holding pattern."
The trouble is that Sun has won its (high-end) reputation based on its proprietary Solaris operating system and SPARC processors. But IT buyers increasingly favor cheaper, standardized computing systems based on Windows or Linux systems, powered by Intel processors.
After steadfastly resisting the Linux incursion, Sun recently relented and began offering server customers the option of Linux as well as Solaris. For the first time, it began selling general-purpose servers running on Intel chips in August.
But analysts grumble about its moves towards lower-end products, which likely will put pressure on gross margins. Indeed, the trend toward low-end commoditization in the server market may help explain why Sun lowered its gross margin guidance for 2003 to a percentage range in the low 40s, at the low end of expectations, observes First Albany analyst Walter Winnitzki in a research note.
"As the mix shift to the low end continues, combined with less leverage going forward, we remain cautious on the
Sun name," says Lehman analyst Dan Niles in a report on Sun. He noted that Sun gained six points of worldwide UNIX revenue market share in the June quarter, but that five points of that was in low-end servers.
"The move to the low end is necessary, I think. They don't have a lot of choice," says Bill Whyman, president of the Precursor Group, a Washington, D.C.-based investor-side research group on tech and telecom. "But it's also fraught with problems for Sun, in potentially cannibalizing revenue and lowering margins."
Big Name Competition
In that sense, Sun's problems extend beyond the economy to its own business model, where it's been hurt by its failure to flesh out the services side. To get a sense of Sun's shortcomings, says Whyman, look no further than rival
, which has moved aggressively to offer more standardized, low-end options.
IBM willingly lets server-buyers choose cheaper Microsoft or Linux systems instead of its proprietary software. From that standpoint, it -- like Sun -- is bound to lose some potential profits by selling lower-margin products. But unlike Sun, IBM can offset that by offering consulting and support through its vast services division. Sun's services business can't compete at the same level.
Meanwhile, at the same time Sun faces pressure from low-end servers, competition from IBM and H-P has been heating up in higher-end UNIX offerings.
In note on Sun's strategy earlier this summer, UBS Warburg analyst Donald Young concludes that the company remains far too reliant on hardware. "We still believe Sun needs to revamp its financial model and reverse the current profitability mix -- 70% hardware vs. 30% services and software -- to adapt to the new enterprise server market economics," he writes.
In response to such complaints, Sun has refocused its software efforts, appointing a new chief of software development in July. It's been talking up its so-called Sun ONE (Open Net Environment) initiative, which aims to make existing hardware more efficient. "They're behind from the standpoint that other software firms have been focused on this for some time. But Sun hasn't really been a software company," says Rob Enderle, a research fellow at Giga Information Group. He adds, "Getting
an initiative funded that would have a negative impact on hardware sales required the recognition that the sales weren't going to happen anyway."
"I think the jury's still out on that
software effort, but they've been put on the defensive," says Whyman. "My fear is that it's too little, too late."
Amid the company's attempt to reinvent itself, Whyman adds, it doesn't help that so many top-level executives -- ranging from the CFO to the president to the head of sales and marketing -- have recently split. "Each had his own individual story, but when a whole management team leaves, you start to wonder. It seems like more than just a bunch of people who are tired and wealthy resigning to pursue their personal interests."
In the meantime, given the weak business outlook, Sun may have no choice but to make deeper cuts in staff, a move CEO Scott McNealy has been resisting. This summer, McNealy said the company would lay off only 1,000 employees, out of a staff of some 40,000. Goldman's Conigliaro speculates the company might need to cut as many as 4,500 workers to bring costs into line.
That's based partly on her gloomy near-term assessment of Sun's business: she expects third-quarter revenue to drop 18%, based on field checks and business trends in the U.S. and Europe.
To be sure, though, not everyone's a bear. For the last month or two, Patrick Adams, manager of the
Choice Long-Short fund, has been accumulating shares betting they'll go up. Like Conigliaro, he expects to hear news of layoffs as the company reacts to the bleak spending environment, and he thinks the stock represents a decent value at current levels.
"I was disgruntled when it broke three
dollars the way it did," he admits. "But I think it's a $6 to $8 stock at some point, not too long from now. I don't think this quarter is going to be fantastic, but it's not as bad as people expect."
That sentiment bodes well for Sun, in light of Adams' prior opinion of the company. Back in the dot-com era, when it traded in the $40s and $50s, he says he made plenty of money shorting the stock.
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