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Executives

Ron Pasek - Vice President and Corporate Treasurer

Jonathan Schwartz - President, and Chief Executive Officer

Michael E. Lehman - Chief Financial Officer and Executive Vice President of Corporate Resources

Analysts

Bill Shope - Credit Suisse

Richard Gardner - Smith Barney Citigroup

Benjamin Reitzes - Barclays Capital

Maynard Um - UBS

Shannon Cross - Cross Research

A.M. Sacconaghi, Jr. - Bernstein & Co. Inc.

Mark Moskowitz - JPMorgan

Katy Huberty - Morgan Stanley

David Bailey - Goldman Sachs

Scott Craig - Banc of America Securities

Bill Fearnley - FTN Midwest Research Securities Corp.

Keith Bachman - BMO Capital Markets

Chris Whitmore - Deutsche Bank Securities Inc.

Sun Microsystems, Inc. (JAVA) F2Q09 (Qtr End 12/28/08) Earnings Call January 27, 2009 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 Second Quarter Fiscal 2009 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 and Corporate Treasurer for Sun Microsystems.

Ron Pasek

Good afternoon, everyone and welcome to our quarterly conference call. Joining me to discuss our Q2 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 Q2 '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 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 will 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 our results for Q2, fiscal 2009. Sun's total revenues for Q2 were $3.220 million, a decrease of 10.9% year-over-year. This compares with $3.615 million in revenue in the same quarter last year. Total gross margin as a percent of revenue was 41.9, an increase of 1.7 points sequentially.

Total R&D and SG&A expenses were $1.327 billion, a decrease of $131 million year-over-year. The income tax provision for the quarter was $17 million. GAAP net loss was $209 million or a loss per share of $0.28. This compares with GAAP net income of $260 million or earnings per share of $0.31 in Q2 fiscal 2008. The Q2 '09 GAAP net loss of $209 million includes a restructuring charge of $222 million.

Non-GAAP net income was $140 million or earnings per share of $0.15. This compares with non-GAAP net income for the same quarter in 2008 of $409 million or earnings per share of $0.50.

Now let's take a look at revenues by category for Q2 fiscal 2009. Total products revenues were $1.939 billion, a decrease of 13.8% year-over-year. Computer systems revenues were $1.369 billion, a decrease of 14.1% year-over-year. Storage revenues were $570 million, a decrease of 13% year-over-year.

Total services revenues were $1.281 billion, a decrease of 6.2% year-over-year. Support services revenues were $946 million, a decrease of 9.1% year-over-year. Professional and educational services revenues were $335 million, an increase of 3.1% year-over-year. We ended the quarter with a cash and marketable debt securities balance of slightly over $3 billion and generated positive cash flow from operations of $36 million, the vast majority of which is attributed to the foreign exchange impact on cash.

We did not repurchase stock in Q2 and we still have $906 million remaining in the $1 billion share repurchase program announced in Q4 2008.

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

Jonathan Schwartz

Great, thanks Ron and thank you all for joining us this afternoon. I will start with some perspective on our Q2 results and the current climate and follow-up with the commentary on our products disclosure, which you can see on slides six and seven in the slide deck. Then, I'll turn it over to Mike for comments on our financial metrics and an update on the restructuring plan we announced back in November.

Overall results for Q2 were in line with what we expected as macro worries factored into customer discussions across all geographies. These concerns resulted in decisions related to higher end system purchases being pushed out. So, billings were down year-over-year for SPARC Enterprise servers alongside the storage and service businesses attached to them, continuing a trend began about a year ago.

Now, with that said, growth in our key areas continued with software a high point and our Open Storage CMT or Niagara along with x86 systems businesses, all delivering double-digit growth. As we shared with you last quarter, Sun's business can be viewed in two categories; traditional and growth depicted on slide seven.

Growth categories now account for over one-third of Sun's product billing, up from just 23% a year ago and are continuing to open new opportunities within our existing installed base and more importantly far beyond it.

On the traditional front, declines in enterprise SPARC systems are by and large the result of purchase delays. And with mission critical systems platforms continuing to age, this business represents significant future upgrade and refresh opportunities. But we were disappointed with the results and the related effect it had in our storage and attached service offerings. Our tape and archived business outperformed the competition, albeit in a declining market that also represents an attractive base of annuity opportunities going forward.

Now, onto the growth businesses; software was the shining light in Q2 as total software billings grew 21% year-over-year and 52% sequentially. Java software billings grew 47% year-over-year as we continued to monetize our distribution power to the world's client devices; from personal computers to set-top boxes and mobile handsets. And as we began delivery of our new platform, JavaFX to OEMs across the world.

As mobile devices and consumer... network connected consumer devices continue to heat up, we believe the Java platform running in front of now billions of consumers represents an increasingly attractive business.

MySQL and Infrastructure software billings grew 55% year-over-year on the surge in demand for open source middleware from identity management and database management to integration software. In the midst of this economic downturn, discussions related to free and open source software have substantially heated up. This is no longer a peripheral discussion with CIOs.

