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Sun Microsystems Inc. (SUNW)

F2Q07 Earnings Call

January 23, 2007 4:30 pm ET

Executives

Bret Schaefer - VP of IR

Jonathan Schwartz - CEO

Michael Lehman - CFO and EVP of Corporate Resources

Analysts

Harry Blount - Lehman Brothers

Bill Shope - JP Morgan

Rebecca Runkle - Morgan Stanley

Ben Reitzes - UBS

Toni Sacconaghi - Sanford Bernstein

Laura Conigliaro - Goldman Sachs

Keith Bachman - Banc of America

Andrew Neff - Bear Stearns

Richard Gardner - Citigroup

Presentation

Operator

Good afternoon. My name is Michael and I will be your conference facilitator. At this time, I would like to welcome everyone to the Sun Microsystems' Fiscal Year 2007 Second Quarter Results Release Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's 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. Bret Schaefer, Vice President of Investor Relations of 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 second quarter, which ended in December 31, 2006.

During the last hour, we published a copy of the operations analysis data sheet with nine quarterly financial and 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 maybe 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. Now let's get to the financials.

Please note Q2 FY07 is the first quarter with full quarter comparisons including StorageTek and SeeBeyond. Sun's total revenues for the second quarter of fiscal year 2007 were $3.566 billion, an increase of 7% as compared with the $3.337 billion in revenue reported for the second quarter of fiscal 2006. Total gross margin was 45.2% of revenue, an increase of 2.6 points over the gross margin for the second quarter of fiscal 2006. Total R&D and SG&A expenses were $1.485 million, a decrease of $112 million year-over-year. In the second quarter of fiscal 2007, we reported a $23 million tax curator. GAAP net income for the second quarter of fiscal year 2007 was $126 million, or diluted earnings per share of $0.03, as compared with the net loss of $223 million, or $0.07 per share for the second quarter of fiscal year 2006.

Q2 products revenues totaled $2.260 billion, an increase of 7% year-over-year. Within products revenues, computer systems products revenue was $1.634 billion, an increase of 14% year-over-year. Data management or storage products revenue was $626 million, an increase of 7$ year-over-year, sorry a decrease of 7% year-over-year.

Q2 services revenue totaled $1.306 billion, up 6% year-over-year. With in services revenue, support services, support services revenue was $1.001 billion up 5% year-over-year. Revenue from Professional Services and Educational Services totaled $305 million, an increase of 11% year-over-year.

With respect to some of the balance sheet items, DSO was 59 days. We entered the quarter with a cash and marketable debt securities balance of $4.837 billion, and had generated positive cash flow from operations of a $153 million in Q2. With that, I'll turn it over to Jonathan.

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Jonathan Schwartz

Thank you, Bret, and hello to everyone. I'll start with the obvious and say I am very pleased with our Q2 results, which show great progress against our overall turn around plan, gives concrete evidence to the market appeal and acceptance of our products, and roadmaps, which all add up to growth in gross margin as well as profitability.

I mean I'll briefly go through each of our four assets as we call them internally, servers, software, storage and services and close with some color on the recent announcements of our partnership with Intel, and the strategic investment in turn by KKR.

In Q2, Computer Systems was clearly a highlight in what appears to be the fourth consecutive quarter of growth far faster than the market. Our SPARC server revenues grew more than 18% year-over-year and the Niagara T1000 and T2000 servers continue to perform well exceeding a $125 million in sales remembering a year ago we had only $16 million in sales, so that's a great ramp. These Chip Multi-Threading systems are allowing us to move beyond our traditional installed base as well as serve the needs of all corporate enterprises that need to save energy costs while boosting efficiency.

Now our UltraSPARC business continues to grow in size and value and we saw particular strengths on the high end of that business which grew 16% year-over-year. After the Niagara server line our Sun Fire x64 platform servers continue to have the highest growth rate of our server lines at more than 46% year-over-year. We expect the introduction of Intel Xeon-based systems running Solaris to broaden that portfolio and provide yet more growth and margin opportunity, again within and now beyond our installed customer base.

So, with the recent tape out of the industry's first [hexa-core], that's 16 core 256 thread Rock microprocessor, the next generation 64-way Niagara II servers looking good and on schedule and one of the industries fastest growing x64 portfolios, we are very optimistic and we're operating from a position of strength.

