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Executives

Ron Pasek - VP Treasurer of Sun Microsystems

Jonathan Schwartz - CEO and President

Michael Lehman - CFO and EVP of Corporate Resources

Analysts

Richard Gartner - Citigroup

Shannon Cross - Cross Research

Ben Reitzes - Lehman Brothers

Jeff Fidacaro - Merrill Lynch

Katy Huberty - Morgan Stanley

David Bailey - Goldman Sachs

Andrew Ness - Bear Stearns

Keith Bachman - Bank of Montreal

Lou Miscioscia of Cowen & Company

Tony Sacconaghi -Stanford Bernstein

Bill Fearnley - FTN Midwest

David Wong - Wachovia

Chris Whitmore - Deutsche Bank

Bill Fearnley - FTN Midwest

Sun Microsystems Inc. (JAVA) F3Q08 (Qtr End 03/31/08) Earnings Call May 1, 2008 4:30 PM ET

Operator

Good afternoon. My name is Kathy and I will be your conference facilitator. At this time, I would like to welcome everyone to the Sun Microsystems fiscal year 2008 third quarter results conference call.

All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer period. (Operator Instructions)

I would now like to turn the call over to Mr. Ron Pasek, Vice President Treasurer for Sun Microsystems.

Ron Pasek

Good afternoon. Thank you for joining the Sun Microsystems quarterly conference call. I am Ron Pasek, Sun's Corporate Treasurer. With me today is Jonathan Schwartz, Sun's CEO; and Michael Lehman, Sun's Chief Financial Officer and Executive Vice President of Corporate Resources. The purpose of today's call is to discuss the results of Sun's fiscal year 2008 third quarter, which ended on March 30th, 2008.

During the last hour, we published a copy of the operations analysis datasheet with nine quarters of financial and operations information including the quarter completed on March 30th, 2008. If you have not received the announcement or the detailed financial datasheet for any reason or you wish to hear a replay of this conference call, you may log on to our website at sun.com/investors.

We have also posted slides you can view on the web which accompany our prepared remarks. These slides may be viewed 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 will be making projections and other forward-looking statements regarding expected future financial results and business opportunities. Our actual results may be very different from our current expectations. We encourage you to read the 10-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 the 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 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 measure and related reconciliations.

Now, let's go to the financials. Sun's total revenues for the third quarter of fiscal 2008 were $3.266 billion, a decrease of 0.5% as compared with $3.283 billion in the revenue reported for the third quarter of fiscal 2007. Total gross margin was 44.9% of revenue, an increase of 0.4 percentage points over the gross margin for the third quarter of fiscal 2007. Total R&D and SG&A expenses were $1.446 billion, a decrease of $25 million year-over-year.

In the third quarter of fiscal 2008 we recorded $52 million tax provision. GAAP net loss for the third quarter of fiscal year 2008 was $34 million or a loss per share of $0.04 as compared with net income of $67 million or earnings per share of $0.07 for the third period fiscal year 2007.

Q3 product revenues totaled $2.3 billion, a decrease of 2.8% year-over-year. Within products revenues computer systems product revenues was $1.473 billion, an increase of 1.8% year-over-year. Storage products revenue was $530 million a decrease of 5.4% year-over-year.

Q3 services revenue totaled $1.263 billion, up 3.3% year-over-year with in services revenue, support services revenue was up $961 million up 1.2% year-over-year. Revenue from professional service and educational services totaled $302 million, an increase of 10.6% year-over-year.

We ended the quarter with cash and marketable debt securities balance of $3.801 billion and generated positive cash flow from operations of $329 million. During Q3 '08 we repurchased 17.5 million shares our common stock, which equates to $300 million. Shares were repurchased at an average price of $17.15 where currently $500 million remaining of $3 billion share repurchase program we announced in Q4 '07.

With that I will turn it over to Jonathan.

Jonathan Schwartz

Great. Thanks, Ron. First let me start with the obvious. Our third quarter was a challenging one, in which US macro factors impacted our overall performance and really over shadowed the progress we made in other parts of the world. Our teams delivered growth in 12 out of 16 selling geographies during the quarter, with double-digit performance in a number of emerging markets.

That being said, I am disappointed and I will spend time today talking you through various factors that came into play throughout the quarter that caused us to come in below our own expectations. I will then turn it over to Mike who will walk through the various operational adjustments we will be making to best position Sun for efficiency and growth moving forward

To start, I want to recognize that it was a seasonally challenging quarter. This was expected. However, in addition, during March, we saw a substantive change in US sentiment, along with change in orders mix and closings, with purchase decisions postponed on the basis of macro economic uncertainty.

