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Executives

Ron Pasek - VP, Corporate Treasurer

Jonathan Schwartz - President and CEO

Mike Lehman - CFO and EVP, Corporate Resources

Analysts

David Wong - Wachovia

Richard Gardner - Citigroup

Ben Reitzes - Barclays

Bill Shope - Credit Suisse

Shannon Cross - Cross Research

Keith Bachman - Bank of Montreal

Katy Huberty - Morgan Stanley

David Bailey - Goldman Sachs

Jeff Fidacaro - Merrill Lynch

Louis Miscioscia - Cowen & Company

Tony Sacconaghi - Sanford Bernstein

Mark Moskowitz - JPMorgan

Scott Craig - Banc of America

Chris Whitmore - Deutsche Bank

Shebly Seyrafi – Calyon

Matt Whitaker - FTN Midwest

Andrew Brown - Conin Asset Management

Sun Microsystems Inc. (JAVA) F1Q09 (Qtr End 09/29/08) Earnings Call October 30, 2008 4:30 PM ET

Operator

Good afternoon. My name is Kathy and I will be your conference facilitator. At this time, I would like to welcome everyone to the Sun Microsystems fiscal year 2009 first quarter results conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer period. (Operator Instructions).

Thank you, ladies and gentlemen. I would now like to turn the call over to Mr. Ron Pasek, Vice President, Treasurer for Sun Microsystems.

Ron Pasek

Good afternoon, everyone and welcome to our quarterly conference call. Joining me to discuss the Q1 results is our CEO, Jonathan Schwartz and our CFO, Mike Lehman. Earlier today, we posted a copy of the operations analysis data sheet with nine quarters of financial and operations information. We have also posted our Q1 '09 earnings call financial slides, which accompany our prepared remarks. All of this data may be viewed at Sun.com/investors.

During the course of this call, we will be making projections and other forward-looking statements regarding expected future financial results and business opportunities. Our actual future results may be very different from our current expectations. We encourage you to read the 10-Qs and 10-Ks that we file periodically with the SEC.

These documents contain a discussion of the risks facing our business, including factors that could cause these forward-looking statements to not come true. We do not currently intend to update these forward-looking statements except as required by law. In addition, we may describe certain non-GAAP financial measures. These should be considered in addition to and not in lieu of comparable GAAP financial measures. Please refer to the earnings call financial slides on page 15, which shows our reconciliation from GAAP to non-GAAP net income.

With that said, let's turn to the financials for Q1 2009. Sun's total revenues for Q1 were $2.990 billion, a decrease of 7.1%. This compares with $3.219 billion in revenue in the same quarter last year. Total gross margin for the quarter was 40.2%.

In terms of operating expenses, total R&D and SG&A were $1.343 billion, a decrease of $42 million year-over-year. The tax provision for the quarter was $24 million. GAAP net loss for Q1 was $1.677 billion or a loss per share of $2.24. This compares with GAAP net income of $89 million or earnings per share of $0.10 in Q1 2008.

Included in our Q1 GAAP results is a $1.445 billion non-cash charge for goodwill impairment. The company expects to finalize its goodwill impairment analysis during the second quarter of fiscal 2009. There could be adjustments to the non-cash goodwill impairment charge when the impairment test is completed.

Non-GAAP net loss for Q1 was $65 million or loss per share of $0.09. This compares with non-GAAP net income for the same quarter in 2008 of $285 million, or earnings per share of $32.

Now, let's take a look at revenue by category for Q1 2009. Q1 products revenue totaled $1.764 billion, a decrease of 11% year-over-year. Computer systems revenue was $1.257 billion, a decrease of 15% year-over-year.

Storage revenue was $507 million, an increase of 0.4% year-over-year. Q1 services revenue totaled $1.226 billion, a decrease of 1% year-over-year. Support services revenue was $963 million, a decrease of 1.6% year-over-year. Professional and educational services revenue totaled $263 million, an increase of 1.2% year-over-year.

We ended the quarter with cash and marketable debt securities balance of $3.121 billion, and we generated positive cash flow from operations of $148 million. As part of our overall stock repurchase program, in Q1 the company repurchased 14.7 million shares for $130 million. Shares were repurchased at an average price of $8.85. We now have $906 million remaining in the $1 billion share repurchase program that we announced in Q4, 2008.

At this point, let me turn it over to Jonathan.

Jonathan Schwartz

Great, thanks Ron. Thank you, all, for joining us this afternoon. I will start with some perspective on our Q1 results then provide a more detailed look at the enhanced product disclosure we have introduced as part of this quarterly report, which you can find on slides six and seven of the earnings call financial slides.

Overall, it was a challenging quarter with Sun's total revenue down 7% year-over-year and certainly Sun along with our customers is experiencing a slowdown as a result of the challenging economic climate. We saw softness in demand across North America, Europe and Asia Pacific. Our emerging markets region, however, did benefit from increased investment and grew 12% year-over-year in Q1 to reach 15% of Sun's overall revenue.

As I mentioned to you last quarter, our traditional exposure to high end enterprise systems across the subset of our customer base has made Sun more vulnerable to the current economic slowdown than of some our more diversified peers. That concentration does not change overnight and we are continuing to make a variety of changes to align our investments and broaden our opportunities to capture new revenue streams and fuel our longer-term business model.