Now, in storage, we began shipping Thumper, the Sun Fire X4500 hybrid at the very end of Q2 and we are off to a good start. As I have suggested on prior calls, we are in the process of building out the next generation storage product line from Sun's server platforms along with Solaris in our ZFS virtualization technology. This strategy maximizes our return on engineering resources, improves our storage margins, and delivers to customers a common set of innovations with familiar interfaces.

In Q2, we had a number of key wins with Thumper in Web 2.0 companies, high performance computing installations along with the financial services sector. We will continue to aggressively cross-sell our current customer base, partner aggressively in areas not well served by this approach, and continue to develop the world's most efficient and cost-effective storage line up from tape to virtual tape to NAS and disk.

Now, our services business was another bright spot in the second quarter. Total services revenues were up 6% year-over-year with professional services and educational services up 11% year-over-year. We continue to see growth in the services business due to the increasing impact of our software business, and the desire by customer to leverage our expertise in mission critical infrastructure deployments. All of this was of course amplified by a strong systems and storage portfolio business with a national service facility.

In terms of our software portfolio, perhaps the biggest news of Q2 was not exclusively financial. It was the open sourcing of all the core Java technology, intellectual property under the General Public License also known as the GPL, the same license underlining the new Linux. Already, we have seen a big surge in both developer's sentiment and wide-scaled option of the new Java platforms. Many of you have probably seen and may in fact be using Google's newest Gmail as well as the Yahoo!'s new mobile applications. Both have elected to use Java as the foundation for their mobile applications.

We fully anticipate that trend to continue resulting in broader acceptance of Sun's technology on client devices alongside further deployment in the network. This also gives us broad exposure to literally billions of mobile consumers across the world. And that means Developer platform also continues to grow nicely and sales of our core Java middleware products in Java enterprise system offering are in line with our expectations. And again, we will be recognized overtime and not as one time licenses, but instead as recurring subscription fees.

Growth of the Solaris Ecosystem, which is available in free binary and open source distribution, continued its healthy trajectory in Q2, ending around 7 million licenses. Now while it didn't formally occur in Q2, I do want to take a moment to discuss yesterday's blockbuster announcement. Intel has agreed to embrace Solaris as a mainstream operating system the default UNIX was Xeon and has assigned an OEM agreement enabling Intel to distribute Solaris to its core customers.

There could be no stronger confirmation of the strength of Solaris in the marketplace. Solaris is now unequivocally established as a leader in network infrastructure and not just on computers built by Sun, and certainly not just on SPARC, but on systems that include microprocessors from AMD and Intel supplied by HP, Dell, and IBM.

This covers the vast, vast majority of the marketplace and position Sun exceptionally well to capitalize on that access. The introduction of new Intel Xeon systems running Solaris in our systems portfolio is also a recognition of the incredible progress our computer systems team has made across both our UltraSPARC and x64 Sun Fire platforms.

From a standing start a couple of years ago, we are now a serious contender in the x64 space gaining round on competitors, who must take notice, while we are growing margin and volume opportunities as well. Now, we also announced today, a private placement of $700 million in convertible notes with KKR. This is a strong endorsement of our strategy and our management team by one of the world's premier private equity firms. KKR has a great portfolio of companies, many relationships in the financial services sector, and fantastic strategic in M&A expertise, all of which we plan on leveraging. We contend or we intend to use the proceeds from this placement to pursue strategic opportunities for growth.

So, in Sun, we are executing well, the market is endorsing our strategy and platforms, and there is a lot of momentum around Sun. In the last two days, we have announced to landmark Intel partnership, we have announced that one of the world's premier investments KKR is betting on Sun and our leadership team, and we have announced improving financial results. Our journey to deliver highly differentiated technologies to drive accelerated growth and to deliver double-digit operating margins is well underway.

I want to finally congratulate the team at Sun across the globe. It's great to be profitable again, gaining new customers, and certainly taking share, focused, discipline and execution matter and you now have proved, so let's go we double those efforts.

With that said, and for more details and specifics, I would like to pass it over to my officemate, Mike Lehman, Chief Financial Officer

Michael Lehman

Thank you, Jonathan. As you can tell, we are more than satisfied with the overall report card for the quarter and the results did exceed our internal expectations. The primary reason for over achievement was due to higher revenues than we had anticipated mainly our systems' business as well as higher gross margins.

