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Sun Microsystems, Inc. (SUNW)

F3Q06 Earnings Conference Call

April 24th 2006, 4:30 PM EST

Executives

Bret Schaefer - VP, IR

Michael Lehman - CFO and EVP, Corporate Resources

Scott McNealy - Chairman

Jonathan Schwartz - CEO

Analysts

Rebecca Runkle - Morgan Stanley

Harry Blount - Lehman Brothers

Laura Conigliaro - Goldman Sachs

Richard Chu - SG Cowen

Andrew Neff - Bear Stearns

Ben Reitzes - UBS

Brent Bracelin - Pacific Crest Securities

Kevin Hunt - Thomas Weisel Partners

Tony Sacconaghi - Sanford Bernstein

Richard Farmer - Merrill Lynch

Presentation

Operator

Good afternoon. My name is James and I will be your conference facilitator. At this time, I would like to welcome everyone to the Sun Microsystems fiscal year 2006 third-quarter earnings conference call. (Operator Instructions). Thank you, ladies and gentlemen. I would now like to turn the call over to Mr. Bret Schaefer, Vice President of Investor Relations for Sun Microsystems.

Bret Schaefer

Good afternoon. Thank you for joining the Sun Microsystems quarterly conference call. I am Bret Schaefer. With me today is Scott McNealy, Sun's Chairman and Chief Executive Officer; Jonathan Schwartz, Sun's President and Chief Operating Officer; and Michael Lehman, Sun's Chief Financial Officer and Executive Vice President, Corporate Resources.

The purpose of today's call is to discuss the results of Sun's fiscal year 2006 third quarter, which ended on March 26, 2006. During the last hour, we published a copy of the operations analysis data sheet with nine quarters of financial and operations information, including the quarter just completed. If you have not received the earnings announcement or the detailed financial data sheet for any reason, or you wish to hear a live broadcast of this conference call, you may log into our website at www.sun.com/investors.

We have posted slides you can view on the web which accompany our prepared remarks. These slides may be viewed at the same URL, www.sun.com/investors. Simply click on the link marked earnings releases. The prepared remarks of our call today will last about 30 minutes, with the remaining 30 minutes devoted to the Q&A session.

During the course of this conference call, we will make projections or other forward-looking statements regarding expected future financial results and business opportunities. Such statements are just predictions and involve risks and uncertainties, but actual results may differ materially. I'd like to refer you to Sun's periodic reports that are filed from time to time with the Securities and Exchange Commission, including the Company's Annual Report on Form 10-K for the fiscal year ended June 30, 2005, and the Company's Quarterly Reports on Form 10-Q for the quarters ended September 25, 2005, and December 25, 2005. These documents contain and identify important factors that could cause the actual results to differ materially from those contained in our projections. We assume no obligation to and do not currently intend to update these projections and forward-looking statements.

In addition, during the course of the conference call, we will describe certain non-GAAP financial measures which should be considered in addition to and not in lieu of comparable GAAP financial measures. Please refer to the earnings call and financial slides and the operations analysis posted in the earnings release section of our website at www.sun.com/investors for our most directly comparable GAAP financial measure and related reconciliation.

Please note that unless otherwise indicated, all reported results include the impact of the StorageTek and SeeBeyond acquisitions for the full quarter ended March 26, 2006.

Now let's get to the financials. Sun's total revenues for the third quarter of fiscal year 2006 were $3.177 billion, an increase of 21%, as compared with the $2.627 billion in revenue reported for the third quarter of fiscal 2005. We had an unfavorable currency impact on revenue of approximately 4% year-over-year and practically no impact sequentially. Total gross margin was 43% of revenue, an increase of 1.6 points over the gross margin for the third quarter of fiscal year 2005.

Total R&D and SG&A expenses were $1.543 billion, an increase of $358 million year-over-year. In the third quarter of fiscal 2006, we recorded a $35 million tax provision. GAAP net loss for the third quarter of fiscal year 2006 was $217 million or a net loss of $0.06 per share, as compared with a net loss of $28 million or a net loss of $0.01 per share for the third quarter of fiscal 2005.

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

GAAP net loss for the third quarter of fiscal 2006 included approximately $87 million or approximately $0.03 per share, principally related to intangible asset amortization associated with acquisitions of StorageTek and SeeBeyond.

As reflected on slide 13, purchase accounting-related items associate with our acquisitions of StorageTek and SeeBeyond affected our GAAP results for the quarter as follows: reduced revenue by approximately $8 million, primarily the result of adjustments made to reduce the acquired deferred revenue balances of StorageTek and SeeBeyond to fair value; reduced gross margin by approximately $43 million, principally resulting from the impact of the deferred revenue adjustments and amortization for acquisition-related intangibles related to develop technology; and increased operating expenses by approximately $44 million as a result of amortization on other intangible assets established on acquisition.

As reflected on slide 12, total stock-based compensation expense for the quarter was $57 million or approximately $0.02 per share. This expense is included in the following components of the P&L: $3 million is charged to cost of sales, products; $7 million is charged to cost of sales, services; $19 million is included in R&D expense; and $28 million is included in SG&A expense. GAAP net loss for the third quarter of fiscal year 2006 also includes restructuring charges of $36 million and a related tax benefit of $4 million and a gain on equity investment of $4 million.

Now back to the revenue metrics. Q3 products revenues totaled $2.035 billion, an increase of 21% year-over-year. Within products revenues, computer systems products revenue was $1.474 billion, an increase of 6% year-over-year. Data management products revenue was $561 million, an increase of 92% year-over-year, as compared with $292 million in Q3FY05.

Q3 services revenues totaled $1.142 billion, also up 21% year-over-year. Within services revenue, support services revenue was $904 million, up 23% year-over-year. Revenue from client solutions and educational services totaled $238 million, an increase of 13% year-over-year.

