Sun Microsystems Inc. F2Q06 (Qtr Ending Dec 25, 2005) Earnings Conference Call Transcript (SUNW)

Sun Microsystems Inc. (SUNW)
Q2 2006 Earnings Release Conference Call
January 24th 2006, 1:30 PM.

Executives:

Bret Schaefer, VP, IR
Stephen McGowan, Chief Financial Officer, EVP - Corporate Resources
Scott McNealy, Chairman, Chief Executive Officer
Jonathan Schwartz, Chief Operating Officer, President

Analysts:

Laura Conigliaro, Goldman Sachs, Analyst
Richard Farmer, Merrill Lynch, Analyst
Keith Bachman, Banc of America, Analyst
Tony Sacconaghi, Sanford Bernstein, Analyst

Presentation

Bret Schaefer, VP, IR

Good afternoon. Thank you for joining the Sun Microsystems Quarterly Conference Call. With me today is Scott McNealy, Sun's Chairman and Chief Executive Officer; Jonathan Schwartz, Sun's President and Chief Operating Officer; Steve McGowan, 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 Year 2006 Second Quarter which ended on December 25, 2005. 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 earnings announcement or the detailed financial datasheet for any reason, or you wish to hear a live broadcast of this conference call, you may log on to our website at www.sun.com\investors.

We have posted slides you can view on the web which accompany our prepared remarks. These slides may be viewed at the same URL, www.sun.com\investors. Simply click on the link marked "Earnings Releases." Finally, we will also post a transcript of our prepared financial remarks on our website after the conclusion of this call. 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 make projections or other forward-looking statements regarding expected future financial results and business opportunities. Such statements are just predictions and involve risks and uncertainties such that actual results may differ materially. I would like to refer you to Sun's periodic reports that are filed from time to time with the Securities and Exchange Commission, including the company's Annual Report on Form 10-K for the fiscal year ended June 30, 2005, and the company's quarterly report on Form 10-Q for the quarter ended September 25, 2005. These documents contain and identify important factors that could cause the actual results to differ materially from those contained in our projections. 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 earnings call financial slides and the operations analysis posted in the earnings release section of our website at www.sun.com\investors for the most directly comparable GAAP financial measure and related reconciliation.

Please note that unless otherwise indicated, all reported results include the impact of the StorageTek and SeeBeyond acquisitions for the full quarter ended December 25, 2005. I will also mention we will speak to a number of noteworthy items during the call this quarter. These items include StorageTek and SeeBeyond purchase price accounting impact to Sun's operating results and net loss per share in Q2; the impact of FAS 123R, stock-based compensation expense to Sun's net income and net loss per share in Q2; the impact of restructuring charges and related tax benefits and gains on equity investments; and the reclassification of certain geographical regions in the discussion of revenue and bookings by geography.

Now, let's get to the financials. Sun's total revenue for the second quarter of fiscal 2006 was $3.337 billion, an increase of 17% as compared with the $2.841 billion in revenue reported for the second quarter of fiscal 2005. We had an unfavorable currency impact on revenue of approximately 3% year-over-year, and an unfavorable impact of approximately 1% sequentially.

Total gross margin was 42.6% of revenue, an increase of 0.4 points over the gross margin for the second quarter of fiscal 2005. Total R&D and SG&A expenses were $1.597 billion, an increase of $424 million year-over-year. In the second quarter of fiscal 2006, we recorded a $76 million tax provision.

GAAP net loss for the second quarter of fiscal 2006 was $223 million or a net loss of $0.07 per share as compared with a net income of $4 million or breakeven earnings per share for the second quarter of fiscal 2005.

With respect to the accounting for the acquisitions completed during the first quarter of the fiscal year 2006, we've estimated the value of certain tangible and intangible assets acquired and liabilities assumed. Some of these estimates are subject to change, and adjustment for these estimates will be included in the allocation of the purchase price which under normal GAAP rules are allowed for a period of 12 months following the close of the transaction.

GAAP net loss for the second quarter of fiscal year 2006 included approximately $145 million, or approximately $0.04 per share in purchase price accounting adjustments and intangible asset amortization relating to the acquisition of StorageTek and SeeBeyond.