In terms of the US vertical performance during the third quarter, our financial services business, specifically in the Northeast was solid and on plan, while the majority of weakness came in our government vertical, as well as industries with significant consumer exposure including retailers and the telecommunication sector.

Collectively, the slowing had the most pronounced impact on the higher end of our system-product sales from high-end tape libraries to enterprise servers. The net result was a gap in US performance, which given its prominence in our overall business typically around 40% of total revenue had a significant effect in our overall results. As Mike will review in a moment, we are going to be making some prudent steps to adjust our spending profile, positioning us for a continued profitability, and again, improving financial performance.

It's important to note we are continuously making choices to align strategically, geographically and operationally with our plan for long-term growth this year will be no different.

Turning our to progress in the quarter, we continue to see the market align with our investment around high-performance computing, open-source innovation, eco-efficiency, and most importantly on using technology in network computing as a source of competitive advantage.

As I mentioned earlier, we continue to see very strong growth in key markets outside of the US, namely across EMEA, Asia Pacific and the International Americas. More specifically, we see the emerging markets across these geographies as key components to our growth strategy as evidenced by 20% year-over-year growth in Brazil, 30% year-over-year growth in India, 8% growth in China, growth in Korea, Russia and 18% growth in the Middle East Africa and Eastern Mediterranean region.

We are committed to making necessary investments to support and fuel the momentum we see, driven by our open-source platform from MySQL to OpenSolaris to our newly announced Open Storage Platform alongside our ultra efficient Niagara and x86 business.

Turning to products, those Niagara platforms once again grew billings at an impressive flip of 110% up year-over-year to approximately $300 million, as productivity and efficiency remain among the highest priorities for our customers across the world. Our x86 systems business also continued to advance and we are seeing strong growth in our blades platform and wins in the burgeoning high performance computing sector.

Our display storage business was up 6% within the quarter, and although we saw declines in libraries in high end storage systems, we have a great variety of new Open Storage innovations delivered in the market within the next few quarters, leveraging our Open Storage DFS system to deliver differentiation, performance and efficiency to a market we have historically been unable to reach.

As for a few other highlighting during the quarter, we signed a landmark collaboration agreement with the People’s Republic of China, Ministry of Education to cultivate integrated circuit engineering talent and industry development based upon our OpenSPARC, open source silicon platform. This endorsement will introduce a generation of Chinese students to sign in our innovation while providing China with the foundations of its own indigenous microelectronics capabilities.

Secondly, we announced an award from the Defense Advanced Research Projects Agency known as DARPA for research focused on microchip interconnectivity via on-chip optical networks enabled by Silicon photonics and proximity communication. This work will create more opportunity and differentiation for Sun in the construction of very high capability and productivity data center facilities.

And finally, we announced the closing of two critically important acquisitions, furthering our presence in the open source software marketplace. The first was Innotek whose VirtualBox products provide free desktop virtualization, especially to developers with multiple run time operating environment on their laptops and then MySQL the world's most popular open source database.

Integration of these acquisitions continues to go well and with MySQL in particular, we found enormous receptivity to the technology and value proposition from among a broad spectrum of our customers who are already signing Sun Services agreements.

Just a sampling of these customers ranging from Web 2.0 startups to large enterprises companies include: Thomson Reuters, Glasses Direct, Newforma and TimeLogic. I am also pleased to report that the MySQL team has performed on behalf of Sun from the minute we closed the deal this quarter.

In closing although this was a tough quarter considering the various factors I just reviewed, we feel the opportunity before us remains as strong as ever, from providing the world’s first open storage platform to deliver solutions based on the number one Open Source database and continuing the ramp of OpenSolaris on Sun and non-Sun hardware, we remain confident in the durability of our business and our ability to improve operational discipline and in the important product and go-to market investments that we are making.

With that I would now like to pass it over to be Mr. Lehman for more details and specifics on our results and a detailed look at the cost structure initiatives underway.

Michael Lehman

Thanks, Jonathan. I am going to provide a bit more detail about our Q3 results, and also talk about our current view of Q4, and the steps we are taking to enable us to make improvements in our business during next fiscal year. As Jonathan mentioned earlier, our revenues came in substantially less than we had expected. This quarter's results truly reflect this one major geography, the US, did not meet expectations.

At our analysts' meeting in February, I stated that we expected revenue growth in the second half of this fiscal year of at least 5%, and that we did not expect all of that growth to occur in Q4. During the first week of March, we began to get signals from our larger US channel partners, that they were not seeing the sell-through products that they had expected. In each of the remaining weeks of March, we experienced a significant number of deferrals of purchases from many of our large US end user customers as well. As a result the US revenues decreased approximately 10% during Q3 on a year-over-year basis. With the U.S. traditionally being approximately 40% of our business, we were not able to offset that decrease by the growth in the remaining geographies.