By geography, U.S. revenues were $1.325 billion, up 35% year-over-year. EMEA revenues totaled $1.119 billion, an increase of 11% year-over-year. APAC revenues were $526 million, an increase of 7% year-over-year. International Americas revenues were $207 million, an increase of 44% year-over-year.

With respect to some of the balance sheet items on slide 14, DSO was 65 days. Excluding acquisitions, ending sales channel inventory was approximately $400 million, or less than five weeks' supply, which is within desired levels. We ended the quarter with a cash and marketable debt securities balance of $4.429 billion and generated positive cash flow from operations in the third quarter of $197 million. With that, I will turn it over to Mike.

Michael Lehman

Good afternoon, everyone. I will focus my remarks on the most recent quarter and give you a sense on how the quarter turned out versus our internal expectations. I will give you an update as to how we see the current quarter shaping up and end off with a brief discussion of what we are doing during the remaining weeks of Q4 to get ready for the new fiscal year.

As in the past, we have provided a slide deck on our Investor Relations web page. I do not intend to go through this in great detail, but will make some comments along the way. I will do my best to signal which slides, if any, that I am referring to.

With regard to Q3, it is fair to say that the quarter's results came in essentially where we had expected them to. As always, there were a few puts and takes, but no big surprises. Looking at slide 4, you'll note that our backlog at the end of Q3 was essentially flat with the end of Q2. You may recall that our backlog had grown at the end of Q2 due to demand for recently introduced UltraSPARC IV+ products.

During the quarter, one of our operational challenges was in fact fulfilling demand for these products and to ensure that lead times returned to acceptable levels. We made very good progress during Q3, yet our backlog stayed at approximately the same level. With most lead times now reaching acceptable levels, this backlog puts us in good shape to start Q4.

If you turn to slide 7, revenue by geography, probably the best news for us was that the U.S. business grew by approximately 12% on a year-over-year basis, excluding the StorageTek and SeeBeyond results. You won't see that number on the slide itself. I'm just providing you a little detail beneath the overall U.S. growth rate of 35%. This was driven by successes in key industries such as telco and energy, among others. This was the first quarter in nearly two years that we have seen year-over-year growth in the former Sun stand-alone business. We do not believe this will be a one-time occurrence.

We did experience slight year-over-year revenue decline in EMEA, excluding StorageTek and SeeBeyond results. I could accurately blame currency movements for the majority of this decline. However, we also saw some impact from telco consolidation in parts of EMEA. Further, we experienced a slight decline across our services business in EMEA.

We experienced solid year-over-year growth in most of Asia, excluding Japan, and even higher year-over-year growth in the International Americas. Scott and Jonathan will take you through some of the key customer and industry wins in a few moments.

If you turn your attention to slide 5, you'll note a few positive things as well. Most notably, we experienced good growth in overall server units, led by continued strong year-over-year growth in both our 4-way to 8-way SPARC servers and x64-based servers, which were buoyed by solid out-of-the-gate deliveries of our Sun Fire P2000 or Niagara servers.

Turning to slide 6, you will note that we grew overall revenues for both products and services by 21% on a year-over-year basis. Beneath the covers, the services revenue was a touch less than what we had expected, largely in the EMEA geography. You will see this reflected somewhat in the gross margin discussion below.

You might be wondering, why would I talk about something that was less than we had expected? Frankly, as you will discover more over the next couple of quarters, we want to increase the level of transparency. We want you to understand better where we are headed, what some of our key expectations are, and let you know when we run into unexpected circumstances.

If you turn your attention to the gross margins, slide 8, you will note that the overall gross margin percent, 43% in Q3, was up slightly sequentially from Q2 and up approximately 1.5 points on a year-over-year basis. You will also note that products gross margin percentage increased substantially on a sequential basis, but this was largely offset by the aforementioned decline in service margins. The decline in service margin was volume-related and somewhat offset by continued reductions in cost of delivery.

The increase in product margins was largely due to improvements in our product costs, supply chain efficiency and improved competitive position, offset somewhat by an expected change in mix to more low-end products. We expect overall gross margin to be relatively flat or slightly lower in the fourth quarter.

If you turn to slide 9, you'll note that our total R&D and SG&A expenses declined slightly on a sequential basis. I would note that this was essentially in line with guidance we had provided at the end of Q2. You'll also see from slides 12 and 13 that the impacts of FAS 123R, stock-based compensation expense, and purchase accounting were also right in line with our previous guidance.

The Company's focus on the cash conversion cycle remains effective. Our combined cash conversion cycle on slide 14 ended up at 29 days at the end of Q3, and we generated $197 million in cash flow from operations in the quarter. You can see from these slides that there were essentially no other major or significant changes to our business model during the quarter.

Looking at Q4, our current view is that we are in good shape entering the quarter. As I noted before, we have a healthy shippable backlog to start with, a strong product line, solid momentum in many geographies and markets, and Q4 has traditionally been a seasonally stronger quarter.

With that in mind, while we are not quite ready to discuss our overall business model expectations, it is fair to expect solid sequential revenue growth. Historically, we have seen sequential revenue growth from Q3 to Q4 in the range of 10% to 15%.

We also expect total Q4 R&D and SG&A expenses to be approximately $1.6 billion. The expected sequential increase would be due primarily to higher levels of commissions and/or annual incentives. We also expect that our Q4 results will include: amortization of StorageTek and SeeBeyond acquisition-related intangible assets of approximately $80 million; and total stock-based compensation of approximately $60 million.

We anticipate interest income of approximately $25 million in Q4. We expect the annual tax provision to be in the range of $200 million to $250 million. We are targeting a cash conversion cycle of 30 to 34 days, which would allow us to generate approximately $200 million in cash from operations. We expect approximately $100 million to $125 million in capital expenditures, including SPARC, in our June quarter. These amounts do not reflect the impact of a proposed financing activity, which I will now discuss.

