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Executives

Ron Pasek - VP Treasurer of Sun Microsystems

Jonathan Schwartz - President and CEO

Mike Lehman - CFO and EVP of Corporate Resources

Analysts

David Wong - Wachovia

Ben Reitzes - Lehman Brothers

Katy Huberty - Morgan Stanley

David Bailey - Goldman Sachs

Richard Gardner - Citigroup

Keith Bachman - Bank of Montreal

Tony Sacconaghi - Sanford Bernstein

Shannon Cross - Cross Research

Louis Miscioscia - Cowen and Company

Scott Craig - Banc of America

Bill Fearnley - FTN Midwest

Jeff Fidacaro - Merrill Lynch

Mark Moskowitz with JPMorgan

Bill Fearnley - FTN Midwest

Sun Microsystems Inc. (JAVA) F4Q08 (Qtr End 06/30/08) Earnings Call July 31, 2008 8:00 AM ET

Operator

At this time, I would like to welcome everyone to the Sun Microsystems fiscal year 2008 third quarter results conference call. (Operator Instructions).

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

Ron Pasek

Good morning. Thank you for joining the Sun Microsystems quarterly conference call. With me today is Jonathan Schwartz, Sun's CEO; and Mike 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 full year and fourth quarter fiscal year 2008 which ended on June 30, 2008. 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 if 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 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 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 to not come true. We do not currently intend to update these forward-looking statements except 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 reconciliation.

Now, let's go to the financials for Q4. Sun's total revenues for the fourth quarter of fiscal year 2008 were $3.780 billion, a decrease of 1.4% as compared with $3.835 billion in revenue reported for the fourth quarter of fiscal year 2007. Total gross margin was 44.3% of revenue a decrease of 2.9 points over the gross margin for the fourth quarter fiscal year 2007.

Total R&D and SG&A expenses were $1.5 billion, an increase of $28 million year-over-year. In the fourth quarter of 2008 we recorded a $46 million tax provision. GAAP net income for the fourth quarter of fiscal year 2008 was $88 million or earnings per share of $0.11 as compared with GAAP net income of $329 million or earnings per share of $0.36 for the fourth quarter of fiscal year 2007.

Non-GAAP net income for the fourth quarter of fiscal year 2008 was $275 million or EPS or $0.35 as compared with non-GAAP net income of $458 million or EPS of $0.50 for the fourth quarter of fiscal year 2007.

Non-GAAP net income excludes the following: Purchased and processed R&D, amortization of acquisition related intangibles, stock-based compensation, restructuring and related impairment of long-lived assets, gain on investments, settlement income and the tax effect of these non-GAAP adjustments.

Q4 product revenues totaled $2.386 billion, a decrease of 4.3% year-over-year. Within product revenues; computer system product revenue was $1.722 billion, a decrease of 7.1% year-over-year. Storage product revenue was $664 million, an increase of 3.9% year-over-year.

Q4 services revenue totaled $1.394 billion, an increase of 3.8% year-over-year. Within services revenue; support services revenue was $1.42 billion, an increase of 1.8% year-over-year. Revenue from professional services and educational services totaled $352 million, an increase of 10.3% year-over-year.

We ended the quarter with a cash and marketable debt securities balance of $3.310 billion and generated positive cash flow from operations of $90 million in Q4.

In Q4 '08 we repurchased 35.7 million shares worth $464 million, shares were repurchased at an average price of $13.01. We now have $36 million remaining of the $3 billion share repurchase program that was announced in Q4 '07. You will note that our outstanding shares for the quarter decreased by 31 million from Q3 '08. Sun also announced today that its Board of Directors had authorized an additional repurchase up to $1 billion of the company's outstanding shares.

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

Jonathan Schwartz

Great. Thanks, Ron, and thank you all for joining us early this morning. Let me start with my perspective on the full year and followed by a discussion of the growth segments of our business and then I'll just end on the operating priorities for FY '09.

Sun's revenue for the year was roughly flat, with growth around the world entirely offset by declines in the US. The declines in the US were about 8% for the year. There's no question the challenging US macro environment has hindered our ability to grow the top line and we've got a greater share of our business in the US than many of our peers, and a more notable focus on data center versus consumer technologies and frankly a historic focus on a fairly challenged Financial Services sector.

With this in mind, we've been aligning ourselves with high growth customer segments, technologies and emerging economies across the world; where our developer communities are healthiest and thus where our business opportunities are growing most dramatically as well.

In the three geographies outside the US, we demonstrated solid growth during the year. Our '08 revenue in Europe, the Middle East and Africa grew 5%, our Asia Pacific business grew 3%, our International Americas grew 16%. Emerging markets growth continued to pace in '08 with Brazil growing 20% year-over-year, Russia growing 12%, India growing nearly 30%, and Greater China growing 13%.

I'd now like to provide a few specific examples of the areas of our business that fueled our progress during the fourth quarter. To start, our MySQL team delivered a solid Q4 with billings growth of over 44% year-over-year. I feel confident in saying MySQL remains the fastest growing database among the market leaders. The adoption of MySQL has been dramatic with 12 million installed users, and adoption that continues to accelerate.