We do not believe that much of this business was lost to competitors as many of the deals and projects that we were tracking are still active in our pipeline today. However, our experience with such deferrals is that don't all come back immediately and become additive to the next quarter.

The overall revenue decrease in Q3 was experienced in both computer systems and storage. In systems the shortfall was most noticeable at the high end of the product line. Volume storage, the shortfall was principally in the high end tape, library and drive products. In fact, both computer systems and storage missed our internal expectations by roughly the same amount, more than $100 million each in the quarter.

The fact that the shortfall was in the higher end of both product lines is the principal reason for the sequential drop in products gross margin, which was 3.6 points percentage decrease from Q2 to Q3.

Our services business, despite challenges associated with the implementation of new systems for coding, billing, and managing support, essentially met our expectations from both a revenue and margins standpoint. There are always difficulties when bringing up new systems, and this was no exception.

Our professional and educational services practices, which principally assist customers with the design and implementation of Sun-based intellectual property showed good year-over-year revenue growth in Q3, more than 10%. At the highest level even with Q3 revenues that were more than $200 million below our internal expectations, and a pronounced mix shift toward the mid-range and lower-end product sets. We improved our product gross margin slightly on a year-over-year basis.

Our services margins are quite volume sensitive, and we also delivered a modest improvement in year-over-year service gross margins in Q3. As we said last quarter, currency continues to provide a positive impact to our EMEA and APAC-based revenues as the US dollar continues to weaken.

Generally speaking our results include some benefit from exchange rate movements in both the revenue and gross margin line, as in the past, such benefits are largely offset by the negative impact of such currency movements on our operating expenses, as local currency-based expenses are converted to US dollars.

We also continue to make progress towards another longer-term goal, that of a more durable and predictable business model. A decreasing amount of deferred revenue is the proxy for that goal, as it provides a stable base for future quarter's results. In Q3, deferred products revenue increased by approximately 28% on a year-over-year basis, this primarily reflects the timing of installation and/or acceptance of a broader set of products, which often has an ancillary benefit to us in terms of additional professional services.

Our deferred service revenue was down 1% on a year-over-year basis in Q3. This is one area in which this system conversion did have a nominal impact on our balance sheet. Due to the timing of receipt of a number of purchase orders late in the quarter, we were able to process only a portion of the service contract for these customers.

We were able to record the appropriate amount of revenue for the quarter, but were unable to record the entire value of such contracts which would have been deferred revenue. We expect that these contracts will be fully processed in Q4. The amount of unbilled and deferred revenue associated with these contracts at the end of Q3 was not significant.

Turning to operating expenses, total R&D and SG&A expenses were down $25 million in Q3 on a year-over-year basis. This is due to continued savings from real estate consolidations, reduction of certain incentive payments and a variety of other factors. I would point out that headcount is up approximately 1100 sequentially. We added approximately 600 people from the acquisitions of MySQL, Innotek, and Vaau and as we had previously indicated, we believe we have opportunity to grow revenues in a number of emerging markets and accordingly have added approximately 300 people in our global sales organization.

Additional headcount was added in engineering and IT. We will continue to hire in areas where there are near-term growth opportunities as well as where we can find and when we can find key engineering skills. I would like to summarize the impact of the MySQL acquisition on the results of the quarter. As most of you know, this transaction closed in late February.

Our income statement reflects the results of the revenues and operating expenses of that business as well as a one-time charge for in-process R&D of approximately $22 million, as well as one-month amortization of certain acquired intangible assets. In short, as we had expected, the overall impact of this acquisition on our Q3 income statement was a decrease of approximately $30 million to $35 million of net income or approximately $0.04 per share.

From an integration standpoint, things are going well. Our teams are operationally connected already and customer response has been great. In Q4, the impact of MySQL is currently estimated to be in the same overall range as in Q3. This will reflect a near-term full quarter impact of the standalone business and ongoing amortization.

In Q1, we began reporting a non-GAAP measure that we entitled adjusted EBITDA. We believe that it is important to look closely at our company's fundamental value in addition to ways reported under generally accepted accounting principals. The principal measure that we use at Sun is adjusted EBITDA as that measure more effectively depicts the cash generating capability of our quarterly results. During Q3, our adjusted EBITDA was $230 million or 7% of revenue, an increase of 7.5% on a year-over-year basis.