Like many companies in technology as well as in other business sectors, we have generated and accumulated a significant amount of cash outside of the United States. Recent legislation provides a one-time opportunity for companies to repatriate a fair amount of this cash for specifically permitted uses and to receive a favorable tax treatment.

For Sun, repatriations eligible for this beneficial treatment must be completed by June 30, 2006. Our preliminary view is that we may repatriate approximately $2 billion in Q4. If the repatriation is approved by our CEO and our Board of Directors, we would incur a tax charge and cash payment in the range of $60 million to $80 million in Q4 and a reduction of interest income of approximately $15 million.

Since my return, I have made it clear that Scott, Jonathan and I agree that we need to address our cost structure. As a result of investments made in the past couple of years, our products, services and software offerings are in much better shape. We have also made two fairly significant acquisitions, StorageTek and SeeBeyond, and a number of smaller ones. Acquisition integration is not an easy or a quick process, but we are making progress on that front. Stay tuned. We've got lots on our plate. We are focused on delivering a strong fourth quarter. With that, I will turn this over to Scott.

Scott McNealy

Thanks, Mike. Good to have you back. You haven't aged a bit -- trust me, gang, he hasn't. Anyhow, it was a real solid quarter and we're very excited about growth in the servers, storage and software business. I will talk about servers and storage, and I will let Jonathan discuss software and talk a little bit about geographies and some of the industry performance.

First quarter since Q4 of '04 that we have had stand-alone revenues grow in the same quarter for both service and storage, so it feels nice to have some broad-based growth. What is driving this? Well, obviously, the UltraSPARC IV+ ramp is going well, and we are keeping TI busy cranking out new chips for us, and that's been real pleasing.

It's fun to have the fastest computer on the block again. We are kicking some butt on the benchmarks. I think we've got 16 world-record benchmarks already and winning and going toe-to-toe against POWER5 and the IBM quite successfully now.

The T2000, as Mike mentioned, is doing very well. The CoolThreads technology is being very well-received. We've got a wonderful try-and-buy program and we are approaching somewhere between 500 and 1,000 try-and-buy sales already through our try-and-buy programs. Go to our website and you can just click and get one. So it is 600 new customers, which are the nice kind of customers, they go to our website. We don't necessarily even have to call on them.

I'd like to do something that I don't usually do: I'm going to quote the CTO, Don Obert, of Banc of America, who is so pleased he's actually going public with his support. I'm actually going to quote him verbatim, and he describes why we developed the whole CoolThreads technology. Banc of America is committed to using the technology to reduce the Company's impact on the environment, especially around energy consumption. Don says:

"We at the Bank of America are doing our part by selecting environmentally friendly products such as Sun Microsystems' Sun Fire T2000 server with CoolThreads technology and Solaris 10 OS. These servers utilize less space and consume much less energy while delivering improved performance. Taking advantage of this opportunity to do what is right for the environment, while the same time improving our customers' experience, helps Banc of America achieve our higher standards with lower cost."

Sorry for the lengthy quote, but it was too good to pass up, anyhow. It's just beginning. In fact, as of April 12, we are now shipping the Sun Fire T1000 server; it uses even less power than the T2000, only 180 watts typical consumption, and takes up less space in the data center. It is a 1 RU versus 2 RU for the T2000. It starts at less than $3,000 per server. That's over 60% less than the starting price of the T2000. When announced, both the T1000 and T2000 beat Intel and IBM price performance measurements by a very, very wide margin.

There is more. We taped out in the last 60 days the next generation of the T1 microprocessor. We call it Niagara II, and it is going to double the number of hardware threads from 32 to 64 in approximately the same power envelope. So we're going from about 2 watts per thread to a single watt per thread. This is just years ahead of what everybody else is doing out in the industry. So stay tuned.

On the flip side, UltraSPARC IV and the T1 products are doing well. Our x64 industry standard server revenues have been steadily increasing to the point where they're now about a $400 million annual run rate business for us, growing about 100% year-over-year. We've got customers across the board running open source Solaris 10, as well as Red Hat, and Microsoft Windows has actually turned into a nice little market for us, too.

We are getting enterprise customers, and even more importantly, we're getting some of the hot new start-ups. Ning, Marc Andreessen's new firm, did a big calculation on the cost of our x64 service plus Solaris, and it came out at less than half the cost of running Linux on Intel. He went public with those calculations. You all can check it out by looking at Jonathan's blog from February 17. He's got all the data there.

So while not every component of our server business grew, overall the server business as a group grew nicely year-over-year. And we are very excited about that progress.

On the storage side, there were also a number of good things that happened. Q3 was the first meaningful year-over-year growth in Sun's stand-alone storage revenue in about four years. We grew revenue double-digit year-over-year in both data center and midrange storage arrays.

Data center storage array revenue was up, in particular as we began to realize revenue and sales force synergy from the StorageTek acquisition. Obviously, they are strong in the mainframe and enterprise data center space. Our new Sun data management sales reps were trained on data center storage systems as a first priority, and the results from additional feet on the street are beginning to show. We are getting a whole new opportunity to go sell in a lot of new and different places that we haven't been.

The tape business continues to chug along. In March we released the new StorageTek 10,000 or titanium tape drives. They have powerful data protection technology built in, and we shipped over 500 units of this product in the last quarter.

Regarding the integration, we are about where we expected to be. We are starting to gain revenue synergies, and moving forward over the next six months, we believe we will deliver even more on the revenue and cost synergies, which were the underlying premise for this deal. With that, I will turn it over to Jonathan.

Jonathan Schwartz

Thanks, Scott. I'm also happy to be speaking about revenue growth, particularly in the U.S., where we grew 35% year-over-year in total and 12% year-over-year for our traditional products. That is fantastic progress by the U.S. team, and frankly, a message from some of the most discriminating IT buyers in the world that are coming back to Sun and doing more business with Sun.

We also grew Sun's stand-alone revenues year-over-year in most of Asia, parts of Europe and almost all parts of the International Americas. And of course, all four geos grew their total revenues year-over-year.

