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Sun Microsystems Inc. (SUNW)

F4Q07 Earnings Call

July 30, 2007 4:30 pm ET

Executives

Bret Schaefer - VP of IR

Jonathan Schwartz - CEO

Michael Lehman - CFO and EVP of Corporate Resources

Analysts

Laura Conigliaro - Goldman Sachs

Ben Reitzes - UBS

Andrew Neff - Bear Stearns

Richard Farmer - Merrill Lynch

Katy Huberty - Morgan Stanley

Harry Blount - Lehman Brothers

Louis Miscioscia - Cowen

Bill Shope – JP Morgan

Toni Sacconaghi - Sanford Bernstein

David Wong - A. G. Edwards

Brent Bracelin - Pacific Crest Securities

Richard Gardner - Citigroup

Keith Bachman - Bank of Montreal

Presentation

Operator

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

Bret Schaefer

Thank you for joining the Sun Microsystems 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 CFO and EVP of Corporate Resources.

The purpose of today's call is to discuss the results of Sun's fiscal year 2007 fourth quarter which ended on June 30, 2007. During the last hour, we published a copy of the operations analysis data sheet with nine quarters of financial and operations information, including the quarter just completed. If you have not received the announcement or the detailed financial data sheet for any reason, or you wish to hear the replay of this conference call, you may log on to our website at sun.com/investors. We have posted slides you can view on the web which accompany our prepared remarks. These slides may be used at the same URL, sun.com/investors. After the prepared remarks of our call today we will devote the remaining time to Q&A.

During the course of this conference call, we'll be making projections and other forward-looking statements regarding expected future financial results and business opportunities. Our actual future results may be very different from our current expectations. We encourage you to read the 10-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 except as required by law.

In addition, during the course of the conference call, we may 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 operations analysis posted on our website at sun.com/investors for the most directly comparable GAAP financial measures and related reconciliations.

Now, let's get to the financials. Sun's total revenues for the fourth quarter of fiscal year 2007 were $3.835 billion, an increase of 0.2% as compared with $3.828 billion in revenue reported for the fourth quarter of fiscal year 2006. Total gross margin was 47.2% of revenue, an increase of 4.4 points over the gross margin for the fourth quarter of fiscal 2006. Total R&D and SG&A expenses were $1.472 billion, a decrease of $206 million year over year.

In the fourth quarter of fiscal 2007 we recorded a $56 million tax provision. GAAP net income for the fourth quarter of fiscal year 2007 was $329 million, or diluted earnings per share of $0.09, as compared with a net loss of $301 million dollars or a net loss of $0.09 per share for the fourth quarter of fiscal year 2006.

Q4 products revenues totaled $2.492 billion, a decrease of 1.3% year over year. Within products revenues, computer systems product revenue was $1.853 billion, an increase of 2.3% year over year. Data management or storage products revenue was $639 million, a decrease of 10.4% year over year.

Q4 services revenue totaled $1.343 billion, up 3% year over year. Within services revenue, support services revenue was $1.024 billion, up 3.9% year over year. Revenue from professional services and educational services totaled $319 million, an increase of 0.3% year over year.

We ended the quarter with a cash and marketable debt securities balance of $5.942 billion and generated positive cash flow from operations of $564 million in Q4.

In Q4 we announced a $3 billion share repurchase program. During Q4 we repurchased 38.8 million shares, which equates to approximately $200 million. Shares were repurchased at an average price of $5.15. You will note that our outstanding shares for the quarter decreased by 20 million as the share repurchase was partially offset by the issuance of shares under our employee equity plans.

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

Jonathan Schwartz

Great, thanks, Bret and hello, everyone. This is a great day for Sun and I want to congratulate the entire team and partner community on a milestone quarter. I'm pride to say that we exceeded our profitability targets, delivered industry-leading innovation in all our core businesses, and yet again, grew new opportunities in the future. For FY '07 overall, we're pleased to report revenue growth of 6.2% and SG&A and R&D expense reduction of 3.7%, and an increase in gross margin of over 2 full percentage points to 45.2%. This progress is a direct result of the continued hard work and effort put in by all employees and partners, and on behalf of the entire management team at Sun, I want to let you know that your efforts are in fact paying off. So thank you.