Cost reduction related to open source adoption has become a focal point for decision makers across the world. Solaris management and virtualization billings grew sequentially but not year-over-year as customers migrated to subscriptions and service offerings and away from more traditional licensing. We believe this transition has largely been completed in Q2, and again positions the Solaris and Open Solaris platforms as one of three surviving operating systems for cloud computing, alongside Microsoft's Windows and Linux.

As a result of our assets from Java and Open Solaris to MySQL and XCM, Sun is positioned to be the provider of the world's most complete open source software platform for enterprise computing and more importantly for the cloud.

Now, on to the systems side of our business; billings for our Solaris-based chip multithreading system also known as CMT or Niagara platforms increased 30% year-over-year in Q2. Based on Q1 and Q2, FY '09 billings, CMT systems have now become a $1.4 billion plus annual business for Sun growing at significant double-digits. And with IBM's Power and HP's Itanium available in only high-end configurations, our Niagara platforms stand alone as volume alternatives to customers running IBM's AIX and HP's HP-UX.

We continue to broaden our Niagara offerings, most recently with the addition of the T5440, a powerful midrange computer fueled by the growing base of volume Niagara units in both blade and rack form, complementing our x86 platform offerings.

Speaking of which, Sun's family of Intel and AMD-based x64 servers increased 11% year-over-year in Q2 billings.

Blades, which include SPARC, Intel and the AMD processor-based systems delivered another outstanding quarter, growing billing 62% year-over-year. We believe, this performance reflects market share gains across both industry standard and blade servers building a footprint that allows for higher margin software service and storage offerings.

To that end, billings for Open Storage products grew 21% year-over-year, which reflected in part a transition to Sun's Flash-based 7000 family, also known as Amber Road around which we're seeing tremendous customer and partner interest. Based on industry standard components and the popular open source ZFS file system, these platforms deliver massive price performance benefits against proprietary NAS vendors. With more than 2000 channel partners now trained and certified to sell Amber Road and with customer buzz among the highest we've ever seen for a new storage product, we have high expectations going forward. This is the first of what will be a complete line of Open Storage-based products, covering the smallest customers all the way up to mainframe storage.

Amber Road also sets us up to broaden our line of appliances. Just as the freely distributed ZFS file system creates opportunity and awareness for Sun's Open Storage offerings, I believe our newly introduced Crossbow networking platform creates similar opportunities for Sun in the networking marketplace. Like the market for traditional storage, the networking marketplace is characterized by very high prices, proprietary software, restricted licensing and restricted hardware, exactly the environment in which open source software and commodity components create choice and competition, welcome changes for customers seeking budget and technical relief along with a great opportunity for Sun.

To conclude, I'll remind you that tough times create unique opportunity for those with differentiated innovation. Although we see customers under stress across the world, that pressure is opening their eyes to the alternatives Sun provides across a wide range of ubiquitous software and systems innovations. Sun can draw upon the most pervasive software brands and ubiquitous development platforms, the broadest user communities and among the most powerful products and distribution assets to drive more aggressive growth in the future.

And with that, I'd like to turn it over to Mike for comments on our financial performance.

Michael E. Lehman

Thanks Jonathan. I will start by commenting on gross margins. Products gross margin increased sequentially by 4 percentage points. We experienced a fairly normal level of component cost decreases and also maintained a disciplined and balanced approach with regard to pricing and discounting. Basically, the combination of lower component costs, disciplined pricing and discounting and a slightly positive mix are the reasons for this sequential increase in products gross margin.

Our services gross margins decreased about 1.2 points sequentially. The principal reason for this decrease was an increased mix of professional services revenues, which typically carry gross margins in the low to mid 20% range. From time to time, we choose to accept a few lower margin PS engagements as a way of maintaining customer loyalty and increasing our overall opportunities.

Turning to operating expenses, both R&D and SG&A were down both year-over-year and sequentially. The year-over-year decrease of approximately 9% is principally due to lower commissions and other incentives as well as some benefit from the restructuring actions announced in May of '08.

The sequential decrease of about 1% is minimal. As you can see, at the current level of revenues, gross margins and operating expenses, our Q2 GAAP operating loss is 199 million, which includes a charge of $222 million for restructuring.

As most of you know, in Q4 '08, we began providing a non-GAAP measure of earnings, which excludes a number of cash and non-cash charges. We have provided the detail of this measurement in our operating analysis for the most recent nine quarters. Our Q2 non-GAAP EPS was $0.15, which compares to $0.50 in Q2 the prior year. However, this does represent an improvement of approximately $0.24 versus Q1 of the current fiscal year.