Now, what is behind the growth? It varies by region, but in general, we are beginning to see tangible results from a persistent drive for measurable improvements in products, innovations, customer acceptance, competitive position and operational execution.

In the U.S., we grew revenues in the retail and education verticals, in addition to telco and energy sectors mentioned by Mike. For example, the University of Texas at Arlington selected various Sun storage platforms to consolidate two data centers into one.

We've also had some interesting wins in some non-traditional verticals such as Fox television stations, which turned to Sun for server storage, and the open-source Solaris 10 is a foundation of a new sales and traffic system and replacing stand-alone solutions based on proprietary alternatives. In addition, HBO is teaming exclusively with Sun to lead a broadcast industry evolution to open standards-based storage and delivery architecture. Their new fully digital content management system and delivery architecture is based on Sun's storage Sun Fire servers and of course the open-source Solaris 10.

In the EMEA geo, emerging markets such as Russia, the Middle East and Africa led in percentage growth rates. We had some interesting wins in traditional verticals such as financial services and government. These wins included London-based CDO2, which tapped the Sun public grid computing utility to offer its financial risk simulation software as a service to customers.

In Holland, the Groningen District chose Sun Ray thin client technology and the open source Solaris 10 for an innovative project to link government departments, schools, universities and hospitals to a central data center.

Mike also talked about revenue growth in Asia. Most of Asia, excluding Japan, showed good growth. India in particular was up 11% year-over-year in Sun's stand-alone revenues, with wins at powerhouse customers such as Geojit, India's leading financial services company; and Tata Sky Limited, India's largest digital television platform provider. Both Geojit and Tata Sky chose Sun Fire servers on the open source Solaris operating system.

International Americas, although smaller in total revenue, had the highest year-over-year revenue growth rate of any of the four geographies at an outstanding 44%. Those of you who read my blog also know that I just returned from Brazil, where there is a very big focus on using an open network to make the country a better place, where we talked about free and open source software, the future of the network, and how Sun could help bring more Brazilians online.

What I learned when I was there, they are only using open source software in their congressional systems, and specifically their voting system is also running the open source Solaris 10. They're also leveraging the Java Platform and other open-source technologies for next-generation IPTV rollout.

In the extreme opposite end of the International Americas, the Montreal Stock Exchange, Canada's oldest and leading derivative products exchange, is expanding its data storage capability protection and availability with an end-to-end storage system based on Sun's StorageTek products.

Since time is scarce, I will just mention that a number of our key software product revenues grew year-over-year in total and also on a Sun stand-alone basis. For example, we recorded double-digit year-over-year growth in both Java and open-source Solaris license revenue.

I will also add that the acquisition of JBoss by Red Hat obviously increases scrutiny on companies without an operating system and their ability to navigate the marketplace. We believe that companies with an operating system and specifically Sun, Microsoft, and Red Hat will drive the future software agenda in the industry, and our focus on open source software continues to create new opportunities in attracting developers and customers to the Sun platform.

I could not close without a reminder to tune in for the 10th anniversary of the Java One Conference, May 16 through 19, in San Francisco. So back to you, Scott.

Scott McNealy

Thanks, Jonathan. There is one other development of note that I would think would be appropriate to share with you all at this point. Moments ago, if you check your machines, our release across the wire announcing that the Sun Board of Directors has appointed Jonathan Schwartz as the Company's next Chief Executive Officer.

It's effective immediately, and it is part of our whole ongoing succession planning process that we have been working on, actually, ever since my days at the GE Board. We have been working very aggressively on this stuff. We've made a lot of progress on our commitments, as you see from the earnings announcements, all the rest of it here, but the job isn't done. There's lots more work to do.

I am certainly going to stay around and support that. I will continue as Sun's Chairman of the Board. I will be working full time, 100%, and will also assume an incremental title of Chairman of Sun Fed. This isn't about me. It's really about a big moment in Sun's history and I'm proud to share it with you and share Jonathan's promotion and congratulate him.

He joined Sun a little more than a decade ago, and he has just done an awesome job in the last few years streamlining operations, creating a world-class product line, advancing our overall competitive positioning. He secured a number of key acquisitions for us. He maintained some of our most important customer and partner relationships.

I spotted him a long time ago. We bought his company that he founded and was CEO of. He got on our list real early as a high-potential candidate. We moved him around to a whole range of responsibilities. I think he has had seven different jobs in the last 10 years; most recently running all of software, doing all of our corporate development and strategic planning, and obviously the last couple of years as COO. So he has a full range, and I think a very appropriate amount of operational experience to assume the role.

As founder, I have been leading this Company for a couple dozen years now and developing many CEOs. I feel like I have funded most of the Valley and other companies. I think we added it up; we found 75 names of companies that have been founded and have CEOs leading who are alumni of Sun. But Jonathan has risen to the top of the class here, and he is ready.

I'm actually pretty excited. This is going to allow me to, unfortunately, spend a little more time on an airplane than I would like, but it allows me to go do what I think I can do: a new role of focusing in on the broad strategic issues shaping the industry and our Company, but mainly getting out there and opening the doors.

There's obviously some very, very large customers out there that I can spend some time working on. The largest customer of all is the U.S. government. My role as Chairman of Sun Fed will allow me to work that. I think we have some important Japanese strategic partnerships I want to go reengage and spend more time working on.

I am going to keep driving our open source initiatives and working to enable global participation in the network. There's a lot of government work that needs to be done outside of the U.S. in areas of education, health care and just generally getting the citizen communities onto the Net.

The time is right. Our product line is fixed. We are winning benchmarks and awards across the board. Our customers are probably happier with us than they have been in a long, long time across the board from a product quality and services support perspective, our vision. Jonathan and I are highly aligned on that. It is crystal clear across the board, our management team right down to every one of our individual contributors.