Now onto Q4. We put a stake in the ground just over a year ago when we announced our growth plan, emphasizing our commitment to deliver at least 4% operating margin in Q4. I'm very pleased to report that we exceeded the target with an 8.5% operating margin on a GAAP basis. We met and we exceeded our plan across a diversity of metrics, namely the steady execution and financial discipline around operating expenses, and the increasing value of our innovation to our customers, as gauged by gross margin performance and revenue growth across key products and services.

I'd like to take a moment to walk through each of these. On the operating expense front, in Q4 we effectively decreased our SG&A and R&D spending by 12% from a year ago, while retaining employee bonuses and performance-based compensation. We're by no means done here, and rest assured we view our progress in FY '07 as the first of many steps to streamline Sun. It's important to note that we achieved these reductions while increasing our focus and commitment to the R&D pipelines and road maps at the core of our business. Coming into FY '08, we have the strongest product road map in the history of the company, driven by new virtualization features in Solaris 10, now with nearly 9 million licenses distributed to date, to our upcoming Niagara 2 processors and a full line of commodity systems based on SPARC Connect 64 platforms; and an even stronger foundation of core innovations in software, in silicon design, networking and storage, all delivered from a streamlined and more efficient Sun.

Now to gross margin, an important gauge of customer confidence. With gross margins hitting a six-year high in Q4 of 47.2%, we are clearly seeing a growing payoff from Sun's R&D investments, evident both in the 225% year-over-year billings growth in our energy-efficient T1000 and T2000 systems; and 39% year-over-year growth in our Sun Fire x64 systems. Our commodity servers as a category grew billings 14% year-over-year in FY07, and our margin profile continued to grow as we shipped more highly configured systems.

In Q4, you began to see the real impact of Sun's virtualization investments with support for Solaris 10 containers and as of this month, support for bundled virtualization giving customers the ability to buy fewer, but more richly configured systems and storage on both SPARC and x64 platforms. I'd like to emphasize all this is achieved without the license fees required by other operating systems.

We clearly see Solaris and its core virtualization properties as opening a world of new opportunity beyond computing. With the Sun Fire X4500, which I've spoken of as Thumper, you've seen it set the foundation for a new line of data warehousing appliances based on general purpose computing and open source operating systems. We shipped nearly 20 petabytes of Sun Fire X4500 -- again, Thumper -- in Q4 and are now on an annual billings run rate of $100 million.

With Sun's Gigabit Ethernet technology, also known as Project Neptune; and Magnum, the 3456 port InfiniBand switch that we recently introduced at the core of our new high performance Sun Constellation System, you can see the leverage of our talent pool and technology, enabling entry into adjacent markets. We'll amplify this in the coming year with a focus on the open Solaris Project Crossbow, a technology to virtualize network traffic that's entirely unique to the open Solaris and Solaris communities.

These platforms in combination position Sun to grow more value and opportunity, leveraging a common base of R&D and a rapidly expanding marketplace, with Solaris at the core of our computing storage and networking products and our open source software offerings continuing to lower the cost of joining the network. All of this said, our commitment to innovation in R&D is unwavering and our commitments are clearly paying off.

As for our revenue results for the full fiscal year 2007, you'll note on slide 6 we saw a significant growth from new products, with outstanding growth in systems based on our UltraSPARC Chip Multithreading, with billings of approximately $550 million in FY07 and nearly $200 million dollars alone in Q4. Additionally, in FY07 our Netra telco servers grew billings 38%. Our embedded Java business grew 60%, and our Identity software business grew 36%. Our Services group continues to execute with almost 9% growth in FY07, punctuating the contribution of Solaris to higher value-added professional services in conjunction with our systems offerings.

This is definite progress and a sign that innovation is selling; however, our top line results weren't as strong as we'd like them to be. Overall, the results namely reflected weakness in the U.S. in storage and in certain legacy systems. Going into the new fiscal year, we'll be focused on accelerating new product adoption in the market to deliver growth across a broader spectrum of offerings. We're focused on improving sales performance in the U.S. as new opportunities emerge on everything from handsets to high performance computing installations.

In storage, we're committed to moving through a difficult transition as we move to Solaris-based systems and remain focused on the compelling storage road map we have, including the Sun Fire X4500.

