Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Sun Microsystems Inc. (SUNW)

F1Q07 Earnings Call

October 26, 2006 4:30 pm ET

Executives

Bret Schaefer - VP, IR

Jonathan Schwartz - CEO

Michael Lehman - CFO

Analysts

Richard Gardner - Citigroup

Keith Bachman - Banc of America

Laura Conigliaro - Goldman Sachs

Bill Shope - JP Morgan

Ben Reitzes - UBS

Katie Huberty - Morgan Stanley

Richard Farmer - Merrill Lynch

Andrew Neff - Bear Stearns

Tony Sacconaghi - Sanford Bernstein

Harry Blount - Lehman Brothers

David Wong - A.G. Edwards

Jesse Tortora - Prudential

Chris Whitmore - Deutsche Bank

Presentation

Operator

At this time, I would like to welcome everyone to the Sun Microsystems' fiscal year 2007 first quarter earnings results conference call. (Operator Instructions) I would now like to turn the call over to Mr. Bret Schaefer, Vice President of Investor Relations, Sun Microsystems.

Bret Schaefer

Good afternoon. Thank you for joining the Sun Microsystems's quarterly conference call. I'm Bret Schaefer, Sun's Vice President of Investor Relations. With me today is Jonathan Schwartz, Sun's CEO; and Michael Lehman, Sun's Chief Financial Officer and Executive Vice President, Corporate Resources. The purpose of today's call is to discuss the results of Sun's fiscal 2007 first quarter, which ended in October 2006.

During the last hour we published a copy of the operations analysis data sheet with nine quarters of financial operations information, including the quarter just completed. If you've not received the announcement or the detailed financial data sheet for any reason or you wish to hear a live broadcast of this conference call, you may log onto our website at sun.com/investors. We have posted slides that you can view on the web, which accompany our prepared remarks. These slides may be viewed at the same URL, sun.com/investors. The prepared remarks of our call today will last about 30 minutes with the remaining 30 minutes devoted to the Q&A session.

During the course of this conference call, we will be making projections and other forward-looking statements regarding expected future financial results and business opportunities. Our actual future results may vary or be very different from our current expectations. We encourage you to read the 10-Ks and 10-Qs 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 not to come true. We do not currently intend to update these forward-looking statements.

In addition, during the course of the conference call, we will describe certain non-GAAP financial measures which should be considered in addition to, and not in lieu of, comparable GAAP financial measures. Please refer to the results call financial slides and operations analysis posted on our website at sun.com/investors for the most directly comparable GAAP financial measure and related reconciliations.

Please note that unless otherwise indicated, all reported results include the impact of the StorageTek and SeeBeyond acquisitions for the full quarter ended October 1, 2006 as well as the one-month sub period results for StorageTek and SeeBeyond acquisitions for the quarter ended September 25, 2005. Now let's get to the financials.

Sun's total revenues for the first quarter of fiscal year 2007 were $3.189 billion, an increase of 17% as compared with the $2.726 billion in revenue reported for the first quarter of fiscal year 2006. Total gross margin was 43.5% of revenue, a decrease of 0.6 points over the gross margin for the first quarter of fiscal year 2006. Total R&D and SG&A expenses were $1.431 billion, an increase of $164 million year over year. In the first quarter of fiscal 2007, we recorded a $34 million tax provision.

GAAP net loss for the first quarter of fiscal year 2007 was $56 million or a net loss of $0.02 per share as compared with a net loss of $123 million or a net loss of $0.04 per share for the first quarter of fiscal 2006. GAAP net loss for the first quarter of fiscal 2007 included approximately $79 million, or a little over $0.02 per share, principally related to intangible asset amortization associated with the acquisitions of StorageTek and SeeBeyond.

GAAP net loss also included approximately $58 million or approximately $0.02 per share in stock-based compensation charges. GAAP net loss for the first quarter of fiscal year 2007 also included restructuring and related impairment of assets charges of approximately $21 million and a related tax benefit of $7 million. The total impact of intangible asset amortization associated with the acquisitions, stock-based compensation charges, charges for restructuring and related impairment of assets and related tax benefit was approximately $0.04 per share. Now back to revenue metrics.

Q1 products revenues totaled $1.951 billion, an increase of 15% year over year. Within products revenues, computer systems products revenue was $1.468 billion, an increase of 15% year over year. Data management or storage products revenue was $491 million, an increase of 14% year over year.

Q1 services revenue totaled $1.230 billion, up 20% year over year. Within services revenue support services revenue was $971 million, up 16% year over year and revenue from client solutions and educational services totaled $259 million, an increase of 39% year over year.

With respect to some of the balance sheet items, DSO was 57 days, we ended the quarter with cash and marketable debt securities balance of $4.671 billion, and generated positive cash flow from operations of $157 million.

With that, I'll turn it over to Jonathan.

Jonathan Schwartz

Great. Thank you, Bret, and hello, everyone. First, it feels great to continue growing. I want to congratulate the team on a great start to the fiscal year. We saw continued growth in the adoption of our core developer tools and platforms. We grew all of our core businesses. We sustained a strong gross margin profile and executed very well against our financial goals.