Hopefully, our new billings disclosure will give you insight into our performance for both the traditional parts of our business, as well as the emerging growth businesses. To start, as you can see on slide six, our traditional SPARC Enterprise business, that is the traditional high-end and mid range data center business, slowed significantly in Q1 and was down 27% year-over-year.

Now, if you recall, we saw signs of this decline in the high-end as early as Q3 of last fiscal year. We saw it accelerate in Q4 as economic shutters from Wall Street permeated the overall business climate. That clearly continued into our first quarter of FY '09 and my conversations with customers reflect a consistent anxiety and a desire to push off large scale systems purchases as opposed to smaller scale or capacity related purchases.

On the storage front, storage had a relatively strong quarter despite headwinds from the overall economic climate and its association with the traditional enterprise systems that I mentioned. To this end, there was 3% billings growth in our disk and array business balanced by a 4% decline in tape. Total revenue for storage grew 0.4% year-over-year.

In contrast to these traditional business lines and in spite of a difficult economic climate, we are seeing aggressive growth in several of our emerging systems platforms. Particularly our Solaris-based Chip Multi Threading System. This line-up grew 83% year-over-year in Q1 as customers continued to demand the nearly 10,000 applications available for Solaris 10, while enjoying integrated virtualization and exceptional scalability and power efficiency. This growth demonstrates popularizing Solaris in the open source community and continuing the long-term investment focus in microelectronics is paying off.

Now, in addition, our Intel and AMD based x64 systems overall grew 4% in Q1 and Blade systems, which are inclusive of Intel, AMD and our SPARC platforms grew 32% in the quarter year-over-year. We are encouraged by the continuing interest and growth we see in the adoption for Solaris on our own non-SPARC, that is x64 platforms, as well as third party hardware. We also continue to see rising interest in Solaris beyond Sun's installed base. On a diversity of platforms, beyond, as I said our installed base.

On the Software front, our Software Licensing and Subscription businesses showed growth across the board, with Java, MySQL, infrastructure as well as Solaris management and virtualization, all growing in double digits. It is obviously important to note that as an open source software company.

To accurately reflect our software assets, you must consider our services revenue, a substantial portion of which is of course for our core platform software versus simply break fix on hardware. We believe that a significant and growing portion of our overall business is attributable to software. This is a fantastic asset whose value continues to grow as our distribution via the web and among the open source community, fuels revenue opportunity for Sun's commercial software, systems and service offerings.

Lastly, we have included our newest product category, Open Storage on slide 6. That is storage systems built from Solaris and based on the increasingly popular and freely-distributed ZFS, the most advanced file system available in the open source community. We believe we can expect strong growth in Open Storage as the adoption of ZFS continues and the need for open systems becomes ever more critical for customers seeking better performance at a lower price than traditional network attached storage.

All-in-all, it was a tough quarter, but we continue to believe the popularity of open source systems and software is opening Sun to new customers and market opportunities across the globe. We realize that these initiatives cannot immediately overcome a slowdown in our traditional businesses, but we are confident these initiatives represent the future of Sun and today are delivering demonstrable value to Sun, our customers and our partners.

To close, in terms of our long-term strategic outlook, we believe that tough times create an opportunity for innovation and business model disruption. We believe that Sun is in a strong position to weather the current storm, given our balance sheet with over $3 billion in cash, our extremely competitive systems products, the strength of our software assets and most notably, the fact that we own and control key IT assets such as Java, the Solaris Operating System alongside MySQL.

With that, I will turn it over to my office mate.

Jonathan Schwartz

Thank you, Jonathan. As Jonathan has discussed the product performance in detail, I want to give you some additional color on the regional performance and give some examples of growing geographies for Sun.

The North America region was the weakest in the quarter and was down nearly 13% from last year. Looking specifically at the northeastern financial services sector, it was down more than 20% in Q1 year-over-year. Telecommunications and government were roughly flat from last year, so a significant majority of the shortfall in North America was directly attributable to the troubled financial services sector.

The Europe region was down 8% year-over-year with the largest decline in the UK of over 18%. In Europe, we are certainly experiencing a slowdown, most notably from our financial services customers. We are also experiencing a shift from higher end SPARC systems to volume systems in the current sales cycle. Two Europe region highlights in Q1 were Germany and Iberia, which both exceeded expectations with strong performance in government sectors.

The Asia Pacific region, which now includes Japan, Korea and Australia primarily and by the way, excludes China and India, which are part of the emerging markets region, was down 4% year-over-year. We still are experiencing strength in some key telecommunications markets, but are cautious overall in the outlook for financial services in Japan and Australia.

As Jonathan mentioned, we are still seeing tremendous growth in our emerging markets region of over 12% year-over-year. In Q1, Latin America, India, and a combined Russia, Middle East and Africa all grew double digits year-over-year. Greater China was the only region in the emerging markets that was down slightly year-over-year due to expected slowing for the summer Olympic Games. We will continue to deploy sales and channel development assets to these regions as the opportunity remains robust.

Turning to gross margin, overall gross margin was down 4.1 percentage points sequentially in Q1. Products, gross margin was down to 35.2% from 42.5% in Q4. There are essentially three major areas that contributed to this sequential decline. The first is pricing and discounting and the relationship of those actions to our cost reductions.