I think we are poised for success in the years ahead. I think Jonathan is the right person to ride Sun forward on this next big wave. I know you all have questions and all the rest of it. We are going to have a media and analyst call at 3 PM today. We have lots of important news, obviously, with the earnings call and Jonathan's new appointment.

As Jonathan pointed out JavaOne, I'd like to tell you all that we are going to be hosting our next network computing launch in Washington, D.C., next week. I'll be hosting that, focused on our data management strategy. That will be May 2. So again, stay tuned. The product calendar continues to spew out lots of new and great stuff. We are moving in the right direction and focused on the bright future ahead.

It has been my pleasure to -- I don't know how many of these analyst calls -- I will miss them. But I really appreciate all of your support over the years. So stay tuned. There will be more details at the 3 PM call and at our next NC. They will both be available on our website. So back to you, Bret.

Bret Schaefer

Thank you Scott, Jonathan and Mike. Before we take questions, let me provide the dial-in information for the 3 p.m. conference call. The call can be accessed at 888-271-9036 from the U.S. or 706-679-4835 outside of the U.S.

For those unable to listen to the live conference call, a telephone replay will be available at 800-642-1687 in the U.S. or 706-645-9291 outside of the U.S. utilizing the conference call ID number 8097178. The telephone replay will be available beginning April 24, 2006 at 6 p.m. Pacific Time, through May 8, 2006 at 8:59 p.m. Pacific Time.

Now, let's take some questions. We'd like to ask that you focus your questions on Q3 earnings, as we have the 3 p.m. conference call scheduled to cover Jonathan's appointment as Sun's next CEO. Operator.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) Our first question comes from Rebecca Runkle, Morgan Stanley.

Rebecca Runkle - Morgan Stanley

Thanks. First, let me say best of luck to both of you in your new roles. Congratulations, Jonathan. Just shifting gears slightly, let me also say thank you for the increased transparency to both Mike, Jonathan and Scott, I guess, all three of you. I think that it will go a long way over time.

My questions -- two quick ones. One, there's a lot in the call, obviously, but I didn't hear anything in particular on Galaxy. I was hoping that you could just provide a little bit more clarity and transparency on that front; in particular in terms of how it is tracking relative to expectations.

Secondly on the cash front, can you just remind me what Sun's top priorities are vis-à-vis cash in terms of acquisitions, buybacks, internal investment, et cetera? Just want to regroup on that front, in particular.

Jonathan Schwartz

Rebecca, this is Jonathan. I will handle the Galaxy question and then turn it back to Mike on the cash question. On Galaxy, we are just seeing absolutely outstanding demand. I will tell you, our biggest challenge, frankly, even at the size that we are at -- which I think we talked about a run rate around $400 million -- is that most of our customers still don't know we have x64 servers. So as we find them, they buy from us. It's a good problem to have, but on the other hand, we recognize we're driving into a market space that is, order of magnitude, tens of billions of dollars and we are still a relatively small player.

So we are very pleased with the innovation, customer acceptance and the ramp of the products. We see no cessation of demand whatever and we've got a full calendar of new products coming out. In fact, the next six months should probably be the busiest we've ever been in rolling out new x64 products. But again, we are pretty happy with it. We just want to, again, see more customers aware of it. That's just a bit hand-to-hand combat for now, and as that continues to roll out, we expect continued growth.

Mike Lehman

With regard to cash, we've been pretty clear that right now, our priority with the cash is to grow the business, and that includes both internally and externally. So internal projects, companies and technologies that we want to acquire, that's really where we are focused. We are not ready to reengage in a buyback discussion at this point. We are principally interested in growing the business.

Operator

Our next question comes from Harry Blount, Lehman Brothers.

Harry Blount - Lehman Brothers

Mike, I wanted to go back to your comment on historic seasonality on the 10% to 15%, and just doing some quick calculations, clearly see that for the last few years. But if we go back a little bit further, it looks like the seasonality over the last five years has been a bit below that, as has StorageTek's.

So I'm just trying to get a little bit better sense of if that is what you are expecting for the June quarter, above normal seasonality in that 10% to 15%; or rather, what range you are looking at? Thanks.

Mike Lehman

So again, I don't really want to give a specific revenue or EPS range at this point. We're trying to give you a sense of, if you strip out some of the anomalies, that is a growth rate that seems to be reasonable for a Q3 to Q4. Actually, frankly, if you go back 10, 15, 20 years, you can get numbers outside of that range. So we just think that that is somewhat of a normal historical growth pattern from Q3 to Q4. Again, this'll be our first quarter having StorageTek and SeeBeyond inside the fold, so numbers may vary from those estimates. But that gives you some sense of what should be normal.

Harry Blount - Lehman Brothers

So just to clarify, then, that is kind of the way you are viewing normal on a combined basis and not on a Sun pre-StorageTek basis?

Mike Lehman

Correct.

Operator

Our next question comes from Laura Conigliaro, Goldman Sachs.

Laura Conigliaro - Goldman Sachs

Thank you. A couple of things. Hypothetically -- especially since you have been able to hold your gross margin through some pretty unusual times over the last several quarters -- as you view other companies compared to Sun, given that you have proportionately as much IT, if not more than they do; can your operating margin ultimately reach as high as 10% or better? Also, your EDOR has actually gone up for the last three straight quarters, including the March quarter. Why is that? And when should we expect that to reverse?

Jonathan Schwartz

Maybe I will talk to the operating margin and then pass over to Mike on the EDOR issues.

On the operating margin, we have been negative operating margin, so certainly we are directing to get the positive operating margin. In terms of what the cap is on the operating margin, time will tell. But again, given the market opportunity especially for some of the higher-margin product, whether it is high-end systems or, frankly, our software business, which has been growing very nicely, we continue to see customers that would like to buy more of the value that we bring to them. So the margin within an account certainly has the potential to rise over time.

