Sun's Financial Strategy -- Can It Work?

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Analysts say the rapprochement between Microsoft and Sun Microsystems — and the huge cash payment Sun got along with its handshake to collaborate on technology — are good news for Sun.

But they also question whether the deal is enough to help brighten Sun’s future.

In return for Sun ending patent and antitrust suits against the software giant, Microsoft will pay Sun a total of $1.95 billion: $700 million for antitrust claims and $900 million for disputed patents. The two also signed a 10-year technology sharing agreement, and agreed to pay each other royalties on technology. The deal included a $350 million up-front royalty payment from Microsoft.

The cash will help replenish coffers that have been hit by ten quarters
of red ink. The Santa Clara, Calif.-based company used the day to pre-announce its financials for its third quarter, which ended March 28, 2004. Expected revenue is approximately $2.65 billion, with net loss on a GAAP basis in the range of $750 million to $810 million, for a net loss per share range of $0.23 to $0.25. The loss includes charges for about 3,300 job cuts.

Sun ended the trading day Friday at $5.06, a 20.76 percent increase from the previous day, in what Koala Capital president Melanie Hollands called “a relief rally.” Sun in effect pre-announced its next quarterly report, and she said that such a move often prompts the market to buy because it assumes the worst is over. “But assuming that the worst is over doesn’t necessarily mean it is over,” she said. “I’m not getting too excited about the real economic prospects for Sun as a result of this agreement, since it could be more a distraction from Sun’s deteriorating revenue outlook rather than a real positive in and of itself.”

Indeed, other analysts agreed that Sun has to do lots more than make nice with its arch-enemy to make it through a rough patch it’s facing. A two billion dollar bump is nice, but cash in the bank isn’t Sun’s problem, according to Illuminata analyst Gordon Haff. “It’s not news that Sun needs to do some things in the relatively near term to boost up revenues and profit.”

He said that where the company decides to cut staff will give an idea of its plans. “Will it be a generalized work-harder-with-fewer-people strategy, or will there be some groups or product lines within Sun which [newly promoted COO Jonathan] Schwartz decides are not where Sun wants to be going forward?”

Yankee Group analyst Dana Gardner said Sun should ditch its hardware side. “I think they are going to make their living on creating solutions and developing the best set of platforms and tools,” he said. “Java used to be write once, run anywhere and Windows Server 2003 was write on anything and deploy only on Windows. The potential here between Microsoft and Sun is to write anywhere and deploy anywhere, which is really going to be something that will roil the industry and be very attractive to developers.”

Hollands foresees a subsistence-level existence for Sun, because there’s a glut of hardware on the market. “Focusing away from buying boxes, buying solutions and software, and solving the management headaches should be its goal.” She noted that Sun has begun to shift its emphasis from proprietary hardware through partnerships with IBM and Fujitsu.

If Sun decides to go that route, said Gartner analyst Daryl Plummer, rumor has it that Hitachi might be a buyer. Even if enterprise customers are already resigned to Sun’s exit from the sector, the company can hang on for another year or so before a dismantling and sell-off became inevitable, he said. To stave off that day, “Sun needs to overcome the loss of confidence from customers. This agreement with Microsoft can help.”

Most observers think that, despite the ten-year cooperative agreement Sun signed with the maker of 90 percent of the desktop software in the market, Sun shouldn’t ditch StarOffice, its desktop productivity suite. Al Gillen, an analyst for IDC, pointed out that Sun has been pushing its desktop strategy without making money from it. “I think it’s reasonable to assume there
will be modification, but they probably won’t fully drop it,” he said.

Sun wants to get back in the game in a big way, said Yankee Group analyst Laura Didio. “They have some bright spots with StarOffice, but they are watching their Solaris hardware base lose out to Linux.”

Illuminata’s Haff said that despite the big announcement and big payoff, it’s unclear what the relationship of the two companies really will be. For example, Microsoft and Apple made a similar deal at one point, but, aside from a version of Office for the Macintosh OS, he said, the agreement didn’t change the posture of the two companies. “It remains to be seen how much cooperative development and love and kisses between the two companies there will really be going forward.”

Sun may be spending too much on R&D for a company its size, and that may be one area newly appointed COO Schwartz will cut. However, he said, “I think it’s far from being proven that R&D and innovation are not still a viable approach in the computer industry.” Haff likes the innovative technologies in Solaris 10, and, “obviously newer initiatives like Java Enterprise Server is some of their future in terms of recurring revenue.”

After Sun has spent the last year trying to convince the Linux community that it’s serious about open source, Yankee Group analyst Gardner said the new coziness with Microsoft might signal a less aggressive stance toward Linux. Stressing that he was speaking hypothetically, he said, “A quid pro quo where cooperation on the
server between Java and Windows leads at some point to less Linux on the desktop from Sun would make some sense.”

Said Koala’s Hollands, “Within Solaris 9 there was much strife about the Solaris x86 (Sx86) and Sun Linux platforms. The spin-doctors with Sun PR and the different product groups are still trying to fight the battle of what it is exactly that Sun will sell. For a short while, Sx86 was going to be on the chopping block, when Sun Linux was in full swing and development. Now it seems that Sun Linux is on the chopping block and Sx86 is in full swing. This seems to be a particular example of where the market hype about Linux coupled with management cogs getting stuck in red tape and political agendas seem to have gotten the best of Sun.”

Ron Miller contributed to this report