Now, at a broad market level we're continuing to see the market segment into those who see IT as a competitive weapon, who invest in network infrastructure to grow value and opportunity, and those who see it as a cost center to be eliminated over time. While continuing to faithfully serve the latter community, we're laser focused on the former and are orienting nearly $2 billion a year in annual research and development to deliver the innovations they need to compete in a rapidly expanding market.

Now I'll warn you ahead of time not all of these innovations are going to be predictable as you recently saw with the announcement of our Project Blackbox, the world's first data center optimized for power efficiency and portability.

As I've said before, the adoption of our developer platforms is key to the growth of our business and in the first quarter we crossed several milestones, most importantly the 6 millionth license download threshold for Solaris 10, Sun's open source, freely available operating system. The majority of these licenses were onto HP, Dell, and IBM hardware, creating new options for customers and importantly new opportunities for Sun. I was also very proud to see that a feature in Solaris 10, eTrace, was recognized as the overall gold medal winner in The Wall Street Journal's annual innovation awards.

Now, as you know, adoption of Solaris and Java present commercial opportunities for companies deploying applications built across the platforms that require leading-edge infrastructure. In the last year or so we have overhauled the entirety of our infrastructure product line. We continued in Q1 with the introduction of the new Sun Fire x4600, the industries first up to 16-way x64 server sold in a miniaturized 4U chassis. The Sun Fire X4500, formerly known as Thumper, with a 24 terabyte hybrid storage server platform and the Sun StorageTek virtual tape library, delivering a 30% performance increase that results in faster backups and fewer failures.

We are thrilled to see that our innovation at selling to old and new customers, resulted in Q1 customer momentum with brands including MasterCard, Alcatel, Time Warner Cable, Verizon Wireless and many more.

Now, Sun is a systems company and one of the principal drivers of our systems, storage, and services business and not simply the driver of developer appeal, is our software. With Solaris and Java as key differentiators, Sun's software revenues in Q1 grew approximately 17% year over year. Growth was driven by the strength of Solaris, the continued adoption of our Java platform on devices, desktops, and through the Java Enterprise system and especially Sun's security and identity management portfolio.

Verizon Wireless, the U.S.-based wireless network provider expects a 5X performance improvement over its current server environment with 20% fewer machines due to the enhanced performance in advanced virtualization provided by Solaris. They also enjoy their ability to run Solaris on non-Sun hardware platforms.

Computer systems for the third consecutive quarter grew by 15% year over year, outpacing most of our competitors. Within computer systems, SPARC server revenues grew over 10% year over year. The Sun Fire T1000 and T2000 or Niagara Servers continue to perform very well, exceeding $100 million in sales for the second quarter in a row. Our focus on power and space efficiency only grows more relevant by the day.

The telco sector continues to be strong for us with customers such as Alcatel choosing our UltraSPARC servers running Solaris for their high speed link customer deployments across Asia, Africa, and Europe. Our Sun Fire x64 or Galaxy Server business had outstanding year-over-year unit growth of 52% with frankly stunning revenue growth of more than 75%. The annual revenue run rate is now in excess of $600 million.

According to IDC in August, Sun maintained its number one position in worldwide UNIX server revenue in shipments and rose to number three in the worldwide server market. Our customers continue to look to Sun for excellence in data management and our storage business grew 14% year over year in Q1. Companies like Rhythm & Hues, a computer generated imagery leader, used Solaris and Sun storage platforms to create digital archive systems for films such as Titanic, Superman Returns, and importantly, Garfield.

Areas of note for storage in Q1 included mid-range disc, the SE 5000 and SE 6000 as well as high-end tape. The recent X4500 hybrid server, Thumper, is built from Solaris which helps to bring the power and economics of Open Source innovation into the storage world. Thumper will allow us to bridge the divide that traditionally exists between the systems and storage markets which creates more choice and options for customers, as well as more opportunity for Sun.

Total services revenues were up 20% year over year with client solutions and educational services up a healthy 39% year over year, and we believe the growth in the services business is beginning to reflect a refreshed product set and improved customer acceptance of Sun's software innovation.

Finally, I'd like to spend a brief moment discussing how we plan to continue growing our business well beyond our installed base. Looking at the Venn diagram on slide number eight, you can see the four fundamental businesses we are in: software, servers, storage, and services. We want to meet existing and new customers where they are today at the edges of this graphic through free software and try-and-buy systems products through a focus on interoperability with existing customer infrastructure, and through breakthrough economics and performance characteristics.

Only by serving customers on the periphery, with free software, with trial systems that work with non-Sun technologies, do we gain permission to sell to those in the middle at the intersection of Sun's core innovations where we believe no competitor can match the value we deliver. It is that intersection point that will receive the bulk of our research and development investment as we continue to drive sales forward, leveraging the core innovations in our developer platform, in our operating system, and in our general purpose systems infrastructure. Couple this approach with our ongoing focus on customer service, aggressive operating and expense discipline, and we believe we are well on track toward a more attractive future.

I want to congratulate the teams once again. We're off to a great start for the year and we're on our way to achieving our goals of at least 4% operating margin in Q4 and our longer term goal of greater than 10% operating margin. The demand outlook is positive, the industry landscape is certainly offering some very favorable recent changes, and our strategy positions us well into the future.

