THE DAY AHEAD: In Sun we trust

Larry Dignan
4 min read

COMMENTARY--As the tech earnings recession intensifies, it makes a lot of sense to cook up a new measuring stick for companies--also known as the "can you take a punch" metric.

This metric won't be found in an index because it largely focuses on the intangibles. It won't be kicked around on CNBC or Wall Street, but it can be used to find some sanity in a sea of bad news. Simply put, investors should focus on companies that can take an economic punch and emerge stronger.

Face it, the economy stinks--for everyone. We've heard dozens of tech execs say that the economy has shut down. Customers are putting off investing in their networks, e-business integration and other vital tasks. Given that malaise, which is affecting everyone, you need to look for the intangibles.

Sun Microsystems (Nasdaq: SUNW) has the intangibles.

On Thursday the maker of servers and network software said it will report third-quarter earnings of 7 cents to 9 cents per share, roughly half of what investors were expecting. Analysts surveyed by First Call predicted a profit of 15 cents per share for Sun's fiscal third quarter, which ends in March.

The company now sees third-quarter revenue growth of 10 to 13 percent year-over-year, which translates into sales of $4.41 billion to $4.53 billion. First Call consensus was predicting revenue of $5.25 billion. Just a few weeks ago, Sun had predicted revenue growth of about 30 to 35 percent. The new outlook is much worse than even the most pessimistic analysts had expected.

To make matters worse, Sun has no idea when the economy will rebound. Second half? Maybe. Next year? Possible. Eventually? Definitely.

Despite all that bad news, I came away feeling pretty good about Sun when the company's conference call ended.

Maybe it was because of Sun President Ed Zander's honesty about trying to predict the economy. Zander, like the rest of us, has no idea when the economy will turn. "I don't know that I can recall something so sudden and of such magnitude in my career," he said referring to the economic slowdown.

He admitted to having good days, where he thinks the second half will look good, and bad days, where he thinks the sector is due for a prolonged slowdown. "Power in California and the sun coming up is about all you can ask for these days," he said.

CFO Michael Lehman said it would be "very inappropriate" to talk about the fourth-quarter outlook because there are too many wild cards.

Maybe it was Zander's unwavering view that Sun is going to keep investing in research and development come hell, high water or falling gross margins. "R&D is the company's lifeblood," he said. Sun will cut expenses elsewhere to operate in a recession, but R&D spending is going to grow faster than revenue.

Sun will continue to hire people too. "We are not going to overreact to the near-term uncertainties," said Lehman.

Maybe it was Zander's confidence that Sun had the right products, the right market and the right strategy. "How can you bet against the Internet?" Zander asked, noting that short-term investors probably would have bet against the telephone and the highway system too. Spending on Internet infrastructure will still happen, but at a slower rate--at least until confidence comes back.

Whatever it was, you got the feeling Sun management knows what it's doing even though it can't predict the economy's course. Wall Street doesn't want to hear it though. Wall Street wants never-ending revenue growth and improving gross margins. Wall Street wanted to hear that Sun wasn't going to sacrifice margins for R&D. But chasing quarterly results is a trap that many tech companies have fallen into only to stumble over the long run.

I'll bet on Sun's approach. Sure, there are risks. Sun is facing tough comparisons abroad and is in the middle of a product transition. The company could conceivably warn again. But in recent quarters, Sun has put up stellar numbers despite a slowdown in telecommunications spending and the dot-com extinction. The easy money disappeared and Sun still delivered great growth numbers to become the top server vendor, eclipsing Hewlett-Packard (NYSE: HWP) and IBM (NYSE: IBM). It's tough to bet against that track record.

Sun isn't the only company that does well under the "can you take a punch" metric. EMC Corp. (NYSE: EMC) and Applied Materials (Nasdaq: AMAT) are two other companies that sound a lot like Sun on conference calls. We'll give EMC a free pass on Thursday's half-hearted warning on Thursday. The common characteristics among the "can take a punch" companies are the following: leading market share, leading products and services, the ability to keep a long-term view and invest in the business in a downturn.

Those characteristics are easy to spot. You just have to swim against the tide to find them. TDAIN

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