The impact of purchase-accounting-related items associated with our acquisitions of StorageTek and SeeBeyond are reflected in the following areas of the income statement. A reduction of revenue of approximately $24 million compared to $14 million in the first quarter, primarily the result of adjustments made to reduce the acquired deferred revenue balances of StorageTek and SeeBeyond to fair value; a reduction in gross margin totaling approximately $84 million, compared to $43 million in the first quarter, principally resulting from the impact of deferred revenue adjusted adjustments, fair value adjustments to inventory, and a full quarter of amortization for acquisition-related intangibles related to development of technology; and an increase in operating expenses of approximately $61 million compared to $20 million in the first quarter resulting from a full quarter of amortization on other intangible assets established on acquisition.

For the quarter, total stock-based compensation expense was $55 million, or approximately $0.02 per share. This expense was included in the following components of the P&L. $3 million is charged to cost of sales for products; $7 million is charged to cost of sales for services; $18 million was included in R&D expense; and $27 million was included in the SG&A expense.

GAAP net loss for the second quarter of fiscal year 2006 includes restructuring charges of $10 million and a related tax benefit of $3 million and a gain on equity investments of $14 million.

Now, back to revenue metrics. Q2 products revenue totaled $2.108 billion, an increase of 14% year-over-year. Within products revenue, computer systems products revenue was $1.438 billion, a decrease of 5% year-over-year. Data management products revenue was $670 million, an increase of 100% year-over-year.

Q2 service revenue totaled $1.229 billion, and was up 23% year-over-year. Within services revenue, support services revenue was $953 million, up 23% year-over-year. Revenue from client solutions and educational services totaled $276 million, an increase of 22% year-over-year.

As part of our ongoing disclosure improvements, in the second quarter, we've adopted the following change to our geographical presentation of revenue and booking. We will present disclosure for the U.S.: the United States; EMEA: Europe, Middle East, and Africa; APAC: Japan, China, Southeast Asia, and Australia; and International Americas: which is Canada and Latin America. In the past, we've disclosed Europe, U.S., Japan, and rest of the world.

By geography, U.S. revenue was $1.373 billion, up 22% year-over-year. EMEA revenue totaled $1.239 billion, an increase of 20% year-over-year. APAC revenue was $531 million, an increase of 4% year-over-year. International Americas revenue was $194 million, an increase of 18% year-over-year.

With respect to the balance sheet, DSO was 62 days. Excluding acquisitions, ending sales channel inventory was $366 million, or less than three weeks of supply, which is within desired levels. We ended the quarter with a cash and marketable debt securities balance of $4.276 billion, and cash flow used in operations for the second quarter was $191 million.

With that, I will turn it over to Steve.

Steve McGowan, Chief Financial Officer, EVP - Corporate Resources

Great, thank you, Bret, and welcome everyone. Let me start with a high-level summary of the quarter. From the demand perspective, we saw a very positive trend in bookings and backlog growth across numerous server and data management product areas. These trends indicate to us solid customer acceptance of our recently introduced products, more about that a little bit later.

Gross margin performance was 42.6%, up 0.4 points, which continues to be strong and reflect the competitive advantage that we have with our product offerings. And we came in directly in line with our R&D and SG&A expense guidance of $1.6 billion.

From a balance sheet perspective, we again improved our working capital management by driving the cash conversion cycle down to 31 days, and we finished the quarter with a cash and marketable debt securities position of approximately $4.3 billion.

For those of you who are able to follow the slide deck, let me now turn to slide four, we can talk about some demand metrics. Our Q2 product bookings were 2.430 billion, an increase of approximately 23% as compared with a year ago. And although most of this increase can be attributed to our acquisition of StorageTek, our traditional Sun business experienced an increase in product bookings of approximately 4%, which is the first such bookings increase since Q4 '04. Much of this increase was driven by our UltraSPARC IV+ products, as well as recently announced Niagara and Galaxy products. In fact, demand for UltraSPARC IV+ drove an increase in our ending backlog of approximately $100 million.