In fact we just announced earlier this week another example of our momentum was LinkedIn, what appears to be the fastest growing professional social network purchasing a multi-year subscription to MySQL and Solaris to power their infrastructure and support their demands.

Our power efficient Niagara-based CMT systems delivered 61% year-over-year billings growth in Q4 with 84% growth for the full fiscal year. This was a $1.1 billion business for Sun in FY '08 growing well within, as well as beyond our install base. These systems really lead the market in energy efficiency at a point where many CIOs and our customers are finding themselves responsible for, and often limited by their energy budgets.

On the storage front, we've moved our investments toward open storage, and are seeing early returns. Our first open storage product in what will be a far broader line in the upcoming year, first product known as Thumper or the Sun Fire X4500 grew billings 37% year-over-year in Q4 and again this was driven by the popularity of our open source ZFS file system, which is the foundation of our open storage product line across the board. You'll see us expand aggressively in open storage in FY '09.

Revenues from professional and educational services were up 10% year-over-year in Q4 and up 9% for the full year. Customers are continuing to look to Sun for the implementation of high scale and mission critical data centers whether they're implementing a global MySQL deployment or a high performance computing facility.

Our x64 based systems were up 1% year-over-year in Q4 and up 3% for FY '08. This was certainly well below our expectations. And reflected both delays in AMD Quad-Core platforms and in fact frankly we did not have a full Intel product line up. During Q4, our Intel line up was more complete and as a result we saw billings for our Intel product platforms grow to over $62 million in Q4, up from less than $1 million a year ago.

As for the traditional SPARC based enterprise systems we were disappointed in the slowing in Q4, more sharply in the US, where delays on large purchases reflect the economic anxiety far more than competitive positioning. Our Solaris 10 based M series products continued to perform well with billings growth of 55% sequentially and over 200% year-over-year.

Now that being said, outside of the macro issues that continue to weigh on our customers, we are making changes to insure we deliver consistent and expanding operating profitability. We are at this point the industry's category leader in open source innovation across every aspect of the data center, and are positioning ourselves to be the biggest beneficiary.

Although the last two quarters were tough for Sun, we continue to see great progress from the accelerating adoption of MySQL to increased traction for ZFS to growing interest from customers that are looking to consolidate data centers with products like our open source virtualization offering Sun XBM.

Most importantly, the ongoing endorsements from customers tell us that open source will be their path forward in enterprise computing. In fact, we're already seeing evidence of this transition with companies like SugarCRM, who provides the world's largest open source customer relationship management platform. As a customer of ours and as a partner in the marketplace they see the value, and as stated and I quote, "The combined strength of MySQL and Solaris and OpenSolaris offers the best price performance in the industry".

As companies continue to compress budgets and move away from proprietary and closed source vendors, whether that's database vendors, storage vendors or operating system suppliers, Sun is uniquely positioned to capture that demand, and we aren't the only ones seeing that transition. According to a recent Gartner report, by 2012, more than 90% of enterprises will use open source indirect or embedded forms.

Now to support the open source strategy, we're making aggressive changes in our resourcing and sales force alignment and will continue to make hard choices to align Sun for the greatest value and opportunity in front of us.

Growing revenue and expanding profitability remain our number one priorities and as such, we'll be executing against and investing in four key focus areas to fuel growth in '09.

First, we'll continue to target incremental resources in emerging economies to take advantage of growth opportunities.

Second, we'll continue to focus on acquiring new customers by leveraging our partners and continuing to cultivate communities such as MySQL, ZFS, Solaris, Lustre and XBM.

Third, we are funding programs and sales alignment activities to support key market segments that align with Sun's innovation, including high growth segments such as high-performance computing, and the global web build out.

Fourth, we'll continue to optimize our software platforms to drive commercial revenue and sales.

The commercial adoption of open source technology is gaining traction, and we have begun to see the effects of this with our open storage products, such as with ZFS. You'll see a similar effect as we further optimize our systems around offerings to include optimizations for MySQL, for Lustre and other key product lines moving into '09 and beyond.

I'll look forward to updating you on these four areas in the coming quarters, and I remain confident in the future in our ability to deliver value to our customers, our shareholders, employees and communities around the world.

With that I'd like to pass it over to Mike Lehman.

Mike Lehman

Thanks, Jonathan. I will focus most of my remarks on the Q4 results, but also look at some things on an annual basis to help put our annual guidance for the current fiscal year into perspective. While overall Q4 revenues were essentially inline with our expectations, total gross margin was roughly a point to a point and a half less than we had expected about 90 days ago.

To be more specific, our products margins which last year improved sequentially in Q4 declined by just over 2 points. While our customers continue to push all vendors and partners for aggressive discounts, the principal reason for the sequential decrease in product margins was in fact the mix. As we experienced in Q3, the percentage of revenues from the high end of the server line decreased as a percent of total revenues and those carry relatively high gross margins.