Discovering customers, as you know, is an expensive proposition and frequently very low margin, whether it is with free software or with a 1 RU server that typically has very low margins. So we certainly see upside on the operating margin. Certainly that's what we're going to be directing our effort toward. Frankly, to that end, Mike and I have agreed we are going to be sharing an office here; just to give you a sense of the spirit of belt-tightening around Sun and the fact that we think that there are tons of efficiencies around the Company and we're going to go off and find them.

Mike Lehman

Again, just to clarify on the expense to revenue. In the last three quarters, you all know that a big piece of that increase has been, frankly, just the acquisitions. The people and the assets and resources that we acquired from StorageTek and SeeBeyond are now in the results during this fiscal year beginning in September. So you see some of that. And then the 123R costs and the amortization of intangibles from the acquisitions are also in there. So those are the biggest drivers of the expense to revenue increase.

Obviously, when I talk about acquisition integration and some of the opportunities ahead of us, going after and rebalancing that is a big part of what I am referring to. So we know that is all ahead of us.

Operator

Our next question comes from Richard Chu, SG Cowen.

Richard Chu - SG Cowen

Good afternoon. My congratulations to Jonathan and Scott as well. The question that I have is, can you give us some quantification of what the combined StorageTek and SeeBeyond revenue contributions were for the quarter? Either sequentially or versus any other metric that you would like to use. And give us some way to calculate the "traditional" Sun core business.

Mike Lehman

Richard, sorry to disappoint you on my first call back on the job, but that's not the level of detail that we want to go into. As you know, we are focused in trying to give you some more information and help you understand it. But the StorageTek results are increasingly a part of the data management group results. We are not even tracking them as much going forward separately. They start to knit together. We see more and more of the synergies between the sales forces. As you know, we have got one person managing that group, and that is how we intend to continue to look at it even more.

Scott McNealy

As an example of that, Richard, the first products we trained the former StorageTek field organization around were the data center storage systems from Sun, where we have begun to see some interesting revenues synergies. We expect as we continue to roll out the training across the entirety of the data management group product portfolio we will be able to leverage that selling engine, as well as the relationships with the customer base, to continue to drive upside.

That will be in a merged and combined entity, not by trying to pick apart what is a Sun product or a StorageTek product, because at this point you probably could not tell the difference anyway.

Richard Chu - SG Cowen

I understand. I ask only in the sense that you report a backlog and a product book-to-bill number for the old operations. To the extent that you think reporting that is meaningful, if you could comment on the post-December 30 shift in the behavior of your acquired operations, especially given the compensation changes and seasonality that you're going through. That was the spirit of the question.

Mike Lehman

Again, Richard, I don't think we have anything specific to add right now.

Operator

Our next question comes from Andrew Neff, Bear, Stearns.

Andrew Neff - Bear Stearns

Just two quick questions, if I could. One, I just wanted to clarify -- when you said the tax for the year, you said $200 million to $250 million for the year, is that correct? When you were given your comments on the quarter?

Mike Lehman

The answer is yes, we have about $154 million in tax provisions through the nine months. So excluding the financing activity, I said the provision for the year would be in the $200 million to $250 million range.

Andrew Neff - Bear Stearns

Then as you look at the factors that drive your gross margin into the fourth quarter, can you give us the factors that could push it one way or the other? Just looking at your gross margin; you gave us comments on the other lines.

Mike Lehman

You know, I think it is the usual suspects. None of this will surprise you, but typically volumes are up in the service business in Q4. That is, again, sequentially. That is typically a business where the margin is largely driven by volume.

On the product side, it somewhat depends upon where one is in the product introduction cycle. We obviously get cost decreases the more that we roll out new products. We see traditional seasonal impacts from discounting and all sorts of other stuff. So it is the usual suspects that drive it up and down.

Jonathan Schwartz

Just to add on to that, of course the software business is obviously a pretty high-margin business. As we continue to drive some of the potential there, we think there's room for expansion.

Andrew Neff - Bear Stearns

In the fourth quarter, let me just clarify -- you're saying for the fourth quarter there is that potential for the software, or just generally?

Jonathan Schwartz

Generally.

Andrew Neff - Bear Stearns

Thanks and congratulations to you both.

Operator

Our next question comes from Ben Reitzes, UBS.

Ben Reitzes - UBS

Mike, now that you've been at the Company for a little while, do you have any views on what kind of timeframe it will take you to get your arms around the cost structure with Jonathan here, and maybe come up with a plan for us? Is that still in the July timeframe? Then just if you could recap, again, if you have any comments as to where $1.6 billion in operating expenses for the next quarter kind of lines up with your views of Sun's potential operating model?

Jonathan Schwartz

Mike and I can answer this together. We are in the midst of our annual planning process. We are going through a pretty exhaustive -- as we do every year -- scrub of R&D, corporate resourcing, what initiatives we have around the Company, and overall how we are spending the dollars here.

So we are going to look, as we do every year, into where do we want to be investing, how do we want to be prioritizing the leadership of the Company, as well as the dollars of the Company. So that is a part of our annual planning process. We are in the midst of it right now.

Mike is probably more involved than he would like to be in getting down to the gory details of where we have individuals and in what offices they are located and what projects they are working on. But, again, that is part of an annual process, and we are underway now and we are going to continue it. Mike, do you want to add?

Mike Lehman

Further, as I have discussed before, we will share a bit more about that in July, not before then. It is our normal fourth quarter planning process. We are going through it in great detail. So we talked about in our July earnings conference call that we will share more details of some of the things we've looked at and just our comments on business model going forward.

The direct answer to your question, is the $1.6 billion the level of OpEx that we expect to have going forward? I would say no, we expect to take that down. But it is too premature to try and quantify it or to give you any more sense of that.

Operator

Our next question comes from Brent Bracelin, Pacific Crest Securities.

