Surprise Sun report shows earnings beating estimates

The company, benefiting from strong sales of servers among both Internet companies and traditional companies moving to embrace the Internet, reported net income of $510 million, an 85 percent increase over the same period the year before. That amounts to earnings of 30 cents per share, excluding acquisition charges, 5 cents greater than analysts expected, according to First Call/Thomson Financial.

The numbers were included in a statement released by Sun shortly after the company inadvertently posted the results Wednesday morning on its Web site. Sun had been due to report earnings after markets closed.

The Nasdaq halted trading of Sun stock from 9:14 a.m. to 10:03 a.m. PT. Sun apologized for any inconvenience the premature release caused, and chief executive Scott McNealy quipped during the company's conference call, "Sometimes we're a little too hasty with our information."

"Clearly the quarter was simply outstanding," chief financial officer Mike Lehman said, a sentiment several analysts said they shared during the conference call.

"Demand continued to be higher than we anticipated," Lehman said, adding that analysts should raise their revenue and earnings estimates further. Revenue growth for the current second fiscal quarter should be in the high 40 percent range compared with the same quarter the year before, and earnings-per-share growth should be at or a little below that level, Lehman said.

However, analysts pestered exasperated Sun executives about a 4 percent drop in gross margin, a core profitability measurement. Sun attributed the drop to increasing memory costs, and by the end of the company's conference call Wednesday, at least some analysts were mollified that Sun wasn't engaging in creative accounting.

Revenue grew 60 percent from $3.15 billion to $5.05 billion for the quarter. Net income grew from $276 million to $510 million, excluding acquisition-related charges, Sun said.

Sun had record orders, revenue, net income and earnings per share, the company said.

Sun Microsystems Stock price from October 1999 to present.

Source: Prophet Finance

Customers placed orders worth $5.05 billion in the quarter, a 60 percent increase over the year before, Sun said. The company said all areas of the globe showed "outstanding" results.

In early trading Wednesday, Sun shares surged as high as $119.50 before the Nasdaq halted trading. After trading resumed, shares settled back to close at $110.19, down about 1 percent for the day.

But during the conference call Wednesday, securities analysts unrelentingly asked about the 4 percent drop in gross margin. Lehman said at least 3 percent of it was from increased memory costs, while McNealy added Sun had to purchase memory on the "spot" market, in which customers often have to pay more than through long-term contracts.

Company executives repeatedly offered reassurances that the margin decline wasn't because of competition from its chief Unix server rivals, IBM and Hewlett-Packard. "This is a memory component issue and not the result of any competitive pricing," said chief operating officer Ed Zander.

The memory cost problem will continue through the end of the year but is expected to ease in the first half of 2001, Sun executives said.

By the end of the call, McNealy began snapping at analysts over the issue. "What part of three-quarters of it (was from memory issues) do you not understand?" he asked one analyst. "I'm flabbergasted we're spending so much time on gross margins," he said to another.

By the end of the call, J.P. Morgan analyst Daniel Kunstler was reassured, he said. "I think it's less of an issue now that the call's over as opposed to before the call," he said. "They scoured around for inventory. I would have done the same thing."

Sun probably also contributed to the decline in gross margin by cutting prices on existing servers so customers won't stop buying in anticipation of upcoming UltraSparc III-based systems, Kunstler said.

Lehman took a diplomatic approach about the issue. "To their credit, it was the number that moved the most in terms of percentage, in terms of business model, and they want to understand it. They're going to push, probe and parry to see if there's any other information they can glean," he said in an interview.

Sun's "dominant position in enterprise hardware remains unchallenged," Goldman Sachs analyst Laura Conigliaro said in a research note Wednesday. The company likely will have strong growth for "several more years" because of the expected new installation of computing infrastructure.

The company had 50 percent revenue growth for its storage products, fueled by the debut of its T3 "Purple" network-attached storage server, the company said. Customers are viewing the T3 warily at this point, however, Merrill Lynch analyst Tom Kraemer said in a report. "We believe Sun needs to crack the high-end enterprise market" for storage, he said.

Kunstler noted that the 150 percent growth is "still off a fairly low base."

Lehman, too, used modest terms to describe the success of Sun's continuing effort to dislodge high-end storage king EMC. "While we don't have all the features and products that EMC does at the high end, it is a healthy business," he said.

Zander said Sun is being helped by the establishment of a storage-specific sales force, which grew by 200 employees last quarter to a total of 500 today.

Keeping up with demand remains a problem for Sun. For the second quarter in a row, the company has a backlog of $1.8 billion--the value of what customers ordered that Sun hasn't been able to fulfill. During the current second quarter, Sun hopes to decrease that by about $200 million, Lehman said.

Services continue to grow at the company, though in a change from earlier quarters, product revenue grew faster, Lehman said. The company hired 800 more services personnel in the last quarter and expects to continue hiring at that rate for the foreseeable future. But, Lehman added, "We do not see ourselves as a global services," referring to the division of IBM that many credited for Big Blue's financial recovery.

Meanwhile, the e-commerce iPlanet software sold jointly by Sun and America Online is becoming more of a Sun operation. Only 800 of the 2,500 iPlanet personnel are from AOL now, McNealy said.

The gradual Sun takeover of iPlanet was part of the plan established when AOL acquired Netscape in 1999, Lehman said. "We're not considering buying it out. We already own all the intellectual property rights," Lehman said in an interview. "Over time, it's just a question of do the companies want to continue to work together in this form, or a different one."