Revenues from our midrange and enterprise storage products increased as a percentage of total revenues. Those products, which do not contain a significant amount of Sun's intellectual property, carry gross margins which are generally less than the corporate average. Our support service margins as expected improved sequentially as such margins are largely driven by the seasonal increase in revenues.

Our operating expenses increased sequentially in Q4 as expected. The primary reasons for the increase include increased commissions and other incentives related to higher revenue. Incremental sales headcount, we added approximately 200 people to the sales teams in Q4, mostly in the emerging markets, and we will continue to make changes to the alignment of the sales resources in the coming months.

Operating expenses also reflect the full quarter's impact of the MySQL team that joined Sun in late Q3. Such amounts also include increased amortization of intangibles acquired and stock-based compensation. With regard to the restructuring that we announced during our Q3 conference call, we recorded a charge of around $100 million in Q4.

As most of you know, many countries have different rules and regulations with regard to how and when individuals may be notified of such actions, and our accounting charge is driven by that. We expect to take a charge of up to a similar amount in Q1 which will largely get us to the levels that we had previously communicated.

Cash flow from operations in Q4 was $90 million the majority of the decrease year-over-year was due to the lower operating income. For all of fiscal '08, cash flow from operations totaled $1.3 billion, which compares to $958 million in the prior fiscal year.

It is also useful to note that total deferred revenues grew approximately 12% sequentially and around 8% versus Q4 of the prior year. This sequential increase continues to reflect two trends. The first is that an increasing number of our installations include professional services which increases the value we provide but necessarily requires that we record revenues when such projects are completed and/or accepted.

The second trend is that more of our software values are being captured as subscriptions, including MySQL and other products. Again, such revenues are recorded over longer periods than any one quarter. We are pleased with the growth of such deferred revenues as they form the foundation for a more predictable revenue and margin stream overtime.

It is also important to remind you that we worked with our channel partners around the world during the past fiscal year and greatly reduced the amount of inventory stocked by them. We also converted to the sellout method of recognizing such revenues during the year, including during Q4 when we converted the majority of our EMEA partners to this method.

During the fiscal year, we estimate that we reduced our revenues by around $150 million as a result of these initiatives. We enter fiscal year '09 with that largely behind us. As many of you know, we are engaged in a multiyear internal systems implementation effort. We have two of our five major modules that have gone live and another smaller one scheduled to go live later in August.

The two largest pieces of this overall effort are still in front of us. The next large phase is currently scheduled to go live in January of calendar '09 with the final phase of approximately one year later.

We continue to invest a significant level of internal and external resources on these necessary efforts. We remain confident that these efforts will result in a more cost-effective, efficient and responsive business model, but we still have our ways to go before being able to take full advantage of these initiatives. We will continue to update you along the way.

As we reflect on fiscal '08, despite the challenging US environment in the last six months, we delivered improved annual results in the following key areas: increased gross margin dollars by approximately 3%. We decreased total R&D and SG&A expenses by approximately $70 million despite acquisitions and the negative impact of currency. We improved our non-GAAP EPS by 21% for the fiscal year and increased cash flow from operations by over $370 million.

We entered the new fiscal year with a number of challenges. As Jonathan mentioned above, we have a plan and a number of specific initiatives underway to help our teams focus on the opportunities in front of us. As we evaluate the current fiscal year, and as we continue to monitor our progress on all fronts, the biggest variable will continue to be the buying patterns of our large base of US customers.

The following are some of the key assumptions inherent in our fiscal year '09 operating plan. And these are annual assumptions. We expect modest low single-digit growth in revenues. We expect year-over-year declines in the US until at least the second half of the fiscal year, and we expect the first quarter in particular, our first fiscal quarter to be challenging on an overall basis.

We expect a slight decline in revenues on a year-over-year basis in Q1. Given the normal seasonality in Q1, and our continued challenges in the US economy, coupled with a restructuring charge of approximately $100 million, pursuant to the previously announced restructuring, we do not expect Q1 to be profitable on a GAAP basis.

We are planning for roughly stable gross margins on an annual basis. There certainly will be the usual seasonal and volume impacts throughout the year. We are expecting total R&D and SG&A to be up slightly in fiscal '09 to reflect the impact, a full inclusion of the operations of MySQL, the impact of annual incentives and the increased amortization of the systems implementation we are undergoing.

We currently expect that our ending fiscal year '09 headcount will be approximately 33,000. We ended fiscal year '08 with approximately 34,900. We expect annual GAAP operating income in a range of 5% to 7%. We have provided a range at this point largely due to the uncertainties associated with the US economy. At those levels, we would be delivering a modest increase in GAAP operating income percentage on an annual basis.

While it is still our intention to drive towards a longer-term operating income level of at least 10%, given the current environment we are focusing on how to improve our results one year at a time. We expect to generate cash from operations in the range of $1.1 billion to $1.3 billion in fiscal year '09.

There are a few key assumptions beneath this overall model which I will highlight now as well. We expect approximately $230 million to $260 million of stock-based compensation expense. We expect amortization of acquisition related intangibles to be in the range of $275 million to $325 million. We expect net interest income of approximately $25 million $50 million. We expect the full year tax provision to be approximately $225 million to $275 million. We expect the full year capital expenditures to be approximately $450 million to $550 million.