Turning to slides five and six in the metrics and revenue, total revenue grew 17% year-over-year as a result of our acquisitions of StorageTek and SeeBeyond. These acquisitions drove the revenue increases across many businesses. And I will discuss those in just a couple of minutes. And for clarity, the remarks I'm going to provide here are going to focus on the other key factors that contributed to our performance.

Let's start with product revenues. They totaled $2.108 billion, an increase of 15% year-over-year. And within the product revenue, computer system products revenue was $1.438 billion, a decrease of 5% year-over-year. Year-over-year decline reflected both an unfavorable currency impact and an inability to fulfill UltraSPARC IV+ demand. In line with recent quarters, approximately 75% of server revenue in Q2 FY'06 was derived from our one- to eight-way offerings. The important message here is that we continue to generate solid product gross margins as we move our server sales into the larger, more rapidly growing one- to eight-way market segment.

During Q2 '06 we shipped approximately 83,000 computer system server units with almost 20,000 being x86/Opteron servers, an 87% year-over-year increase in Opteron server shipments.

From a software perspective, Java Enterprise Systems subscribers climbed 15% sequentially, and we are delighted to report the cumulative JES count is now up to 1.105 million subscribers.

Looking now at our new data management products revenue, it was $670 million for the quarter, an increase of 100% year over year. StorageTek products contributed $368 million to this total. Although these data management results were solid, they were negatively impacted by some weakness in demand for the entry-level storage offerings and, to a lesser extent an unfavorable currency move.

And finally, we are seeing a mix shift towards our midrange and data center arrays as well as strength in the entry-level SMB tape market.

Turning to our services business, overall, our services organization has continued to deliver solid performance in a very competitive environment. In Q2, we've made excellent progress in improving productivity and in driving cost efficiencies with a more variable cost model. Services revenue was $1.229 billion, an increase of approximately 23% year-over-year, including an unfavorable impact of currency. StorageTek services contributed about $228 million to this total.

Within services, the support service revenue was $953 million, up 23% year-over-year. And we are seeing a shift towards multivendor site support and managed service contract offerings and away from our traditional spectrum service contracts. We believe this trend will have a long-term positive impact on our service margins.

Client solutions and educational service revenue was $276 million, an increase of 22% year-over-year, and a bright spot in this growth was the growth of Solaris 10 training, an indication of the broadening acceptance of Solaris 10 within the marketplace.

Now, taking a look at revenue by geography, on slide seven, U.S. revenue was $1.373 billion, up 22% year-over-year. The modest decrease in the Sun standalone business was more than offset by the increase that was attributed to the addition of StorageTek business. We did, however, see products booking growth in Sun standalone business of 15% year-over-year. This is the highest bookings growth level since Q1 '03 in the U.S.

Sun's standalone product backlog grew $131 million, which is approximately 80% growth year-over-year. And then looking at the industry verticals in the U.S. for the Sun standalone business, we saw strength in the Telco Sector offset by some weakness in the financial services sector.

In EMEA, revenue was $1.239 billion, a year-over-year increase of 20%. UK grew their revenue significantly, and was primarily driven by strength in Financial Services, government, and Telco. Eastern Europe and Russia continued to see growth with strong high-end server business, particularly in the Telco and financial service areas, while Italy grew year-over-year with strength in the financial services and government sectors.

Asia-Pacific revenue was $531 million, an increase of 4% year-over-year, and in APAC, most all regions were up modestly.

And finally, our International Americas, revenue in International Americas was $194 million, up 18% year-over-year, primarily driven by solid performance in the Latin American regions led by Mexico.

Now let's take a look at the margin story. If you look at slides eight and nine for margin, the total gross margin was 42.6%, an increase of 0.4 points year-over-year. Product gross margin for the quarter was 42%, a sequential decrease of 1.3 points, but if we look at the underlying components, those are like this, we had a favorable impact from cost reductions of 1.8 points due to decreased costs for material, primarily processors, disk, and memory, as well as reductions in supply chain costs primarily in the freight and warehousing areas. Secondly, a favorable impact in volume and mix of 1.6 points due mainly to a higher mix of software. And that was offset by unfavorable impact of pricing and discounting, which was 2.4 points, and unfavorable 1.9 points due to purchase price accounting, which Bret described earlier.