In November, we announced a further restructuring, for which we incurred a charge of $222 million in Q2. To remind you, we stated that the total restructuring would result in charges of approximately 500 to 600 million and that the vast majority of those charges will be incurred or accrued in Q2 and the second half of this fiscal year. The restructuring charges are essentially severance and other head count related charges. The timing of the accruals is based upon our process for identifying the areas impacted and the various notification requirements that differ by country. We still expect that we will reduce our head count by approximately 5 to 6000 from our Q1 ending head count, which was approximately 33,425. Our head count at the end of Q2 was up nominally to 33,500.

Keep in mind that the notifications associated with the Q2 restructuring accrual will take place in this March quarter.

We still expect that the resulting annual cost reductions will be in the range of 700 to 800 million once all actions are completed. Further, we expect that the majority of the benefit of these cost reductions will be achieved beginning in Q1 of fiscal 10.

Turning to the balance sheet, days sales outstanding came in at 72 days and days of supply at 28 days, both of which were slight improvements sequentially. In addition, the days payable outstanding increased to 62 days. These improvements contributed to a sequential improvement in our cash conversion cycle of 13 days. And as Ron mentioned, operating cash flow for the quarter was 36 million.

At this juncture, consistent with past practice, we are not going to provide any specific guidance with regard to revenues, gross margins or other elements of the business model. We do expect that the March quarter will be challenging at a minimum due to the normal seasonal revenue decline that we have historically experienced. We intend to complete the previously announced restructuring and are focused on delivering longer term improvements in operating income, non-GAAP earnings and cash flows.

With that, I will turn it back to Ron.

Ron Pasek

Thank you Mike and Jonathan. Before we begin the question and answer session, I'd like to request that each of you ask just one question and then requeue for additional questions. Kathy, will you 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 Bill Shope of Credit Suisse.

Bill Shope - Credit Suisse

Okay, great, thanks. Last week, IBM made the argument that virtualization and increasing focus on utilization rates was pushing demand towards higher end server systems. Yet, we are seeing the opposite trend in your results. Can you help us understand why things may be different on your end and how you view the current server industry trends?

Jonathan Schwartz

You bet. I think more than anything else, customers are looking for value and when they see innovation in the marketplace that gives them that value, they will gravitate toward it quickly. So we clearly view our industry as one that's driven by the volume effect or kind of the volume on entry level systems eventually allows people to create technical alternatives to more traditional proprietary high-end systems. And I think we are progressing very nicely with that strategy. So the growth we saw on our low-end platforms, the growth we saw on our x86 systems, reflected by the growth we see for example in our MySQL and Infrastructure businesses, these are all growth trajectories that are spawning from volume opportunities.

And again, when we think of virtualization, we don't think of it simply as a software technology; we view it overall as an opportunity to build systems that deliver fundamentally what people traditionally only got on high-end systems, which is consolidation. Our CMT platforms, the most recent of which are actually 256-way computers are fabulous consolidation platforms, but at a fraction of the price of more traditional proprietary high end.

Ron Pasek

Next question please.

Operator

Our next question comes from Richard Gardner of Citigroup.

Richard Gardner - Smith Barney Citigroup

Thanks very much. Jonathan, first of all, I was hoping that you could give us an update on Solaris attach rates on your x86 server line.

Jonathan Schwartz

You bet. That continues to be kind of difficult to lens because obviously the customers tend to buy licenses to the platform and then buy systems to run the platform on. But simultaneously, if you look at our Open Storage line up, there is a 100% attach rate to Solaris on those platforms. So we continue to see growing interest. We've had a fair number of both high performance computing wins as well as fairly large scale both MySQL as well as Oracle buildouts being done with Solaris on x86. And we have some fairly high profile financial services customers, big web service companies and a fair number of customer references that are just giving us more and more opportunity. I think as customers leave proprietary UNIX behind, they are moving toward open source operating systems, and Solaris and Linux are obviously the two that they have to pick from. And that represents a big opportunity going forward, and not just on x86, but obviously on our CMT systems as well.

Richard Gardner - Smith Barney Citigroup

Okay. And then as a follow up, sorry, Ron, I was hoping that Mike, you might be able to give us a sense of what the impact in the quarter was on gross margins from the recovery versus the write-down that you took last quarter on traditional SPARC servers?

Michael Lehman

So, it's hard to quantify, I'm not sure how to respond specifically. We... in Q1, we had a higher than level normal of excess and obsolete inventory. We quantified that back then. If you are asking, did we recover all that yet? The answer is no. We're still evaluating our inventory. We feel good about our inventory levels in terms of the quantities and the parts. But we still have some amount of excess and obsolete inventory every quarter. And again apologize for maybe not understanding your question, we did not get benefit from the write-off that we made in Q1, if that was your question.

Richard Gardner - Smith Barney Citigroup

Okay. Actually, yes, that helps. Thank you.

Ron Pasek

All right. Thanks, Rich. Kathy, next question please.

Operator

Our next question come from Ben Reitzes of Barclays Capital.