With regard to the impact of MySQL in the current fiscal year, as we had stated at the end of Q3, we currently expect the overall impact of this to be slightly negative on a GAAP basis and essentially breakeven on a non-GAAP basis in fiscal year '09. We are clearly making decisions for the longer term and not simply attempting to maximize short-term income statement or balance sheet metrics. We are working to build a long-term sustainable franchise based on ownership, delivery, and monetization of intellectual property.

With that, I will turn it back to Ron.

Ron Pasek

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 is time remaining we'll be happy to take your follow-up questions. Laurie, will you please start the question and answer session?

Question-and-Answer Session

Operator

Yes, thank you. (Operator Instructions). We'll take our first question from David Wong with Wachovia.

David Wong - Wachovia

Thank you very much, if I heard correctly, you said x64 sales were up 1% year-over-year in Q4 but your slide shows 28% unit growth, so are ASP declines of the order of 18%, you've had fairly large ASP declines and can you give us the percentage of sales of Intel based systems, please?

Jonathan Schwartz

This is Jonathan. So, the breadth of the offering is extended pretty dramatically within the year for example, we actually drove quite a considerable expansion in our blade platforms. So the ASP declines aren't going to be all that illustrative in terms of what we are selling. We are selling everything from a spectrum of open storage products all the way down to kind of the low-end commodity side of the marketplace.

So, in general, I think we are pretty happy with the progress. Intel right now is making up an expanding portion of our overall business, but we are not actually breaking out the exact splits. And again, I think we'll probably have a more balanced growth between the two vendors in the upcoming year.

David Wong - Wachovia

Great, thanks.

Ron Pasek

Next question, please?

Operator

Thank you. Our next question comes from Ben Reitzes with Lehman Brothers.

Ben Reitzes - Lehman Brothers

Yeah, good morning, thank you. You just said revenues were going to decline in the September quarter. I was just wondering if you could be, I think you said in the single digits but if there's anymore color there in terms of demand trends and why and maybe the mix between high end and low end. And then, if there's as we go throughout the year, I assume your guidance assumes that revenues get better and why we should assume that that can happen? Thanks.

Mike Lehman

It's Mike Lehman. I'll start. What I said was that we expect Q1 revenues to decline year-over-year. I didn't quantify the percentage and that's due to the normal seasonality that we have and the fact that we expect to still be down year-over-year in the US at least in the first half of the year and I'm not going to attempt to quantify that anymore.

So again, with regard to the full fiscal year, again, we don't expect any growth in the US until at least the second half of the year and we don't expect a lot in the US even in the second half of the year. The growth is continuing to come from the geographies that we've highlighted on the Ops analysis of basically the other three major geographies have shown growth. There are pockets of those that are continued to be challenged as in the past like our business in Japan and Asia-Pac and a couple of the EMEA countries in particular, the usual suspects. But we are seeing significant growth in the other areas, but net-net, I was highlighting Q1 because when you look at the overall normal seasonality and the US being down year-over-year, we expect revenues to be slightly down.

Ben Reitzes - Lehman Brothers

Anything on the product front Jonathan?

Jonathan Schwartz

No, I think if there is anything we feel very good about the breadth of the product line that we are sitting in front of and the feedback we are getting from customers almost across-the-board has been fantastic. The one area of the product line we are probably most excited about where we are hearing the most aggressive feedback from customers is everything around open storage, and what open storage is doing is really bringing the value of open source software and innovation to the storage marketplace which has been historically proprietary and expensive. It's somewhat reminiscent of the server market back in the late 90s. And the fact that ZFS is so popular it's just giving us a great opportunity to bring out innovations in flash memory, in Next-Generation Network Attached Storage. So that's probably their area we feel most confident in.

Ron Pasek

Next question, please?

Operator

Thank you. Our next question comes from Katy Huberty with Morgan Stanley.

Katy Huberty - Morgan Stanley

Good morning. Mike, what's your comfort level with the US cash balance, given you have burned cash in the last the four quarters and cash flow from operations this quarter was positive but lower than what you have been tracking at historically? How comfortable are you with the US cash that's on the balance sheet?

Mike Lehman

Yeah, obviously based on the fact that the board has authorized a buyback, we feel confident not only in the cash balance but the generation of cash. We also do have the ability as we do every year to bring back some of our cash that we generate from offshore. We intend to do some of that during the current fiscal year, so we are quite comfortable that we have the cash and the cash in the right places.

Katy Huberty - Morgan Stanley

And if the prices…

Ron Pasek

Next question, please? Next question, please?

Operator

Thank you. Our next question comes from David Bailey with Goldman Sachs.

David Bailey - Goldman Sachs

Great, thank you. After hanging in there, your gross margin particularly on the product side has really started to drop-off and I understand that's a mix, but is there any reason that we should assume that that's going to change in the next six months?

