Sun Profits in Q4 Thanks to Microsoft Settlement.

By Timothy Prickett Morgan

When Sun Microsystems Inc said at the beginning of the year that it wanted to be profitable by the end of fiscal 2004, no one could have predicted the way in which it happened. Sun did indeed report a profit of $795m for the fourth quarter after booking $1.6bn of its $1.95bn settlement with Microsoft Corp, but the company is still in the midst of a number of product transitions, and Sun's prospects for profits and revenue growth in fiscal 2005 are a big question mark.

This is the sort of thing that makes investors uncomfortable, but Sun is not as worried about investors as it is customers these days - and rightly so. The subscription-based pricing model being championed by new president and chief operating officer, Jonathan Schwartz, does offer Sun a chance to differentiate itself from the pack in the IT market.

Who knows what affect Sun's transitioning from product sales on a quarterly basis to subscriptions spread out over the course of a year or more will have on sales or profits, but what seems clear is that what Sun wants Wall Street to keep its eye on is the amount of deferred revenue that the company has booked. This is exactly the trick that former chairman Lou Gerstner did when he took over IBM Corp more than a decade ago and got everyone to focus on the Global Services business and its quarterly bookings and growing backlog of orders as sales for servers and other products moved a bit chaotically.

In the fiscal fourth quarter ended June 30, Sun's total sales were $3.11bn, up 4.2%. Steve McGowan, the company's chief financial officer, said that Sun had product sales of $2.07bn in the quarter, up 3.1% from the same quarter a year ago. Sun said that $1.64bn of that came from computer product sales, and that $427m of that came from Network Systems, which is what Sun calls entry servers based on its Sparc and x86 architectures.

McGowan said that Sun's sales across entry, midrange, and enterprise Sparc server lines were all up, and that machines using its new dual-core UltraSparc-IV processors comprised 30% of Sparc server sales in the quarter. As the transition to these new chips continues, McGowan said that Sun expected the UltraSparc-IV processors to account for about half of server sales in the first quarter of fiscal 2005. This, he said, was slightly ahead of plan. He also said that while Sun's fledgling x86 server business, which is dominated by its Opteron-based Sun Fire V20z server, did not yet represent a measurable revenue stream, sales more than doubled in the quarter.

Scott McNealy, Sun's chairman and CEO, reiterated that the company was focused on driving unit volumes, which have traditionally been the forerunner of profits for Sun. "This is a company that is in control," he said in a conference call with Wall Street analysts. "Volume is a leading economic indicator, and it is what will drive future revenue at the company." To that end, Sun pushed up x86 server sales by 327% in the quarter, and overall shipments (including both x86 and Sparc servers) were up 46% in the quarter.

All of Sun's executives were excited that the company booked its first quarter of services sales of more than $1bn, with $1.044bn in sales. McGowan said that Sun had some 771,000 systems under maintenance, which represented about 48% of the Sun installed base, an increase in 8% in the past year. The Sun executive team was similarly thrilled to report that subscriptions to the Java Enterprise System software stack grew by 74% sequentially in the quarter, and that the company now has 303,100 end users licensed for the software stack, which includes Solaris and a whole slew of middleware. While these are great growth numbers, Sun needs an installed seat count that is two orders of magnitude larger to be a player. That said, this is a start, and such growth could, as McNealy is fond of saying, create a positive feedback loop. Such a loop is, after all, how Sun came to dominate the Internet and then the dot-com era.

Sun has deferred another $350m payment from Microsoft as it awaits some advice from the Securities and Exchange Commission on how to treat it. Sun's CFO could be confused because the Microsoft settlement is complicated, but then again, it could be that Sun has decided to be cautious about how it books this money so it can cleverly save that unearned revenue to apply in a quarter with a rainy day or two. By booking the $1.6bn in the fiscal fourth quarter, Sun was able to book a $795m profit, and that was enough of a contrast with the $1.04bn loss it had in last year's fourth quarter to make Wall Street happy. But without the Microsoft money, Sun only generated $276m in positive cash flow, and would very likely not have booked a profit in the quarter.

For the full fiscal year, Sun's sales were $11.185bn, down 2.1%. Product sales were $7.355bn, down 5.6%. Services revenues for fiscal 2004 were $3.83bn, up 5.2%. Sun booked a loss of $376m for the full year (and that extra $350m would not have wiped it out), which was a lot better than the $3.43bn loss it booked in fiscal 2003.

Going forward, Sun's executive team did not provide any guidance on what fiscal 2005 would be, except to say that the company would make modest cuts in R&D spending and continue to drive out sales and other costs. McNealy said that the company's compensation and bonus plan for fiscal 2005 was oriented on the basis that Sun would have revenue growth, strong cash flow from operations, and profits. Exactly what they might be, McNealy and his team are just not going to say. Given the tumult Sun has been through, this is perhaps the wisest course of action.