Sun Microsystems Inc faces a shrinking customer base, competitors who are gaining market share and a shift in the computer industry toward lower-cost servers that threaten future profit, investors said.
You'd never know, listening to Chief Executive Scott McNealy.
"The nice thing about being No. 1 is that tough times only make No. 1 even stronger," McNealy said in an interview last week.
PHOTO: BLOOMBERG
Until this year, McNealy has been able to make good on his boasts, investors and analysts said. Sun's sales rose an average 19 percent a year in the past decade. Now, some said McNealy needs to chart a new course, as reduced corporate spending, renewed competition from International Business Machines Corp and the disappearance of many dotcom customers threaten growth.
Formidable competitors
McNealy has "financially powerful competitors with good brand names," said Louis Kokernak, senior equity strategist at Martin Capital Advisors, a Sun shareholder who manages US$55 million. "He's got to continue to differentiate Sun Microsystems from well-entrenched competitors at the high end and from approaching competition from below."
The company, whose servers run large corporate networks and Internet sites, on Friday reported its biggest quarterly loss ever, US$0.13 a share in the second quarter ended Dec. 30. The loss was US$431 million on sales that fell 39 percent to US$3.11 billion.
Palo Alto, California-based Sun had net income of US$0.12 a share on sales of US$5.12 billion a year earlier.
Excluding job cut expenses and investment losses, Sun said it would have had a loss of US$99 million, or US$0.03 a share. On that basis, which doesn't comply with generally accepted accounting principles, the average estimate of analysts surveyed by Thomson Financial/First Call was for a loss of US$0.04.
Last year's slump in technology spending came just as IBM, the largest computer maker, emerged with new servers to compete with Sun's in the high end of the market.
At the same time, PC makers' servers running on Intel Corp chips and Microsoft Corp software were becoming more powerful and reliable for running networks and dishing up Web pages. These machines, which analysts said cost as much as 40 percent less than Sun's, pose a new challenge in the market for cheaper server computers.
In the quarter ended Sept. 30, Sun's share of the market for servers that run on the Unix operating system fell to 33 percent, from 36 percent in the previous quarter and 39 percent a year earlier, according to market researcher Gartner Inc.
IBM's share, meantime, climbed to 21 percent from 20 percent in the previous period and 17 percent a year earlier.
Investors haven't lost faith in McNealy, 47, who earned US$100,000 in fiscal 2001 and received stock options worth an estimated US$44.4 million in 10 years. He also was paid US$2.23 million under an incentive plan started in 1990.
McNealy has steered Sun through a recession that has buffeted the entire computer, software and services industry, shareholders said. Under his watch, Sun's cash hoard grew to US$1.86 billion, and the company in 2001 spent US$2.02 billion, or 11 percent of sales, on research and development to spur future business. Sun shares, which have dropped 62 percent in the past year, rose 49 percent during the quarter.
The shares fell US$0.25 to US$12.12 Friday on trading of 77.6 million shares, making them the third most active on US exchanges.
McNealy pushed Sun, which lagged competitors such as EMC Corp in the high-end storage market, to close the gap by teaming with Hitachi Ltd. He's also revamped Sun's server line with a speedier chip called UltraSparc III.
"They made the investment in pretty challenging times, so when revenue growth does kick in, it's going to be great," said Sunil Reddy, portfolio manager at Fifth Third Bank, which owns 1.75 million Sun shares.
Product delays
Other analysts and investors said Sun moved too slowly in introducing UltraSparc III into all its server products. IBM, which introduced its Regatta server late last year, has had an easier time selling the high-end Unix machine because it took Sun 12 months to complete the transition, they said.
"Sun did hand the ball back into IBM's court," said Gartner research director George Weiss, who estimates Sun was nine months behind schedule. That could be a costly mistake, now that Sun is trying to win business from Standard & Poor's 500 companies, where IBM has been selling for years, investors and analysts said.
Sun's focus on machines that don't work with competitors' products may turn into a liability, some analysts and investors say. As Microsoft and Intel make inroads in servers, customers want to buy gear that will work with those machines.
Sun's hardware business might also go the way of desktop companies such as Gateway Inc and Compaq Computer Corp, which have watched profits disintegrate as price competition heats up, forcing them to lower prices.
"At some point [McNealy] is going to have to compete on price, and I don't think he's addressed that yet," said Kevin Fujimoto, an analyst at Banc of America Capital Management, a Sun shareholder with US$280 billion under management.
IBM `no threat'
McNealy responds that IBM isn't a serious threat. The Armonk, New York, company's product line, which includes the Linux and Unix operating systems, mainframe and server computers and other kinds of software, is too varied to work well together, he said.
McNealy also dismisses predictions that Intel-based servers will steal business from Sun in enterprise computing. In the market for 64-bit servers, which process data in chunks twice as big as standard 32-bit machines, he says Intel and Microsoft are far behind.
"They don't play in the 64-bit arena at all, and who knows when they will?" McNealy said, adding that sales of his company's low-cost Sun Fire V880 servers, which compete against machines running on Intel chips, are strong.
IBM and Microsoft will have trouble winning accounts because they compete with their customers in providing Web services, McNealy said. He also still insists that computing is migrating from desktop machines toward central computers, an area where McNealy said Sun is unbeatable.
"Time is going to solve this problem," McNealy said. "It's just predicting when and how and in what way."
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