Total storage revenues were down slightly on a year-over-year basis, largely due to the fact that the former StorageTek business had a very strong December quarter last year. That was the final quarter in which their separate independent compensation plan was in place, before the sales force was integrated into Sun, and their annual incentives were quite strong.

In addition, as noted earlier, our hybrid server storage product, also known as Thumper began shipping this December and revenues for that new product were in the range of $20 million. We expect the storage business and this particular product to perform even better in the second half of this fiscal year.

Currency had more of an impact on our results this quarter than in the recent past. Frankly, we don't see much impact from currency movements in our products business as pricing actions are taken each quarter to reflect not only currency movements but changes in the competitive environment. The principal place where we experienced currency impact is in EMEA and parts of Asia Pacific where a portion of our service contracts are denominated in local currency, such as the Euro or the Pound or in Yen. When these currencies strengthen versus the dollar, and they did quite noticeably in the December quarter, we experienced slightly higher dollar revenues. We also experienced an increase in our gross margins; however, this impact is somewhat offset by increased expenses. It is not simple to quantify the impact on our income statement because we also hedge a portion of our projected net currency exposure. Having said that, we estimate that the positive impact of currency on our bottom line in Q2 '07 was in the range of $0.01 per share.

Turning to revenues by geography, you will note that revenues in the U.S. declined by approximately 4% on a year-over-year basis, while those in EMEA group by approximately 9%, and those in Asia Pacific by 20%. The lower growth in the U.S. is due to a couple of things. As noted above, the former StorageTek product line had a very strong December quarter a year ago, and most of the impact of that was evident in the U.S.

Also, as we have mentioned over the past six months, we continue to lower the level of inventories in some of our channel partners, as we improve our ability to ship with more predictable lead times. We lowered our U.S. channel inventories by approximately $20 million in Q2 and by approximately $40 million on a worldwide basis. We expect to further reduce such channel inventories in the next couple of quarters. Our goal is that we end the fiscal year with approximately one week or so of inventory in these channel partners. We ended Q2 with just under four weeks of inventory on a worldwide basis. You should also note that our ending backlog of $1.21 billion was basically flat year-over-year and up 3% sequentially.

Deferred revenues continue to exhibit the usual seasonal pattern. Such revenues grew 9% year-over-year and were down minimally sequentially. The yearly increase in deferred revenues reflects increases in both products and services revenues, which improves our predictability over the longer term.

Our gross margin exceeded our expectations, probably due to the currency benefit noted above, but mostly due to a combination of cost reductions, increased efficiencies, and operational execution. We also saw improvement in the mix of mid-range UltraSPARC systems and software in the quarter. The market is always competitive and we continue to see that across the product lines from the usual competitors. Having said that, we continue to win business based on the merits of our products and services, as we offer both innovation and choice to the market. Our improving financial results, including the market share gains that have been widely reported for the past few quarters have further opened doors of existing and new customers.

We were particularly pleased with the improvement in our products' gross margin, which is up 3.1% sequentially, which reflects the breadth and strength of our product line and operational discipline. We experienced growth sequentially and year-over-year in the low-end, the mid-range, and the high-end our systems business.

Operating expenses came in essentially in line with our expectations even with higher expenses related to increased revenues and the currency impact. We continue to work on our overall cost structure. To that end, we recorded restructuring charges associated with our previously announced plans of approximately $26 million. We ended the quarter with approximately 34,600 employees, which is approximately 1,600 lower than the end of the September quarter. We are on track to achieve all cost savings outlined in our May '06 restructuring plan and continue to examine all opportunities to lower our cost structure.

Turning to our income tax line, during Q2, our tax provision was favorably impacted by approximately $25 million, primarily due to a tax law change in Germany and final resolution of two state tax claims. As a result, the total tax charge in the quarter was $23 million. For the entire fiscal year, assuming no other unanticipated items occur. We now expect the annual provision to be in the range of 150 million to 200 million. During Q2, we generated approximately 153 million in cash from operations. Frankly, we had accepted to use cash during the quarter. The improvement is directly related to the higher revenues and slightly improved linearity, as well as outstanding collection efforts by our team.

Our cash conversion cycle, which is a comprehensive measure of operating inflows and outflows improved by 5 days to 26 days on a year-over-year basis. We now expect to generate cash in both Q3 and Q4, and are on track to exceed our annual targets in that area as well.