In most quarters, we expect the effect of pricing and discounting to be largely offset by product and component cost reductions. During Q1, we did not experience the normal level of cost reductions. Accordingly, the impact of additional discounting and pricing actions resulted in approximately three points of the sequential reduction in products gross margin.

The second factor is the mix of products shipped in any quarter. As mentioned earlier, we experienced a decrease in the percentage of shipments from our high end products including FAPE which carried higher relative margins. We have experienced increases in both our Chip Multithreading Technology and x64 base products. As a result, the impact of the mix shift resulted in a sequential decline of approximately two points.

The third factor in Q1 related to an increase in excess and obsolete inventory. As we approach the end of any major product family, in this case, the UltraSPARC IV family, we estimate our requirements for inventory to accommodate customers who will want to keep these products in their infrastructure longer and for certain long-term contracts. In essence, we make what is commonly called last time buys for components well in advance of when these products will be phased from our price list.

This is not a new practice here at Sun. What was different this time was the near term impact. Since much of the UltraSPARC IV family is at the high end and since demand has dropped off considerably in the last few months, a larger portion of the last time buy has necessarily been considered excess and obsolete at this time. There were some other elements to this, but it is fair to say that there was about a two point sequential decline in product gross margins due to the incremental excess and obsolete inventory related to the last time buys. We view E&O at this type of level as nonrecurring.

Some quick clarifications on expenses; as Ron mentioned, R&D and SG&A expenses were down slightly year-over-year by $42 million principally due to nearly 1.5% headcount decrease. The restructuring charge of $63 million in Q1 was related to the restructuring action we initially discussed with you on the May 1st call that happened in the beginning of Q4 '08.

Recently, we also concluded that a probable impairment expense was required for one or more of our reporting units based on a combination of factors including the current economic environment, Sun's operating results, and a sustained decline in Sun's market capitalization. The charge for that impairment in Q1 was $1.45 billion. At this point, that amount reflects the write-off of the entire amount of goodwill associated with our systems reporting unit. We still have approximately $1.7 billion on our Q1 balance sheet, which represents goodwill associated with our software and services reporting units.

To close, we are clearly experiencing an extremely challenging environment given the current global economic situation. We are also not at all satisfied with our current financial results and are evaluating actions aimed at returning the company to growth and profitability. In this environment, we are not giving guidance for the remainder of the fiscal year on this call. When we have further details and plans, we will share those with you. Given that, we will be only taking questions relating to our Q1 fiscal '09 performance at the conclusion of our prepared remarks today.

With that, I will turn it back to Ron.

Ron Pasek

Thank you, Mike and Jonathan. Before we begin the Q&A session, I would like to request that each of you ask just one question consisting of one part. Operator, please start the question-and-answer session.

Question-and-Answer Session

Operator

Ladies and gentlemen, we will now begin the question and answer portion of today's call. (Operator Instructions). Our first question comes from David Wong of Wachovia.

David Wong - Wachovia

Thank you very much. When you said you saw a shift of high-end spark to volume systems, are you referring to volume Niagara-based system or do you mean x86? And for the same amount of computing capability, does your revenue and profit dollar get impacted the customer shifts to the volume systems?

Jonathan Schwartz

So, to the extent that we saw a shift, is to both. I mean there is no clear pattern in one way or another. In general, companies running the Niagara platforms tend to be more focused on very high scale and power efficiency and those running x64 systems were a little more focused on kind of single thread performance.

So, overall, I am not sure it's as much frankly as a shift from high-end to volume systems as a slowing of the high-end which, by definition, makes it look like the low-end is going to grow. I think the low-end was kind of be growing anyway. What appears to us to have happened is a lot of customers said, you know, I think I'll put off for a quarter or so a decision about the next big out.

In terms of the profitability, over the long-term, the profitability of the low-end systems, I mean the high-end systems come from somewhere. They come from the low-end continuing to grow and expand and upgrade.

So, clearly, the high-end systems are more lucrative in the near term but again, we just want them on Sun. That gives us a better shot at the future. And again, we feel pretty good about our offerings on both sides.

David Wong - Wachovia

Great, thanks.

Ron Pasek

Operator, next question please?

Operator

Our next question comes from Richard Gardner from Citigroup.

Richard Gardner - Citigroup

Hi.

Jonathan Schwartz

Hi, Rich.

Richard Gardner - Citigroup

I just had a couple of questions. First of all, I was hoping you could give us some sort of indication of solaris attach rates on your volume systems these days and whether that's going up or down or sideways?

Jonathan Schwartz

I think for the most part, it's going up. What we are seeing and clearly you can see this on the open storage line, the open storage are almost completely solaris-based. On the others, you know, on the broader x64 platforms and some of the blade offerings, it's a pretty strong mix between Linux, Windows and Solaris.

And frankly, we tend to be more exposed to the Linux and solaris side than we do to the traditional windows side given that hasn't been our historical focus but it's a pretty even balance at this point and we've a good proposition both on our own x64 systems as well as non-Sun platforms.

Richard Gardner - Citigroup

Can you give a sense of the trend though, Jonathan?

Jonathan Schwartz

If anything, I'd say the trend on solaris is up. We're seeing more customers specifically drawn to Sun because of ZFS, which is the file system at the core of solaris. But the fact that we've really built out the ISV portfolio really been added, we continue to talk to customers who had originally thought they might move away from solaris who are now moving back and not only on our own hardware but on third-party hardware.