Services margin for the quarter was 43.6%, a decrease of 1.8 points quarter-over-quarter, and the components of this decrease were a favorable impact due to mix of 1 point, offset by unfavorable impact from costs of 1.7 points, purchase price accounting of 0.7 points, and pricing and discounting of 0.4 points.

Let's move onto R&D and SG&A expenses, and some productivity and efficiencies on slide 10 and 11. Total R&D and SG&A expense for Q2 were as we guided, $1.597 billion, an increase of $424 million year over year. However, of this increase, $332 million is from the recent acquisition of StorageTek and SeeBeyond, and $45 million is from the inclusion of FAS 123R, stock-based compensation expense.

Let me just say a few more words on purchase price accounting and stock-based compensation expense. Due to the size of these charges in Q2 and their ongoing impact, we've shown on slide 12 and 13.

GAAP net loss for the second quarter of fiscal 2006 included approximately $145 million, or approximately $0.04 per share, in purchase price accounting adjustments relating to the acquisition of StorageTek and SeeBeyond. Now, going forward, purchase price accounting related items are expected to affect our results of operations by approximately $75 million per quarter for the next 3.5 years.

And for the second quarter, total stock-based compensation expense was $55 million, or approximately $0.02 per share. Going forward, we expect FAS 123R stock-based compensation expense to be approximately $60 million per quarter in Q3 and in Q4.

Moving on to the balance sheet, some of the core balance sheet items in slide 14 -- I'm pleased to say we ended the quarter with approximately $4.3 billion in cash and marketable debt securities and our cash flow used in operations was $191 million. Now, our cash generation is typically lower in the second quarter of the fiscal year, driven by increased working capital as a result of a sequential increase in revenue from quarter-to-quarter.

Q2 cash flow is not an indication of a trend moving forward. Although we used $191 million in Q2, our cash flow from operations was positive for the first half of FY '06. And we are planning for positive cash flow from operations of the full year, I will talk more about that when I get to the guidance section.

The overall cash conversion cycle in Q2 was 31 days, and excluding the cash conversion cycle attributed to our acquisition, our cash conversion cycle was 20 days, which is eight days better than Q2 '05, and three days better than Q1 '06. We are very pleased with our performance in effectively managing our working capital needs. In line with our guidance last quarter capital spending came in at $102 million.

Now some comments looking forward. The first comment I want to talk about acquisition integration update, and we will be doing this on a regular basis going forward. The piece I want to address on this call is to make a few comments on the progress and integration in the area of cost improvements. We are proceeding with our real estate field office consolidation, and we planned to close 160 redundant field offices by the end of calendar year 2006 with an annualized benefit of approximately $20 million and that's annual. Secondly, we are underway with purchasing initiatives to leverage our buying power across the company with particular focus on direct materials and service delivery.

We look at Q3 in terms of R&D and SG&A, we anticipate that expense to total approximately $1.6 billion or the same level as Q2 FY '06. Now included in that 1.6 billion as a reminder, expect amortization of StorageTek and SeeBeyond will be approximately $75 million. The components of this expense will be $35 million in COGS and approximately $40 million in R&D/SG&A.

Secondly, we expect total stock-based compensation of approximately $60 million in Q3 '06, with the components of that being $10 million in COGS and $50 million in R&D and SG&A. Again, both the amortization and stock-based comp are in that 1.6 billion.

We anticipate interest income of approximately $20 million. We continue to forecast the full-year tax provision to be between $200 million and $250 million. We're targeting a cash conversion cycle combined of 36 days by the end of the fiscal year. We expect capital expenditures to be approximately $150 million in Q3. And finally, we anticipate positive cash flow from operations for the full year '06, and remind you that we goal our management team on being cash flow positive from a free cash flow perspective for the year.

With that let me turn it over to Scott.