Jonathan Schwartz

Hey, David. I think as we pointed out, as the products that are built out of Sun Intellectual Property begin to really overtake the non-Sun Intellectual Property products, especially in our storage portfolio. With ZFS continuing to expand, Solaris being a great platform for the storage marketplace, that causes gross margins to rise, so I think as customers turn towards Sun Innovations and as we begin to maybe lessen our dependency on some of our historic OEM partners, we are pretty confident that we got lots and lots of opportunity to see those gross margins go up.

I think specifically if you look at a product like Thumper, which was really the beginning of our open storage offerings, the gross margins there are higher than for example, our enterprise SAN products. So as Thumper and products of that design again leveraging Sun software and Sun Intellectual Property begin to grow at a rate that eclipses our traditional storage offerings, we are pretty comfortable, there is room to expand there.

David Bailey - Goldman Sachs

And can you just give us an idea of how big Thumper was in Fiscal '08?

Jonathan Schwartz

Yeah, it was relatively small. It's about $120 million or so in billings, but again, that product line, CMT as well is a fairly high margin product set that's continuing to expand as the configuration and breadth of the portfolio broadens. So I think we've got lots of room to expand margins.

Ron Pasek

Next question, please?

Operator

Thank you. Our next question comes from Richard Gardner with Citigroup.

Richard Gardner - Citigroup

Thank you. I just wanted to ask a question regarding Niagara. It looked like billings for Niagara were probably down double-digit sequentially, and I'm just wondering why that would be the case during the final fiscal quarter, and what you attribute that to? Thank you.

Jonathan Schwartz

Where are you looking?

Richard Gardner - Citigroup

Jonathan, yeah, I think you said that billings were up 61% year-over-year versus more than 100% in the previous two quarters, and our math could be off by a little bit, but it does look like we are down sequentially on billings?

Jonathan Schwartz

We're not down sequentially.

Richard Gardner - Citigroup

Okay. Can you discuss what you saw in terms of Niagara adoption and traction during the quarter?

Jonathan Schwartz

Oh, happily. So, I think we were up about 60% quarter-over-quarter, and about 80% year-over-year.

Richard Gardner - Citigroup

Oh, okay so the 60 was the sequential number? Got it.

Jonathan Schwartz

No, it was Q4 over Q4, and then the 80 was FY '08 over FY '07. And again, what's really driving that at this point is the popularity of OpenSolaris and Solaris. So, that as we've pointed out historically is basically the business model. The more popular the open source software innovation has become, the more opportunity we have to monetize that popularity in our product line. That's obviously not going to affect every business we're in, because some businesses aren't affected by the adoption of Sun software platforms, but Niagara and our open storage products really represent the future of how the company is being rebuilt which is around products that deliver outstanding innovation and really differentiated innovation compared to our peers.

So, in general, folks we are moving toward Niagara that see themselves constrained by their power budgets whether that's an economic constraint or a technical constraint, folks that are trying to fit a large amount of performance into a small physical space or a small energy budget have a great opportunity to do so with Niagara.

Ron Pasek

Great. Next question, please?

Operator

Thank you. Our next question comes from Keith Bachman with Bank of Montreal.

Keith Bachman - Bank of Montreal

Hi, good morning. Jonathan, I have a question for you. In the past when we've talked about share particularly against IBM, your comments are the AS-400 is transitioning to PE, so you can't do like-for-like comparison which I agree with, yet if I look at the combination of what IBM put up this quarter, if you aggregate the AS-400 and PE's, your server growth was about 10% or 11% versus yours were down 7%. If I include the x64 against what your total servers were in, IBM again outgrew you by about 3%, where you were down 7%. So, I'm just trying to understand your view on share versus IBM in particular?

Mike Lehman

You bet. So I think in the last quarter, I don't have the numbers sitting in front of me, IBM was down on X series on their x86 systems. We were up on x86 and again, are building out the blades and are building out really the whole portfolio. So I think we feel fairly good on the x64 side. On the P Series side, we definitely do compete. On the M Series, we see a lot of break-ups, we feel very good about our competitive positioning. We have a different sector concentration than IBM obviously. We tended to serve a disparate set of customers.

But all that said, IBM really doesn't have an offering comparable to what we're do with Niagara with our CMT systems, which were again were up 80% year-over-year with not a lot of comparable performance within the IBM portfolio. So again, they've got four disparate portfolios, they've got a different sector concentration. We feel very good competitively when we're going head-to-head in our ability to hold our own, if not take share.

And again, the fact that we've got an open source operating system that we've got, that we can offer customers the choice. Frankly that IBM has elected to OEM Solaris really represents a great opportunity for customers that are seeking choice and don't want to be locked into one vendor. So, we welcome the competition. We think we can do quite well with it.

Ron Pasek

Next question, please?

Operator

Thank you. Our next question comes from Tony Sacconaghi with Sanford Bernstein.

Tony Sacconaghi - Sanford Bernstein

Yes, thank you. You've disappointed versus Street expectations in each of the last two quarters, and you're lowering expectations once again for fiscal year '09. I guess the question is, I understand the environment and I understand that given the US focus, or the US concentration and enterprise focus and financial institutions that Sun might be a little bit more vulnerable. I guess the question is why has Sun uniquely disappointed consistently over the last six or seven months, relative to your expectations when not one single other vendor has?