Looking at Q4 and beyond, there are a number of factors that we are looking at. We continue to focus on revenue growth as a top priority, and we are taking action to improve the level of profitability. In Q4, we intend to take a restructuring charge between $130 million and $220 million. The actions include a reduction in force of approximately 1500 to 2500 people. We expect that this will result in a more efficient coverage model with resources aligned to growth opportunities, as well as a more focused and effective demand creation capability.

We expect that this restructuring will lower our annual operating expenses by approximately $100 million to $150 million on an annual basis. We expect the majority of this run rate benefit will be reflected in our income statement by Q2 next fiscal year. Given our Q3 experience in US, we have revised our view of Q4 revenues. There still appear to be a number of customers whose spending plans are uncertain. We now view that our Q4 revenues will be roughly flat on a year-over-year basis.

We still plan to complete the conversion of a number of our EMEA channel partners to sell out, as we did with our US and China partners in Q2. The impact of that change, which will be in the range of a $20 million $40 million reduction in revenue in Q4, is contemplated in the above statement.

We do expect a sequential increase in gross margin for both, products and services due to improved mix and volume respectively. Excluding the impact of MySQL, and the restructuring charge, we expect to be solidly profitable in Q4 at the revenue level noted above. Our previously stated guidance ranges for the full fiscal year 2008, for R&D SG&A of $5.7 billion to $5.9 billion, stock-based compensation of $215 million to $240 million, amortization of intangibles to $250 million to $300 million, and a tax provision of $200 million to $250 million are all still in effect. Net interest income is now expected to be $150 million to $170 million for the full fiscal year 2008.

As we look at next fiscal year, the same uncertainties are on our minds. We had previously stated that we are targeting, prior to the MySQL acquisition, a GAAP operating income of at least 10% next fiscal year, and we are targeting a 9% level after this acquisition. As I spoke about this, I articulated that we were basing this on a combination of revenue growth, gross margin expansion, and operating expense reduction. It is clear the single biggest inhibitor to our ability to achieve such results is in fact what we are seeing now, in major economy in some difficulty.

We believe we are on the right track; we are making the right investments, and disinvestments, and plan to improve our profitability next fiscal year on an annual basis. At the highest level, we intend to grow our revenues, maintain annual gross margins, and reduce both R&D and SG&A in absolute dollars next fiscal year. We intend to capitalize on the previously identified opportunities to grow our business due to the acquisition of MySQL.

We are currently targeting a GAAP operating margin, including the impact of MySQL of at least 7% in FY’09. In our June quarter conference call, we will talk more about next year, but I wanted to at least give you a sense of where we were headed at this time.

With that, I will turn it back to Ron.

Ron Pasek

Thank you, Mike, and Jonathan. I need make one correction, computer systems product revenue was $1.473 billion, a decrease of 1.8% year-over-year. Before we begin the question and answer session, I would like to request that each of you ask just one question consisted of one part, this way we hope to get through most of the questions in queue today. If there's time remaining, we will be happy to take your follow-up questions. Operator, Kathy, will you please start the question and answer session.

Question-and-Answer Session

Operator

(Operator Instructions) We will take our first question from Richard Gartner from Citigroup.

Richard Gartner - Citigroup

Thank you very much. You talked about the weakness primarily being in the United States, but Europe also experienced a pretty sharp deceleration in local currency, and all of the signs from your distribution partners point to further deceleration in Europe. So, I am wondering if you can talk a little bit about what you are seeing in Europe, whether you have seen any slowdown in business there toward the end of the quarter, and what you think the outlook there is for the next quarter or two. Thank you.

Jonathan Schwartz

Richard, this is Jonathan. For the most part we have not seen a similar slowdown or anything even close to what we saw in the US, interactions with our partners and customers from Europe has been as strong as ever. Again, if anything they are probably a little more focused on energy efficiency and moving toward open source. So I think we remain pretty confident and pretty optimistic about the opportunity in Europe.

Ron Pasek

Operator, next question?

Operator

Our next question comes from Shannon Cross of Cross-research.

Shannon Cross - Cross Research

Hi, yes, good afternoon. Can you talk a little bit more specifics about the restructuring, where you are targeting? How you think it will roll through anything you can give us just to give a little more clarity, since you have obviously been restructuring for a while. How you can do this without really impacting your growth revenue opportunities more than they are being impacted right now from the economic standpoint.

Michael Lehman

So it's Mike Lehman, and as Jonathan mentioned up front, we are always looking at ways to invest more effectively, and disinvest where we can. And generally speaking the disinvestments that we will be making will be in areas that we believe will not have an impact on near-term and longer-term revenues. So it is not like, we have not been thinking about this. We have been talking about for years the overall intention to reduce absolute dollar R&D and SG&A expense, lots of ways to go do that. We have ongoing programs to do that. And in particular, this particular time around we are targeting the reductions where we believe there will be not near-term impact on revenues.

