The Sun Microsystems Conundrum

There may be only marginally good news out of Sun Microsystems (SUNW-NASDAQ) since there was at least some growth, but the street is giving this a negative focus.  It is also hard to blame the negative reaction.  When companies don’t perform up to expectations in the middle-stage of a turnaround Wall Street pulls out the swatting board.  The company is in a conundrum because its turnaround plan may be stumbling and it may need to consider buying another earnings vehicle.

Sun Micro posted a small profit of one-penny per share, matching First Call estimates.  Its revenues were a bit light at $3.28 Billion, under the $3.42 Billion estimate but above last year’s $3.18 Billion.   Net income after items was $0.02 on an EPS basis.  The company also gave guidance that was under street estimates for the coming quarter: it guided revenues and margins down slightly.

The company blamed order pushouts at the end of the quarter, and it looks like you can make the argument that their core sales in servers may be underperforming against expectations.  Total product revenues barely grew at all: $2.06 Billion compared to $2.04 Billion in the year before.  Computer systems sales rose 2% to $1.5 Billion.  Industry research was showing market share gains pointing upward, but now the issue is the price they are selling units at or the physical units sold.  The company also gave guidance that was under street estimates for the coming quarter.

Shares had risen to $6.78 earlier this year before the recent weakness and shares were at $5.94 at yesterday’s close.  SUNW shares closed 2006 out at $5.42, so with the 10% drop to $5.35 today the shares are back to negative for the year.

Goldman Sachs maintained a buy rating, but it lowered fiscal 2007 (June end) from $0.14 to $0.09 and it lowered 2008 (June end) estimates from $0.25 to $0.17 on an EPS basis.  This now gives the company a forward P/E ratio out to Fiscal 2008 of nearly 32 if the Goldman Sachs number is reached.  The consensus estimate before the earnings release out to 2008 was in the neighborhood of $0.20, still a 27 forward P/E ratio.  H-P (HPQ-NYSE) and even Dell (DELL-NASDAQ) trade at lower forward multiples. 

Its last huge cash infusion from KKR of $700 million was supposed to be a stabilizer and a signal from ‘Smart Money Buyers’ that things were coming back.  You can bet KKR isn’t too happy with what they saw.  Shares traded up to $6.00 on the news of that inflow in January and then went even high.  Jim Cramer probably wishes right now that he could take back his call on February 23 when shares rose to $6.40 on his endorsement after he had been negative on the name for years.

After that cash infusion and after cash flows in this last report Sun has more than $4.3 Billion in cash and equivalents, so you have to wonder if the company is going to go make an acquisition now.  Sun Micro still has a market cap of $19 Billion and that may put it out of reach for any outside predator or partner because that would be a huge gamble for a turnaround play.  The company still needs more layoffs as well.  Sun purchased Stroage Tech before, so where would it look?  That recent SPARC relaunch was deemed dead on arrival by us and by Wall Street, so the company has to look elsewhere.  The question is WHERE……

We will probably issue a list in the coming days of potential add-on names that could make Sun Micro more profitable and more attractive.

Jon C. Ogg
April 25, 2007

Jon Ogg can be reached at [email protected]; he does not own securities in the companies he covers.