Scott McNealy, Chairman, Chief Executive Officer

Thanks, Steve. And to reiterate very quickly, again, stable performance in revenue, good improvements in gross margin, and a solid cash position with nearly $4.3 billion in cash. But the big takeaway here is a resurgence of demand as evidenced by the strong bookings in backlog growth and deferred revenue. We haven't witnessed backlog this high in years, I do have a New Year's resolution, we just underestimated how attractive and popular the UltraSPARC IV+ product line would be, and we shipped above our plan and all the rest of it, and TI is executing well to our order. We just didn't order enough of it so the leadtimes are longer than we would like to be. Yields are solid, and we expect to get caught back up hopefully by the end of this quarter. And certainly at the beginning of next quarter, we should be back to a normal lead times, it's a high-class problem but our New Year's resolution is to not underestimate the popularity of some of our new products moving forward.

To detail the demand is a little bit more, x86 server unit shipments up 87% gave us some fantastic customer wins, NewEnergy, tough U.S. technology, USC, the University of Alberta, have all chosen the product, and we just launched it in September. The x64 workstation business was up 337% year-over-year. Services revenue up 23% year-over-year. And that combined with good solid gross margin improvement of 43.7% for service year-over-year.

Software delivered nicely. The Java Enterprise System subscriber numbers are on the rise, up 15% sequentially. A big win with American Express, they are going to deliver a new integrated software environment for their global IT infrastructure. That brings the total users of JES to 1.1 million users throw-in Northwest University, Equifax, we've got a ton of -- we've got an all-star list of subscribers to the Java Enterprise System.

Solaris 10 has now been up on the net for almost a year. We have registered downloads reached 3.7 million at the end of Q2, and we're doing tens of thousands of downloads each week. The most advanced operating system is literally flying off the web shelves these days. And I think if you go look now, we are pretty close to 4 million downloads registrations in less than a year, so pretty stunning volume there.

In terms of products, the $2.2 billion or so of R&D continues to crank out to completely revamp the product line. The big highlight of Q2 is obviously the UltraSPARC T1 chip. Some people still call it like our CFO still call it Niagara, but it is the new Sun Fire T1000 and T2000 servers using our CoolThreads technology. They are off the charts, kind of exciting, and the benchmarking and the evaluations that are going on are making us very, very excited about the prospects of this product. And with power usage - I'm not talking about power performance, I'm talking wattage being the number one issue in so many data centers, we think this is going to be very exciting.

The UltraSPARC IV+ I mentioned is backordered right now and that's a high-class problem. What has happened is that this chip has put us on par or ahead of the game. For the first time in a while, we've actually caught and leapfrogged the competition in the midrange and high-end markets. And we're seeing some very, very interesting demand, we are going to be cranking -- we've got TI working overtime to try and deliver us more product there, so that's a good step forward.

We also continue the march towards free and open source software. You see our software revenues are growing nicely. Our strategy of three is working, and we are finding some very effective ways to monetize that. On November 30, we introduced the Solaris Enterprise System, which integrates the Solaris 10 operating system with the Java Enterprise System with our N1 Management software, our tools, all into a single software distribution. It's the only comprehensive and open infrastructure software platform available today.

And again get this, we made it available at no cost for both developers and for deployment to drive volume and reduce the cost of entry. And with open source, we reduce the cost of exit. We expect to monetize the growing community around Solaris and Java Enterprise System in the coming quarters through support contracts as customers deploy products built on this platform.

We also announced that we've incorporated into the Java Enterprise System open source Java database, so there should be no doubt about our commitment to the open source community. We are basically open sourcing the bulk, if not all of our middleware software.

Early in the quarter, we had SunForum, an event we hosted on the East Coast with 1,000 Sun customers, partners, media, and analysts as we introduced the new Data Management Group, which combines Sun's storage environment with the StorageTek folks. And we rolled out a new enterprise capacity tape drive, the T10000. There will be more news, there will be a heavy product calendar here on the storage side as the Data Management Group really kicks into high gear. We've got a great product lineup today, lots of new stuff coming, and a wonderful team now to go carry the ILM story out there in the marketplace.