Brent Bracelin - Pacific Crest Securities

Thank you. I wanted to follow up on the computer systems segment of the business. It looks like you had the best growth rate in the core server business in several years. Obviously, you had a spillover from Q4 with some of the shortages. But how do you look at that business? How sustainable is growth in that business, considering the bulk of that business is kind of the core UNIX business. Against the backdrop of IBM, that actually had a 9% year-over-year decline in their segment.

Jonathan Schwartz

I can maybe talk to the strategic positioning at a top level, and then Mike can get into some of the data behind it. At the end of the day, customers buy based on the efficiency of what they get whether it is power efficiency, speed efficiency, performance, management efficiency. We've got the single most competitive server product line, I believe, in the whole industry. That applies across the x64 business, as well as onto the UltraSPARC and traditional business.

So one of the single biggest drivers of the opportunity to go sell into the marketplace is the fact that we have a free and open source operating system that can be distributed broadly across the world. I think we are nearing in on about 5 million licenses. Again, as that goes out into the world, that that begins to take share from the proprietary operating systems that are neither free nor open source nor available on x64 servers; that just creates a pretty broad market.

Frankly, I'm not worried about the size of the market or the demand that is out there; I'm worried about intercepting it. So I think we continue to view raw innovation in the server space, where some others have said it is a commodity, it's not worth investing in, we actually see it quite the opposite. The most attractive markets in the world are commodity markets because everybody needs what you've got and they are going to need it for as long as they are on the planet. So we are pretty excited by the opportunity.

Brent Bracelin - Pacific Crest Securities

I guess the increase in the UltraSPARC platform was the big surprise relative to what has happened over the last three or four-year period. Is that sustainable? That is the most important question.

Jonathan Schwartz

Well, I think the question is, is the innovation sustainable? Certainly, I think if you read any of the reviews online right now, we slowed down the chip and parallelized it so that we could get work done eight times faster than a traditional Intel chip. So eight times has a pretty big impact on how much you spend on servers or electricity.

Again, given that those $2 numbers are the focus of large-scale data centers across the world, we continue to see more opportunity in the marketplace rather than less.

I don't want to dip onto the technology side of this -- there was a day when what ran on the desktop determined what ran on the server. Now it's less about what runs on the desktop and more about what is on the handset or set-top box or billboard or automobile. So there's a real split between the end user device on the network and what is powering it in the data center. That is creating a new wave of opportunity for things that aren't just Windows servers.

So with Sun's position both on the handset, set-top, dashboard, what have you, that's just outlets for the generators, the infrastructure we provide in the data center. That's just creating more pull and more demand and opportunity.

Operator

Kevin Hunt, Thomas Weisel Partners.

Kevin Hunt - Thomas Weisel Partners

I had a couple of follow-up questions. First, on the server business, you gave a 6% number for growth in total units. Then it looks like your revenue also was up around 6%. So that's quite a different trend than what you've seen in historical quarters, where you have had unit growth often higher than that and revenue growth much below that. So can you comment a little bit on the ASP and why we are seeing that sort of gap narrow?

Then on the storage side, I think, Scott, you said it's double-digit. I wonder if you can quantify that any more on the core storage from Sun. You are down it looks like around 16% in your total storage business sequentially, which gets back to Richard's earlier question of, it doesn't look like that StorageTek business had all that great performance, if you just look at those numbers. Can you comment on that as well?

Mike Lehman

There were a few questions in there. I'm going to start at the end. StorageTek typically has had a very seasonal business. If you look at the way they were run, the December quarter was their old end of the calendar year, end of the fiscal year for them. So there was a normal expected drop-off in the March quarter. That was in line with what we had expected from a seasonality perspective. There was no big surprise there at all to us.

The rest of your questions were fairly detailed. They almost sound like the kind we're going to have to go over one by one. Like I said before, we weren't really surprised at all on the ASP side, on the discounting side. Their products are very competitive. I'm not sure how to answer your questions without spending a whole lot more time on them.

Kevin Hunt - Thomas Weisel Partners

Well, why are the ASP and the units growing about the same, when that has not been the trend historically?

Jonathan Schwartz

Well, they are linked, and linked in the sense that if you get the low-end unit volume over time, you will get the high-end margin. We have certainly been investing over the past three years in rebuilding the low end so we could go drive the unit volume. Now that we have that unit volume, we are certainly beginning to see some of the reflection back up in the data center.

One of the interesting things, and I think especially with UltraSPARC IV+, is we have said consistently although the world is moving toward a horizontal architecture, we have seen history repeat over and over again -- all horizontal architectures scale up and they become vertical architectures before they become horizontal again.

So the good news is, we are very strong in the horizontal side right now with the UltraSPARC T1000 and 2000, very strong on the x64 side with the Galaxy platforms, as well as having pretty strong offerings on the high end. Really we only see IBM and Power as the alternative out there. So with UltraSPARC IV+, we think that there's lots of headroom and certainly lots of opportunity on the high end.

You have to couple the volumes to get the long-run high-end margin. If all you do is nurse the high end, over time your volumes diminish and you can't afford the business.

Operator

Our next question comes from Tony Sacconaghi, Sanford Bernstein.

Tony Sacconaghi - Sanford Bernstein

Thank you and congratulations and best wishes to both of you, Jonathan and Scott. I have just a few quick ones. Mike, my read is that you will have a 14-week quarter in the fiscal Q4. Can you confirm that? If so, why was that not provided as an important part of guidance?

Secondly, you talk about gross margins being lower in your guidance for Q4, despite seasonally higher volume and what you viewed as disappointing services margins this quarter. Can you comment on that? Then I have one follow-up, please.

Mike Lehman

Well, let me start. I guess the reason that we haven't commented on June being different is that it is like that every fiscal year. Our fiscal year to route, the first three quarters ends on a particular date which is not the end of the calendar quarter. It has always been that way. So the fact that we have a little bit of extra time in the June quarter is just like every other June quarter.

I talked about gross margin is going to be relatively flat or perhaps slightly lower. So it can go both ways. There are lots of things that we talked about that can drive it both ways. We're just trying to give you a general sense of what we're thinking without getting locked into a specific range. So one can have at that comment with the glass is half full or the glass is half empty. I wasn't trying to give you a specific number.