Benjamin Reitzes - Barclays Capital

Hi. Good afternoon. Could you guys talk about your bookings and deferred revenues? Some of your bookings on the services side look like the decline is in the 20s and the bookings for products have decelerated as well to negative 16, but your deferred revenues grew. Which is a better indicator of how you are doing and how should we think of that going into the seasonally weaker March quarter with those two numbers?

Michael Lehman

So, it's Mike Lehman again. The overall book-to-bill is essentially one-to-one. So that's a good indicator. Again, we have typically deferred products revenues associated with the high end and other products that are shipped in the last couple of weeks of the quarter, typically because customers don't have time to install them, certify them, sign-off on them. In many cases, our products are packaged as part of professional services implementations that we have talked about.

And so the deferred products revenue typically represents products that were shipped in the last month of the quarter. And the vast majority of those I'd say 75 to 80 % will turn into revenue in the succeeding quarter.

In services, again it's typically most of our contracts are annual. Some are slightly longer than that. So the services deferred revenues get recognized over the next year. So, there really wasn't anything that unusual in the pattern. Again, overall book-to-bill of essentially one-to-one and the increase in deferred products revenues really just reflects the timing and somewhat back-end loaded nature of the quarter.

Benjamin Reitzes - Barclays Capital

So, it's making it look like a normal seasonality in terms of 1Q or would that be guidance?

Michael Lehman

It would probably be guidance. And then what I was trying to say as I wanted to remind people which you obviously caught that we always have had a seasonal decline in the March quarter versus the December quarter. We would certainly be remiss if we didn't expect that and it's hard to predict too much more at this point, Ben.

Benjamin Reitzes - Barclays Capital

Thank you.

Ron Pasek

Thanks Ben. Kathy, next question please.

Operator

Our next question comes from Maynard Um of UBS.

Maynard Um - UBS

Maybe a broader question in terms of the overall industry. In your discussions with customers, can you just talk about what customers are telling you relative to what they anticipate spending would be... would look like either for the full year in 2009? Thanks.

Jonathan Schwartz

Yeah, you bet. So, it obviously depends upon the customer. I'll give you actually a great example of a recent conversation. I was with a very large financial institution, that is as we speak consolidating an enormous breadth of retail accounts through their website right now. And again they are managing hundreds of millions of accounts though the web. Simultaneously, they are running video surveillance in all their bank branches. And while that's going on, they are also doing some very high end, back-end consolidation work.

And what the CIO reflected to me was they are probably going to put the big ERP consolidation activities on hold, kind of big, lumpy but relatively discretionary purchases. But, in the interim, it's not as though just because the economy went down that they are going to be turning off their videos surveillance. If anything they need to keep bulking up their stores and they are looking for more economic ways to go achieve that. And simultaneously, they're trying to deal with this onslaught of traffic now, coming into their website is they're interacting with users who are kind of frequently checking in on account balances and trying to manage their finances.

So, that's kind of a general reflection of the marketplace. Where customers find revenue opportunity and alignment efficiency they are going to go after it aggressively, especially our customers who tend to see technology as a competitive weapon more than simply as a cost. But, on some of the larger and lumpier purchases, they might be putting those on hold, specifically those that tend to be at the very high end with kind of single large purchases.

So, again, if you're talking to social media companies, they're booming right now. The inauguration was a great example of more people watched it online than watched it on TV, and that had a great effect on our business with some of our media customers. So, we don't see any cessation in demand or any view away from IT as a means of building business and creating opportunity. But certainly, for some of the larger decisions, that might be more discretionary in the near-term, we are seeing some of those put off.

Ron Pasek

Thanks, Maynard. Kathy, next question please.

Operator

Shannon Cross from Cross Research. You may ask your question.

Shannon Cross - Cross Research

Thank you. Good afternoon. My question Mike, is basically, looking at currency, since it's been such a swing factor for so many companies. Can you just kind of walk us through where the puts and takes are on your P&L and your balance sheet and how you're able to hedge? And then how we should think about currency movements with regard to bookings and billings in that as well? Thank you.

Michael Lehman

So that's a frankly a very long conversation. The impact on every line item in the P&L. At the highest level as most of you know, we do a minimal amount of hedging of few of our net currency exposures that has an impact, which mitigates the net income swings. We can still see swings on individual line items. It's most pronounced in the services, revenues areas if you will. And as Ron mentioned, it even shows up in translating the non-U.S. dollar denominated cash.

So it's kind of a long topic. We'd probably better take it offline. It's still fair to say that the net impact on the overall income statement in the quarter is relatively minimal as it has been for number of quarters. I mean that's about as much as we can go into in a one minute answer.

Shannon Cross - Cross Research

Okay, thanks.

Michael Lehman

We're happy to follow-up with you offline.

Shannon Cross - Cross Research

Fine. Thanks.

Ron Pasek

Thanks, Shannon. Next question please.

Operator

Toni Sacconaghi, Sanford Bernstein.