So with that said and for more details and specifics I'd like to pass it over to my office mate, Mr. Lehman.

Michael Lehman

Thanks, Jonathan. I will begin by reiterating that we had a very solid quarter. Revenues came in a bit higher than we had anticipated, principally due to our ability to ship more systems than we had expected. The decrease in the product backlog of approximately $140 million from June to September illustrates this. Having said that, we were pleased with the overall demand in the quarter and did not see anything unusual in terms of order rates or linearity right through the end of the quarter.

Our channel inventories were slightly lower than they were at the end of June. During the remainder of the fiscal year, we expect to continue to reduce those gradually. As we continue to improve our ability to ship within predicted lead time guidelines, our channel partners will not need to hold as much inventory to satisfy their customers.

I would also note that our year-over-year revenue growth was well dispersed geographically. U.S. revenues grew at 12%, revenues from EMEA grew at 17%, and those from Asia Pacific and Japan grew at approximately 20%. There were also significant wins in all key vertical markets, government is particularly strong in the September quarter due to the fiscal year-end of the U.S. government.

With regard to deferred revenues, we experienced a normal seasonal decline from Q4 to Q1 of approximately $240 million. Total deferred revenues were up by approximately $200 million or 10% on a year-over-year basis. The year-over-year increases are due primarily to the acquisitions last year, but also reflect increases related to software subscriptions and services revenues.

Turning to gross margin, as many of you may recall, in our last conference call I indicated that we expected gross margin to be in the range of 42% to 44% during this fiscal year. Q1 gross margin came in near the high end of that range at 43.5% and we are pleased with those results.

On the products front, improvements in pricing, channel mix and product mix, including both a larger contribution from both software revenues and higher end systems, was somewhat offset by expected higher materials costs and lower volumes -- this all compared to Q4. Services gross margin benefited from increased utilization of our professional services staff as well as increased delivery efficiencies for our support services business.

Total SG&A and R&D decreased by approximately $245 million sequentially, essentially right in line with our internal expectations. We have made progress towards the annual cost reductions that we outlined in May. Our total headcount has been reduced by approximately 2,000 since the end of June, and we expect that number to be further reduced by another 1,000 to 2,000 by the end of the fiscal year.

We continue to implement the facilities consolidations and cost reductions that we outlined in May and expect that the full impact of such actions will be reflected in our cost structure by the fourth quarter of this fiscal year.

Our balance sheet metrics were slightly better than we had anticipated in Q1 and overall cash outflows were lower than planned due principally to the level of severance payments. As a result, our Q1 cash usage was less than anticipated and our cash balance at nearly $4.7 billion, was higher.

Now I'll say a bit about our plans for Q2. We expect a sequential percentage increase in revenues in the high single-digits. We expect overall gross margin to be in the previously expressed annual range of 42% to 44% and expect total R&D and SG&A expenses to be in the neighborhood of $1.5 billion. The sequential increase in this category is mostly due to planned focal increases for our employees as well as increased incentives related to higher revenues and certain engineering expenses that were initially planned for Q1 but will now be incurred in Q2.

We also expect that the following will be included in the remainder of the FY '07 business model. We expect amortization of acquisition-related intangible assets of approximately $70 million a quarter. We expect stock-based compensation of approximately $70 million in Q2 and approximately $60 million each in Q3 and Q4.

During Q1, we determined that certain taxes formerly provided within our European holding structure were no longer subject to withholding. As such, we reduced the current provision to reflect that approximately $15 million previously accrued was no longer owed. As a result, we estimate that our tax provision for the entire fiscal year will be in the range of $200 million to $225 million.

With regard to net interest income, our current view is that interest income will be in the range of $30 million to $40 million per quarter for the remainder of the fiscal year. While our overall cash balance was slightly higher at the end of Q1 than had we anticipated, some of the severance payments will now be disbursed in Q2. As we have previously indicated, we do not expect to generate cash on an operating basis in first half of this fiscal year, but do expect to generate cash in both the second half of the year and on an annual basis.

I will echo what Jonathan said earlier. We are on track to deliver operating income on a GAAP basis of at least 4% in the fourth quarter of this fiscal year. The principal driver of our ability to attain our longer term goal of operating income of at least 10% remains acceptance of our products and services by the marketplace. We are pleased with the top line results in Q1, which follow a very strong June quarter. We remain focused on all aspects of our cost structure and we'll continue to take aggressive action to reduce our fixed and variable costs as we go forward.

With that, I will turn it back over to Brett.

Bret Schaefer

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 consisting of one part. This way we hope to get to most of the questions in queue today. If there is time remaining we will be happy to take your follow-up questions. Dennis, will you please start the question-and-answer session?

Question-and-Answer Session

Operator

(Operator Instructions) We'll take our first question from Richard Gardner - Citigroup.

Richard Gardner - Citigroup

Mike, I was hoping you could provide a little more detail on the out-performance in the quarter on the cost side? It sounded like costs were obviously a little bit below the guidance that you provided for the quarter. Can you talk about how much of that was related to the expenses that you expected to incur in the current quarter that you said will now be incurred in the second quarter? Thank you.