Is there a product issue? Is there an execution issue? Have you been overzealous in your guidance? But you know your business, you know your concentration, you know your business models, yet certainly over the last six or seven months you've been significantly overzealous relative to your actual performance. Can you provide a perspective on why that is?

Mike Lehman

So thank you for the filibuster. It's Mike. I think it's pretty unfair to say that we're the only company that has disappointed in the last six months, but we don't need to have that public debate and disparage anybody else. Certainly, we've been very transparent and very open in terms of what we are trying to go accomplish and we've made it very clear.

As you pointed out that we have a number of large customers in the US. We have had a historical concentration. The number of those customers have been fairly publicly and negatively impacted and that has shown up in our results, and that's why one of the initiatives that Jonathan talked about is, that we will be extremely focused this year on improving the number of customers we have, increasing the number we have, trying to improve our mix going forward from that perspective. So we recognize we have a concentration and are doing everything we can to diversify.

Ron Pasek

Next question, please?

Operator

Thank you. Our next question comes from Shannon Cross with Cross Research.

Shannon Cross - Cross Research

Yes, good morning. You mentioned weakness in financials, but can you discuss the status of other verticals, and also if you could talk about any linearity of revenue during the quarter? Thanks.

Mike Lehman

Yes, it's Mike. I would say that telecommunications was probably the area that was most impacted when we look at Q4 on a year-over-year basis, that, that particular segment, especially in the US was fairly challenged. And again, we don't need to name names, but just looking at the overall industry as you can, you can see that there has been some consternation in the US in the telco space. And again, historically, telco and financial services and government have been pretty large for us, and I'd say that all three of those were challenged even the US government in the second half of the year didn't meet our expectations, but those are the big three if you will.

Ron Pasek

Next question, please?

Operator

Our next question comes from Louis Miscioscia with Cowen and Company.

Louis Miscioscia - Cowen and Company

Okay, thank you. Maybe to drill in a little bit deeper about the core of the problem here, maybe if you could go in, do you think it's a sales execution issue or if it's a product issue? If you look back at the last growth spurt you had that ended in March of '07, you really were running on the tail end of a major process or upgrade and I guess the question would be that is it mainly that you're still mainly focused on the install base even though we have after acquisition that you've actually talked about acquiring new customers, you're really not penetrating in there, or is it more of a product issue right now that you've actually got out to new customers, but until the rock rolls out, really you're still going to be behind the curve until the tail half of '09 calendar?

Mike Lehman

So I think as we pointed out, we've seen growth in geographies across the world with the same product set we have in the US, the same strategy we have in the US and the same set of messages and resourcing models. We have 40% of our revenue in the US that's fairly concentrated. We are fairly concentrated in the industries we've been approaching and we are seeing good growth, but that growth doesn't happen in $100 million lumps. That growth happens 1 million at a time, if not, $50,000 at a time.

So we're certainly diversifying the customer base that we have. We're being as aggressive as we can about it, but at the end of the day, when we see Henry Paulson bailing out, yet another customer of ours in the front page of the Sunday paper, we don't expect those businesses to recover or their IT budgets to recover anytime soon.

So, our customers in the US are not immune from the downturn. That downturn has an impact on their spending. The good news is they are all increasingly and at an accelerating rate turning to open sources as a means of lowering the cost and increasing the efficiency of the operations they have. That is exactly the bow-front that we are pushing and that is exactly where we see our customers headed. Do all of our customers map into that exact model right now? Do all of our product lines benefit from that?

No. We've got obviously a breadth of product lines that have been here for awhile. We're going to go through transitions. We feel very good about the growth products as we've pointed out. We feel our product sets are great. We've got a great set of opportunities. We just got to get out into growing customers, growing segments of the market and growing segments of the planet, and we'll show more growth.

Louis Miscioscia - Cowen and Company

So then, in the US and Europe then, is it more of a sales execution issue because when you look at it, if you go even back to the StorageTek acquisition and the other ones you've done and giving away free Solaris you've continuously talked about getting out to more customers, but if your products are good, then is it just sales isn't able to sell the products and match some of the industry growth rates?

Mike Lehman

So as I said, when you've got $100 million customer that is not going to be growing its IT purchases, but instead they're taking it down 80% that's a lot of new customer acquisition to make up that quickly. So, we're definitely adding customers to our role and we're certainly accelerating those activities, now but we're not necessarily assuming that's going to be a large amount of revenue growth. The significant revenue growth is going to come from expanding the share of the customers we're selling into and continuing to grow in those economies and parts of the market where we think there's opportunity to do so.

The mature economies in the world are probably the most stressed in terms of their linkage to the US economy, as well as some of the anxiety that they see coming from the financial services sector specifically, but as I said, I think we feel pretty good about the products and pretty good about the strategy across the world.

Louis Miscioscia - Cowen and Company

Okay. Thank you.

Ron Pasek

Next question, please?