As I said earlier, today is a good day, a great day in the life of Sun. It's an important milestone to deliver on our commitments for FY07 and to make significant progress toward achieving our goal of at least 10% operating profit for all of FY09. We have our work cut out for us and we look forward to a new year focused on growing share, attracting new customers, forging new partnerships and gaining even more leverage in our operating model; this all in an effort to strengthen our position in network computing and to attract opportunity with our innovation at the core of the network.

With that said, I'd like to pass it over to my officemate, Mr. Lehman, for more details and specifics.

Michael Lehman

Thanks, Jonathan. We are clearly pleased with the leverage that exists in our overall business model and with the progress we made during FY07. On an annual basis, we improved GAAP operating income by nearly $1.2 billion over the prior year, improved our gross margin by just over 2%, and generated more than $950 million in cash flow from operations. It was a solid year in terms of execution. We improved the underlying business model and we have set the stage for further improvements in FY08. While we have a lot more work to do we have made measurable, and we believe, sustainable progress.

There are a few things relative to the quarter's performance that I want to be sure you understand. Currency has been a hot topic for some of our listeners and been profiled in competitors' announcements. While imprecise at best, we estimate that net revenues were favorably impacted by around 2% based on exchange rate movements. This was partially offset by a higher level of operating expenses. We estimate that the overall net impact of exchange rate movements on the bottom line in Q4 was less than $0.01 per share.

Our linearity was well within normal ranges throughout the quarter. We did not experience the kind of fall-off in demand at the end of June that we experienced in March. Having said that, as you look at our revenues by geography, you will note that the U.S. revenues were down just under 2% on a year-over-year basis in Q4. For the most part, that continues the trend we saw in the March quarter. A number of vertical markets in the U.S. are doing well, most notably financial services, government and telco.

Overall revenue growth in EMEA at just under 2% reflects growth in central and northern European countries, Liberia and the southern and eastern European countries, somewhat offset by continued softness in the U.K. and Italy. The year-over-year growth in Asia Pacific revenues at just under 2% reflects very strong growth in Australia, Asia South, Korea and India, offset by a continued decline in Japan.

One area that we did not make further progress on was our channel inventory in the U.S. Outside the U.S., channel inventories decreased as expected. In the U.S., one of our major partners ordered an increased level of products as a specific investment aimed at growing their revenues. At the end of June, our worldwide net channel inventory was slightly more than $250 million, which reflected a $10 million sequential increase rather than a modest decrease as we had anticipated going into Q4. During the next few quarters, we intend to continue to work with our partners to decrease the overall levels of inventories. We intend to change our channel business practices to a sellout model later in FY08.

Gross margins were clearly the highlight of our income statement in Q4. The gross margin did come in above our estimates. Product gross margins were up 3.1 points sequentially. Frankly, lower component costs were the largest element of the increase. We also had an improved mix of software, as well as a beneficial mix of commodity CMT and more richly configured x64 systems, while continuing to manage our pricing actions relative to the competitive landscape. Service gross margin increased more than 2 percentage points sequentially, principally due to the benefit of higher revenues and a fairly stable cost structure.

Turning to operating expenses, our total R&D and SG&A expenses were basically flat sequentially. However, there are a couple things beneath that which you should understand. As many of you know, we closed on the sale and leaseback of an east coast facility in late June. We recognized a one-time game gain on that transaction of approximately $39 million in Q4. That amount is reflected as a reduction of SG&A expense in Q4.

We did incur higher incentive compensation expense during Q4 related to the sequential revenue increase and due to achievement of our quarterly operating income targets. Those increased expenses somewhat offset the gain from disposition of the facility.

The income tax provision for the quarter was $56 million, in line with our estimates. I would also point out that we generated approximately $560 million in cash flow from operations during Q4. We continue to focus on improving our cash conversion cycle. We ended the fiscal year with approximately $5.9 billion in cash and marketable investments. This strong cash generation ability and liquidity position us well for continued growth. We expect to generate an increased amount of cash from operations in FY08 compared to FY07.

Looking forward to fiscal year '08, we expect the following to be reflected in our annual business model: we expect revenue growth to be in the low to mid single-digits on a year-over-year basis. Based on the timing of product introductions, we expect revenue growth to be a bit higher in the second half of the year relative to the first half. We expect gross margins to be in the range of 43% to 46%. We expect total operating expenses, excluding any potential restructuring charges and based on current exchange rates, to be in the range of $5.6 billion to $5.8 billion.