Jonathan Schwartz

And maybe just to piggyback on that. In some of the decisions we make, we decide to concentrate on one investment, rather than two, and but use that initial investment to go in to both markets. So the example would be we recently announced a full line of those open-source Solaris platform those are now built of as entirely the Solaris operating platform leveraging open source ZFS File System.

So, on the one hand we took R&D down as we removed some of the proprietary technology, but preceded that decision, but on the other hand we can now take Solaris, which was historically vestured at computers and begin to use it to build out our storage business. So that's an instance, obviously of doing more with less, and again, I think that reflects the priorities we hear from our customers as we move away from proprietary technologies, and really begin to eliminate their usage inside of Sun or across our product line. We see our customers doing the same thing.

Ron Pasek

Operator, next question?

Operator

Ben Reitzes of Lehman Brothers you may ask you question.

Ben Reitzes - Lehman Brothers

Yeah, good afternoon. I mean could you talk a little bit more about your product line and, it's just -- perhaps you saw some weaknesses at the high end, et cetera. How do we know it does not get worse in the economy? IBM has a couple of new products coming out or already out, and its increasing competitiveness. Can you just give us a better feel for why it might not get worse at the high end before it gets better?

Jonathan Schwartz

Yeah Ben.

Ben Reitzes - Lehman Brothers

Hey.

Jonathan Schwartz

We are seeing a couple of things. Firstly, new customers are clearly using large numbers of small computers to replace the need for very large computers, and that is why we saw our Niagara business grow as rapidly as we did and there really is no analogy in our competitors product line for what we are doing with Niagara it's an 8-core, 8-thread chip it is the equivalent of a 64-way piece of silicon and that obviously allows us to achieve levels of efficiency that our peers can't. And again, I think that is reflected in the growth. Secondarily, we actually feel quite good about the competitiveness of our high end. And some of the decisions we saw in the third quarter were decisions to push out revenue in the fourth quarter and we have seen some of those decisions now closing in the fourth quarter

So we were very careful to go look through and see are these competitive issues, are these distribution issues, are these economic issues, or execution issues, and in every event that we could identify they were decisions based on, I think I will exercise some caution and just put off the decision and see how things turn out.

Not surprisingly there is notable investment bank on the East Coast that found itself being sold to another investment bank. Around the time of that transaction we saw a lot of people wondering what was going to go on in the economy, and again, there is some level and anxiety building up to that, but we see some lightning of that, and again we feel very, very good about the competitiveness of our APL product line and high end in general. Same thing by the way applies to the tape platforms.

Ron Pasek

Kathy, next question.

Operator

Our next question comes from Jeff Fidacaro of Merrill Lynch.

Jeff Fidacaro - Merrill Lynch

Yes. I was wondering if you could elaborate. The revenues appear to be flat in to the fourth quarter; how are the regions looking within that guidance and if you can talk a little bit more about some of the deals that got pushed out via attached rates and the impact there?

Michael Lehman

So it is Mike Lehman, and I am not going to give a forecast by the 16 geographies, but it's pretty clear at the highest level. We expect that the US would still be down slightly year-over-year. We do not expect it will be down as much as we saw in Q3. However, we still expect as we look at the overall flat number of years it would be down a bit offset by the growth in EMEA and APAC.

Clearly, many of the deals that we are talking about have systems and storage associated with them, absolutely. They are not separate deals. The fact that the two numbers were relatively close to each other is not just a coincidence. There are a lot of them that are linked that are system's end storage, when I talked about the shortfall. However, they are not all one for one, but clearly there is a lot of affinity and a good attached rate.

Jonathan Schwartz

I think just alongside that and just to make sure everybody is aware of this, it is going to be increasingly difficult for us to talk about attached rates when what is the storage device are exactly the same components and exactly the same operating systems that are used in building out our servers.

So the industry is converging, we are one of the drivers of that convergence, and going forward we going to be clear about what our overall revenue is, and using the intellectual property we have to enter as many markets with that common platform.

Jeff Fidacaro - Merrill Lynch

Thank you.

Ron Pasek

Kathy, next question.

Operator

Thank you. Our next question comes from Andrew Neff of Bear Stearns. Andrew Neff, you may ask your question. Our next question comes from Katy Huberty of Morgan Stanley.

Katy Huberty - Morgan Stanley

Thanks, good evening. Mike, can you go back over why product deferred revenues grew so much, given the market slowdown you saw late in the quarter, and maybe touch on what you have seen in terms of the deal closings so far in April?

