If You’re Thinking Of Buying SUNW, Consider These Points…
Sun Microsystems: Long-term concerns; Shorter-term
positives
After three years earnings
losses, during which it delivered only two positive EPS quarters (and marginal
at best — one or two pennies), the worst could be over for
Sun
Microsystems. But the worst being over doesn’t necessarily mean that its
fundamentals are robust.
Sun has done a great job of
cutting operating expenses, which has helped Sun deliver margin improvement over
the last few quarters: last quarter (ending September, 2004) Sun’s gross margin
was 42.9 percent, up year-over-year from 40.1 percent, and up sequentially from
39.4 percent. Other positives include the recent release of Solaris 10, open
source Solaris, progress making money from Java (including phones, handhelds,
and ID card), strong Java sales in Asia, and a solid new pipeline of products
from Sun Labs. Sun has a great management team, which unfortunately has made
some bad product decisions in the past. And then there’s Sun’s war chest of cash
— around $3.5 billion (in cash and equivalents) as of September 2004 – that
could be useful for acquisitions and can certainly finance its turnaround plans.
But I don’t think these
improvements are sufficient to help propel Sun into the top tier of hardware
companies. For that, it needs sustained earnings momentum; cost controls alone
aren’t sufficient. To generate that momentum, Sun needs revenue growth in the
mid-to-high single digits. This goal is made more difficult since Sun operates
in mature enterprise IT markets, and competes against companies with
significantly more share (IBM, Dell, HP) and in a climate of fierce price
competition. Furthermore, although Sun’s new Solaris 10 system is an
improvement, in my opinion it’s not sufficient to capture significantly more
share and drive much higher revenue growth.
Sun
needs keep moving if it wants to be something other than a niche player. Linux
and the new Java initiatives appear to be the brightest spots in Sun’s business.
Perhaps it will be bought, but I doubt a merger would happen with the current
Sun management team.
As for
what Sun can realistically achieve over the long-term, I still believe survival
on a "subsistence" scale is the best-case scenario. That said, in October last
year investor expectations (and Street numbers) for Sun were still so low that
all Sun had to do was show some margin improvement to take the stock higher. And
SUNW is up around 60 percent since then, when SUNW hit three-year lows after the
company’s earnings report. But whether this makes SUNW stock a good long-term
bet, I’m not so sure.
Some Muted Positives at Sun
Solaris 10. This
latest version of Sun’s operating system was released in November. Sales
of Solaris 10 should help boost Sun’s margins, but I don’t see it generating
meaningful revenue growth or share for the company. Solaris 10 isn’t a
bulletproof operating system: by that, I mean one that is more reliable than
Windows, is easier to learn and use than it’s now (or than Linux and Unix et.
al., and is more secure. Sun needs to find the missing pieces ASAP. In addition,
I’m hearing that independent software vendors (ISVs) are not all in a hurry to
support Solaris 10. Although Linux can run on a virtualization layer of Solaris
10, ISVs are not set up to operate their programs in this hybrid environment;
not yet. A new Solaris that doesn’t best Windows won’t build Sun, although it
might hold in a little of the eroding base. Sun needs a new system that far
outstrips Microsoft and then the small and medium business (SMB) and enterprise
buyers should have reason to jump.
Solaris open source.
Sun made a good strategic move in opening the code of Solaris 10, because it
brings in a whole new, worldwide community for enterprise development that it
had lacked. Solaris could be an attractive alternative to current UNIX (AIX and
HP-UX) and older WinNT enterprise systems, due to its maturity, company support
(tech, sales, marketing) and lack of licensing fees. When UNIX licenses expire,
enterprises running UNIX or WinNT could consider open source Solaris as an
alternative. Solaris is also tailor made to run with Linux servers and desktops
(such as Java Desktop System), so it all kind of fits into place. This could
translate into increased sales of Sun hardware as a result; although how much is
yet to be determined. But I have some concerns with Solaris open source. I’ve
not heard whether enterprises that use Solaris 10 will have the right retain the
rights to derivative works, including potential rights of redistribution
without royalty of those derivative works. If
not, then I don’t see Solaris being enthusiastically supported in the way that
Linux is supported.
Some Stronger Developments at Sun
Java
phones/handheld devices.
Sun has quietly made good headway into the mobile phone / computer market by
partnering with Nokia, Samsung, Motorola and virtually all the top handset
makers. Java may also help Sun move into the consumer video game business with
Java-based games; and it’s also a good connector between handheld devices and
enterprise / home computers.
Java
in Asia. A recent
breakthrough for Sun was the JDS sale to Chinese government. Other governments
are also looking at this option, to extract themselves from Windows obligations.
Germany and the U.K. are leading the way in JDS in Europe. With a general shift
to Linux over next five years, this could be a big deal relatively soon.
Java
ID card. The U.S.
military already has four million Java cards issued, and U.S. federal employees
are next. The U.S. government is the biggest employer in nation, and according
to Sun state, county, and city governments are next, and then eventually, the
general public. So, there’s a big market here. In one chip on a card in your
wallet, you have all your personal information right there to be had. Only a
sanctioned Java card reader can read the chip, so security is not expected to be
an issue.Â
Product pipeline / Sun Labs.
Lots of interesting products look like coming down the pike in next three to
five years, including some scheduled for release in 2005. The biggest is a huge
government / contract for a supercomputer (with Cray and IBM also involved).