Tony Sacconaghi - Sanford Bernstein

But why wouldn't there be a potential impact from volume in the quarter and why wouldn't there be a possibility for services margins to be better following some disappointment this quarter? If anything, why wouldn't you have emphasized the glass half full rather than the glass half empty?

Mike Lehman

You're absolutely right that both of those things are possible. I know my audience. So I am trying to play to all sides.

Jonathan Schwartz

Mike was trying to emphasize the glass.

Tony Sacconaghi - Sanford Bernstein

Finally, just on the annual planning process, I think there is a lot of expectation about what might come out of that and I would like to ask you directly. The sentiment in the investment community is that there needs to be or will be a significant 20%-plus workforce reduction. I want to first understand whether that possibility is on the table or not.

Secondly, to the degree that such a possibility is on the table, why are small reductions like the 200 or so people in the scaleable systems group happening in Q3? You are making relatively small reductions and trimming on the sides, when ultimately it looks like you are looking at the business much more holistically going into Q4.

Why are such reductions being made when ostensibly a more integrated thought process around expense is being looked at going forward?

Mike Lehman

I will comment quickly. If you look at numbers, we are down just over 900 people from Q2 to Q3. So what that tells you is that we are not waiting for some big event. We're looking at this right now in every place. It is happening all the time. So we are not sitting here, just going to do one particular thing. Frankly, when we have something to announce, like we did with the 200 people you referred to, it gets announce and gets handled.

There's also an issue that I know you all understand that has to do with the timing and one's ability to do this around the world in various countries. It is different. There are Works Councils, there are approvals that have to be obtained. So none of this happens immediately. That's why you see, in some cases, the numbers happen over time.

Tony Sacconaghi - Sanford Bernstein

Are there any restrictions on the planning process this year or expectations? Specifically, is it incorrect for the Street to be thinking about a major resetting in the cost base at Sun? Or do you believe that the Street should be setting an expectation for more gradual incremental cost cuts going forward?

Jonathan Schwartz

I think in something you wrote recently, you suggested that cuts could range up to 12,500 heads, and in the next sentence suggested that would completely undermine the business. So I don't think we are interested right now in undermining the business when we've got the most competitive product line we've ever had in the history of the Company.

Frankly, our competition appears to be bowing out of a variety of the battles in the marketplace, the operating system probably being chief among them. I think, as we have consistently over the past decade, we have an annual and very well-coordinated planning process that allows us to make the best in the areas that make sense; and where prudent and responsible, go diminish the investments around areas that don't seem to make sense anymore.

So we are going to continue to look at the cost structure. To Laura's earlier point, we are going to continue to look at growing the operating margin; but looking at expense as a portion of revenue, there's two ways to hit it. One is to get expense down. The other is to get revenue up. We are going to be just as focused on that latter part of the equation as we are on the former.

Again, there is no plan whatsoever for a cut of the magnitude, certainly that you referenced. We are going to continue to look at the right decisions to get the right resources in the right places to go drive the right business model next year.

Bret Schaefer

One more question, please.

Operator

Our final question comes from Richard Farmer, Merrill Lynch.

Richard Farmer - Merrill Lynch

A few quick ones, if I could. What percentage of the customers who receive the demo T1 systems have decided to purchase them? Also, you mentioned the next-generation Niagara chips. When will those be announced and shipping? Finally, Jonathan, a broader question: how do you think that your approach as CEO might differ from Scott's? By the way, congratulations to both Jonathan and Scott.

Jonathan Schwartz

Thank you. Maybe I will answer the latter question first and then the former. What is going to differ between the two of us? Scott plays hockey. I don't play hockey. Scott has a short haircut. Unless he pulls something out that mandates it as a part of my employment contract, I'm keeping my haircut.

Realistically, we have been lockstep on a whole number of different issues across the past four or five years, especially. I think the principal difference between the two approaches that you are going to see -- and frankly, I think you saw it evidenced this quarter -- is we have been focused on stabilizing the customer base, as well as really driving into the R&D to ensure that we have the innovations that allow us to grow.

So my team is probably going to be a little bit more focused right now on growing to business and on finding new customers, seeking the new adoptions, finding the new opportunities around the world. Where we have been a little bit more focused over the past four or five years, whether it is on Wall Street or in start-ups, in trying to stabilize the business.

So certainly, an orientation toward growth, an orientation toward financial performance now that the technical performance and the customer performance is back at a level that we both think is reasonable.

The try-and-buy, I think we are pretty early days right now. We are at 50% plus on acceptance. I think the actual numbers -- I don't have the data with me -- are pretty encouraging, enough to suggest that we will roll out that try-and-buy program, which to us is kind of the moral equivalent of a free software download, except with hardware. We are going to roll that out across all the products we have at Sun. That is going to yield lots and lots of new systems going to new customers that we believe we can convert pretty aggressively.

Richard Farmer - Merrill Lynch

Thanks. Any comments on the next-generation Niagara, when the timing of that might materialize?

Jonathan Schwartz

We have obviously announced Niagara II and --

Scott McNealy

We said late next calendar year is the target. The second half of next calendar year.

Bret Schaefer

Thank you very much.

Operator

This concludes today's conference call. We appreciate your participation. We are again providing an encore replay service this quarter. If you joined us late or wish to hear any part of the conference call again, you may call the replay service any time after 3:30 PM Pacific Time tonight to hear a recording of this conference call. The phone number for the replay is 1-800-642-1687 or 706-645-9291 outside the U.S., and you must enter the conference reservation ID 6170205.

Thanks again for taking part in today's Sun Microsystems call. You may now disconnect.

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Source: Sun Microsystems, Inc. F3Q06 (Qtr ending Mar 26, 2006) Earnings Conference Call Transcript (SUNW)
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