Overall despite the fact that not all parts of the business are operating at peak efficiency the quarter represented substantial progress towards our stated objective in Q4 of recording at least 4% operating income on a GAAP basis. With regard to the current quarter, here are some of the factors that we have anticipated. With regard to revenues, we expect a seasonal sequential decline in revenues in the range of about 3% to 5%. This is in line with our historical norms. We expect gross margin to be in the range of 42% to 44% for the quarter reflecting the sequential revenue decline. We expect total operating expenses to be in the range of 1.45 billion to 1.5 billion for the March quarter.

And finally, we expect the following to be reflected in our business model during the second half of the fiscal year. We expect amortization of intangibles of approximately $70 million per quarter. We expect approximately 60 million of stock-based compensation charges per quarter. We expect net interest income to be in the range of $40 million to $50 million per quarter. As noted above, we now expect the total tax provision for the fiscal year, to be in the range of $150 million to $200 million including the total first half provision of 57 million.

When we had [meet] all the above, we are looking at our March quarter that is seasonally challenging. In terms of the Intel relationship, we do not expected to have any noticeable impact on the current fiscal year. Our expectation is to deliver Intel based systems in volume early in fiscal year ‘08. I will reiterate, we are on track to deliver Q4 operating income of at least 4% on a GAAP basis, and are firmly committed to a longer term operating margin of at least 10%. We have a lot of opportunity in front of us and are focused on taking full advantage of the momentum we have generated.

With that I will turn it back to Bret.

Bret Schaefer

Thank you, Mike and Jonathan. Before we begin the question-and-answer session, I would 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. Michael, will you please start the question-and-answer session?

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Andrew Neff with Bear Stearns

Andrew Neff - Bear Stearns

Sure, thanks very much. I wonder if you could just take a second and sort take us to the thinking on a KKR transaction. You are in a cash flow positive situation, your operating results are coming in yeah then we are looking at, what's the thinking behind that? You don't, sorry you need the cash here, is there something -- is there another gender here. Can you give us a sense to that?

Jonathan Schwartz

Certainly, why don't I talk on the strategic side and I will let Mike talk to the financial aspects. Strategically, KKR certainly helps us raise awareness among community that we think it's pretty important which is the financial services community and frankly, they have got expertise and access to not only their portfolio companies but across a line of opportunities we see in the marketplace. So, we fully intend on leveraging our balance sheet to the extent that we can go after the marketplace and we don't have all of those skills in-house. And frankly, it's helpful having a partner who has got the wisdom and skills and potentially access to assets that we wouldn't otherwise have. So, we certainly don't need the money. It's an opportunistic transaction and frankly, we are thrilled to have KKR participate in the business. And to speak sense, that we can get a leg up out of it. We are certainly going to take advantage of it. Mike?

Michael Lehman

And I would echo all of that. The quick financial picture as you can tell by looking at it is that with a convertible debenture and exercising a call spread as we have outlined, essentially this will be a mildly accretive transaction for us just looking at the P&L if we simply hold the cash. So, obviously over the longer term, we intend to grow the company and Jonathan talked about, we will use it for strategic opportunities but on day one, essentially it will be a mildly positive financial transaction as well.

Bret Schaefer

Next question?

Operator

Your next question comes from Ben Reitzes with UBS.

Ben Reitzes - UBS

Yeah. Congratulations on the quarter. Could you talk about units versus mix, the unit growth of 1% in the quarter obviously is below the growth in computer systems, which was pretty solid. Obviously, you are having positive mix and a resulting impact on gross margins. Can you just talk about the dynamics there and perhaps whether that can continue going forward? Thanks a lot.

Jonathan Schwartz

So I don't think we can necessarily predict where the unit volumes are going to end up or frankly where the mix is going to end up. I will say despite some of the other comments we've seen in the market place, we've seen strength across the line. And as we continue to say volume precedes value, you probably not going to make a lot of money on free software, or one-way server, but it certainly going to give you access to selling a 4-way, 8-way, or 32-way. And so I think some of the strength, you've seen this past quarter is a reflection of our focus on volume in prior quarters, but we obviously don't want to be biased in one direction or the other. We want to capture the overall market.

Bret Schaefer

Next question, please?