We've just got a lot of customers, and frankly we're seeing more customers today that are coming to Sun, running solaris, not on sun and then wanting to know what else we have to offer.

So, it's always going to be a mix. I mean we want our hardware platforms to run non-Sun operating systems and we want our operating systems to run on non-Sun hardware. What we want is it's not the intersection we necessarily want to grow. It's the win diagraph we want to grow.

Richard Gardner - Citigroup

Okay. Thanks, Ron and Jonathan. I'll save the others for the offline conversation.

Jonathan Schwartz

Thanks, Rich.

Ron Pasek

Next question please?

Operator

Our next question comes from Ben Reitzes of Barclays Capital

Ben Reitzes - Barclays Capital

Thanks. Good afternoon. I wanted to drill down cost a little bit. Mike, you said on the last call that OpEx for '09 was budgeted to be up. I was just wondering given the current environment, your OpEx was actually under control pretty good in this quarter, lower than I had expected. I mean can you give a little comment about OpEx going forward and not topline but OpEx based on that comment before.

Also, just a clarification on the gross margin comment. If 200 basis points is non-recurring, does that just mean that we should take the gross margin up in the next quarter? Thanks.

Mike Lehman

So, it's Mike. And again, I am going to refrain from making comments with respect to guidance for any particular line of the P&L, whether it's revenue margin or cost. And yes, we agree that we had a good line of visibility in the cost in Q1. And as I said and as Jonathan has talked about, we're certainly going to be looking at all of our alternatives going forward, but we aren't going to make any specific comments on the line items.

The point about products gross margin and what I call the non-recurring E&O is not necessarily to predict that all things equal margins would go up by that amount, but just to point out that that was unusual. It is always a challenge to do a last-time buy, especially when the product line isn't going to be phased out for quite a bit. But we need that kind of lead time to work with our suppliers.

And it was clearly larger than normal and the reason that, we count it as one-time is that we really haven't had this kind of write-off in past product lines. It's really because the high-end is tailed off fairly quickly. So, over the long run, we frankly expect to get that back as we sell components, but our accounting policies are such that if we don't see specific demand within the next six months, we've got to write that off. So it was a bit of a one-time thing and I just want to give some color and sizing of it.

Ben Reitzes - Barclays Capital

Great. So, we're not sure what to do in the future with it. But that's that. And then just your plan with regard to costs and what you're going to do in evaluation. When can you expect you'll be done with that, Jonathan or Mike and I'm done.

Jonathan Schwartz

So, look, we understand we need to balance our costs in light of the new economic reality. And we're obviously, going to be paying very careful attention. And as soon as we have any update for the market place, we'll absolutely be delivering it.

Ben Reitzes - Barclays Capital

Thanks.

Ron Pasek

Thanks, Ben. Operator, next question.

Operator

Our next question comes from Bill Shope of Credit Suisse.

Bill Shope - Credit Suisse

Okay, great. Thanks. I understand you can't give quantitative guidance at this point in time, but I have a qualitative question just on how you think about Op Ex. You've noted that part of your challenges are customer concentration issue and presumably, that justifies the OpEx investment plan you had 90 days ago.

Given this quarter's results and the economic environment, can you help us understand at least how you consider balancing the needs for R&D investments and sales investments when there's clearly deterioration on the gross profit line. And outside of variable costs, if you could answer, what do you think you have the most opportunity to reduce OpEx without a major change in your go to market and development strategy?

Jonathan Schwartz

You bet. So, first of all, again, at the risk of repetition, we understand and we are very focused on examining all of the line items at Sun to make sure that we're going to optimize for the new reality and there is very much a new reality in the marketplace. We're obviously very focused on that.

Probably the most important thing we can do at Sun isn't necessarily to look at our existing financial services customers and just go spend more time with them and hope they buy more. I think that’s a little naive at this point. We are very focused. I would argue more focused today than we've ever been in the history of Sun in going after new customers.

And the way we meet those customers is by looking to the marketplace, finding out who's running MySQL and again, we know at a fine level of detail, exactly who is and then going to sell to them. So, the biggest cost we can take down is the cost of acquiring a new customer. So, we are very focused on continuing to go to market with that model, which is selling to customers that are already running our core intellectual property and selling commercial software as well as commercial services and systems.

And in terms of what other line items we have at our disposal, we've got a fair amount of flexibility in how we go to market. We're very much focused on the long-term and the long-term is going to be from where we sit, going to be defined by the kinds of open innovations we've been delivering and for Sun, probably a change in how we welcome those customers into Sun.

So, like I said, we can't really talk about, details about what we're considering but we're he very focused on making sure we match up our spending model with the current economic model.

Bill Shope - Credit Suisse

Okay, thank you.

Ron Pasek

Thanks, Bill. Operator, next question.

Operator

Our next question comes from Shannon Cross from Cross Research.

Shannon Cross - Cross Research

Hi, good afternoon. Question on cash, given pressure on cash flow and your expectations, obviously you're not going to talk about the future. But you know, the challenging environment, have you had any changes in terms of your thought on the use of cash and the level of cash that you feel comfortable holding? Thanks.