We expect amortization of intangibles to be in the range of $250 million to $275 million. We expect approximately $225 million to $250 million of stock-based compensation expense. We expect net interest income of approximately $200 million to $225 million. We expect the full-year tax provision to be approximately $200 million to $250 million.

As noted earlier, during Q4, we repurchased approximately $200 million in stock in the open market. During fiscal '08 we intend to continue to repurchase stock as part of our previously announced $3 billion buyback program. Jonathan had mentioned earlier that we are still working to achieve increased levels of profitability and we are still committed to achieving an annual operating margin of at least 10% of revenues on a GAAP basis for the full fiscal year 2009. Our goal is to achieve at least 8% operating margin in Q4 of FY '08. We believe this level of operating margin will balance the need for increased investments to grow our business and allow us to set the stage for achieving our fiscal year '09 goals.

We are pleased with the results of Q4 and FY07. We recognize we have to continue to lower our cost structure and are evaluating ways to do that. You should take some comfort in both our stated resolve and the demonstrated progress that we achieved in fiscal '07.

We will be hosting a financial analyst meeting in New York City at 8:00 am on September 5th this year. Details will be available through our investor relations team and our investor relations web site. At that meeting, we will have a more in-depth discussion of our growth and cost initiatives for the new fiscal year, as well as discuss any potential changes to our capital structure.

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'd like to request that each of you ask just one question consisting of one part. This way, we hope to get most of the questions in the queue today. If there's time remaining, we'll be happy to take your follow-up questions. Brooke, will you please start the question-and-answer session?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Laura Conigliaro - Goldman Sachs.

Laura Conigliaro - Goldman Sachs

Yes, a couple of questions. Notable was the absence of any commentary about your expectations for the September quarter. Might we expect normal seasonal progression, at least on the revenue side?

Also, can you talk a little bit more about your views of your storage business? How you are going to address what has been continued weakness and disappointment? You obviously have the Solaris storage goal, but that is going to take a while to ramp up. Have you given any thought to more radical measures, either in COGS or divestitures as far as storage is concerned?

Michael Lehman

I am not sure what normal seasonality is in this macroeconomic environment, so one of the reasons we wanted to focus on the entire fiscal year is to give a sense of the overall revenue growth that we expect to see, which is the low to mid single-digits. Obviously there is a level of seasonality that is typically associated with our businesses and we should expect some of that, but we are more focused on looking at the annual results at this point.

Jonathan Schwartz

When we look at our storage business, we are really looking at a few separate categories. We are running the business somewhat as we expected on the archive or tape side, which is the result of the StorageTech acquisition, that continues to play out for us reasonably well. The low end, we think, is being completely redefined by the types of offerings and data warehousing appliances that we are now building with Thumper and with Solaris. We see no cessation of that business. There are a lot of proprietary vendors who are going to try to build proprietary technology there, we think we have a very good and compelling advantage. Given that Thumper was in the marketplace for under three quarters now and we are already at a $100 million run rate, that is actually a pretty good ramp and we are pretty pleased with it.

The rest of the business, I mean we have got an OEM business, we have a low-end disk business; frankly the OEM offerings weren’t as strong as we would have liked. We know we have some work to do there, but from our vantage point we are pretty comfortable executing on the IP that we have been building and believe that is where our focus will be going forward. So eyes wide open, we are aware of some of the execution challenges as well as some of the strategic challenges, but feel like we have got the right foundation to really march forward.

Operator

Your next question comes from Ben Reitzes – UBS.

Ben Reitzes – UBS

Good afternoon, thanks. In talking about the fiscal year, maybe you could just talk a little bit more about how you might bridge us to 10% in ’09? I mean, it looks like by the end of the year you need to be at least at 10%. And then in order to have that climbing throughout four quarters, would you be open to any incremental cost-cutting measures or whatnot to achieve your goal?

Michael Lehman

We believe that the path to the fiscal year ’09 10% operating in income continues to have three main drivers. One is revenue growth; the second is increased gross margins over time; and the third is lower operating expenses. We are going to be working on all of them and our view is that at least 8% operating income target in Q4 of FY08 will set us up well to achieve that.

Jonathan Schwartz

To amplify on that point, we are always looking at balancing and taking advantage of our market position with trying to fuel new market opportunity, so we want to make sure that we are not simply delivering tactical near-term results, but instead we are setting the right foundation for the long term.