Operator

Your next question comes from Harry Blount with Lehman Brothers.

Harry Blount - Lehman Brothers

Thanks. Just want to come back to the KKR question again. Still trying to understand the strategic opportunities that you are eluding to that, you might pursue here in, and Jonathan, I appreciate some of the relationships that they may bring you, but certainly Sun has had a pretty good experience already and reputation in a lot of very high profile customers. So I am not sure I understand that part of the commentary either. So if you could expand on the strategic side a little bit and then the rational some more?

Jonathan Schwartz

Though, again, it's an opportunistic and as Mike outlined, it's pretty no downside transaction for Sun. So we are very interested in leveraging the access and the opportunity and, by all means, I agree with you. I think we've got a great reputation among the financial services community, but it can always be better and frankly we can always have more customers. And we surveyed very small portion of the overall financial services marketplace, and again this transaction isn't just about going after a financial services companies. It's about looking at all the market opportunities and making sure we have all the right wisdom and expertise and potentially assets around the table. So, there is no way one definitive reason for the transaction other than it represented a good opportunity and we wanted to take advantage of it.

Bret Schaefer

Next question, please.

Operator

Your next question comes from Laura Conigliaro with Goldman Sachs.

Laura Conigliaro - Goldman Sachs

Yes, given the progress you've already made on the operating margin side. How is it that you actually going to be able to stick with your 4% target exiting fiscal '07, it really looks pretty logical that you could comfortably be well ahead of that, and even more, what would it take to actually get you to 10% which seems quite possible at this point, maybe exiting the calendar year? When is the more likely timeframe for an achievable 10% operating margins target?

Michael Lehman

I was just waiting to make sure that you're finished with your one part question, so, I will attempt to answer as much of that as I can, keep in mind we do have Analyst Day coming up in February when we will all be able to spend more time together. But keep in mind that we have said, over and over that we intend to deliver at least 4% operating margin in Q4 that is our goal, we've got 34,000 plus employees, focused on that. From our perspective, we've now delivered significant progress towards that, a couple quarters early that's good, having said that we still have a lot ahead of us. I mentioned that not everything is running at peak efficiency and we'll continue to work on that. So, we're not here today to give newer term guidance on changes and next year business model, we're focused on doing as much as we can in the next couple of quarters.

Bret Schaefer

Next question please.

Operator

Your next question comes from Keith Bachman with Banc of America.

Keith Bachman - Banc of America

Hi guys, Mike, I was hoping to go back to gross margins for a second, very nice performance there. Just want to review the put and take. I know you said FX contributed about a penny per share and just my quick math suggests that that's almost 100 basis points. But you are still above 44%. I just want to understand some of the puts and takes there and specifically against your guiding down in the March quarter, and in the past volume variances hasn't necessarily impacted the gross margin. So, I just wanted to get some more color on the gross margin since that was the least relative to our model of the real outstanding part of the quarter?

Michael Lehman

So, we will - I will try to be brief on that. Certainly currency had a benefit in the second quarter and we don't necessarily want to forecast a continued tail-wind from currency as we go forward. We do see a volume impact in the fiscal third quarter typically, certainly in the services business, as there are lower revenues over a traditionally more stable cost base, we see it a bit. On the systems side in that quarter as well, so typically we do see that. I also allude to the fact that we had a higher mix of mid range and high end servers in the second quarter and software, with a lot of things go our way in that quarter and we don't necessarily want to predict that everything will go our way every quarter. So, lots of opportunity out there, but in planning our business we think the range that I referred to is more realistic going forward.

Bret Schaefer

Next question please.

Operator

Your next question comes from Bill Shope with JP Morgan.

Bill Shope - JP Morgan

Okay, great. Thanks. On the Intel transaction, I understand that you are not going to see any benefits this fiscal year, but beyond this fiscal year, do you believe it allow you to generate any material procurement savings? And then also, can you give us an idea of how you are going to differentiate your marketing to customers for the Intel versus AMD platforms going forward?