Mike Lehman

So, again, we certainly are pleased with our cash conversion cycle. We're going to stay focused on that. We generated cash during the quarter. Even in a difficult environment on an operating basis. We're going to try to stay focused on that. And again, as part of our overall evaluation of where we are, what are our choices. We will make decisions about what to do with the cash and the levels of cash. And at this point, we're comfortable with the cash that we have and our liquidity and we'll leave it at that for today.

Shannon Cross - Cross Research

Just curious, at this point what level of cash do you feel you should have to run the business?

Mike Lehman

So, without going into the specifics, we obviously have a very strong balance sheet and we're going to take advantage of the fact that we have a strong balance sheet to go make targeted acquisitions, to go look at means of progressing our business in the long-term. But, we have the luxury of being able to have a longer-term view and we're not going to make any rash decisions one way or another. We're comforted by having a very, very strong balance sheet and that affords us choices and opportunities. We're going to make sure we avail ourselves of exactly that.

Shannon Cross - Cross Research

Thanks.

Ron Pasek

Thanks, Shannon. Operator, next question please.

Operator

Keith Bachman from Bank of Montreal, you may ask your question.

Keith Bachman - Bank of Montreal

Hi, guys, thanks for the disclosure on page 6, Jonathan. That's helpful. Mike, on the price, the gross margin on the product side, why wasn't components, why weren't they a tailwind given what most of the components did during the course of September. Did you guys carry inventory into September?

Mike Lehman

No, it wasn't so much that, it is just that frankly, the level of component cost reductions that we saw was less than we had seen in the past. It wasn't so much that discounting and pricing actions were greater. It was just that we had a bit of a tail off in the cost reductions. Not dramatically but, you know, noticeable and it was just a bit more than normal.

So, it wasn't so much a reflection of our inventory but I think just less, near term opportunity from our supply chain given the volumes that we had. So, it wasn't anything dramatic. We expect more of a balance as we go forward throughout the fiscal year. But just wanted to point out that again, all things equal, there is a little bit less cost reductions in that one quarter than we had typically seen.

Keith Bachman - Bank of Montreal

Okay. Thank you.

Ron Pasek

Thanks, Keith. Operator, next question please.

Operator

Katy Huberty, Morgan Stanley.

Katy Huberty - Morgan Stanley

Mike, just a follow-up on the cash flow. Working capital was up year-on-year despite the decline in revenues. Is there something systemic, a systemic change in the business perhaps due to the shift to sell out accounting that limits you from reducing working capital year-on-year? Is that something you'll work on through the rest of fiscal '09?

Mike Lehman

Yeah, it is nothing systemic. If you look at the details, it was a couple of days of DSO, a day or two of inventory, nothing dramatic, nothing systemic, nothing that we're look at that surprised us. So clearly, that's an area that we're going to continue to focus on in this environment. As you can imagine, customers certainly are expressing a desire for slightly longer terms. That's fairly normal in this kind of period. But, no fundamental shifts and certainly nothing caused by the change to sellout.

Katy Huberty - Morgan Stanley

Thanks.

Ron Pasek

Thanks, Katy. Operator, next question please.

Operator

The next question comes from David Bailey from Goldman Sachs.

David Bailey - Goldman Sachs

Great, thank you. Could you talk a little bit more about the distribution where you saw the weakness? Was it more on the direct side or the indirect side?

Jonathan Schwartz

I think it was more uniform, kind of across the board. And again, if you look at the chart, I think we provided it on slide seven. We saw a fairly aggressive ramp-up in a core set of products. And I think even if you look at our x64 business, that business is performing reasonably well. And we've continued to open new doors and create new revenue opportunities.

To the extent that we saw weakness, it was specifically on the very high-end of our systems portfolio. And that isn't necessarily purchased directly or indirectly, that's more a class of applications and a class of customer. Not everybody runs a mainframe and mainframe customers, at least, in this instance have a somewhat greater capacity to say, I think I'll just put on hold for the next 60 days the decision I was going to make this week.

Ron Pasek

David, anything else?

David Bailey - Goldman Sachs

No, thank you.

Ron Pasek

All right. Thank you. Operator, next question please.

Operator

Jeff Fidacaro from Merrill Lynch. You may ask your question.

Jeff Fidacaro - Merrill Lynch

Jonathan, just along the same line when you look into a channel, did you see any difference in purchasing behavior, let's say outside of financial services and more focused on the SMB market and especially within the mix, if you could touch on the x46 mix as well?

Jonathan Schwartz

Again, nothing so clear. I got to admit from what I hear from customers, they more often than not show me the headlines in the papers and say, this is why I am going to put on hold the decision I was going to make for today. For a lot of folks, especially in the financial services industry, it's is not because they're getting orders from on high saying stop your spending, at least that wasn't the case 90 days ago.

I think that appears to be, certainly a factor, just the overall anxiety as I reflect it as a factor. You know, a characterization between large customers and small customers, just what you would expect large customers tend to have more durable budgets, smaller customers tend to have a little bit more discretion and control over their spending.

And at this point, you know, I don't think we have any specific swing in the marketplace or any expectation. Customers are going to move in one way or another. If I could point you back to slide seven, those growth areas really are the areas where we're seeing growth. And they're amplified by people knowing about our technology and more to the point, they are amplified by people using our technology.