Operator

Your next question comes from Andrew Neff - Bear Stearns.

Andrew Neff - Bear Stearns

I want to amplify on slide 16, if you can elaborate on some of the points you were alluding to before. I mean, the year-over-year growth in some of your core growth initiatives, again there are lots of them in those numbers. X64 number is down, the total servers are down, and there are lots of advance units versus revenue, and things like that. Can you address what is going on there, what is going on behind that and what you are doing to address that?

Jonathan Schwartz

You bet. I think just as the market saw a decline of tower servers which were eventually replaced by rack level servers, our view is that the volume of rack level servers will eventually be somewhat displaced by much more highly configured and virtualized larger scale systems, and that is both on the systems side as well as on the storage side.

The good news is that plays to our strength. We’ve got a tremendous amount of intellectual property there, both on the storage design as well as with an operating system that knows how to scale up quite well. So I think we definitely saw a bit of a slowdown in the U.S. specifically, but we also saw an increase in revenue and margin dollars available to us because we have got more, and better, frankly, higher scale systems than the rest of the marketplace. Whether that is on the blade side or on the core computing platform side. So we don’t view this as in the least bit discouraging; I think our view is that in a way the market is going to play to our strength now and we can reflect that with better returns going forward.

So virtualization in the near term looks like it has a depressing impact on units, but our view is that actually contributes to demand for more richly-configured systems. That is what we’ve got, that is where we think we can grow revenue, margin and ultimately units as well.

Andrew Neff - Bear Stearns

Just to clarify then, what you are saying there is that that is not reflecting CPUs, that is reflecting just boxes in that chart?

Jonathan Schwartz

Very much so.

Operator

Your next question comes from Richard Farmer - Merrill Lynch.

Richard Farmer - Merrill Lynch

Jonathan and Mike, on the 47% operating margin you talked about the factors. I just wonder if you could talk a little bit about how those are or are not sustainable going forward? Presumably the component pricing is going to be less favorable in the second half. What about the software mix and the other factors you mentioned? How should we think about those going forward?

Jonathan Schwartz

There is no way I could have possibly suggested we would have 47% operating margin. I will turn that over to Mike to answer.

Michael Lehman

I would clarify, we were talking about gross margin, thank you.

Richard Farmer - Merrill Lynch

Sorry, gross margin.

Michael Lehman

47% operating would be nice. The factors that I mentioned, the one that obviously we don’t have control over is costs, and certainly we always see cost reductions. Those tend to go in cycles. I think it is pretty clear from looking at the Q4 results that there was a pretty healthy dip in memory prices and we and others took advantage of that. We don’t expect that the same rate of cost decreases will continue every quarter, so there was probably a bit of a one-time effect there but it is a little hard to quantify.

The other things that we mentioned – the pricing discipline, the mix, the performance of our products, the richer configurations that Jonathan just referred to, improving our results in our storage offerings over time – those all are generally speaking, a net positive for us. So that is why when I step back and we look at the business for the fiscal year ’08, we are now talking about a gross margin range of 43% to 46%, which is slightly up from what we had projected for fiscal ’07.

Operator

Your next question comes from Katy Huberty - Morgan Stanley.

Katy Huberty - Morgan Stanley

Thanks, good evening. Given your confidence in the product portfolio and guidance for revenue growth in fiscal ’08, how comfortable are you cutting operating expenses again, before you fully understand the adoption rate of some of the new products on the road map?

Jonathan Schwartz

I think we have a fairly good understanding and are fairly comfortable with the adoption rate of the new products, but all that said, we also believe that there is yet more efficiency we can garner from the system and we are going to continue streamlining to the extent that we can. We are going to make prudent decisions about that because we want to build a foundation for the long term, not just for the near in. But we think we have our eyes on the right set of issues and challenges to move forward.

Operator

Your next question comes from Harry Blount - Lehman Brothers.

Harry Blount - Lehman Brothers

Thanks. Mike, I want to come back to the September question. I heard your answer earlier. As I look at historic seasonality, I see the product revenues typically down 18% and services typically down 5%. What do you see in the macro environment that could cause you to be better or worse than those numbers?

Related to that September question, do you expect to be able to be profitable on a GAAP basis in earnings in the September quarter?