Operator

Thank you. Our next question comes from Scott Craig with Banc of America.

Scott Craig - Banc of America

Thanks. Mike, can you talk about the gross margins in the product side on a quarter-over-quarter basis for the fourth quarter? Because, if I look at the charts that you guy provided and you can't give the numbers exactly, and you're just using the year-over-year growth numbers, it actually doesn't look like your mix got meaningfully worse on a quarter-over-quarter basis and actually it looks to be even a little bit better, yet the gross margins were down pretty significantly quarter-over-quarter. So, it seems to me just based on that, that it's more of a pricing issue. So, can you maybe put some commentary around that for us? Thanks.

Mike Lehman

Yeah, so again if you look back to Q4 over Q4, the decrease in products margins is even greater, and that frankly again does really involve two factors versus a year ago. The principal component is still mix and that comes back to the high-end of the server line, as certainly down in total year-over-year, but it also is the fact that our low end, mid range and enterprise disk space, all of which is essentially OEM'd showed pretty decent growth year-over-year.

I would say that a year ago, we were probably benefiting in a short-term from larger component cost reductions, and I'm pretty sure we talked about that a year ago that we would be having these larger than expected component cost reductions and then all companies could take advantage of those for about 90 days at most, then they would be passed on. So, in effect the discounting versus component cost discussion is essentially normal if you will in our current Q4. We typically have cost reductions and those are generally speaking matched by price reductions and/or discounting. That's what we saw. I think we saw a bit of a benefit from component costs a year ago and the other principal change is mix.

Scott Craig - Banc of America

What about on a quarter-over-quarter basis though, Mike?

Mike Lehman

That's what I was talking about.

Scott Craig - Banc of America

You were talking year-over-year.

Mike Lehman

I'm talking Q4 over Q4.

Scott Craig - Banc of America

I'm talking Q4 over Q3.

Mike Lehman

I already addressed that in my script.

Scott Craig - Banc of America

Okay.

Ron Pasek

Next question, please?

Operator

Thank you. Our next question comes from Bill Fearnley with FTN Midwest.

Bill Fearnley - FTN Midwest

Yeah, Jonathan, if I can address what's happening in Asia here, more color there and what you saw in fourth quarter of '08 and what your expectations are here for the first half of '09? Where were the strength and weakness by geo, and where was the strength and weakness by segment, please?

Jonathan Schwartz

We don't have the explicit detail of which customers and which segments within Asia. I'll tell you that the weak spot for us has been Japan broadly, and for the most part, that's really the only economy that's been not delivering and the only geography that's not been delivering for us.

I think what we see happening increasingly in China is just extraordinary adoption, especially of MySQL across their academic environments, and the reason why that figures in, the same applies in India is, those individuals end up graduating, end up starting companies, end up really influencing how IT architectures are rolling out, and that to us is just a broad range of MySQL opportunity which translates to storage opportunity, systems opportunity, etcetera.

On the enterprise side of the business, that's going to be more reflective of decisions that were made a few years ago as people scale out their traditional business systems, again as they were architectured or selected, five or six years ago and those business systems continue to be scaled out as the economies are scaled out.

So, I think the focus we have to have is both on making sure we're investing to capture the next wave of demand, as well as executing on behalf of the demand that's in front of us. And as I've said before, we feel pretty good about the product set and the one low light there, the one area of stress has been Japan and even there, financial services within Japan has been weak for us as well.

Ron Pasek

Next question, please?

Operator

Our next question comes from Jeff Fidacaro with Merrill Lynch.

Jeff Fidacaro - Merrill Lynch

Great. Thanks for taking my question. You mentioned that the US is expected to be down until the second half of '09. Could you talk a little bit about your plans for the US as far as direct versus indirect sales, and do you plan to leverage your partners more and is this reflected in the headcount reduction you mentioned earlier on the call?

Mike Lehman

We are increasingly turning our business towards one defined by our partner model, which is a market where we cultivate and develop skilled partners across the world who can leverage the innovations we build, and again as we pointed out, the adoption of MySQL on the marketplace now represents an extraordinary opportunity for value-added resellers and partners across the world to go deliver MySQL optimized solutions to those customers, and our expectation is to have systems that execute MySQL three to five times more efficiently and more effectively than our competition in the marketplace.

Again, that's going to be a good selling environment for partners across the world, and our strategy has been to try to build out a greater and higher value proposition for those partners so that they feel incented and trained and skilled and capable of getting after that opportunity. That's going to be reflected in how we resource our sales force going forward, which is a bias toward incentives and infrastructure to support partners rather than simply more incremental headcount additions.

Ron Pasek

Next question, please? Laurie?

Operator

(Operator Instructions) Our next question comes from Mark Moskowitz with JP Morgan.

Mark Moskowitz - JP Morgan

Yes, good morning. I appreciate the wider guidance range for operating margins for '09 in terms of giving a little more wiggle room, but I want to get a sense Jonathan or Mike in terms of how are you apportioning the related expenses to your four-prong attack in terms of investment in the business, trying to boost the revenue profile. Does that 5% to 7% factor in a stage rollout, or is it a full-bore, and there's other factors that play in terms of the wiggle room in terms of the 5% to 7%.