It's obviously a lot easier to sell MySQL optimized storage products to companies that are already running MySQL and the good news is, there's an awful lot of them in big companies and small all across the world. That's very much our target audience.

Jeff Fidacaro - Merrill Lynch

Great, thank you.

Ron Pasek

Thanks, Jeff. Operator, next question, please.

Operator

Louis Miscioscia from Cowen & Company.

Louis Miscioscia - Cowen & Company

Yes. Can you maybe go into a little bit more detail about your x86 strategy, in a sense of is that market it really grown at march. You were doing a very good job back, I guess back in fiscal '07 of gaining share, but it seems to be stagnating here. Where do you think that product line is going to be going in the future?

Jonathan Schwartz

Yeah, so, I guess I don't look at 4% growth when we just saw one of our competitors decline by 18% year-over-year as stagnating. I'd like to believe we're gaining share. We'll see how that comes out as the year unfolds.

We're not really focused on being an undifferentiated box vendor. So the systems we build, for example, are blade platforms, deliver higher scale, higher power efficiency, greater manageability and, we're seeing, for example, very large opportunities opening up in high performance computing, where folks care about the engineering and the management of the overall system, not just the box itself.

And you can see again our blade platforms are growing pretty aggressively and our open storage, which are also today built off of x64 platforms are also growing.

So, our strategy overall is to be an integrated systems vendor. It's to deliver the necessary components that provide data center operators with the economics and the productivity they want out of the core assets that go into data centers from storage to systems to networking. And we don't see that market getting smaller as time goes forward.

And again, just pointing back to slide seven, the blades architecture for Sun is, in some sense, a good indicator of where the overall market is heading. Those are systems from Sun that incorporate Intel blades, AMD blades and Niagara blades or spark blades in a whole diversity of configurations and breadth along with storage, along with network running a whole diversity of operating systems.

When we talk to customers, that's what they want. They want the ability to make choices and to reconfigure those choices as time moves forward given the growth we've seen in blade, we'd like to believe we have the most flexible and the most innovative platforms out there. So I think our growth suggests we're continuing to make a lot of progress even though the line items is kind of divvied up in one or two or three lines, overall, I think the growth is still pretty healthy.

Louis Miscioscia - Cowen & Company

Thank you.

Ron Pasek

Thanks, Lou. Operator, next question, please?

Operator

Our next question comes from Tony Sacconaghi of Sanford Bernstein

Tony Sacconaghi - Sanford Bernstein

Yes. Thank you. You've both commented on a new economic reality and looking toward alignment. In light of that, I was surprised that your restructuring charge was actually lower than you had anticipated in the quarter. I think it was $63 million. You were looking due to a $100 million and your capital spending was up substantially year-over-year and was a $170 million. Can you comment on each of those relative to expectations for last year?

And then, separately, given the alternatives and actions that you are evaluating, can you comment on whether sales of businesses or technologies is a potential set of actions that you're evaluating at this point?

Mike Lehman

It's Mike. First of all, with regard to the restructuring, while the amount that we're able to accrue in Q1 was less than the ceiling that we had provided earlier, that all again comes down to timing and as many of you know, the difficulties associated with making sure that you do the proper notifications in working with certain worker's groups and things like that.

So, with regard to the overall restructuring that we announced in May, we still will ultimately get to the totals that we had talked about. It just takes awhile longer and in this case, we weren't able to complete some of the notifications and just the due process around that. So, we will get there over time. It just takes a little bit longer.

With regard to capital spending, the largest piece of that, on a year-over-year basis was some of the cost capitalized related to the systems development effort that I've been talking about for the last year and a half. We completed an implementation that went live in August. We're heavy into the next phase. A significant ramp up of that is going on and those costs get capitalized during the phase that we're in now.

Jonathan Schwartz

And with respect to the sale of assets, we're a little more focused right now on growing the customer base we have with the portfolio we've got and acquiring assets to expand that presence.

Ron Pasek

Thanks, Tony. Operator, next question, please.

Operator

Our next question comes from Mark Moskowitz of JPMorgan.

Mark Moskowitz - JPMorgan

Thank you, good afternoon. Jonathan, can you talk a little more about the increasing interest outside of your install base in Solaris. Maybe you know the customer verticals, what regions, this has taken place, not a large or midsize enterprises? I guess that the last part of the question, will you get a better services pool for these type of customers going forward?

Jonathan Schwartz

So, in general, what you'll find in any systems business is that the low end systems tend to be lighter on service attached than the higher end systems. Again, when you're running a 911 network, for example you don't do that without a service contract, because you want to make sure that in the event there's any problem, you can get a one hour response time and not a three day response time.

In terms of where we're seeing Solaris being adopted, we've had a strategy that we've articulated for a couple of years now of making sure we bring Solaris kind of out of the glass house and cast it across the world and make sure that we're discovering new customers and identifying new opportunities. So we continue to run those 911 networks in big hospitals and run carrier fleets and run large financial institutions, especially those that remain. And all of that said, we continue to invest in smaller companies and in start-ups and where you've seen that most recently is a fair amount of new interest in ZFS specifically.

