Software // Enterprise Applications
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10/2/2003
03:17 PM
William Schaff
William Schaff
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Taking Stock: Sun Struggles To Remain Relevant

The company is seeing competitive pressure from Dell and HP

Investing in technology is never easy, but some companies make it more difficult than others. Recently, Sun Microsystems dropped a bomb. After the close of the U.S. stock market's normal exchange hours, it revealed a noncash $1.1 billion charge for its fiscal fourth quarter that ended in June. This was primarily for valuation allowance for net deferred tax assets. In other words, I believe management has lost confidence that Sun can generate enough pretax income to use the tax benefit. Now that's a weak statement of confidence for forward-looking business prospects.

At the same time, the company also unveiled a weaker-than-expected earnings forecast for the fiscal '04 first quarter, which ended last week. This can be attributed to weak revenue and declining gross margins--but aren't we supposed to be in a recovery mode? More important, is Sun a bargain today, or will we continue to see it struggle?

I wish it were a bargain as I believe there's a dearth of real value in today's stock market. However, I suspect the latter may be true. First, the company faces rising competitive pressure. Intel-based servers are offering extremely competitive price and performance characteristics over Sun's proprietary Unix-based servers. Dell and Hewlett-Packard come to mind. Using cheaper operating systems, such as Windows and Linux, pushes the economics even more in favor of Intel-based servers, and pricing pressure is coming from all sides despite Sun's introduction of low-end, low-priced Linux/Intel-based servers.

Second, the company continues to be a complete enterprise network end-to-end platform and solutions vendor. This goes head-to-head with the business strategies of IBM and HP--both are more firmly entrenched in the enterprise market, with better financial resources. Competitors like these will make profits hard to come by, I believe.

The problem will get worse, as I estimate that cash flow from operations turns negative without some additional expense cuts in fiscal 2004 and 2005. Cost cuts will probably come in the form of reducing staff from its current count of more than 35,700. I estimate that adjusted tangible book value is about $1.85 to $1.90 per share, which may be the floor for the stock unless Sun continues to lose more money.

But not all the financial news is bad. The company still had about $5.7 billion in cash and investments at the end of fiscal 2003 and only about $1.5 billion in total debt, which is about $4.2 billion in net cash and equivalents. I don't believe the business is at risk of going away anytime soon.

Unfortunately, some areas turned from bad to worse for the company. Moody's credit-rating agency downgraded Sun's senior unsecured debt rating to one level above junk-bond status. This will reduce the company's financial flexibility and increase borrowing costs.

Sun is still a substantial presence in enterprise networks. But with declining market share and weakening financial fundamentals, it may lose relevance in the IT landscape over time. I, for one, would be sorry to see this happen.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with, nor does it receive compensation from, any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.


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