Red Ink the Rule at Sun - TheStreet

Updated from Oct. 16

Investors were mostly prepared for the surge of red ink in

Sun Microsystems'

(SUNW) - Get Report

first quarter of fiscal year 2004.

Shares of the server company were dropping only 11 cents, or 3%, to $3.52, the day after it announced that its loss had widened and sales had fallen year over year.

With atypical humility, on a postclose conference call Thursday CEO Scott McNealy sought to convince Wall Street analysts that he recognizes the depths of his company's troubles. He emphasized its efforts to drive down costs and offer low-end hardware that appeals to budget-conscious customers. But in a mark of skepticism about his management, he was forced to answer a question about whether Sun's board of directors is paying sufficient attention to its problems.

The server and storage maker posted sales of $2.54 billion, down 8% from last year's levels and slightly above expectations for $2.52 billion.

Sun posted a net loss of $286 million, according to generally accepted accounting principles, considerably worse than last year's red ink of $111 million. Earnings per share on a GAAP basis amounted to a loss of 9 cents, within the range of the 7-to-10-cent loss that Sun forecast last month.

On a pro forma basis, the company matched Wall Street's expectations for an EPS loss of 8 cents.

Reflecting the company's difficult straits, revenue fell in every leading geographical area, down 6% year over year in the U.S., 3% in Europe and 26% in Japan.

Gross margin shrank 1.1 percentage points from the prior year to 40.1%. Sun said its margins were hurt by pricing pressure, echoing similar comments from

IBM

(IBM) - Get Report

yesterday.

Said McNealy: "It's brutal out there. Everybody's got overcapacity and they're all looking for an extra gross margin dollar. It's a dogfight."

Reflecting diminished confidence in McNealy's single-handed leadership, Goldman Sachs analyst Laura Conigliaro bluntly asked on the call whether Sun's extensive problems had prompted the board of directors to step up their involvement and also whether the board has considered hiring a chief operating officer to help run the company. Last month, a Merrill Lynch analyst likewise broached the issue of filling the COO post that has been empty since the summer of 2002.

McNealy said the board has always been "100% involved" in the business, adding, "There's been no consideration of a COO role. We've been there, done that. I think the board is entirely supportive of the current structure."

"We're taking the steps we need," he said in a separate comment. "We understand we've gotta grow this company."

Nonetheless, management remains loath to commit itself to specific guidance. Pressed to comment on whether Sun's revenue will grow sequentially, a reluctant McNealy finally allowed that the company had seen seasonal sequential growth in the second quarter for almost every year of its existence.

Wall Street currently expects December-quarter sales of $2.70 billion, which would reflect a 5.9% quarterly increase. Analysts are gearing for a loss of 3 cents per-share loss.

One of the biggest buy-side complaints about Sun is that management has refused to admit the size of the challenges it confronts; today McNealy seemed to try to defuse that impression, saying, "We're listening; we're evaluating. The feedback on our strategy and road map has been incredibly positive," he said, citing the company's 11th-hour decision to expand and promote its low-end server line.

McNealy also said the company doesn't currently plan any wide-scale layoffs, noting it had reduced the work force by 20% over the past two years or so.

On the plus side, CFO Steve McGowan noted that the company had reached the highest level of services revenue ever for a fiscal first quarter and made gains in the one- and two-way server market. It also reduced expenses by $84 million.

On Sept. 29, one day before the close of its fiscal quarter, Sun

warned in a release that it had been "a particularly difficult quarter for the company due in part to intense market and competitive dynamics."

On the same day, it outlined its expected GAAP EPS loss for the quarter. The company didn't revise prior guidance because it hadn't offered any; in a measure of its uncertainty over even its near-term prospects, Sun stopped giving financial forecasts last year.

In a further reflection of its worries over the September quarter, Sun also announced last month that it would take a noncash charge of $1.051 billion against its already-reported June quarter. The accounting maneuver shows diminishing confidence in its ability to generate taxable income.

A few days afterward, Merrill Lynch analyst Steve Milunovich penned an

unusual and highly critical letter calling on Sun to push through sweeping changes or be rendered irrelevant.