The other place that's obviously getting newly interested in Solaris is the user base that has traditionally been using MySQL. And so MySQL has been more traditionally an online application. And then kind of social media companies, which are really a booming market right now and we're just being introduced to those shops in ways we haven't before had access to in part. Because MySQL gives Sun the affinity that’s about 11 million users of MySQL in the world and not very many of them know about Sun's platform offerings. And I assure you that is going to change in the next 60 to 90 days. In fact I think we have got a launch event on November 10th. I would encourage you all to attend in which we'll detail our MySQL optimized systems offerings that will be a lot clearer.

So, I was just with a large German bank recently that is migrating a lot of their x64 operating systems on to Solaris. What we hear from companies is that they enjoy being able to run it not only on HP, Dell and IBM but also on x86 and SPARC Platforms. So it really is the core of Sun. It provides Sun with an opportunity to differentiate in storage, differentiate in servers, differentiate ultimately in networking.

Operating systems really are the boundary systems that connect everything together. They're how your application ultimately meet your infrastructure and that's why we're obviously pretty excited with the growth that you can see on slide seven. The more traditional businesses are frankly reflective of designs that were chosen a few years ago. And they're going to be less sensitive to the new adoption that we're finding in the marketplace, but we're aggressively pursuing new adoption.

And as I've pointed out historically, innovation tends to love a crisis. When people are open to change, they're going to be looking at everything from operating systems and databases to application, infrastructure and storage. We're going to be going after all of those opportunities today. I think we were probably on our back foot after the pop of the internet bubble, I think you're going to find us on our front foot with the current economic reality.

Ron Pasek

Thanks, Mark. Operator, next question please.

Operator

Scott Craig from Banc of America. You may ask your question.

Scott Craig - Banc of America

Thanks, good afternoon. Just on the cash balance, Mike. Can you take us through that in a little bit more detail and whether or not you see any potential write-downs there, whether its commercial paper or the like. And then secondly, on gross margins, just theoretically, from a product mix perspective, we continue to see the growth coming from things like x64. Why shouldn't gross margins in the systems business continue to go down? Is there anything you can offset that. Any levers you can pull there? Thanks.

Mike Lehman

Okay, so, with regard to the cash balance, the investment balance is very conservative, very high grade. We have always focused on safety and security versus yields. We did have a couple of holdings that we had to write-down during the quarter. I would say under $30 million total of write-downs. We feel very good about the rest of the cash and investments portfolio and don't anticipate anymore at this time.

Jonathan Schwartz

And then with respect to the margin equation, it is certainly the case that kind of a naked undifferentiated low end x86 box is very low margin. That's not necessarily our focus. If you look at open storage, as an example, those are systems offerings from Sun alongside our Blades whose gross margin profile is, at or around our corporate average, maybe just below today, but certainly going to trend up and our objective is to trend it up overtime.

So we have stated historically that our objective is to get to 10 points of operating margin and in part, of one way to do that is to go drive towards 50 points of gross margin and at least with some of the Open Storage products we're building out, some of the -- even the low end Niagara Systems and our Blade offerings, we believe we have a path to go get there.

So, as I said, we don't plan on simply being an undifferentiated white box vendor, that's a category well occupied by others. We plan on delivering differentiated systems and using our intellectual property whether its MySQL, or ZFS, or Solaris itself to go achieve those market objectives.

Scott Craig - Banc of America

Okay, thanks.

Ron Pasek

Thanks, Scott. Operator, next question please.

Operator

Our next question comes from Chris Whitmore of Deutsche Bank.

Chris Whitmore - Deutsche Bank

Thanks, just a follow-up on the last question. In your view of this changed world in which we all now live. Do you expect that high end business to ever return in your planning process and resizing the company? How are you thinking about that gross margin target? Previously, it was 50%. Has that changed?

Jonathan Schwartz

It has not changed in the least. I'll give you a good example. As I pointed out, the NAS storage space, which he will be pretty assertively present in this year is a systems category that is more like 60 or 70 points of gross margin. So we think there is ample gross margin out there. It is just being spent on the wrong vendors. So, we're going to be moving that toward Sun overtime.

With respect to the kind of mainframe products for Sun. It is a lumpy business just because the decisions tend to be much, much longer-term and can be planned a little more proactively, but its also a wonderful business, because the contribution and gross margin profile is so high, that service attach tends to be very high.

When you, for example, implement a large scale tape library or run a 911 network, just to kind of pick two examples, those tend to be very durable wins that last for a very long period of time. But as I pointed out, we're expecting to get a lot more predictability out of those growth businesses on page seven.

And although, we're going to do what we can’t take love of our install base and our traditional businesses, we understand that the predictability there is going to perhaps be less than the predictability on the emerging businesses. So we want to make sure that we again, love our install base and do what we can to take care of them, especially in the midst of a crisis. But simultaneously, we want to go after a market that is far larger than sun is right now.

And then again, just picking on the MySQL opportunities, 11 million users out there, very few of them are currently running Sun infrastructure. We'd like to make a change there. And as that happens, there is a lot of margin to be had on the software side and on the service side and on the systems side. And we plan on being a leader.

Chris Whitmore - Deutsche Bank

Thank you.

Operator

(Operator Instructions). Our next question comes from Shebly Seyrafi from Calyon

Shebly Seyrafi – Calyon

Thank you very much. So comparing your results to IBM in the latest quarter, IBM's Unix server business p series was up 7%. Your computers systems business was down 15%. I know you mentioned that, you referred them to the x series being down 18%, but my question really is in the main high-end server side, why are you losing to IBM? IBM has the same planned exposure that you have, but why are they doing so much better in that segment? Thanks.