A.M. Sacconaghi, Jr. - Bernstein & Co. Inc.

Yes. Thank you. Can you comment on support services, which were down about 9% year-over-year, and I think that was the lowest that Sun has ever seen. How do we think about that as being something that happened just this quarter or perhaps is reflective of some of the weakness that we've seen in the high-end over the last several quarters? And then related to that, how do we think about services deferred revenues going down a couple of hundred million, I think unprecedented in the history of Sun?

Michael Lehman

So, the principal relationship; Jonathan, talked about earlier Toni is that the principal services revenues do relate to the systems that are sold. So, there is a pretty healthy relationship to the decline in the high-end systems, because they are typically higher valued contracts as well. And frankly our attach rate is highest at the high-end of the product line.

So, there is a relationship there. Ron is pointing out to me that while we hedge our net currency exposures, we don't hedge specific revenue line items. So, services revenues also show the impact. And I mentioned that quickly of the change in currency movements. That's where we see it most pronounced on an individual line item basis.

With regard to deferred revenues, not really much of a story there. We have a bit of a backlog of service contracts that we weren't able to record. It's not a huge number. But that certainly would have been reflected in bookings and deferred revenues. So, again, it's not a big deal. We continue to work on implementing our financial systems. I've talked about that for quite a while. So we have a bit of a unrecorded bookings and deferred revenue of services simply because we couldn't process the transactions not material, not huge. When you add it at all up, Toni, the principal impacts were the ones I cited, which is the higher attach rate and the higher value of services contracts associated with enterprise servers and the fact that there was an impact from currency year-over-year in that line, sir.

Jonathan Schwartz

The other thing to think about is basically our service attaches to wherever our software is running. Customers sign service agreements so they get the next upgrade or the next update. So our Open Storage product line for example should have reasonably high, if not very high service attach rates, our libraries, our larger scale systems, our blade platforms. So we think there is actually a fair amount of opportunity to go after more of that service revenue stream and we really don't look at this quarter necessarily as indicative of much of anything other than a kind of reflection of the quarter and where we are in terms of some of the businesses.

Ron Pasek

Thanks Toni. Next question please.

Operator

Mark Moskowitz of JPMorgan, you may ask your question.

Mark Moskowitz - JPMorgan

Thank you. Good afternoon. Jonathan, can you talk a little more about Amber Road? You seem to be pretty optimistic about the penetration rates in the early days here. Maybe you could talk just a little about where you're seeing the penetration. Are these departmental level, back office, front office? What type of applications should we think about you enjoying the early stage wins here?

Jonathan Schwartz

You bet. So actually I just did a pipeline review with the team this morning. And suffice it to say the opportunities span every industry, every geography, every scale of company, every operating platform. So we're seeing just a pervasive opportunity to go deliver innovation into a marketplace that's really been characterized by fairly rigid vendors and very high and proprietary pricing regime. So in essence, just for those who aren't familiar with what Amber Road is, it takes an open source file system called ZFS, which is at this point probably the most popular open source file system out there. And alongside some innovations with Flash memory allows you to accomplish in terms of storage economics about, for a comparable capacity, a fraction of the power envelope, a fraction of the purchase price and a fraction of the maintenance cost in markets that are well beyond Sun's install base.

So the comment I made about seeing opportunities outside of our install base, this is a storage device we can attach to a Windows server, to an Oracle, to an HP server, a Dell server, a Sun server, it really allows us to kind of span the planet. And the customers we are talking to your employer among them, are just giving us tremendous feedback and from what we see a tremendous pipeline.

So I haven't seen in my career at Sun an opportunity to kind of blossom as quickly as this one has. And it's partly a reflection of where we are headed strategically. We've done a good job in the past two years, sowing the seeds of Amber Road by popularizing ZFS through free distribution and OpenSolaris. We can now go back to those same customers and leveraging that same technology, build appliances that are very high gross margin, very high value and ultimately quite differentiated. And as I pointed out in my comments as well, that strategy is exactly what we are now stepping and repeating.

So there is a, I would argue, one of the most important innovations Sun delivered into the technology community in the past sixty to ninety days has been the release of something called Crossbow. Crossbow is a basic technology that allows us to build very high performance routers with commodity components. And again, as you might assume, that's also a market characterized proprietary... by proprietary vendors who don't really want to use commodity components, or at least don't want to price to their customers as if they do. And we think that represents ample upside for Sun.

Mark Moskowitz - JPMorgan

Thank you.

Ron Pasek

Thanks Mark. Next question please.

Operator

Our next question comes from Katy Huberty of Morgan Stanley.

Katy Huberty - Morgan Stanley

Thanks. Good afternoon. Mike, in light of the net use of cash in the December quarter and some of the remaining cash sitting overseas, do you feel that you can fund the debt maturity and the restructuring outlays over the next year or might we see you restructure the debt?