Michael Lehman

So expenses were really right in line with what we had expected, within the range that we had provided, perhaps towards the lower end. The only thing that I was alluding to with regard to engineering expenses is that some of those are difficult to predict in terms of when prototypes actually are spent and then the expense of those are incurred, so many times those slip from one quarter to another. They are not entirely predictable. But that's not a large amount of money. It's just an example of the type of thing that can move around from one quarter to the next.

Bret Schaefer

Next question, please.

Operator

We'll take our next question from Keith Bachman - Banc of America.

Keith Bachman - Banc of America

Hi, guys. Thanks for taking my question. My question is on the gross margin, you just had roughly 43.5% gross margin. You're going to get positive volume variance. Why wouldn't your gross margin be higher in your fiscal Q2 than it would be in Q1, please?

Michael Lehman

I think I'm just more comfortable continuing to give an overall range that gives us some latitude. We, as always, want to be opportunistic and aggressive where we can on pricing and our view is that we want to build our business model with that range of gross margin so that we can achieve our goal. So I'm just making sure that we have enough room in there for opportunities in the marketplace.

Keith Bachman - Banc of America

But, Mike, if I could just follow-up. Is there anything more specifically on mix or on product cost variances that we should be concerned about, or is it just more you're trying to give us a range and be conservative as it relates to the range?

Jonathan Schwartz

A couple things. One, we're certainly continuing to build out, as an example, some relatively low margin x64 systems products into a far higher margin profile of more innovation with products like the 4600 and the 4500. So we believe that we're going to continue investing in the volume products that allow us to attract new customers but we're also going to be building out a higher value and higher margin profile going forward.

So we think there definitely are volume pressures on the downside of margin. There's also volume opportunities on the upside and I think to what Mike said, we just want to give ourselves the latitude to go after the market as much as we can.

Operator

We'll take our next question from Laura Conigliaro with Goldman Sachs.

Laura Conigliaro - Goldman Sachs

Yes. You talked about high single-digit revenue increase as your target for the December quarter. But particularly with part of the product line that's been growing really well, becoming a bigger portion of the base and also having a seasonally stronger quarter, and then, finally, with StorageTek, typically having extremely strong sequential growth in the December quarter, why shouldn't you be at the very least at the high end of your historic sequential growth? Which would be more like 9% to 10% rather than merely high single-digits?

Michael Lehman

One of the things that's difficult to predict, as we have found out, is merging the historical growth rates of the former Sun business and that of StorageTek and it's just difficult to look at that and use that as the only basis for it. So clearly there are opportunities for revenue. Jonathan talked about that. The marketplace is certainly looking at us very favorably. But, as I have said many times, we want to make sure we plan this business so that we can achieve our milestones and put pressure on our cost structure to achieve that. So I'm just trying to give you a sense of what we're looking at.

Laura Conigliaro - Goldman Sachs

So, in other words, this is another instance as in the September quarter where you are trying to give yourself enough latitude so that you don't have a hiccup?

Jonathan Schwartz

As we discussed previously, we're trying to be prudent. We're trying to ensure that we keep the pressure inside the Company on the assumption that revenue's going to be in high single-digits. And if do better than that, I think it would be good for everybody involved. But we want to make sure we can plan the business around prudent estimates.

Bret Schaefer

All right. Next question, please.

Operator

We'll take our next question from Bill Shope - JP Morgan.

Bill Shope - JP Morgan

Jonathan, in light of Oracle's announcement yesterday to offer support for Red Hat Linux. Can you give us an idea of how you think that might change the competitive landscape for Solaris and Open Source?

Jonathan Schwartz

What is that now? I'm sorry, that was a joke.

I think it certainly feels great to have an operating system that allows us to control our own destiny. Certainly I think it really amplifies the point that operating systems are an absolutely crucial technology for a systems company that wants to do more than try to rebadge other people's intellectual property.

So we're very comfortable with the investments we made with Solaris. We've seen frankly, an increasing interest from the competitive installed base to want to understand how Solaris runs on Dell, HP, and IBM, provides Open Source innovation, still gives plenty of choice -- and by the way -- runs every ISV in the marketplace that we can find. So we think it's certainly very positive for the direction that we're headed and we'll see how things turn out.

Bret Schaefer

Next question, please.

Operator

We'll take our next question from Ben Reitzes - UBS.

Ben Reitzes - UBS

According to my model you beat every number except storage, down 31% sequentially. Can you talk about what happened there? Maybe vis-a-vis the prior quarter where it was above our expectations potentially, and what happened there? Also there's just been a lot of talk about what you guys want to do with storage. Is there anything with your strategy that you want to clarify on this call in terms of positioning in the future?

Jonathan Schwartz

Yes. I guess I don't see where the numbers came from. So I'm not going to comment on the exact number. I think we are definitely seeing the market biased somewhat in a polar direction in the sense that the appeal of tape continues to grow, in the sense that it has environmental characteristics like it doesn't require electricity to maintain data integrity. So you can actually keep a large amount of data around without powering it. It obviously provides some portability attributes in the sense that it's easier to put a petabyte of data on a sailboat to get it to Asia than it is to try to pump it over the Internet. So in that sense, I think that's a very attractive part of the business for Sun and we're going to continue investing in it.

On the near line storage, we continue to see that the Solaris operating system and the general purpose computing infrastructure allows us to build tremendously attractive price points and market offerings like Thumper, where we've seen absolutely outstanding demand.

