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An Early Network IT Apostle Hits the Deck; Another Hits the Jackpot

Coffee Beans and Sun Spots

Java: Delicious Internet Café Mocha; But How Long Will the Party Last?


PHOENIX, Aug 26, 1998 - Some early "network is the system" apostles hit the deck (DEC, for example).  Others seem to rising on the horizon (Sun, for example).  

Why the differences in fortunes?  Did DEC hit the deck against the backdrop of a rising or a setting Sun?  And is Sun really rising, or is its glow actually a Sunset?

It all depends on the backdrop.  One can stand still and still appear to be rising into the heavens - against a background scene of a crashing jet.  Or one can rise in a hot air balloon and still seem to be falling - if another aircraft climbs faster behind it.

A case in point.  It took a Sun roast to make the Java applets taste like real coffee to the bleary-eyed software developers - possibly the world's greatest (stale) coffee and pizza consumers.  Which, in turn, turned Java (applets) and Sun (Microsystems) into IBM's and Wall Street's darlings. 

But it took more than Java applets.  After all, Apple (Computers Inc.) had plenty of those.  Creativity and innovation were practically synonimous with the PC company which gave the IT industry its first mouse.  Yet, Apple almost hit the deck itself.  And was nearly consumed by Sun two and a half years ago (see "Could a Bad Apple Give Sun Some Spots" - Annex Bulletin FB96-02, 1/24/96).

Java: Industry Leader in "ROH"

It took innovation mixed with hucksterism to accomplish Sun's Java marketing feat.  "Interest in Java had a 'halo effect' on Sun," the Investors Business Daily noted in a February 1997 report.  It had to have been a very large halo serving as backdrop to a rather small Java bean head.  For, Sun's actual revenues and profits from Java have been miniscule, while its R&D expenses related to it have been quite substantial.

As of the end of FY98 (year end June 30), for example, Sun had sold 140 Java licenses to various computer and software companies around the world.  We estimate, therefore, that its aggregate direct revenue from Java was about $18 million, a mere 0.07% of its total business volume in the three years since its announcement of Java in May 1995.  Yet, Sun's R&D expenses, in which Java figures prominently, have nearly doubled during the same time frame - from $563 million to over $1 billion per year.

Which means that Java has been a financial disaster for Sun if taken on its own merit.  But measured in terms of ROH ("return on hype"), it has been a huge success.  It would not be an exaggeration to suggest that, in terms of perceptions, Sun's has now replaced Apple as the IT industry's innovation foundry in most people's minds.  Which has undoubtedly indirectly bolstered Sun's other businesses.

Buying an Illusion of Prosperity

Who says you can't buy an illusion of prosperity nowadays on Wall Street?  Just take a look at the above charts.  Sun and IBM look like the Bobbsey Twins.  Each company has spent tons of money on stock buybacks in the last three years.  And each has been rewarded by Wall Street with substantial increases in their average share prices.  Sun's stock is up nearly four-fold since 1995; IBM's is up more than 2.5 times.

But the price of such perceived stockmarket prosperity was quite high.  Sun has spent $1.3 billion on its share repurchases or 9% of its revenues during the corresponding period; IBM over $21 billion or 7% of its revenues.

Flat Earnings, Big Write-offs

As to Sun's business fundamentals, unlike its soaring stock prices, Sun's FY98 net earnings were flat compared to the year before - at $763 million on revenues of $9.8 billion, up 14% from FY97.  But Sun and Wall Street preferred to emphasize another net profit figure of $906 million, which is what the company's net would have been without the $176 million one-time write-offs for "in-process R&D."

The R&D write-off was a result of several Sun's acquisitions during its latest fiscal year.  In its first quarter, the company wrote off $52 million when it acquired Dina, Inc. and Integrity Arts.  The second quarter included the biggest R&D quarterly charge of $110 million, related to Sun's purchase of Encore Computer's storage business, and the Chorus Systems, S.A.

But some of Sun's FY98 deals which weren't acquisitions held a promise of good business returns downstream.  During its third quarter, Sun licensed its Solaris operating system for use on Intel architecture-based servers to Fujitsu and Amdahl, the Japanese vendor's subsidiary.

Business Segment Analysis

Geographies.  The U.S. market continues to be Sun's biggest business segment, accounting for 52% of its worldwide revenues.  But it was Europe that recorded the fastest revenue growth in the FY98 (up 24% to $2.7 billion).  Now take that IBM, DEC and a host of other computer vendors which have been complaining about a sluggish European market and the strong U.S. dollar.  Sun has evidently faced the same odds and ended up winning - handily.  And growing its market share on the Old Continent.

Even a better news for Sun's shareholders is that the company has been growing its European business very profitably.  In fact, Europe has generated higher operating profits even in absolute figures than the much larger U.S. operation.

If there is a "weakling" among Sun's international segments, it is Japan.  Sun's revenues from the Japanese market have been declining for several years now, although they are still over $900 million, and account for about 9% of the company's business. 

But even in its best years (e.g., FY96), Sun's Japanese business has only been marginally profitable.  And although the company has not yet released its Annual Report for FY98 with the detailed breakdowns, we estimate that Sun's operating profits in Japan were break even at best.  In other words, another example of "much ado about nothing" emanating from Japan; this time regarding a U.S. based competitor's business in that country.

Products. Although Sun does not break down its business results by product segments, its is now quite evident that its financials are starting to look increasingly like that of a software company.  Its gross margins are much higher than those of its main hardware competitors, but so are its SG&A and other expenses.

For example, Sun's gross margins in its FY98 were at a record 52% level.  Yet five years ago, they were at 41% level.  In other words, while everybody else's gross margins have been dropping (IBM's for example, dropped from 42% to 36% in roughly the same time frame), Sun's has been rising.  And sharply at that.  The only way this can be done is by growing the share of a more profitable business, namely software in Sun's case.

Similarly, while Sun's selling, general and administrative (SG&A) expenses have climbed from 23.9% of revenue in FY90, to 28.4% in its latest fiscal year, IBM's (and most other hardware competitors) SG&A expense ratio had dropped from 30% of revenue to 21% during the same time.  And IBM's gross margins plummeted from 55% to 36% since the start of the 1990s.

Mitigating against this trend is a parallel and rapid growth in Sun's services revenues.  Estimated to be well in excess of $1 billion now (i.e., more than 10% of its total revenues), services have been growing at roughly 40% per year. 

Unlike software, however, services tend to carry relatively low margins, along with lean SG&A expense-to-revenue ratios. 

For that reason, Sun is no longer the mini-computer maker that it once was; it is not yet a software company which it is striving to be; nor it is a major league IT services vendor.  Yet it is all three.  Which is why Sun's financial statements reflect a "multiple personality" syndrome which such a business blend represents.

Happy bargain hunting!

Bob Djurdjevic

Volume XIV, No. 98-33
August 26, 1998

Editor: Bob Djurdjevic
Published by Annex Research
e-mail: annex@djurdjevic.com

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