Michael Lehman

So the short answer is we are very comfortable and confident that we can fund the debt maturity and the cash payments. As we mentioned, we did have a modest amount of operating cash flow, but we did have net CapEx obviously. So free cash flow was negative. But having said that, we have our eyes on what the CapEx is the next couple of quarters and what our opportunities are. So we feel confident that we have the financial ability to handle the debt maturities, and we will look at that and make that decision as we get closer to that debt maturity which is in August.

Ron Pasek

Thanks Kathy. Operator, next question please.

Operator

David Bailey, Goldman Sachs, you may ask your question.

David Bailey - Goldman Sachs

Thank you. Could you give a little bit more detail around your geographic performance? It seems like you saw a sharp slowdown in Asia Pacific and in the emerging markets.

Michael Lehman

Yeah, it's Mike. I'll give a quick cut. In Asia Pacific, keep in mind that with the reorganization of the territories, that principally consists of Japan, Korea, Australia, New Zealand and the ASEAN area, it's principally reductions in Japan and Korea. If you follow currency, you saw that the Korean currency devalued significantly versus the dollar. There were some other issues just in the Korean operating environment that we don't think were unique to Sun, but -- so Korea had a pretty tough quarter, Japan was down again. And so it's a combination of those that caused the Asia Pac region to be more noticeably down. And frankly, as Jonathan mentioned, this economic slowdown is affecting everybody, even hitting into the emerging markets and you saw that there as well.

Jonathan Schwartz

And we were roughly flat in the emerging markets, which was obviously a deceleration. And I think folks are just trying to get a handle of this situation. But we are not worried about long term the role that IT will play in those developing economies.

David Bailey - Goldman Sachs

Thank you.

Ron Pasek

Thanks David. Next question please.

Operator

Our next question comes from Scott Craig of Banc of America.

Scott Craig - Banc of America Securities

Thanks. Good afternoon. Hey Jonathan, in the tape business you, mentioned that you had gained some share this quarter even though it was down on a year-over-year basis. I'm just looking at the numbers from IBM, that's the first quarter that's happened in a while. Was there any competitive dynamics that changed there or product dynamics from your standpoint that drove a share gain?

Jonathan Schwartz

Yeah, we think our latest release is giving us an opportunity to go talk to IBM customers. They haven't really had much of an option. And I think in general, the new innovations we had both from a performance perspective and a quality perspective, we are just seeing more and more of those opportunities open up across the world. I think frankly, it helps to be in the storage dialogue with so strong a message around Open Storage. I think simultaneously, out of the more traditional definition of the tape market, for the most part, when you say tape, most people envision insurance companies who are going to keep actuarial data for a couple of decades.

But we are talking to genomics companies, social networking companies who are aggregating petabytes of photos, we are talking about folks who do weather forecasting or seismic simulation. All of those are creating just petabytes and petabytes of data which end up being more economic obviously tape than they do on spinning media. So I think we've got, I would argue, one of the strongest product lines in the storage industry right now and it spans everything from the lowest end kind of commodity storage on the Open Storage side all the way up to the strongest archive solutions in the industry.

Scott Craig - Banc of America Securities

Okay, thanks.

Operator

(Operator Instructions). Richard Gardner of Citigroup, you may ask your questions.

Richard Gardner - Smith Barney Citigroup

Thanks for taking the follow up. I was just hoping that maybe you could talk a little bit about your win rate on traditional SPARC servers outside of your install base? I know that you said that you think most of the negative impact there is related to just deferrals of large projects, given the overall macro environment. But do you really feel like you are maintaining share of new projects or is most of what your selling going into the install base? Thank you.

Jonathan Schwartz

So it's on a dollar basis, obviously, our revenue streams are going to be dominated by the customers to whom we have already sold products, as they scale up and scale out their platforms. But in terms of our ability to attract new customers, Niagara systems have turned out to be a pretty reasonable technology for customers who are bound by energy requirements or application performance. So we've certainly been able to get out of the installed base with Niagara platforms. It's obviously a lot easier, given the presupposition with Niagara that you are going to run Solaris or Linux. That obviously limits somewhat the market opportunity out there. With our open storage platforms as I pointed out earlier we can attach to any customer in any environment at any scale.

So we're going to continue investing to go acquire new opportunities. The way we see those investments is we create the installed base with our software platforms into which we then sell commercial products, both commercial softwares as well as commercial systems. And the larger the Solaris Community grows, the more attractive the Niagara product line becomes and that's our OpenSolaris platform just continues to grow and it's fed not just because we're pushing, but because of innovations like ZFS and Crossbow that really capture the attention of administrators and technologists around the world to whom we can then talk about the other related innovations, whether they are MySQL optimized systems or Amber Road storage or Niagara.

Richard Gardner - Smith Barney Citigroup

Okay, thanks Jonathan.

Jonathan Schwartz

Thanks Rich. Operator, next question please.

Operator

Bill Fearnley of FTN Midwest. You may ask your question.

Bill Fearnley - FTN Midwest Research Securities Corp.