I think the question for us is really what happens to everything else in between? If the market really moves towards archived platforms and network attached storage, there's an awful lot of other technologies that are sitting in between those that are beginning to look less economic going forward.

So we are absolutely committed to the storage marketplace. It's a core portion of the value that we can deliver into the data center. But we continue to see a very rapid migration toward the value of Open Source platforms in the storage marketplace and again, given that we can use Solaris and can leverage technologies such as EFS to go after that marketplace. we think there's plenty of opportunity.

So notwithstanding any specific results quarter to quarter, which I don't know Mike if you want to give any more specifics on, I think we continue to see it as an attractive marketplace, even if the quarterly performance on some of the disk products weren't where we would like them to be.

Michael Lehman

So again that number that you talk about doesn't jump out at me, we'll probably have to catch up with you on a call afterwards to understand your math, but I think Jonathan said everything in answer to your question.

Bret Schaefer

Next question?

Operator

We'll take our next question from Katie Huberty - Morgan Stanley.

Katie Huberty - Morgan Stanley

Hi, guys it's still a little difficult to compare bookings and backlog given the storage a year ago, but on the face of it if I look at sequential trends, it appears that those bookings and backlogs fell less than what is typical for a fiscal first quarter. Is this the case and if so what does that reflect for momentum in December?

Michael Lehman

You're absolutely right. It is difficult to compare bookings and backlog and I think finally by next quarter we may have it all sorted out. The only thing I'll say is that the bookings momentum and the bookings pace that we saw throughout the quarter was really what we expected. It tracked well with what we had thought right through the end of the quarter. There were no particular issues with linearity one way or the other so it was a very solid quarter from that perspective.

Katie Huberty - Morgan Stanley

And just to be clear, there's no new products that you expect to announce in December in the backlog number? Is that right?

Michael Lehman

Sorry, I'm not even sure how to answer that question.

Jonathan Schwartz

Can you try to clarify the question?

Katie Huberty - Morgan Stanley

The products you would announce in December won't be in the backlog number today, correct?

Michael Lehman

We take orders and if something is shippable within the next three to six months, it can be in backlog, but we're not going to comment on what products might be announced when and all that stuff. So our policy is that if we have an order that we can ship within a specified time period, it is in backlog.

Katie Huberty - Morgan Stanley

Okay. Great. Thanks.

Bret Schaefer

Next question, please.

Operator

We'll take our next question from Richard Farmer - Merrill Lynch.

Richard Farmer - Merrill Lynch

Thanks. Mike, just trying to get a sense of what your organic growth was separate from the acquired revenues. Can you help us at least estimate what the StorageTek revenue was, particularly also separating from the stub last year?

Michael Lehman

So Bret's trying to point me to a number on the ops analysis. As we've said before, we're not really in the business of breaking out what the former ex-business was and all that. We're looking at them as one and we will continue to do that as we go forward.

Richard Farmer - Merrill Lynch

All right.

Jonathan Schwartz

It's also complicated by what was sold between the two companies and by where we've merged the product line so we're not trying to be opaque here, it's just a little tough here to do the apples-to-apples comparison.

Richard Farmer - Merrill Lynch

Maybe I can try a different one then. Just on the pricing environment. It looks like in your breakout you've talked about 240 bips of positive quarter-over-quarter margin effect from volume mix and pricing combined. What was the contribution from pricing specifically? What are you thinking about pricing going forward?

Michael Lehman

We're not going to break out any more detail than that and our view of pricing is that we have an extremely competitive product line and we are right in there with anybody on any particular deal and that's the way we want to continue to be able to price.

Jonathan Schwartz

To a certain extent we've got a little bit more latitude on the pricing side given that we've got a little bit broader product portfolio. So if we're in a bid on a deal where we're going toe to toe with someone who doesn't have an operating system, as an example, it's certainly a little easier if we've got added value.

Bret Schaefer

Next question, please.

Operator

We'll take our next question from Andrew Neff - Bear Stearns.

Andrew Neff - Bear Stearns

Thanks. Just a slight geographic question. Your U.S. growth lagged the other markets. Is there anything on a year-to-year basis -- I know there's some comparison issues. Is there anything that we should look at? Is there anything going on there? Can you give us some color on the geographic trends?

Jonathan Schwartz

Yes, I can give you a little color. So we certainly have more developing economy growth. We're seeing very, very attractive growth throughout Latin America, which is somewhat reflected by what we see in Asia as well as through even Eastern Europe and the Middle East. So I think the U.S. economy is the best developed of the businesses that we're in and we're seeing kind of large enterprise spending begin to return.

We're seeing a lot of more fundamental spending beginning to occur throughout the planet as in some sense the global build out of the network continues to occur. So I think we're going to continue to look outside of North America for the most rapid growth, but I think the thing that's been gratifying for us is just seeing the solid double-digit organic growth inside the U.S. But I'm not sure there's much to read into it beyond that.

Bret Schaefer

Next question, please.

Operator

We'll take our next question from Toni Sacconaghi - Sanford Bernstein.