Jonathan Schwartz

Well, thanks for the question. Let me be a little clearer about IBM results. IBM has a system category called i series. i series, I believe was down 80% within the quarter. So, if I had a legacy platform that I could end of life and move on to my high-end systems, I would be aggressively doing it. But we're not end of lifing our platforms, we are continuing to grow them.

So I think you have to look at the total offerings and I think on a hardware basis in general, they had declined and certainly on the growth segments, they were declining and x series was a good example of that.

So we're, obviously, making lots and lots of headway on the low-end where for the most part, IBM doesn't participate. There really is no comparable or no comparator for the Niagara platforms we build. And we're continuing to build out our operating system off of our own hardware to give ourselves new market opportunity and the fact that we can decouple our OS from our hardware gives us strategic flexibility, which includes by the way running on IBM's x series platforms.

So, that's not really an apples-to-apples comparison. And certainly, we're going to go after as much of the market as we can. I think our concentration and financial services to me is more indicative of our overall performance. I'm far less worried about the competitive landscape right now. I mean when I talk to customers, I don't hear them saying we decided not to buy you, we've gone with another vendor.

I tend to hear, I'm sorry, we have a credit crisis and a liquidity problem and we are trying to raise capital. We'll call you as soon as we got our funding issues resolved.

Shebly Seyrafi – Calyon

Great, thanks.

Jonathan Schwartz

Thank you.

Ron Pasek

Thank you. Operator, next question, please.

Operator

Your next question comes from Bill Fearnley of FTN Midwest.

Matt Whitaker - FTN Midwest

Yeah. This is Matt Whitaker on for Bill today. One of the challenges that we have is assessing the value of MySQL. I know it opened sort of software like Solaris (inaudible) but you talked on this on past saying that it factors into 70% to 57% of sun products. So I was wondering if you were able to get to a similar range for MySQL and any other metrics or guidelines we can use to estimating its contribution overall revenue.

Jonathan Schwartz

Yeah, so, again, as you look at our page six, the billings disclosure by category, I think it was on page six. You'll get a sense for the scale of those revenue opportunities. But again, those are environments and opportunities where customers are actually paying for the software.

The vast majority of the future is going to be defined by organizations and companies who are running free software without a commercial support offering behind it, for example, just a majority of businesses are by definition small. Many of them will elect to run free software. We want them to choose us and not to choose someone else.

For, as you go up to the scale of customer and typically up the scale of applications, they tend to want to buy commercial support and a subscription to that software as well as purchasing the hardware platforms themselves.

So, I will tell you that the vast majority of our new customers are being brought to Sun as a result of MySQL. We're meeting a lot of folks that we're not historically talking to. We are also frankly finding a lot of our traditional customers that are looking to MySQL as a means of radically reducing their pricing on proprietary databases.

It is probably the number one discussion we are having with customers in our visits with them. So, today, solaris, as I pointed out, is a component in probably 75% to 80% of our current revenue business. And I think MySQL is probably upwards of that in terms of the new opportunities we're going after. But that kind of defines a little bit of how we go to market as much as it does what the revenue picture is.

And again, just to be clear on how we go to market, it's a lot easier for Sun to sell our diversified offerings to a MySQL customer than it would for us to sell to a customer who's running an all Microsoft platform. Microsoft tends to be excellent at monetizing their own software and frankly a lot of the system value around it.

We plan on, you know, using that similar approach, but we want to make sure the world knows about our software and is able to use it. That's why we distribute it so freely. So I don't have a perfect answer for you because customers don't predisclose. I'm only talking to you because of this one product.

I think if anything, the one overwhelming trend we see is, given them the new economic reality, the number of companies that we're talking to that are now considering and embracing open source, is rapidly growing. And as I've stated before, we will be the category leader in open source software. I believe that this revenue level we've now disclosed, you can see that we are. We just think there is a lot of not only software revenue to be had as a result of that, but a lot of systems and service as well.

Matt Whitaker - FTN Midwest

Thank you.

Ron Pasek

Thanks, Matt. Operator, next question, please.

Operator

Okay. We'll now take our final question from Andrew Brown of [Conin] Asset Management.

Andrew Brown - Conin Asset Management

Thank you. I was just wondering given all of the cash on the balance sheet, how you're going to finance the maturity that's coming due next August, whether you do that with cash or you'll refinance it through another offering. Thank you.

Mike Lehman

Yeah, it's Mike Lehman. We haven't decided yet. We have some time before then. We have some flexibility in choice and that's one of the benefits of having the cash position and the ability to generate cash gives us. So, we haven't made that choice yet and we have plenty of time before then.

Jonathan Schwartz

And again, from our advantage point, we've got the luxury of choice. And I think that's what such a strong balance sheet gives us and certainly that plays a part in our thinking going forward.

Andrew Brown - Conin Asset Management

Okay. Thank you.

Ron Pasek

Well, thank you for joining us today. Investor Relations personnel will be back in our offices shortly to respond to any further questions. You may contact us through our Investor Relations main number at 408-404-8427. Thank you.

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Source: Sun Microsystems Inc. F1Q09 (Qtr End 09/28/08) Earnings Call Transcript
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