Yeah, thanks. Looking at the demand environment, when you guys look at your pipeline, it's measured by outstanding quotes and proposals, both direct and in the channel. What's your view here on visibility here for the next couple of quarters directionally. What are the gives and takes, and what has it turned into versus your expectations a few months ago, when you look at the pipeline. And then I have a follow up?

Jonathan Schwartz

So without commenting on guidance, which I think is what you are asking for?

Bill Fearnley - FTN Midwest Research Securities Corp.

No, I'm actually asking just directionally, I mean is it better, is it worse?

Jonathan Schwartz

I think that's guidance, but it again it really depends on customer and innovation. Because right now as I pointed out some of the social media companies, especially those that have new sites for example that are trying to give you an update on where President Obama is headed. They are some of our most aggressive customers right now because they're just being saturated with traffic and we have got a very healthy pipeline with them.

Some of our larger financial institution customers, some of the employers or folks on the phone here are definitely putting off some of the larger scale ERP platforms and consolidation activities. So it really... it depends on the customer.

We just had a partner conference recently. We brought together about a 150 of our largest partners from around the world and the variation in the folks in that room was extreme, from folks who were growing 100% year-over-year to folks who have not seen purchase orders in 60 days. So I'm not sure we have the any way of lensing the market more effectively than the rest of the industry or for that matter the governments that we talk to.

I think what we are seeing universally is a very rapid and continued uptake of open source software and commodity components as the vehicle to get better price performance and economic performance out of that infrastructure people invest in. So I think the performance of the software business this past quarter was very encouraging to us. We are again seeing great growth in opportunity around MySQL and our open source operating system and middle ware platforms.

I see no reason why the adoption of those platforms will slow at all in the next year. In some sense they are amplified by the anxiety in the marketplace. And that again creates footprint opportunities for Sun and opportunities to sell our innovations.

Bill Fearnley - FTN Midwest Research Securities Corp.

And then also if I can ask a follow-up Jonathan on the partner conference. Any concerns or did you hear any concerns from the bar the channel here, from any of your partners on credit issues, or their accessibility to credit?

Jonathan Schwartz

You know I guess I was more focused on talking about what they wanted to talk about, which wasn't credit. It was, how many trial units of Amber Road platforms could they get and then in what timeframes. So, I think credit issues are obviously affecting our customers around the world as much as they are any of our partners. But I think for the most part, they are all looking at ways to save money and financing is one discussion. But obviously innovation is where we are more focused.

Bill Fearnley - FTN Midwest Research Securities Corp.

Thanks.

Ron Pasek

Thanks Bill. Next question please.

Operator

Keith Bachman of Bank of Montreal. You may ask your questions.

Keith Bachman - BMO Capital Markets

Hi Mike. This is for you. I just wanted to understand of the cost savings that you outlined, how much do you think about between COGS and OpEx? And separately, how do you think about potentially using that cost savings to offset ASPs versus dropping to the bottom line? Thanks.

Michael Lehman

Yes. So, we have not gotten to the point where we want to break out the impact of OpEx versus COGS. Cleary, there is going to be more impact and it will be more noticeable in OpEx than it is in COGS. But certainly it some meaningful portion of the cost savings will show up in the cost of sales or cost of service. But we're not ready to quantify at this point.

And, as you can see from our results in Q2, we are focused on taking some of those cost savings and bringing them back to the bottom-line as opposed to having them all go out the door in the forms of pricing and discounting. It's clear from the choices we made in Q2 that we're not just chasing any business out there. We want there to be profitable business, good business, long-term business. So and as we mentioned when we talked about the initial restructuring, part of the intention to that is to lower our cost base so that we can generate more return to shareholders, cash and GAAP all kind. So...

Jonathan Schwartz

And just kind of on the overall economics for Sun just so you understand how we view the marketplace and some of the discontinuity we see with some of the coverage of Sun. We are not particularly focused on products that are undifferentiated against our peers. So some of our peers that are simply remarketing a third-party microprocessor end up in kind of tough situations where they are bidding against three other people who have exactly the same product.

We tend to build differentiation into the products, and that means that the value we deliver to the customer in the form of our intellectual property through systems engineering and software engineering, gives us more of a buffer. And therefore gives us the capacity to build the gross margin profile that's a lot more attractive than some of the remarketers.

So, obviously I think we executed well in Q2 down that path. And we're investing from the R&D perspective as well as in how we bring our products to market to ensure that we build a more attractive gross margin profile going forward and overall more attractive business model.

Keith Bachman - BMO Capital Markets

Okay. Can I ask a follow-up question Jonathan?

Jonathan Schwartz

Sure.

Keith Bachman - BMO Capital Markets

Just you mentioned Amber Road quite a bit. How does it differ from Thumper? Is this the next rev of the Thumper product line?

