Sun: Promise of Red-Shift, Risk of Virtualization

I last looked at Sun Microsystem (JAVA) back in April of this year, focusing on Sun’s approach to start targeting “red-shift” markets, and taking advantage of new opportunities being created by disruptive technologies like SaaS and Web 2.0/3.0 to open up new growth markets. This was an interesting direction given that Sun’s CEO of 22 years had stepped down, and Johnathan Schwartz was now in charge. So is the approach being implemented?

2008 Q4 Gross revenue posted $3.219 billion versus $3.189 billion 2007 Q4. Sun earned (GAAP net) $89 million in Q1 net profit, compared to a net loss of $56 million 2007 Q1. A significant portion of the improved 2008 Q1 profit margin comes from a reduction of $46 million in operating expenses to $1.385 billion (R&D plus SG&A) versus $1.431 billion YoY.

On a geographic basis US demand was poor (only showing strength in government and financials which are also now weak). But similar to other tech companies Sun’s international business was stronger, particularly in Asia (up 6% with top earners in India and China).

Q1 product revenues totaled $1.98 billion, an increase of 1.1% YoY. Within products, computer systems product revenue was $1.475 billion, an increase of 0.5% year over year. Storage products revenue was $505 million, an increase of 2.9% year over year. The Q1 Services revenue totaled $1.239 million, up 0.7% year over year. Within services, support revenue was $979 million, down 0.8% YoY. Only professional and educational services were touted as improvements.

Product revenue is expected to be higher in 2008 with a competitive Sun server lineup for the first time in 7 years. However, this could be hampered by the current march to virtualization led by VMware. In fact, many companies and government agencies grabbing VMware are now dumping their physical hardware en masse for physical space and equipment savings. Nonetheless, this new server is Sun’s strategic move into the “red-shift” (SaaS, Web) markets that require highly scalable datacenters powered by high-performance computers.

Meanwhile, financial engineering continues. Previously, while indicating the company was bullish, Sun announced that it intended to repurchase $3 billion in a stock buyback program (Q4 2007 announcement). Since then Sun has bought back 244.6 million shares costing $1.25 billion (avg price of $5.11/share), not yet half way to the $3 billion target. Share buyback programs are generally a method to attempt to boost the share price by lowering the number of shares in float. Q4 2007 and Q1 2008 purchases where subsequently hampered when the price went from $5 to $6 per share with recent tech market run-up. November is now back at previous price levels, and may accelerate the program.

Additionally, Sun is doing a 1-for-4 reverse stock split this week, catapulting its share value into the low $20s. Why? There are administrative reasons for a reverse split (e.g. remove small shareholders that are an administrative expense), but it’s normally done to artificially pump up a low level stock and get increased institutional interest (note, however, that JAVA is already 60% owned by institutions).

The real secret to Sun’s turnaround is in what they have presented as the “red-shift” market idea, but we have to wait till 2008 to evaluate proof of its implementation. The strategy, however, is not without risks, since the virtualization movement is also expected to charge ahead in 2008.

This segment is a part in the series : Sun