Michael Lehman

Yes, so again, the growth in product deferred revenues we have seen actually continue fairly strongly in the last year, and it really is a reflection of the packaging of products and services that that customers want, and again, as you saw with our professional services revenue growth of more than 10%, we are participating in the design and build-out of data centers with our customers, and so there is often a combination of hardware and professional services that results in a longer time for implementation and acceptance, and that's what we are seeing.

As Jonathan indicated, we were tracking a pipeline in Q3. A lot of the deals are still there, some of those have closed, but as I said, I do not think it's prudent to assume that all of the deals that got pushed out are going to close in this quarter and then necessarily become additive to the prior run rate, which is why we think prudently just looking at the overall number in Q4 to be relatively flat year-over-year.

Jonathan Schwartz

And just for a little more insight on the deferred. We obviously have looked at what's the calendar and the timeframe within which we expect those deferred to convert to revenue. We have also looked at the overall mix of the deferred and it tends to be higher end systems and richer configurations because they are part of the higher-value deals. So, again that's just a little bit of insight into what the future holds for us.

Ron Pasek

Next question, please?

Operator

David Bailey of Goldman Sachs. Your line is open.

David Bailey - Goldman Sachs

Yes. Thank you very much. In addition to the macro environment, could you please give us an update on what's going on in the competitive front and I think you had said that you didn't move any share, but IBM was up 2% in their Unix business this quarter and you were down 2%. So, if you could give us an update, that would be great.

Jonathan Schwartz

I do not really know how IBM counts because I think I see this as being off, and I think it was 20%-plus. So, it is really tough to get it on a unit-by-unit basis. So, I think the one geography in which we tended to struggle was the US. And again I do not know how IBM breaks out US hardware performance specifically, that might be an interesting question to ask.

But broadly speaking, we have seen endorsement and growth in the Solaris platform and that's both on our own hardware as well as in the markets that our partners are creating. And we have continued to sign up OEMs for Solaris and the fact that we have an open-source operating system really doesn't have an analogy with most of our peers because they do not have operating systems in the open-source community.

And I think in terms of the share, we are gaining on the Niagara front, we are up 100% year-over-year, and I think it would be interesting to look at how you measure that. I think we tend to measure it on the whole, and just see ourselves competitively placed, somewhat uniquely with a very attractive open-source operating platform and again one that we can use to enter not only new areas of the server market, but we can begin to much more aggressively push out into the storage market.

Ron Pasek

Next question, please.

Operator

Andrew Ness with Bear Stearns, your line is open.

Andrew Ness - Bear Stearns

Sure. Mike, I want you to go back to the guidance you had given. In the prior projections that you served you, it depends on the comp growth, you surely talked about that you would get to the margin guidance, and you would take steps, as I recall, to get there regardless. And now you seem to be saying, well, the economy is what it is, we just have to bring the guidance down. Why can you not pull additional leverage to stay with the margin guidance that you gave before?

Michael Lehman

So, I have talked about this long and often and probably in every meeting that I have been in, and the good news for me is that I keep track of what I say and I have other people help me keep track of it. I have consistently stated for the last couple of years that in order to hit the 10% operating income, we needed reasonable but not dramatic revenue growth. We talked about that in low- to mid-single digits for a couple of years compounded.

That is a big factor. And while we have made tremendous progress on the gross margin expansion, and we will take further actions to reduce our operating expenses, at the end of the day, and I have been very clear and consistent about this, meaningful revenue growth for a couple of years compounded is a principal driver, and absent that it is going to be very difficult, because we do not want to make short-term choices to just hit and arbitrary operating income goal that would impact the longer term-health of the business.

Ron Pasek

Next question, please.

Operator

Keith Bachman of Bank of Montreal.

Keith Bachman - Bank of Montreal

Hi, Mike. I wanted to ask a question about gross margin. You mention that mix negatively influenced gross margin. Given how you described the environment, as well as the strength of Niagara will mix continue to be a headwind as you look out over the next couple of quarters on gross margin? And also I just want to sneak in, if you could give us your views on what you think FX did for you on an annual basis? Thanks

Michael Lehman

So, I am not going to say anything more than about FX than I have already. It is not a science in calculating that, because the principal thing that FX does not take in to account is pricing actions, and the mix of the products. So it has a minor impact on revenues and margin positive. We can see the negative impact on expenses and net-net it's not a huge number in our overall P&L.

In terms of the mix, again, many of the customers that we were tracking in our pipeline are the types of customers that were buying the high-end systems and tape platforms. We do expect that a number of those and many of those deals are really pause and deferral as opposed to the fact that they went away. So we expect that we will see a rebound in the mix. We typically see a rebound in the mix in the fourth quarter as well, so some of its historical, but a lot of it is just based upon the deals that we are tracking.