Jonathan Schwartz

Sure. Again thank you for the one part question there. I think the, just to make this clear; we are augmenting our existing very rapidly growing, if you look at the numbers this quarter, our product line with Intel; we are operating from a position of strength both with respect to the adoption of Solaris as well as the appeal of the products we are delivering. The margins are going up because we are delivering value. Now, how are we going to differentiate the marketing between AMD and Intel? Frankly, that's what AMD and Intel have the luxury of doing, we are going to differentiate based on the systems value proposition we can build into it, because again, we can leverage an operating system as well as systems engineering in larger sales systems that some of the other vendors can't. So, for us, adding Intel to the product mix means we have the access to obviously all of the Intel OEM customers out there, both HP and Dell server customers, and although we had access to them before, this really changes the manner in which we can go forward and drive that business. And that just opens the doors to a whole complement of the different businesses we are in. So, this is just isn't about replacing microprocessors, or substituting, or getting a better purchasing efficiency; it's about getting access to markets they are interested in, investing in the product and innovations that we can build.

Bret Schaefer

Next question please?

Operator

Your next question comes from Toni Sacconaghi with Sanford Bernstein

Toni Sacconaghi - Sanford Bernstein

Yes, thank you. Can you comment on the performance in the US business? I understand the adjustments that you put forth to account for, but if you add $20 million and you put the storage business that's flat year-over-year and say 50% of it's from the U.S., you still have the U.S. business down year-over-year. You also had a much smaller backlog build than you typically have in the second quarter or so. Was there anything specific to the U.S. that beyond the two factors that you mentioned that didn't meet your expectations or might account for some of the regional disparity in performance?

Michael Lehman

The answer is, yes. And one of the other not quite peak efficiency that we experienced in the quarter was we did combine some of the legacy StorageTek front-end systems with those of Sun. We have been -- that's one of the smaller pieces of our longer term systems implementation plan. It didn't go wonderfully smoothly in the beginning. It took a while. And frankly, that affected the storage business as much as anything in the quarter. That's now behind us and we should be able to operate much more efficiently this quarter.

Bret Schaefer

Next question please?

Operator

(Operator Instructions). Your next question comes from Richard Gardner with Citigroup.

Richard Gardner - Citigroup

Hi, thank you. I wanted to go back to the earlier question on server mix. Second consecutive quarter where server ASPs and mix look like they are up pretty significantly year-over-year; second quarter, where you have talked about better than expected mix in the mid-range and the high-end, and I am just wondering if that's a conscious push by Sun, whether it's a shift in customer buying behavior? What exactly you think is fueling this significant increase in mix and whether you feel like it's sustainable?

Jonathan Schwartz

So, I guess a few points to make onto there. First and foremost, we have certainly seen accelerating growth in the systems' business. We are seeing our ability to get access in the marketplace really improving. That's with the addition of the AMD products into the product line, the adoption of Solaris across all of the different accounts. So, this task isn't just about selling into our installed base anymore, and obviously given the numbers we are posting here, we are gaining share and it's got to come in at somebody's expenses, not just that the overall market is going at that rate. It's certainly not.

Richard Gardner - Citigroup

Yeah. The reason I ask this, Jonathan, is that the unit growth has been pretty anemic for the past two quarters, but the revenue growth has been great.

Jonathan Schwartz

And I think we are not as -- I mean, look, we would love to see more unit volume growth that just presents opportunity going forward, but we are going to win the businesses that we can get access to. I think we are certainly more focused on getting more and better unit volumes in the low-end, but we are also pretty happy with the performance and the value we have been able to deliver on the top-end. So, I would like to see stronger unit volume growth. I would like to see that low-end business continue to drive out. It's not that we necessarily expect that kind of positive impact on margins. But again, as we showed this quarter, it does have a positive impact on opportunity and it's up to us to execute against that.

Bret Schaefer

Next question please?

Operator

Your next question comes from Rebecca Runkle with Morgan Stanley.

Rebecca Runkle - Morgan Stanley

Good afternoon. Thanks. Just curious if you could extrapolate or explain a little bit more as it relates to the cash proceeds from KKR. I mean, you are clearly emphasizing acquisitions, I am curious whether or not that same comment translates over to your overall cash balance and/or we could start to see some buybacks given the improvement in the operational performance that we have seen over the last few quarters?

Michael Lehman

So, as Jonathan mentioned and as I echoed, we clearly are more interested in growing the company, we will address the whole notion of return to shareholders from the standpoint of buybacks or other things as we get to the -- toward the end of this fiscal year. We are not ready to go and do anything different at this point, so no near-term change in our current philosophy. We will continue to evaluate our growth opportunities more than stock buyback.