Tony Sacconaghi - Sanford Bernstein

Yes, thank you. If we take your guidance of high single-digit growth sequentially, it implies a year-over-year growth rate, which is the first true organic growth rate for four quarters of 3% to 4%. Currency should help by a point or two. So effectively you're suggesting that year-over-year growth at the high end of your guidance range would be 1% to 3% organic at constant currency next quarter.

Can you comment on whether that is the go-forward assumption in terms of how investors should think about growth for Sun on an organic constant currency basis? Can you talk about, in terms of groupings within Sun, what parts of the business you expect to grow faster than that and which parts slower?

Michael Lehman

I think there were more than one question there but I will try. And we do have a follow-up scheduled with you later and we can probably get to the second and third question.

Organic constant currency must be an IBM term because that's not one that we use or we're familiar with. Having said all that, I will just reiterate that we are planning the business in what we believe is a very prudent way and we are going to go after the market geographically, product-wise, systems-wise, et cetera, and do as best as we can. I wouldn't take any particular comment that we make about revenue growth and how we're planning the business model as at all indicative of the market opportunity, or our competitive position.

Bret Schaefer

Next question, please.

Operator

(Operator Instructions) We'll take our next question from Harry Blount - Lehman Brothers.

Harry Blount - Lehman Brothers

Hi, guys. Jonathan, this is a question for you. A while back you indicated that you were trying to move the entire business model over to more of a recurring revenue stream and also measuring it historically along traditional telco-like metrics. Can you maybe give us a little bit of an update on where you're at in terms of being able to move the business model? It's not entirely apparent so far based on the metrics how much progress you've made on that front.

Jonathan Schwartz

So we have definitely made more progress in the software and services business than we have in the traditional infrastructure businesses, both systems and storage. But all that said, we've begun to make some progress, especially on the new low-end systems, as we integrate service offerings into the products as they're sold into the marketplace.

I think one of the challenges we certainly face. It's a lot easier to walk into a new customer with a new pricing regimen than it is necessarily to sell into one that has established procurements guidelines and purchasing habits. So we're still committed to move down that path. We still believe that that's going to give us the best flexibility as well as margin profile as we introduce products and services to the marketplace. But it's not going to be the only way we do so.

I probably would be happier if we were more rapidly going down that path, but again, that's not just a matter of our putting the products and offers together. It's a matter of customers wanting to buy that way.

Harry Blount - Lehman Brothers

But if I look at the metrics, would you point us to any of the particular metrics that you disclose as a good way of measuring that progress?

Jonathan Schwartz

I guess continuing to look at deferred revenue and as the service business grows, it's not going to be necessarily representative of simply a break/fix business or a professional services business. You're beginning to see some amount of the Niagara revenue lines show up in the services offering. You're going to continue to see a lot of other offers that we put together, cause some of our systems revenues to appear as services revenue, clearly a big portion of the software business is already moving in that direction.

So I guess at a top level just the proportion of services as a portion of the overall revenue mix is probably the best-leading indicator.

Bret Schaefer

The next question, please.

Operator

We'll take our next question from David Wong - A.G. Edwards.

David Wong - A.G. Edwards

Thank you very much. Could you give us some idea of the trends in R&D spending? If I understand correctly, the R&D drops are more than your SG&A drops? Would we expect R&D to stabilize around here and grow slowly in absolute terms as a percent of revenues or does it keep going down with your cost-cutting from here?

Jonathan Schwartz

So I think obviously as revenue rises R&D as a percentage of revenue is probably going to fall a little bit. I don't think we are planning on any major increases in R&D, but partially what you're seeing with the R&D coming down is that we're focusing more and more of the investment in Sun around the core platforms we already own.

One way of thinking about that is we're building everything at Sun out of Solaris. As an example, Thumper, which is the 24 terabyte storage offering we announced to the marketplace is actually built out of the Galaxy platform that our systems team builds as well as the Solaris operating system that the software team builds. That allows us to get to very high levels of gross margin with very nominal incremental R&D costs. The result of that is higher operating margins as well as ideally higher gross margin as well.

David Wong - A.G. Edwards

But do we see R&D in absolute dollars continue to drop from here then, or does it stabilize?

Jonathan Schwartz

I don't think so. It should stabilize at this level.

David Wong - A.G. Edwards

Great. Thank you.

Bret Schaefer

Next question, please.

Operator

We'll take our next question from Tony Sacconaghi - Sanford Bernstein.

Tony Sacconaghi - Sanford Bernstein

Can you just comment on the size of your software business? Jonathan, you alluded to its strong growth rate several times. Can you dimension it in anyway?

Jonathan Schwartz

Yes. Tony, we're actually into a discussion you and I had a while back. We're moving down the path and I wish we had made more progress for this call. But we're moving down a path of breaking out the software business as a stand-alone business. Now, part of the complexity in doing that is that a very significant portion of our services business, for example, really represents service on Solaris even though it was sold as a part of a overall systems deal.

So as we break apart the business and to allow you to compare it, for example, to any other independent software company, we want to be able to present both the license revenue as well as the relevant service revenue as well as the kind of grey area in between whereas we sell software as services, it shows up as a service business.

So we're hoping to make more progress in the next 30 to 60 days down that path. But for now I think we're just going to leave it as we've seen healthy growth. It's obviously a material business to Sun. We think it represents significant potential to us.