Jonathan Schwartz

So, what Amber Road does that Thumper doesn't do is first and foremost allow you to kind of seamlessly attach to any operating environment, not simply a traditional server environment. So we are enabling through sys support the ability to attach to Windows. And in essence that opens up a big portion of the marketplace that we couldn't get at before.

Secondarily, it adds Flash. And as result of adding flash we can get very, very high performance delivery into the marketplace. Thumper didn't incorporate Flash. And in using ZFS, what we ask the file system to do is basically to move files that are hot or that everybody wants to see up into flash. And that enables you to get extremely high performance. And that enables us to use very low performance, but very low cost drives as kind of the backing storage, as kind of just commodity storage in the background.

The net result along with a kind of killer user interface is we can deliver tremendous performance benefits at a fraction of the cost of some of our peers and competitors in the marketplace using an open source software platform that is distributed to millions of licensees around the world. So this really is the embodiment of strategically what we are attempting to do: create very broad communities around our core software innovations and then sell to them the commercial offerings that they find interesting, both commercial software as well as commercial systems and storage.

Keith Bachman - BMO Capital Markets

Great. Thanks very much.

Ron Pasek

Thanks Keith. Next question please.

Operator

(Operator Instructions). Our final question comes from Chris Whitmore of Deutsche Bank.

Chris Whitmore - Deutsche Bank Securities Inc.

Thanks very much. Mike, you gave us color sequentially in terms of gross margin drivers. I was hoping you can do the same on a year-on-year basis. I am particularly interested to understand the mix effects year-over-year and what kind of impact the decline in the SPARC business is having on gross margins year-on-year. Or maybe put another way, what percentage of your total gross profit dollars do you think is tied to the UltraSPARC business? Thanks a lot.

Michael Lehman

Yeah, so I don't have all that data available. At the highest level, year-over-year, mix was the biggest impact. You can look at the billings chart that we gave you and look at the year-over-year declines at the enterprise level in the server space and you can see, and as we've talked about, those carry the highest gross margins that we have. So the principal decrease in products gross margins year-over-year is the mix. That's plain and simply what it is. We have sort of the normal ongoing cost reductions throughout the year, of which we, as I said in Q2, did probably a better job of managing the pricing and discounting in relation to that. But it's essentially a mix of the impact year-over-year in products.

Chris Whitmore - Deutsche Bank Securities Inc.

And Jonathan, if I read into your comments a little bit, it seems you suggest that you are not anticipating that high-end UltraSPARC business to come back any time too soon. Is that a fair characterization of the color or the feedback you're getting from your customers regarding their budgets?

Jonathan Schwartz

It really depends on the customers, it depends on a whole variety of scenarios. We're going to plan the company prudently. And I think you've seen us take actions that presume the macro environment doesn't improve. But it's important to understand about high-end systems, when customers make those decisions, they last for about a decade. So almost independent of the immediate revenue, the install base of business gives you refresh opportunities, service opportunities, attach services and cross selling. So that business will tend to be more lumpy. And just to give you an example of how lumpy it can be, a year ago in this quarter, I think the high-end business grew 8%.

In Q1 a year ago, it grew 20%. So there is clearly a very vibrant and attractive business there. And even in the macro environment, sharing my office with our CFO, I can tell you that most CFOs enjoy saying no. They've got plenty of opportunity to do so in the current environment, but only for the POs that they see, they tend to see the POs on larger systems. They tend not to see them so much on low-end or capacity-based systems. And that's I think reflected somewhat in what we see in purchase trends in the marketplace. You can also see it in our business. Our low-end systems business did very, very well; storage as well as systems as well as software for that matter. The high end is definitely where some of the slowing is occurring and it's for those reasons.

Chris Whitmore - Deutsche Bank Securities Inc.

Jonathan, can you give us an update on the timing for Rock in your upgrade in that segment?

Jonathan Schwartz

So I think we've said to plan on it later in the year and I think we are still on that. And the good news is we are building a very large base of customers that understand Chip Multithreading, which is the family that Rock systems will tend to amplify. So I think the acceptance of multithreading systems now that every single microelectronic vendor I am aware of is building multi-core and multithreading CPUs. Clearly, we were kind of first into that trend and hopefully we'll be one of the principal beneficiaries.

Chris Whitmore - Deutsche Bank Securities Inc.

Okay, thanks a lot.

Jonathan Schwartz

Thanks Chris. Next question please.

Operator

At this time, we show no further questions.

Ron Pasek

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

Operator

This concludes today's conference call. We appreciate your participation. If you joined us late or wish to hear any part of the conference call again, you may call the replay service anytime after 3:30 PM Pacific Time today to hear a recording of this conference call. The phone number for the replay is 866-395-1650 or 203-369-0470. No passcode is required and the replay will be available until midnight on February 4th. Thanks again for taking the time to join the Sun Microsystems call this afternoon. You may now disconnect.

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Source: Sun Microsystems F2Q09 (Qtr End 12/28/08) Earnings Call Transcript
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