Bret Schaefer

Next question, please?

Operator

Your next question comes from Ben Reitzes with UBS.

Ben Reitzes - UBS

Yes, thanks. Thanks for getting me in again. Software, Jonathan, how did that do in the quarter? Last quarter, I think you said 17%. And then, could you just talk about the momentum for Solaris you might be seeing against unit -- it's Linux - excuse me -- and how that's trending in your business?

Jonathan Schwartz

So on a revenue basis I think we were up 2% year-over-year and again that's somewhat disguised by the deferred revenue that we get in as a result of our collecting the business in the form of a subscription rather than in the form a license. And again you can see some of the deferred revenue growth in those numbers. In terms of Solaris versus Linux, its not versus Linux, its really versus any other mainstream operating system out there and Linux represents a collection of operating systems in which Red Hat is I think clearly the leader. But it's also compared to HP-UX and AIX and a variety of others. And so, the fact that we are at 7 million licenses distributed in the past 24 months or so, I think that's probably more licenses than HP and IBM have distributed in the history of their companies combined. So, we're definitely seeing an upsurge, we are seeing it grow and I think in part that's what allowed Paul to endorse and embrace Solaris to the extent that he did yesterday during the Intel announcement and really opens the doors not only to our computing business but our software business and our storage business. So, I am very happy with our adoption of Solaris, I think we have to continue to work on ensuring, we connect that into financial opportunity for Sun it's all well and good to be popular but we would like to be successful as well and that's certainly an area of focus. So, in general, I think the numbers on the job enterprise system sign they are in line with expectations. We would always like to see that line grow a little bit more aggressively. We certainly think there is opportunity out there for us and both the adoption of Java, Net Beans and Solaris are good leading indicators that are a opportunity we got to get after making sure we close them.

Bret Schaefer

Next question please.

Operator

(Operator Instructions) Your next question comes from Toni Sacconaghi with Sanford Bernstein.

Toni Sacconaghi - Sanford Bernstein

Yes, thank you again. Could you just update us on where you are in terms of the work force reductions, I think you had mentioned at the end of last quarter your progress in terms of positions eliminated, could you just give us a sense on -- on positions eliminated, if appropriate in fiscal Q2, and where you are versus your original target of about 4000?

Jonathan Schwartz

Yes, I apologies, if I wasn't clear, I said our headcount was down by about 1,600 from Q1 to Q2, that's basically in line with what we had expected and we expect to continue towards the overall number that we talked about. Again, we are not focused too much on a particular headcount number, as we are in terms of cost reductions and taking cost and process redundancy out of our system. So, we certainly are on track as I mentioned with all of our cost reduction efforts and did reduce headcount by about 1,600 in the second quarter.

Michael Lehman

And I think just to amplify that any successfully have on the top line and on the margin line is not going to suggest or encourage that we get distracted from taking the cost out. So, we are very committed to making sure we get the cost out as well we grow the operating leverage of the company. And again, I think, Q2 showed a good progress but obviously we still have more to do.

Bret Schaefer

Next question please.

Operator

Your next question comes from Laura Conigliaro with Goldman Sachs

Laura Conigliaro - Goldman Sachs

Yes, thank you again. For most companies moving some volume from AMD to Intel, while having real strategic value would probably represent something of a margin hit. What kind of impact should we expect in your case and why would it be different in your case. And then maybe you can give us some updates, as you have done in the past on what's going on in the world of component cost?

Jonathan Schwartz

So maybe I will talk to the Intel, AMD opportunity first. Let met be very clear here. We are not moving opportunities from one vendor to the next; we are expanding our product line and going after the total market rather than only the market made acceptable by one microprocessor supplier. So, this is all about adding strength to a growing business, it's not about displacing one supplier with another. And so may be on the component cost, I will turn it over to Mike.

Michael Lehman

Again, component cost reductions are going to happen, vendor competition is part of it, we will now see that in the microprocessor space as well as in the other component cost that we look at across the board including memory and others.

