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Sun Micro Punished for Earnings Miss

The shares drop 20% after the company's profit comes up a penny short.

Updated from 12:21 p.m. EDT

Shares of

Sun Microsystems

(SUNW) - Get Report

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plunged nearly 20% a day after the company failed to offer evidence of a turnaround to long-suffering investors, turning in weaker-than-expected sales and net income. On a per-share basis, the hardware maker proved unable to push its finances all the way into the black.

Demonstrating Wall Street's lack of faith, this morning a couple of skeptical analysts said they now expect the company's sales to tread water for fiscal year 2004, which just got under way.

The stock was down 92 cents, or 19.3%, to $3.95 in midafternoon trading.

In analyst notes this morning, Sun's lower-than-expected gross margins came in for criticism. Compounding the relatively weak profit levels, Sun's sales left something to be desired, said Merrill's Steve Milunovich. "We were disappointed that a lower margin didn't result in better revenue," he said in a morning note.

Milunovich expects Sun to keep struggling at the break-even point for the whole of fiscal year 2004, which just kicked off. "Sun continues to invest in innovation, but the payoff looks to be a couple years off," he writes. A worrying sign: one Merrill survey found that one-third of server customers are thinking about migrating away from Sun in the long term. (Merrill has done banking for Sun.)

Likewise, Morgan Stanley says its 2004 estimates assume revenues will stay flat. (It hasn't done recent banking for the company.)

Meanwhile, Lehman's Dan Niles says he expects Intel-based servers to keep grabbing share from Sun at the low end, while IBM and H-P steal sales at the high-end with their Unix offerings. "These results are more disappointing given Sun is well into a very significant new product cycle," he writes. (Lehman has done banking for Sun.)

"I think people are very skeptical of the turnaround; this is still a show-me stock," says Brent Bracelin of Pacific Crest Securities. "They didn't deliver this quarter and based on bookings and backlog, I think people are skeptical about next quarter as well."

According to consensus estimates, Wall Street expects Sun to limit its typical seasonal sales drop in the September quarter to down 9%, less than the usual double-digit decline.

Yet against a backdrop of relatively high expectations, Sun has been faring worse than its competitors. "If you look at IBM, their Unix business is up 20% year on year this quarter," says Bracelin. "Dell's saying they're seeing growth. So if you look at the overall server and storage industry, fundamentals are getting better. But fundamentals clearly are not improving for Sun."

The server and storage maker posted break-even EPS for the quarter ended in June.

On a pro forma basis, it managed a one-penny profit, below the 2-cent consensus estimate. Net income amounted to $12 million, down from last year's $61 million for the same quarter.

Revenues slumped 13% from year-ago levels to $2.98 billion, a little shy of analysts' forecasts for $3.07 billion.

Gross margins gained 2.4 percentage points from the same quarter in 2002, but slipped 0.9 points from the prior quarter, to 43.7%.

Most of the sequential margin pressure came from hardware, which saw a 1.6 percentage-point margin decline at the same time the services margin grew 0.9 percentage points.

"The cost of components didn't decline as fast as it did in the previous quarter," said Sun chief Scott McNealy, explaining why gross margins fell in the June quarter.

But he sought to evade a question about how Sun's margins are likely to fare in the longer term, given the company's push into lower-margin hardware.

Earlier in the call, Sun had touted the debut of such products over the coming year. But McNealy declined to comment on how the move would affect Sun's profitability levels.

As has been its practice over the past few quarters, Sun declined to give any guidance. Typically, it sees a seasonal revenue decline of some 10% to 15% in the September quarter.

As for Sun's full 2003 fiscal year, revenues totaled $11.43 billion, down 8.5% from the prior year.

Sun's net loss ballooned to $2.38 billion in '03, compared to $587 million in 2002. The 2003 loss includes a noncash impairment expense of $2.13 billion.

Although its accounting loss grew, Sun managed to squeeze more profit out of sales. Gross margins in the just-ended year rose to 43.2%, an increase of nearly 4 percentage points from 2002. By business line, gross margin in fiscal 2003 increased 4.9 percentage points for products, and 1.9 points for services.

Sun said it paid down $200 million in debt and repurchased $500 million in stock last year, exiting the period with cash and marketable securities of $5.7 billion.