Michael Lehman

Let me be really clear. I don’t want to be and I am not going to be forecasting quarterly revenues and profit during this call. Certainly there are seasonality factors that historically we have looked at and understand. I think we all are looking at the U.S. economy and looking at what is going on in the markets and trying to understand what the impact is on capital spending and how that relates to our customers, et cetera.

We are planning the business on an annual basis. We obviously have [the use] of a quarterly basis, there is going to be some seasonality associated with that, but our basic view is that we are doing some work during the year to get us ready to achieve higher levels of sustainable profitability towards the end of the year and going forward.

Operator

Your next question comes from Louis Miscioscia – Cowen.

Louis Miscioscia – Cowen

Thank you. John, let’s go back to virtualization for a second. At the analyst meeting I did ask you about this and your comment was that customers would increase their IT budget due to making use of the power that was there. Obviously, systems have been weak the past two quarters now, and it looks like the projection for the next two they are going to be weak also. Do you still stick to that customers are going to start to accelerate? When should we start to see it in your revenue numbers?

Jonathan Schwartz

I don’t view our systems business as being weak. I think we demonstrated growth, and frankly, demonstrated growth throughout the year, and especially year over year. I think what we are going to see is customers looking towards system vendors that know how to scale, and that is both on the network side, the systems side as well as on the storage side and have a full complement of offerings that actually make it happen, as opposed to band-aid solutions after the fact.

When we double the speed of our computers, people don’t buy half as many. When we double their utilization, we don’t expect them to buy half as many either, we actually expect them to buy more. They just may come in a different set of packages and a different wrapping of sheet metal.

So I think we expect there to be a continued growth in demand for computing capacity, storage capacity and bandwidth certainly, and again, we plan on fully participating in that with our own intellectual property. I am not sure I have any greater lens into what the specific changes are and when they occur, but in general, our customers tend to see IT as a weapon and tend to use it as a vehicle to differentiate themselves. They are looking to buy more technology at this point, not to invest in less.

Operator

Your next question comes from Bill Shope – JP Morgan.

Bill Shope – JP Morgan

In looking at the product mix within your SPARC based systems, can you discuss whether higher-end systems continued to benefit the overall mix and margin in the quarter? If so, how did this rank with the other factors you mentioned for the overall gross margin profile?

Jonathan Schwartz

I think we saw a rise the very high end systems, the enterprise class systems. There was some slipping off on the mid-range side, but again that is a balance depending on where customers are in their growth cycle that it moves one way to the next. The single most important leading indicator for the demand of systems from Sun as well as increasingly systems from other vendors related to Sun, is the adoption of Solaris. As we continue to see that being deployed in the highest scale data centers or even in very large scale high performance computing facilities, I think we tend to look at that as a great leading indicator of opportunity in front of us.

This is a marathon, not a sprint. These are adoption waves that roll in waves, they don’t change the marketplace instantaneously. I think we’ve got enough of a lens on the future right now just with the 9 million licenses we’ve seen to suggest there is going to be ample opportunity on the back end of it.

Operator

Your next question comes from Toni Sacconaghi - Sanford Bernstein.

Toni Sacconaghi - Sanford Bernstein

I wanted to revisit the margin question. Mike, I think you had said that the majority was associated with components. Often in the past you have provided a bridge of the forces at work on gross margins. Can you help us with that, and what contribution you do believe was from components? I presume that is DRAM, which was down so dramatically.

Then, consistent with that, if there really are other forces other than components that you think are ongoing, how come your guidance range, the midpoint of your guidance range, is actually lower than your gross margins reported in FY07?

Michael Lehman

I will not be providing a more mechanical or mathematical bridge. I have given you all a highlight of what the key issues were. I did say that component costs were the principal driver of the sequential change in product gross margin; a lot of that was memory, absolutely. There certainly are other components that decreased and we expect continued component cost decreases going forward – perhaps not in the magnitude that we saw in the fourth quarter. There are a lot of other factors that I mentioned that play into the products gross margin, including the mix, the software mix, the product mix, the storage mix, et cetera. A lot of those we have some control over, and some we don’t and certainly as I mentioned, the discipline and the practices we have around managing the pricing in the competitiveness of our offering.

So there are a lot of factors at play, and for those of you who know us and our tendencies towards predictions, we want to manage the company based upon reasonable revenue growth rates, reasonable gross margin percentages and put discipline in the system and ensure that we take costs out of the system to help us to achieve our operating income targets.