Jonathan Schwartz

And I may be just to make one other quick point on the Intel announcement, Paul and I were both amusing yesterday that the headline seemed to focus on a chip sale or vendor supplier customer relationships and both of us had kind of expected quite the opposite which is that folks would understand this was the comprehensive relationship around the endorsement and an OEM agreement to promote Solaris into the Intel installed base, and certainly to collaborate on systems design and that as much as possible to go work together on identifying innovations that the two companies could almost uniquely build together, because we have pretty broad expertise shared between the two of us. So, this was certainly around one of the media coverage that said we are going to put some Intel chips in our systems, and we are certainly going to be doing that and we are happy about it. But we also believe that the strategic nature of the deal just opens a lot of doors and frankly for both of us, and we think there is just a - that's where the opportunity is for both us.

Michael Lehman

One other quick note in follow up to Toni's, question for those listening. We are down in headcount about 3,700 from Q3 a year ago and about 3,400 plus some Q4 a year ago and we obviously started looking at our cost structure in the fourth quarter. So, even compared to the 4,000 number we are pretty well along towards that, and as I said, it's a cost structure that's most important to us.

Bret Schaefer

Next question please.

Operator

Your next question comes from Keith Bachman with Banc of America.

Keith Bachman - Banc of America

Hi, guys. Thanks for fitting me again. On the data storage side, Mike you commented on your seasonal patterns. Could you comment on the seasonal patterns associated with data storage since the StorageTek has different patterns plus Thumper seems to be ramping? Could you give any color there on what you are anticipating for March?

Michael Lehman

I don't necessarily want to give a Thumper or a product line description. The only thing I would say is that hopefully, we won't have as much a seasonal impact in storage, as we certainly saw last year in the March quarter following on the StorageTek large December quarter.

Bret Schaefer

Next question please.

Operator

Your next question comes from Andrew Neff with Bear Stearns

Andrew Neff - Bear Stearns

Sure. I just want to clarify something, just on the math. If your book-to-bill is greater than one, how is it that your backlog went down in the quarter? Can you just go through the math on that?

Michael Lehman

Well the backlog is slightly up, Andy.

Andrew Neff - Bear Stearns

Sequentially?

Michael Lehman

Yes. Sequentially, it's up just a few percent, Andy.

Andrew Neff - Bear Stearns

Okay. Sorry, then my mistake.

Bret Schaefer

Next question.

Operator

Your next question comes from Richard Gardner with Citigroup.

Richard Gardner - Citigroup

Hi. Thanks again. I was wondering if you could give us some color on how Niagara is fairing versus your expectations. You had a very quick ramp right out of the gate from 0 million to $100 million, but you have been stuck at $100 million to $126 or so million for the last three quarters in a row. Can you talk about how customer uptake has been for that platform versus expectations and may be give any sense of what conversion rates are from eval-units into broad-based deployments?

Michael Lehman

The conversion rate from eval-units to deployment is very high. And I don't have the numbers in front of me, but its the majority convert from being an evaluated unit into deployment, the question is how quickly are those deployments going to absorb workloads coming on to the network? And -- so, on the one hand, getting from 0 to $125 million, we are pretty happy with the progress we are making. We are meeting as many new customers as we are serving existing ones, which again is a good measure of progress for us, and we expect that business to continue growing going forward. We haven't seen any frustration of opportunity. But the good news as well is that given that we have Niagara II systems currently built and running and we can profile their performance. We are seeing really outstanding metrics on that. And then, the fact that we've taped out a hexa-core platform really put this in a category that no one else can really touch. So, we are definitely seeing a lot of interest in and around that platform. And again, whether it's on the low-end or the high-end, for us it's somewhat secondary to they are being interest in Sun and our being able to meet the opportunities.

Jonathan Schwartz

Let me just get back to Andy's question on the backlog. If you look at the charts on page 12, our package, it does show that the product and service backlog did decline slightly on a quarter-over-quarter basis, that's because of the deferred revenue impact from -- on the service side, which is included in there. It should also be noted that the book-to-bill ratio that we are calculating in there is assuming a 1-1 ratio on services. So, that's why you get some of that disparity in those ratios that we are filling on that page.

Bret Schaefer

Next question, please?

Operator

(Operator Instructions). There are no further questions at this time. Gentleman, are there any closing remarks?

Jonathan Schwartz

Thank you for joining us today. Investor Relation's personnel will be back in our offices shortly to respond any further questions. You may contact us through our 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 the conference call again, you may call the replay service anytime after a 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 and you must enter the conference reservation ID number 4619428 on your touch-tone telephone. Thanks again for taking the time to join the Sun Microsystems call this afternoon. You may now disconnect.

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