Merrill to Sun: 'Cut and Focus' or Be Acquired

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A prominent technology analyst for Merrill Lynch is urging Sun Microsystems to slash as much as 15 percent of its workforce and focus on being a niche player in mission-critical computing — or risk joining the “carcasses” of formerly-great companies DEC and Data General at the bottom of a tech “ravine.”

In an open letter to Sun’s chief executive Scott McNealy urging the company’s board to take action, Steven Milunovich wrote that “Sun faces a crisis. It’s necessary to cut expenses to assure profitability and narrow the product focus to reestablish a clear value proposition.”

If the company stays on its current course, the note continued, “we believe Sun is likely
to suffer further share and financial losses, become irrelevant to most users, and
eventually be acquired for its installed base.”

The research note comes on the heels of a warning by Sun on Monday that it would have to report an even bigger loss — between 7 and 10 cents per share — than it expected in the most recent quarter. Analysts were expecting a loss of about 2 cents per share. The news drove down Sun’s price the next day by as much as 15 percent.

Following the Merrill Lynch research note Thursday, which contained the open letter to the company, Sun’s shares were off by as much as 3 percent to $3.16 during the midday trading session.

Despite a concerted effort to expand its support for Linux across more of its product lines, the systems vendor still finds itself on the defensive about its support for Linux in relation to its high-end Solaris operating system, while trying to withstand intensifying competition from IBM and HP and a tech recession that has wrought two years of declining revenues at Sun.

The Merrill Lynch note urged the Santa Clara, Calif., company to drop some product lines and cut its costs by reducing headcount between 5,000 and 7,000. It also urged Sun to “focus on creating mission-critical computing systems where it can add value through innovation.

“That includes operating systems (Solaris, Orion), system architecture (blades), systems management (N1), and services.”

The note continued: “Solaris is critical to why users like Sun. Being late to Linux is unforgivable both because Linux is a kissing cousin to Unix and because Linux is a disruptive threat to Microsoft.

“Sun needs to convince users that Linux is a subset of Solaris and push two messages: (1) if you’re
doing Linux, go to the Unix expert, and (2) use Linux on
the edge, but when you need mission-critical capability it’s
time to graduate to Solaris. Linux is not associated with
Sun, so at this point the best Sun can do is make clear it
aggressively supports Linux.”

Michael Hakkert, director of communications for Sun, said while the company is in a quiet period ahead of its next earnings release, Sun “welcomes Steve [Milunovich] to visit the company, meet with executives” and hear more about how it is “driving back to profitability.”

Namely, Hakkert pointed to Sun’s fiscal 2003 results, which showed that Sun improved its margins by close to 5 percent on servers, and 1.9 percent in services, while cutting $477 million from its administrative and overhead costs during the year.

The note also said it was “tempted to advise giving up on middleware, but the
sedimentation trend of middleware moving into the OS [operating system] and the disruptive pricing of Orion (Java Development System) may be a hand worth playing though the selling
model is unclear. Sun has made strides in improving its maintenance contract attach rates but may need to invest more in consulting/systems integration (though we don’t
see a major acquisition).”

It also urged the company to de-emphasize its SPARC processor system and save the roughly $200 million to $300 million that Sun spends on research and development for the processor systems.

“At the same time, Sun can’t just dump SPARC outright given the size of the installed base and importance of migration paths,” Milunovich wrote. “Customers must be assured that there will be multiple generations of SPARC to support their needs, especially high-end customers, much as HP has had to do
with PA-RISC. The pure Solaris/SPARC story would be
gone, but it already is.”

The note was also hard-hitting about Sun’s Java strategy, urging the company to spin off its Java division, asserting that “Java has been a technology success, a so-so branding effort, and a financial failure.”

The note apparently kept its powder dry for perhaps the hardest-hitting suggestions to “bring in a COO” and to “Give Scott a makeover,” referring to McNealy, also one of the company’s founders.

“Scott’s brash and contrarian personality have been synonymous with the company’s image and success. Unfortunately, the act is getting old,” Milunovich wrote. “Sun does need to make contrarian bets but must do so in ways palatable to conservative CIOs. Sending a clear message with a more pragmatic tone could help. More (some) respect for the competition and for different
viewpoints is needed. In addition, Scott should not be the only face of Sun (we consider the brilliant Jonathan Schwartz cut from the same cloth), which is why a strong COO could balance yin with yang.”

The note urged Sun to “return to its roots while looking to the future.” Sun is an innovator, it continued, “but even IBM became selective about its R&D efforts when the red ink flowed. [Sun’s]Solaris, Linux, Orion, Mad Hatter, N1, SPARC, x86, storage, Java-‘The Network is the Computer’ tent is bursting at the seams,” he wrote of some of Sun’s main product and services lines.

Hakkert declined comment on the suggestions, but stressed that “Sun is focused on executing on its strategies,” with a strong management team in place and a pipeline filled with new products and aggressive pricing models for both high-end and lower-priced Intel-based server systems. In addition, he noted that Sun has reduced corporate spending, paid down $200 million in debt and ended the year with $5.7 billion in cash and securities, while working its way back to profitability.

But Milunovich wrote that a large installed base of customers and strong balance sheet will only act as brakes on a “slippery slope to the bottom of [a] ravine filled with carcasses such as DEC, Data General, Compaq, and others.”

“We have an open invite for Steve to come to talk with us” about the company’s focus, Hakkert added. Sun will release its earnings for its fiscal first quarter of 2004 on October 16th.