Other big news in Q2 is we have set the bar for eco-responsible computing. We had a summit on 21st century eco-responsibility, and rolled out the new T1-based CoolThreads servers high-performance eco-responsible. We refreshed our products for our partners, in fact, at a recent show of support 40 ISVs, including BEA, Oracle, and Symantec all demonstrated an unprecedented endorsement of the Sun Fire T1000 and T2000 systems at our quarterly network computing event.

And most recently, just a few weeks ago, we kicked off the next phase of a 20-year partnership and alliance with Oracle. Oracle reiterated that Solaris is its preferred x64 development platform, endorsed NetBeans as its development environment of choice, and recommitted to Java for another 10 years along with IBM, so pretty stable and compatible non-fragmented environment for Java over the next 10 years.

And that's not all there is to that deal. As an OEM, Sun is bundling the server, the storage, the licensing and support into an Oracle database package at an unbeatable price, effectively allowing you to get a Sun computing environment with Oracle at effectively no extra charge, and no IBM Global Services required, pretty cool deal, and that really brings down the effective cost of delivering the Oracle database platform on UltraSPARC IV and IV+ technology down significantly, and our field is so excited about that.

We've got the Google partnership, the Oracle partnership, we've got IBM shipping Solaris on BladeCenter. And I even saw a little leak of an internal HP memo that they're supporting explicitly, I don't know if it that's true, it's just a rumor but they are supporting Solaris on their Opteron products. So we've got partnerships we don't even know about out there but anyhow, we will continue to partner like crazy, offer choice and innovation like never before.

Two, customers, I thought I'd run through some of the customers in the financial services. Obviously American Express is the biggie with the Java Enterprise System. But we won or expanded contracts in Q2 with Equifax, the Philly Stock Exchange, and Ping An Insurance in China. In the government space, the Mexico Ministry of Education, we have -- the team in Mexico did a great job closing a $400 million contract to provide the Ministry of Education with Sun Ultra 20 workstations with a five-year services contract for their public schools. The province of Nova Scotia is adding Sun Fire T2000 product running on Solaris 10 to its efforts. Guangdong Mobile and NingBo Bird are two excellence wins in the communications space that shows we are experiencing momentum in the Asia-Pacific market.

Retail, we had a big presence at the most recent national retail show. Harrods, for those of you who haven't been to London, you might not know about this but if you have been there you have probably been to Harrods. The London department store selected the Java Integration Suite to enhance its multichannel retail operations. NewEnergy in the energy and utilities space chose Sun Fire servers for its good computing processing for performance and power savings.

And in education, we got a couple of big wins. The one I am very excited about is the Tokyo Institute of Technology, TITECH awarded Sun the contract to build its supercomputer campus grid infrastructure system. We are back on track and back in the game in high-performance computing. Japan takes supercomputing very seriously, and Tokyo Institute of Technology is a lead dog in that hunt to be the fastest supercomputer out there. And they've chosen our products to go drive that. Big wins with Scripps Florida, UCLA, USC and again, we're gaining traction in our core markets. We're getting new design wins and getting other traditional customers to re-up.

So with all of that we've got the integration going along. It's going along very well as planned if not better. We are realizing at least as many synergies if not more on the cost front, and we are starting to see the revenue synergies flow through, but there is a lot more to come and you know, we’re really going to need the next two to four quarters to execute on all the costs and revenue synergies. But again, we are on plan from an execution perspective, both on cost and revenue synergies.

You will hear more as we go forward here. We've got a strong product calendar from an R&D perspective. You will see more initiatives on January 31st. We're going to partner with the EPA to host the global conference on enterprise efficiency and the data center. We will be talking about what customers can do to improve data center efficiency and major power consumption.

Next month on the 1st and 2nd of February, we have the Annual Analyst Conference, that’s a highly informative event for the analyst community, and set the tone for how to think about and measure Sun's progress moving forward. And again, lots of new products which I can't share with you right now but we will have a heavy product calendar here in Q3 and Q4, so Bret, back to you.

Bret Schaefer, Sun Microsystems, VP, IR

Okay, thanks, Scott and Steve. Now, let's take some questions. Derek, will you please start the question and answer session?

Question & Answer

Operator

Ladies and gentleman, we will now begin the question and answer portion of today’s call. If you have a question please press “*