There are also more consumer-type products in works, which could potentially
expand Sun’s total market.
Overall, Fundamentals Remain
Mixed
Positives
aside, I don’t particularly like Sun’s business model, because it can limit the
company’s longer-term development and potentially relegate the company to being
little more than a niche player. One problem at Sun has been its failure to have
a lead-in to a consumer presence, although Sun Labs may be addressing this. Sun
is also in sore need of integrated circuit (IC) technology to give it a more
equal footing with Intel.
Sun's continued lack of focus is not encouraging, although
it’s better than 18 months ago. It also has a cultural issue, to the extent that
it’s very U.S.-centric. Localization is a problem, since a lot of marketing
activity comes from the U.S. groups. Consequently, there’s a lot of back and
forth since Sun has product marketing and field marketing.
Software seems to be
the sleeping dragon for Sun. It's now a substantial division at Sun and, in my
opinion, it's probably the largest area of growth for the company. It’s good to
see that Sun is focused and committed to building software; although one thing
to watch is its ability to execute on a software strategy. It remains to be seen
whether or not Sun can pull itself away from the "lost boy" image it’s had for a
couple of years.
This also needs to be closely tied to its professional service organization.
SunPS has always been good at delivering solutions. It’s often times underrated
in their abilities. If both groups create more synergies, we might start to see
the beginning of a mini-IBM machine, where Sun sells the customer on a solution,
makes significant revenue on the licensing and consulting, while virtually
giving away the hardware.
Sun has several hardware
products, from storage to desktops, workstations, blade servers, and very
high-end servers. For the most part, hardware sales have been slower in general,
with EBAY and the secondary market putting a crimp on selling new equipment.
Since much of companies’ older equipment is pretty good, this impacts purchases
of new equipment so long as IT budgets remain relatively tight. Akin to the HP
laser printers, they just don't quit and break. The problem is that there are a
lot of new features in the latest processors that Sun is releasing. These new
processors take advantage of new architectures, materials, and processes that
leapfrog the previous version. But what can you do when Intel and AMD are
spending millions to market to the masses? Which is part of the reason why Sun
decided to work with AMD on their blade servers. This is a smart idea. Lower
costs and a good upgrade path will help Sun to build new customers from their
inception, such as a startup to successful enterprise or a company looking for
inexpensive power to run a compute farm or Web, file, and email servers.
In
terms of end-demand, I haven’t heard any distributor chatter about a pick-up in
the channel for Sun hardware.
Sun has never warmed up to
understanding how channel financing can help its channel partners. Instead, it
either sells direct on open account, or dumps product onto its distributors. All
I’ve heard about seen this past year is that traditional top-heavy Sun
distributors have been working hard to diversify away from Sun with other vendor
offerings and don’t want to be dependent on Sun products. So, that doesn’t
indicate iminent or robust improvement in sales of Sun hardware, which, if it
were occurring, would give me more confidence in higher revenue growth and,
therefore, confidence in SUNW as a long-term play.Â
Valuation and Risks
Over the past six weeks, SUNW
surged from the $3.90 to a high of $5.55. (Recall that for most of this year,
SUNW has been range-bound between $3.50 and $4.50.) Solaris 10 is Sun’s most
positive product release in over a year, and this helped propel the stock.
Furthermore, after having delivered earnings losses for 10 out of the last 12
quarters, Sun finally broke into the black when it reported its fiscal first
quarter 2005 on October 14 — an important milestone.
In terms
of a long-term investment in SUNW stock, expectations are much higher now than
they were this time last year. But incremental margin improvements (in Sun’s
case, due to significant expense cuts) can only propel a stock price so far. A
long-term investment in SUNW depends on Sun’s ability to deliver real top-line
growth; last quarter, Sun’s revenue growth was a light 3 percent. If Sun can
deliver more margin improvement (Solaris 10 has potential here), as well as
mid-single digit revenue growth, this could take the stock higher. It would be
even better if Sun can deliver sustained profitability and revenue growth in the
high-single digits, which in turn would help leverage Sun’s manufacturing unit
costs.
Technically speaking, SUNW could potentially move even higher over the next few
months. SUNWs
chart looks very good. It recently broke through major resistance and the
volume continues to pick up on the recent highs. As long as it trades above
$5.25 in the near-term then the intermediate-term upward trend should fine. The
stock has pulled back to $5.25 from its recent high of $5.55, SUNW was starting
to run into overhead supply – and a move under $5.25 would suggest that $5 is
likely for a near-term pull back.
Shorter term the stock
probably consolidates and it
would be good to see it rest around the $5.25 to $5.50 level before heading
higher. The
medium-term momentum in SUNW
is Sun’s can show revenue,
margin, and EPS growth over the next couple of quarters, then the stock could
hit $7. If (stress if) SUNW does rally that far then provided the
fundamentals are sustainable, that’s where more consolidation could happen
longer term.
While I
think SUNW stock can move up over the next few months, I’m on the fence about a
long-term position.
Aside from light revenue growth, a big risk to the SUNW stock price over the
next two to three years is that some other technology lab(s) will beat Sun to
the punch. So, if I did “buy and hold†SUNW I would not get greedy and hold it
for too long. Another
risk is that Sun keeps toying with a consumer play, and I still don’t think it
has the right people who understand that space.
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