The fact that we give a gross margin range that is a little bit wider and a little bit higher than what we gave last year should give people some insight that we feel there is some potential upside, but we are going to continue to manage the company and plan the company conservatively.

Operator

Your next question comes from David Wong - A. G. Edwards.

David Wong - A. G. Edwards

Your fiscal 2009 guidance, do you reckon that you can get down operating expenses, will they drop in absolute dollars ’09 over ’08 or is it a question of just reducing the percentage of it?

Michael Lehman

I think we believe that there will be absolute spending reductions. That there are ongoing efficiencies that we will identify through existing IT projects and other operational activities that will bring the total dollars spent down.

David Wong - A. G. Edwards

And similarly, your projection assumes that you can continuously improve gross margin?

Michael Lehman

At this point our projection doesn’t assume we can increase gross margin. I think our strategic agenda is to do exactly that. One reason why we were able to rather fully enjoy the benefit of operations team executing with better margins or better costing on memory is we tend to ship fairly highly configured systems and have an operating system that knows how to deal with very large pools of memory. So we are going to continue to build out the R&D portfolio with technologies that add value to customers, and our assumption is that if we do a good job of expressing that value, we will be rewarded in the form of higher gross margin.

Operator

Your next question comes from Brent Bracelin - Pacific Crest Securities.

Brent Bracelin - Pacific Crest Securities

Thank you. I had a follow-up question around virtualization. Looking at your support services, it looks like it is slowing there. How should we think about virtualization and declining server units impact on the growth in support services?

Jonathan Schwartz

I think whatever slowdown we might see now from the impact of virtualization I think is probably amplified, if not entirely dwarfed, by a slowdown in the broader macro economy, especially in the U.S. So I think going forward, we believe having more differentiated virtualized systems means we will have access to more of the market. If we have access to more of the market, my belief is we can win more than our fair share. And when we do, not only will our systems revenue or units rise, but we expect that to be reflected on the services side as well.

As we sell virtualized systems, customers tend to buy integrated racks as opposed to piecemeal components that they try to integrate on their own. Again, that just gives us more bites at more apples and ultimately, a higher margin profile as well.

Operator

Your next question comes from Harry Blount - Lehman Brothers.

Harry Blount - Lehman Brothers

A quick follow up. Mike, you gave a lot of the FY08 expectations. I don’t recall hearing any specific guidance around the CapEx or the depreciation.

Michael Lehman

That part is true. I actually don’t have a specific number with me and that is probably one of those things we will give a little bit more clarity on in the September meeting.

Harry Blount - Lehman Brothers

Related to the financial statements, your warranty reserves dropped about $40 million year-over-year. Was there any other significant changes or reductions in absolute reserves or allowances that enhanced the FY07 results?

Michael Lehman

No, and in fact the fact that warranty reserves are lower reflect the increased quality of the products and services that we are offering, so that is a good thing.

Harry Blount - Lehman Brothers

Lastly, you mentioned you had a sell in benefit in the quarter and that you are moving to sell out accounting. Can you help quantify what that sell-in benefit was? Thank you.

Michael Lehman

The only thing I will do is reiterate that net worldwide channel inventories are up about $10 million sequentially. We expected them to go down modestly during the quarter. The principal reason that they went up was that one major channel partner took a real specific action and intentionally bought a little bit more inventory than we had expected, as they were driving their Q4 revenues and promotions.

It's not a big change, not a dramatic change. We're still heading down the same path we've been talking about for the past year, to work with our channel partners, reduce the inventories to levels that can ensure that they ship to customers as is needed, that reduces carrying costs in the overall business model and that's a good thing for ourselves and our partners.

Jonathan Schwartz

We're thrilled with channel partners that love to buy from Sun.

Operator

Your next question comes from Richard Gardner - Citigroup.

Richard Gardner - Citigroup

I was hoping that you could maybe address what looks to be roughly a 30% decline in traditional UltraSPARC units in the quarter. Also maybe give us a sense of how customers are responding to the new SPARC 64 product that you just came out with, the M series, at the very high end? Thank you.

Jonathan Schwartz

We are seeing a bit of a resurgence in our customer base right now, and frankly, that's a derivative of two things: number one, that we have a new set of product offerings with Fujitsu that allow us to play in a very different segment of the marketplace than we have historically. The response to those products has, frankly, been great. We're very happy with the performance we're seeing; it's actually above our own expectations.

