Even with settlement, future cloudy for Sun

Sun Microsystems settled long-standing legal disputes with Microsoft on Friday, but several major problems still loom for the server maker.

Difficulties with sales, more layoffs and a bevy of competitive pressures are all bearing down on the Mountain View, Calif.-based company. To top it off, Sun is amid a transition from deriving most of its revenue from servers to selling software licenses, a kind of shift that very few companies have ever achieved.

On the positive side, Sun historically has shown it is one of the more nimble companies in the industry. It won't likely cost-cut itself to death like many other former giants, Illuminata analyst Gordon Haff said. But the company does have a lot of work ahead.

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"Sun has a history of doing 180-degree turns that no one expects. Remember, they used to be a workstation company," Haff said. "Their problems are very real and very severe, but I would say they are far from terminal."

The pact with Microsoft will also lead to $1.95 billion in payments to Sun, the bulk of which will transfer in the relatively near future. Sun already had $1.48 billion in cash and cash equivalents at the end of the December 2003 quarter, or $5.5 billion including short-term assets such as stocks and receivables. In all, that gives the company access to close to $7 billion. Sun, though, will take a $475 million charge over the coming quarters to cover costs for the roughly 3,300 layoffs announced Friday.

In many ways, Sun's slide, which has been taking place for more than three years, can be attributed to the fact that it got surrounded by competitors. Because of its success in selling servers in the dot-com era, Sun became a target for larger companies with more engineers, resources and money. These competitors also were able to spread out R&D investments by using standardized components. Typically, Sun has relied on its own UltraSparc chips and Solaris operating system.

"More or less for the past two years, they (Sun) were in a situation where their expenses exceeded their revenues," said Jean Bozman, an analyst at IDC.

In 1999, when Sun was one of the fastest-growing server manufacturers, IBM reorganized its server unit with the goal of knocking Sun off its perch. IBM is now the largest server maker.

The server market in terms of revenue grew by around 5 percent to $46.1 billion in 2003, market research firm Gartner said earlier this year. Sun, however, saw its revenue decline 15 percent to $5.4 billion and its market share drop 2.8 percentage points to 11.8 percent.

All the other major server makers grew. IBM's server revenue rose 10 percent to $14.8 billion from 2002 to 2003, and the company saw its market share inch up to 32 percent. No. 2 seller Hewlett-Packard grew 5 percent to $12.5 billion while fourth-place Dell posted the fastest growth, 22 percent, to $4 billion.

Intel has also contributed to Sun's downfall. In 1997, Intel-based servers barely accounted for a few percentage points in the market. Now, servers running chips from Intel or Advanced Micro Devices account for over 90 percent of server shipments in terms of units and over half of the revenue.

X factors
Several analysts and executives have said that the shift came because so-called x86 chips are cheaper, but also because servers based on these types of chips began to equal and then surpass the performance of the more expensive RISC (reduced instruction set computer) servers of the kind that Sun sells. The increased numbers of Intel-based servers on TPCC benchmark lists and the Top 500 supercomputer list bear this out.

Then there was Linux. Linux server revenue grew 63 percent to $960 million from the fourth quarter of 2002 to the fourth quarter of 2003, IDC said in February. At the same time, unit shipments grew 53 percent to about 250,000. Linux is a derivative of Unix, the same core behind Sun's Solaris operating system, but it runs on Intel and AMD servers.

Sun has actually been selling Intel and AMD servers for four to five years and it has been selling Linux for two years. But the company only began to actively promote these products last year.

Before 2003, Sun CEO Scott McNealy and other Sun executives would describe their x86 servers as relatively generic products that were assembled in Taiwan, no more special than servers Dell was selling. Now, the company actively supports these product lines.

"Sun has committed itself to the reality of the fact that the world is heterogeneous with respect to processor platforms and operating systems. The strategic things to come out of this are extremely interesting, and we're only just getting a first glimpse of it," said Frank Gillett, an analyst at Forrester Research.

The Microsoft settlement will directly benefit Sun. Under the terms of the deal, Sun will receive close to $2 billion from Microsoft. More importantly, the software offered by the two companies will interoperate better. Currently, Sun software can work in a Windows environment, "but it requires expense, cost and time" to work smoothly, Bozman said.

"There has been interoperability, but this is interoperability at a more profound level," she added.

The settlement, along with the promotion of Jonathan Schwartz to president, will also likely help tone down Sun's continual sniping about Microsoft, which has become a distraction, according to Neil Macehiter, research director at Ovum.

"As Microsoft has continued to prove its worthiness as an enterprise IT player, Sun's posturing has looked increasingly quixotic," he wrote in a report Friday. "The only concern we have now is that although he (Schwartz) has undoubted vision and brains, he's still unproven in terms of driving large-scale execution. Given Sun's history, he's going to need these skills in spades if the ship is truly going to be turned round."

"This is probably something McNealy couldn't have done, given the personal stake he has made in the anti-Microsoft crusade," Haff said.