Bret Schaefer

Next question, please.

Operator

(Operator Instructions) We'll take our next question from Jesse Tortora - Prudential.

Jesse Tortora - Prudential

Hi, guys. Any thoughts on how your existing products are stacking up against your competitors' new server offerings that were introduced over the last quarter or so?

Jonathan Schwartz

Yes, you bet. We have plenty of insight on that. So if you look at, for example, Niagara, it is a 32-way system that consumes about 70 watts. So that's anywhere from 3X to 5 X more power efficient than anything else produced in the marketplace. As we look at our Blade platform, I think if you look at some of our competitors, they are now growing in the 1% to 2% range. We are seeing fabulous growth numbers there, admittedly off a smaller base, but that overall x64 business is now 50% unit based, 70% plus revenue base so we're making a lot of very strong progress.

I would highlight the single most attractive aspect of our systems business right now is the fact that you can run one operating system across both. And that operating system even runs on our competitors systems platforms. I would argue we have the most competitive product line that we've had in the history of the Company at a point where many of our competitors right now are trying to figure out what to do around their OS strategy because they've elected three or four years ago to disinvest in their operating systems and now, for example, at least in most of their cases they can no longer run their core UNIX on their new x64 systems, which we obviously can do quite well.

So I'm very optimistic about the growth opportunity, but, more than the competition, I just think we've continued to see customers express an interest in getting more competition into their supplier base and getting more innovation around things that most folks weren't focused on, like power consumption or space consumption. So we're pretty optimistic.

Bret Schaefer

Next question, please.

Operator

We'll take our next question from Chris Whitmore with Deutsche Bank.

Chris Whitmore - Deutsche Bank

Good afternoon. Just a follow-up on the last question. What are your views on Intel's x86 road map and how it compares to Opteron and would Sun ever consider using Intel? Thanks.

Jonathan Schwartz

Well, we're a huge supporter of Intel already. The majority of the Solaris downloads that have been delivered into the marketplace run on Intel and we run extremely well on Intel. We've continued to want to deliver to customers the performance that they've sought and to date just given some of the share gains obviously we've made, along with AMD, a lot of those new purchases have gone to AMD.

All that said, we think Intel's doing a great job and we're looking forward to continuing to explore the relationship with Intel. We think there's a lot of potential out there and certainly again on the operating system side, we have seen a lot of customers, we support a lot of customers running on Intel. How we may include Intel in our future product lines is really up to the future. So stay tuned on that.

Bret Schaefer

Next question, please.

Operator

We'll take our next question from Richard Gardner - Citigroup.

Richard Gardner - Citigroup

Just a very quick follow-up. In past quarters you've provided a total server unit shipment number. I was wondering if you'd be willing to provide that number this quarter?

Jonathan Schwartz

Yes. And I don't know why we didn't, so if we don't have it for you right here we'll get it to you later.

Michael Lehman

We're checking our slides. If we don't have it on there we'll publish another slide.

Jonathan Schwartz

Slide number 33. And the number for Q2 is 107,000.

Bret Schaefer

Or Q1 you mean.

Jonathan Schwartz

Sorry. Q1 for -- it's calendar quarter.

Richard Gardner - Citigroup

Yes. I thought that was a historical number on 33?

Jonathan Schwartz

It may be. We'll get the numbers out to you.

Richard Gardner - Citigroup

Okay. Thank you.

Jonathan Schwartz

Across the board one of the more gratifying things about being so strong on the low end now, especially with Niagara, is that our unit counts are really growing aggressively. As you know, one of the big issues in the systems business is you don't want to find yourself isolated on the high end. So we've seen not only good unit growth on the x64 business but also very good unit growth on the SPARC side of the house as well.

Bret Schaefer

Next question, please.

Operator

We'll take our next question from Ben Reitzes - UBS.

Ben Reitzes - UBS

Yes, thanks. Jonathan, anything you want to update on your partnership with Google or your philosophy on partnering and how maybe to further the business even beyond them?

Jonathan Schwartz

Obviously we can't talk about any relationship with Google. But I will tell you and if you just look at the slide, which I think is slide 8, we are very interested in doing what we can to partner with companies out in the marketplace. Look, at 13 billion, folks who are partners of ours are also competitors of ours. So we can't be religious about who we elect to work with. I think that religion has not necessarily served technology companies very well.

So we're embracing with open arms those that are willing to entertain a relationship and we think there's more customers to be had as a result of that openness than by kind of claiming we're pro this or anti that.

So I think there's lots of opportunity in the marketplace. And at a top level, I can tell you the interest level in having a dialogue with Sun is very, very high. There's just lots of folks who want to talk to us on the basis of everything from Project Blackbox to the next generation of our operating system.

Ben Reitzes - UBS

Thank you.

Bret Schaefer

Next question, please.

Operator

We'll take our next question from Keith Bachman - Banc of America.

Keith Bachman - Banc of America

Hi, guys. Mike, I was hoping you could just clarify a comment you made on taking out 2,000 in headcount. I think you said taking out 1,000 or 2,000 more just additional thoughts on how we should be thinking about your perspective on cost reductions looking out into the balance of '07?