I think with respect to unit volumes, we're obviously looking to grow those unit volumes going forward, but we're also looking to grow the number of cores that we ship. As we move to more highly threaded and highly multi-core systems that's going to have a short-term depressing effect on unit volume.

To be a bit of a broken record here, the single best leading indicator of our SPARC business going forward is the extent of the adoption of Solaris. Given that we saw increasing momentum, incorporation of certain technologies from Solaris and other operating systems really broadening the overall pool of available customers for Sun, we're continuing to be very optimistic about not only the future for Solaris, but the future of systems built with Solaris at their core, and SPARC is certainly the flagship of those.

Richard Gardner - Citigroup

Jonathan, if I could ask one follow-up. Do you believe that customers are viewing the new jointly developed products with Fujitsu, the M Series, as a replacement? Or say the E20K, or do you believe that this is more of an incremental opportunity for Sun?

Jonathan Schwartz

I think it's hard to tell, it's probably a little bit of both. We're seeing some folks decommission mainframes and replace them with M9000s. We're seeing folks that never expected to see the level of demand that they are seeing in their transactional systems want to move to M9000s. We're seeing new super computing facilities that like having a teraflop in a box, and we're just about the only company out there that can provide that.

So it's always tough to tell, I think if you're running a system at that scale, you're unlikely to be a start-up in Silicon Valley or a social networking company. There's a little bit of a market that's been predefined in that way, but even there, there's a fair amount of movement in those markets and there's always new opportunity for us to go after.

Operator

Our final question comes from Keith Bachman - Bank of Montreal.

Keith Bachman - Bank of Montreal

Jonathan, I was just wondering, you're calling for a revenue acceleration if you look out over the course of the next fiscal year, I was hoping you could highlight the product areas you think are going drive the revenue acceleration?

Related to that, should we be thinking about this as mostly a share exercise? That is to say, gaining share in your product categories given the commentary that you've made about the macro backdrop.

At the analyst day you commented that there was a slide that suggested about 20% of the customers through the U.S. direct sales force were new to the brand, or were new customers to Sun. Given my question on share, I was hoping you could update us with any anecdotal evidence you have on share gains that you think you've experienced during the recent quarters?

Jonathan Schwartz

You bet. Why don't I start on the share side. This is going to be a little repetitious, even on the call. But the single best leading indicator of the adoption of Sun Systems opportunity is the adoption, first and foremost, of the network and secondly of Solaris on that network. We're seeing a broad scale adoption of the network, largely at this point, driven by mobile handsets and social networking as much as it is by enterprise IT.

Secondarily, we're seeing a very aggressive adoption of Solaris. Some 70% of that adoption of Solaris is now occurring on IBM, HP and Dell hardware, and that's all upside opportunity for those vendors, and ideally an avenue for improved partnering activities, as well as an opportunity for Sun, as we deliver higher scale innovation that allows folks to take developed systems and put them into deployment.

If you look at Solaris, you'll see us having planted very successfully at this point the seeds of a growing storage business and that's what led to the amplification of our Thumper business, from literally a standing start some eight months ago to about a $100 million dollar run rate business is a pretty good ramp, and I'd like to believe we can continue to project that.

If you look at Crossbow, which is a new community forming in the open Solaris world, that's what allows you to take a general purpose server like a Niagara or a Niagara 2 platform and actually build network devices out of it. That allows people to compress their existing systems and, again, give Sun yet more market opportunity.

On the computing side, the numbers that some of the analysts will pose say it's about a $50 billion, $55 billion market which looked relatively stagnant over the past ten years or so. But I think if you look under the covers, you'll see that it's actually a bit of a boiling cauldron of competitive activity, loss of shares, swaps one year to the next, and we'd like to believe we're on the front end of taking a lot of share. But also as the world moves more toward the network, we think there's a broader market to be had going forward.

Across the board, I think what will grow Sun will be the core innovation and the value of that innovation for our core marketplace. So long as our core market continues to look to technology as a vehicle to grow and differentiate their business, we think the value of our business will only increase.

Bret Schaefer

Thanks 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.

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Source: Sun Microsystems F4Q07 (Qtr End 6/30/2007) Earnings Call Transcript
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