Ron Pasek

Next question, please.

Operator

Next question come from Lou Miscioscia of Cowen & Company.

Lou Miscioscia of Cowen & Company

Okay. Thank you. I guess if you just focus a little bit more on the product and maybe also on sales in the sense it has been five quarters now where the high-end really has not, really built up I think to your expectation. I know you have these APL servers out there, but do you have to accelerate bringing Rock in and until you sort of get to that, is it really going to be just reentering? The alternative with relays obviously doing very well with Solaris and Niagara, but do you have to do something to really get outside of the install base to really sell some of your more high-end other accounts to really get the revenues growing again?

Jonathan Schwartz

Yeah. So in Q1 2008, this is Jonathan, we were, the high-end was up 24% year-over-year, Q2 they were up 8% and this year I think were down, so it tends to be a pretty lumpy business. But we are pretty pleased with the performance, and again, the fact that we have such a large Solaris community to draw really helps to drive the competitive into the platform. So we feel pretty good about the high-end and our high-ends are only improving as we speak.

So now simultaneous to that, we are definitely building our Solaris business outside of our hardware business, as you know, Intel signed on as a Solaris OEM, DELL signed on as a Solaris OEM and IBM is also now a Solaris OEM. We recently signed another system's vendor as an OEM, and we continue to work with a customers and partners across the world to bring Solaris to every platform on which they run.

And now increasingly with CFS again on their storage devices. So, I think broadly-speaking we are pretty happy with the adoption of the operating system on and off Sun. In terms of high-end opportunities those are not going away. Typically horizontally scaled system tend to scale vertically, which is a just a polite way of saying when you end up with 500 servers sometimes they end up with 500 two ways and 500 four ways and then they end up thinking maybe SMPs were a good idea. So we are pretty comfortable.

Ron Pasek

Next question, please?

Operator

Your next question comes from Tony Sacconaghi of Stanford Bernstein.

Tony Sacconaghi -Stanford Bernstein

Yes, thank you. Mike, I just wanted to follow up on your comments around guidance around 2009. You and Jonathan had stated right from the beginning that your goal was to set objections that were achievable and to meet them. That was basically what you wanted to do. When pressed on the guidance for 2009, and the 10% operating margin, you basically said, well, there were conditions around our meeting that, and those conditions do not hold any anymore, so that guidance doesn't really live up anymore. Can you reconcile this notion between setting targets that basically you are saying we are going to hit, and that being a philosophy of yours and Jonathans? Accordingly, how do we think about your now fiscal year '09 guidance of 8% operating margin? Is that also predicated on certain conditions, and what kind of confidence can we have on those conditions?

Michael Lehman

Hello Tony, it is Mike. It is a fair to say that we are disappointed that we are not able to go after the operating income targets that we set a couple of years ago. We do believe that is largely driven by the US economy, and what is going on in the economy. We are not the only company affected by that. We believe that is a fairly significant impact, and it would be damaging to the long-term health of the company to take arbitrary action just to hit that number. So we believe that in the circumstances and by the way I previously described those circumstances that if the macro economic factors went against us, that that might cause us to revisit this area. So that is in fact what has happened. So while we are disappointed, we believe it is more prudent to take this action than set new goals for next year, so that people have a sense of how we are looking at the business.

Ron Pasek

Next question?

Operator

Your next question comes from Bill Fearnley of FTN Midwest.

Bill Fearnley - FTN Midwest

Yes, thanks. Mike, if I could add another follow-up question on the restructuring here. How much is outside the US? And does that delay the timing of the actions and the progress? Addressing your earlier comment, if the economy does improve, would you restructuring guidelines here would the cutbacks get smaller here over the next couple of quarters if you saw a recovery?

Michael Lehman

So as we look at the areas that we are investing and disinvesting, when we make an announcement like this we intend to make the disinvestments. Certain of the people affected are outside the US. We will know better about that early next quarter at the highest level there is a pretty good better than a majority that are in areas, and that is why we said we are record the majority of the restructuring charge in Q4.

Ron Pasek

Next question?

Operator

David Wong of Wachovia, you may ask your question.

David Wong - Wachovia

Thank you very much. I think you said services were pretty much in line with expectations but hardware was quite a bit short for the quarter. Is there a different customer mix or at least to these results? Or it is the same people that are finding they need services but less hardware.