Michael Lehman

Yes. I tried to be pretty clear about that. Gave you a sense of what happens in the near term and gave you a sense that we still have more reductions in head count ahead of us in the second quarter and beyond. So we're going to continue to march down that path. There's been absolutely no change in terms of the magnitude of the cost reduction that we're going after inside this fiscal year and beyond and we're at it every single day.

So I was just giving you some data points as where we are along the way. But the important message is we're absolutely on track with everything we've said we're going to go do.

Bret Schaefer

Next question, please.

Operator

We'll take our next question from Laura Conigliaro - Goldman Sachs.

Laura Conigliaro - Goldman Sachs

Yes, briefly. Can you just give us an idea of how many of those 6 million Solaris downloads you're monetizing and what the trend is on the monetization of that?

Jonathan Schwartz

You bet. I would claim we're monetizing every single one of them because they all lead to relationships, which, may be monetized by a Solaris subscription.

Laura Conigliaro - Goldman Sachs

I meant a little more directly, if possible.

Jonathan Schwartz

It's just not how the business is built. And I'd love to be able to give you a discrete number X percent convert to licenses but with so many start-ups we're working with and so many copies distributed through mirrors, we're more focused on building a healthy ecosystem and making sure that we can monetize it through everything else that we build.

So our Solaris revenue on a standalone basis is up year over year. Again, going forward we're going to try to break all these numbers out. We've continued to see training dollars aggressively grow, our service business is growing, the number of ISVs we've got today I think is broader than we've had in the history of the Company on the basis of the volume we've achieved out in the marketplace.

But I just can't give you an X million subscribers, as a percentage of total distributed. What we're trying to do is drive the distribution of that platform as broadly as we can because frankly, with some of the destabilization we're seeing right now in the Linux marketplace we're having a whole set of customers talk to us about moving back onto Solaris that we may have lost historically, partially because of how vibrant the Solaris community has become.

So again, we want to see those volumes go up but we also want to do a good job of monetizing it. It's not simply going to occur on the basis of an update or support relationship.

Bret Schaefer

Just to get back to the question on server units. Year-over-year growth on server units overall was 7% and we'll get that slide posted with the rest of the slides later today. Next question?

Operator

We'll take our next question from David Wong with AG Edwards.

David Wong - A.G. Edwards

Thank you. Could you update us on your roadmap for microprocessors developed internally? Secondly can you give us some feel for the development cycle time on x64 type systems if you decided to make a switch of microprocessors? How long does it take for you to actually produce systems based on a different type of x64 microprocessor?

Jonathan Schwartz

So just to look back into history. We originally started in the x64 business and the x86 business with Intel. We then moved on to AMD frankly, because of overwhelming customer feedback. Intel looks strong again right now and we're going to do the systems development that allows us to be somewhat agnostic as we move forward into the marketplace. So we're going to optimize for flexibility for Sun and choice for customers. I'm not sure I can give you any more specifics other than that.

And, look, we're constantly examining our options and choices in the marketplace. At the higher levels of scalability, AMD has some very obvious advantages. On the lower levels, things have become a lot more competitive certainly but we think that's good for Sun, certainly good for consumers.

Bret Schaefer

We will take one last question.

Operator

We'll now take our final question from Jesse Tortora - Prudential.

Jesse Tortora - Prudential

Thanks. Can you provide us with some commentary around the margin profile for your different product lines namely UltraSPARC, Niagara, and Galaxy?

Jonathan Schwartz

Sure. There's no one answer to that because if you sell a 64-way highly configured system with services you're going to have a much higher margin profile than if you sell a naked x64 box. So the low end tends to be lower margin than the high end. The more richly configured systems tend to be higher margin than the stripped out naked boxes. But if you know the dynamics of the marketplace, for the most part you don't want to build your business based on pedestal servers sold into flower shops. That's a tough place to build a margin business. You want to make sure though that you've got the volume base covered so you can pick up the developer and pick up new customers who want to trial a system. Customers who trial a system tend to want to start with a low-end system and not with a 64-way platform.

We've got both ends covered and as you've seen this past quarter and as you'll continue to see throughout this fiscal year, on the x64 side we've really begun to pound away at building much higher scale, much higher value, higher margin systems like the 4600 and the 4500 along with the 8000, the modular Blade platform. As we do that the margin mix and the margin potential for Sun really goes up quite a bit.

The good news is at this point we have a very interesting low-end customer base and frankly, we've invested in acquiring those customers and we now have the opportunity and the privilege to bring higher margin systems back into them, both on the x64 and the SPARC side.

And, again, at a top level, the good news is we have one operating system that runs across both and we're in control of our own destiny in ways that many of our competitors may not be.

Bret Schaefer

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.

Operator

This concludes today's conference call. We appreciate your participation. We are again providing an encore replay service this quarter. If you joined us late or wish to hear any part of this conference call again, you may call the replay service at any time after 3:30 p.m. Pacific time tonight to hear a recording of this conference call. The phone number for the replay is 800-642-1687 or 706-645-9291. You must enter the conference reservation ID 6597370 on your touch-tone telephone. Thanks again for taking the time to join the Sun Microsystems' call this afternoon. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Sun Microsystems F1Q07 (Qtr End 10/01/06) Earnings Call Transcript
This Transcript
All Transcripts