Ron Pasek

So, we don't really apportion by those priorities. I mean again, when we're making R&D investments, those are multi-year investments which again have been in the works for quite a while.

Looking at the overall operating margin of the company, we've obviously expanded that over the last couple of years and that expansion has come in the form of expense reduction and greater efficiencies and gross margin expansion. We would like to drive more of that to our revenue growth. And again, we've highlighted how we're going to be growing revenue, and what we're trying to do to go achieve that growth, but that is not to say we're done being more efficient as a company. We're going to continue to look at ways of getting OpEx down.

As I highlighted to David earlier, we're obviously doing things to go continue to build out the value proposition in our products to expand gross margins, and we feel very good about the prospects for both in the next 12 months. So, it's not been a line item-by-line item change, but certainly we're moving more headcount into emerging economies and emerging growth opportunities, we're moving more of our time and attention toward emerging sectors of the marketplace, as well as adding more resources around capturing new customers. But it hasn't been a line item change in the OpEx of the company.

Ron Pasek

Next question, please?

Operator

Our next question comes from Keith Bachman with Bank of Montreal.

Keith Bachman - Bank of Montreal

Hi. Thanks for the follow-up question, guys. Jonathan another one for you if I could, I want to understand, you identified your four metrics, and number four, you're talking about the commercial adoption of open source software. How are you going to provide investors with some metrics that suggest in fact this strategic objective as being realized, will you begin to break out software sales? And related, you mentioned that MySQL had I think 44% bookings growth. It's a fairly small number.

Can you give us a little sense about what the attach rate is there? Your x86 sales were frankly a little bit weak this quarter and I would assume that MySQL was more against the x86 platform, but if you could just address those two, thank you.

Jonathan Schwartz

Yeah, the complexity in breaking out the software business, and let's take Niagara and our CMT platform or Thumper as another great example. When we sell those products to the marketplace, we don't have a separate line item for the software that runs just as when you buy a cell phone, they don't break out how much you're paying for the software on the cell phone, you just buy the phone or even more opaquely you're buying a subscription and we obviously have both when we offer our platforms to the marketplace.

So the best guidance we can give is to the value of the software business is continue to highlight the performance of MySQL independently. And yes, a lot of that growth has been off of Sun hardware, but a fair amount of that growth is now accruing to Sun's hardware platforms, including our Niagara platforms.

So, as best we can, the best measures of the opportunity are the measurements we have and you can see then as well. There's many out in the industry of how well adopted these platforms are. Secondarily, we'll provide as much clarity as we can around MySQL and specific, breaking out Solaris is exceptionally difficult because it factors into about 70 to 75% of products inside of Sun that you don't think of as software products. For example, the systems we sell or the $4 billion plus service business we have which is largely a reflection of the value of Solaris as much as a break fix hardware or service business.

So, as I said, we're going to be optimizing our systems platforms to run open source software. We believe we'll have multiples of performance benefit as a result of really synchronizing our innovation and the best way to measure the success is going to be my measuring the growth rates on the products that we'll see the benefit of that innovation.

Again, I don't expect this to change the dynamics of the tape marketplace by further evangelism of open Solaris or MySQL or ZFS. So, I don't expect to change the dynamics of the enterprise sand marketplace. We do expect to amplify the success of our open storage offerings. We do expect to amplify the success of our CMT offerings and going forward, certainly the success of our virtualization offerings and all of the platforms that run XBM.

Ron Pasek

Next question, please?

Operator

We'll now take our final question from Bill Fearnley with FTN Midwest.

Bill Fearnley - FTN Midwest

Yeah, thanks for the opportunity for the follow-up. Mike, on the restructuring charges, you're taking $100 million this quarter. How much is left over from previous actions, because you had mentioned timing issues. Let's assume that some of those might be in places like EMEA, but how much of it is new actions that you're thinking about going forward from today on the restructuring charges? Thanks.

Mike Lehman

Yeah, so, what I was attempting clarify is that we announced a range of restructuring at the end of Q3 in our conference call, and in effect what we're doing is completing the notification process and the accrual process in Q1. So, it's essentially the same restructuring. It's just a timing of that; the majority of the rest of the actions will be accrued in Q1. So it's the same restructuring not changed, not increased, just sort of finalizing it and getting to roughly to the levels that we had expected.

Bill Fearnley - FTN Midwest

Thank you.

Ron Pasek

Thank you for joining us today. Investor Relations personnel will be back in our offices shortly to respond to any further questions. You may contact us through our Investor Relations main number at 408-404-8427.

Operator

Thank you. And this concludes today's conference call. We appreciate your participation. We are again providing an encore replay service this quarter. If you joined us late or wish to hear any part of the conference call again, you may call the replay service anytime after 3:30 pm Pacific Time today to hear a recording of this conference call.

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Source: Sun Microsystems Inc. F4Q08 (Qtr End 06/30/08) Earnings Call Transcript
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