Jonathan Schwartz

No, this is Jonathan. Typically what happens is you services tends to be a recurring revenue stream, which is on the one hand sensitive to unit volumes going out the door because people have the opportunity to buy services on new systems, but also there is curtail to that business, because they have an existing installed base of systems and they do not want to let them fall out of service, or keep in current. So this was what we expected when we began to see the decline, which was that the services business would be more predictable, and less bumpy than the sale of new systems.

Ron Pasek

Next question, please?

Operator

Our next question comes from Chris Whitmore of Deutsche Bank.

Chris Whitmore - Deutsche Bank

Thanks, good afternoon. When you see sharp slowdowns towards the end of the quarter, the channel tends to get caught with excess inventory. Some contacts have suggested that is the case and there is too Sun inventory out there in the channel. Can you comment on channel inventories in both the US and Europe as you exited the quarter? Thanks.

Michael Lehman

Yes, it is Mike Lehman again. And the good news for us is that we have been working very closely with our channel partners over the last six months, nine months as we talked about, so we can improve our ability to ship predictably on time with minimal lead times, and therefore, they have been able to lower the amount of inventory that they have. I as mentioned we have now gone to sell-through revenue recognition in US and China, we will move to that in most of EMEA by the end of Q4, and so our view is that frankly the channel inventories are low, continue to be low at reasonable levels, and that's been an effective partnership.

Ron Pasek

Next question, please.

Operator

David Bailey of Goldman Sachs.

David Bailey - Goldman Sachs

I just wanted to follow up on that with your internal inventory, was up quite a bit sequentially. I was wondering if you could discuss the composition, whether you will be able to work that down in the fourth quarter.

Michael Lehman

Yes, it is Mike Lehman. The answer is yes. It was up a bit sequentially that was in our view, as I mentioned we had a revenue shortfall. We were building inventory for that revenue. We expect we will be able to work through that revenue in the fourth quarter with no noticeable impact.

Ron Pasek

Next question, please?

Operator

Our next question come Keith Bachman of Bank of Montreal.

Keith Bachman - Bank of Montreal

Hi. Thank you for taking my follow-up. Two things on just the restructuring, Mike. Again, I want to go back to where the people are coming from, because I did not hear the answer to that. Secondarily, if you are taking, I think you said 1,500 to 2,500 people out and expect savings of $100 million to $150 million that seems like a low ratio in terms of the benefit per person.

Michael Lehman

Yeah, so, again, I am not going to attempt to quantify by geography. There will be a significant number that are in….

Keith Bachman - Bank of Montreal

Not by geography, Mike, I was just thinking about R&D, sales, admin, any kind of categorization by functional area.

Michael Lehman

So what I have said is, we are going to take down total R&D spending, and SG&A spending. Some of that will be because of headcount reductions, some of those will be programs, as Jonathan alluded to you earlier, so we are not going to, again, forecast a breakdown by function.

Ron Pasek

Next question, please.

Operator

(Operator Instructions) We will now take our final question from Bill Fearnley of FTN Midwest.

Bill Fearnley - FTN Midwest

Yes. Thanks for the follow-up. Jonathan, in the past you talked about systems -- about customers replacing existing systems with larger systems during projects like virtualization. Is that still true? What did you see for the trend on the quarter just past, and what do you see here for the near-term trend as well? Thanks.

Jonathan Schwartz

That is still very much true. We saw actually outstanding growth on our blade business. We saw a very good growth on more richly configured Niagara 2 systems. Again, those were really quite highly in demand, and so in some ways it comes down to your definition of what is a big system?

With the evolution of blades you can get 48 blades in one rack. Are they small systems, or is that a big system? We still see that trend toward higher value systems and more richly configured system as continuing unabated. I do not think that frankly at this point is ever going to slow down, so we see ample opportunity not only on the systems front and the storage front, but again, the good news with working in the OpenSolaris community is the kernel at the heart of Solaris knows that it's scaled to the tallest mountains and biggest systems, so we can provide an operating system for a couple of -- for both laptops, for the storage platforms, for the systems platform, for small systems and big systems alike.

Ron Pasek

Thank you for joining us today. Investor relations' personnel will be back in our office shortly to respond to any further questions. You may contact us through our Investor Relations main number at 800-801-7869.

Operator

This concludes today's conference call. We appreciate your participation. We are again providing an encore replay service this quarter. If you joined this late or wish to hear any part of the conference call again, you may call the replay service anytime after 3:30 p.m. Pacific Time today to hear recording of this conference call. The phone number for the replay is 866-469-5765 or 203-369-1464. No pass code is required. Thanks again for taking the time to join today’s conference call.

This concludes today’s call. You may disconnect at this time.

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Source: Sun Microsystems Inc. F3Q08 (Qtr End 03/31/08) Earnings Call
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