JAVA: Cost cutting may not be the long-term EPS driver

Sun Microsystems, Inc. (JAVA) continues with its resurrection of earnings by treading into positive turf and achieving an operating profit in FY07, the first time since FY01. JAVA recorded three consecutive quarters of positive EPS in FY07 and is now targeting an operating margin of at least 10% in FY09.

However, underlying this growth is a scenario that bristles with complexities, and not everything is as rosy as it seems. For instance, growth appears anemic—sales are expected to rise in low single digits this quarter. And it’s not yet clear whether JAVA is making new money through open source or simply finding new ways to save money. All eyes are now on Jonathan I. Schwartz, who took over as CEO of JAVA from Scott McNealy in Apr-06; justifiably so, because Schwartz is not merely seeking to turn around operations by paring payrolls, reducing headcount, and restructuring. He has set out to redefine the way a company can do business in the new Web age. If Schwartz can reestablish Java as a credible trendsetter, it would make for one of the Valley’s more spectacular comebacks.

We analyze whether Schwartz’s pronouncements of growth objectives match JAVA’s performance across sectors and whether the targets can be achieved by cost containment rather than revenue growth. We set out to gauge whether this turnaround is a temporary blip or a true resurgence.

Management change and new objectives
When Schwartz took over as CEO in FY06, he outlined five broad objectives:
1. FY07 revenue growth in low-to-mid single digits
2. FY07 gross margin of around 43%
3. Operating margin of at least 4% in Jun-07 quarter and long-term operating margin target of 10%
4. FY07 operating expenses of $5.6-6B
5. Reduction in workforce by 11%-13%.

We look at JAVA’S performance against each of these objectives and indicators that could substantiate its ability to achieve the FY09 target of 10% operating margin.

Revenue growth
JAVA’s three major revenue streams are: 1) Computer Systems; 2) Data Management; and 3) Support Services. JAVA has achieved its FY07 target of low to middle-single digit revenue growth. However, Data Management and Support Services revenues have displayed declining trends in the past two quarters and CS revenue growth has been muted. Although the March and June quarters are seasonally strong for Java, revenue growth seems to be a concern area next fiscal.

While the StorageTek acquisition boosted revenue initially, JAVA has not been able to leverage the acquisition to cross-sell storage with its server systems. JAVA attributed the decline in FY07 Data Management products’ revenue to decreased sales of entry level and data center disk storage products and drive and virtual tape storage products, and competition. Moreover, JAVA does not expect its competitive position to improve significantly over the future quarters. In contrast, the storage market seems robust, based on the revenue growth achieved by pure-play storage vendors such as NTAP and EMC.

Given management’s outlook on Data Management, JAVA probably will need to focus on Computer Systems products for revenue growth. In sharp contrast to its past confrontationist moves, the company has chosen to befriend its foes hitherto, and has started taking initiatives to increase its products sales by entering into alliances with companies such as Intel, AMD, and Fujitsu.

Although these alliances have not yet started contributing in revenue terms, they are likely to do so in future quarters. Overall, the potential for revenue growth looks bleak since both Data Management and Computer Systems revenue streams appear growth-challenged and the Support Services revenue depends on product sales.

Gross margin
Gross margin has seen a marginal uptick due to a combination of cost reduction, increased efficiencies, and operational execution.

Exhibit 1 |QE Sep-05 |QE Dec-05 |QE Mar-06 |QE Jun-06 |FYE Jun-06 |QE Sep-06 |QE Dec-06 |QE Mar-07 |QE Jun-07 |FYE Jun-07 | |Gross margin |44.1% |42.6% |43.0% |42.8% |43.1% |43.5% |45.0% |44.5% |47.2% |45.2% | |Gross margin-Products |43.31% |41.98% |43.39% |41.13% |42.34% |42.67% |45.66% |44.27% |47.35% |45.15% | |Gross margin-Services |45.40% |43.61% |42.38% |46.09% |44.39% |44.88% |43.80% |44.89% |47.06% |45.18% | |Source: Gridstone Research.

Product gross margin increased about 200bp to 45.2% in FY07 due to decreasing material costs and favorable changes in volume and mix. Services gross margin rose 80bp due to cost savings associated with better utilization rates and the positive impact of changes in services mix.

Improvement in gross margin is crucial in achieving overall profitability. In fact, JAVA attributed the positive EPS achieved in the Dec-06 quarter (last positive EPS was in Jun-05 quarter) to higher gross margins.

Operating margin
JAVA gradually improved its operating profitability due to various restructuring programs it implemented during FY06 and FY07.

Operating margin in the Jun-07 quarter was 8.5%, exceeding its 4% target (SG&A expenses in the Jun-07 quarter included a $39MM gain related to the sale and leaseback of an east coast facility. Excluding this, operating margin would have been 7.5%). SG&A and R&D expenses remained flat sequentially and were down 12% Y/Y. The effect of restructuring started reflecting from Dec-06, leading to: (a) decrease in SG&A and R&D expenses; (b) streamlining of workforce and facilities; and (c) 3% operating margin. The last time JAVA achieved a positive margin was in Dec-04.

The decrease in R&D expenses was not at the cost of product innovations and introductions. JAVA achieved these reductions while simultaneously increasing focus on R&D pipelines. The company claims to have the strongest product map, driven by a new virtualization feature in Solaris 10, the upcoming Niagara 2 processors, and strong foundation of core innovation in software.

Total operating expenses of $6B for FY07 were in line with its target of $5.6-6B, decreasing 8% from FY06. The decrease in restructuring expenses, to $97M in FY07 from $294M in FY06, was an important contributor.

As shown in the chart below, JAVA has made significant progress in reducing SG&A expenses; however, a comparison with peers indicates that further reduction is possible. Using HPQ and IBM as benchmarks, reducing SG&A expenses to 21-23% by FY09 of revenue appears to be an achievable target.

Exhibit 2: Peer comparison on SG&A as percentage of revenue

| |QE Sep-05 |QE Dec-05 |QE Mar-06 |QE Jun-06 |QE Sep-06 |QE Dec-06 |QE Mar-07 |QE Jun-07 | |JAVA |SG&A% of revenue |30.37% |31.65% |32.11% |29.65% |30.04% |27.43% |29.15% |24.98% | |HPQ |SG&A% of revenue |12.16% |11.88% |12.67% |12.93% |11.75% |11.59% |11.92% |11.83% | |IBM |SG&A% of revenue |21.52% |21.50% |22.28% |22.46% |22.64% |21.40% |23.10% |23.69% | |
Source: Gridstone Research.
*- The data for HPQ is for QE Oct-05, QE Jan-06, QE Apr-06, QE Jul-06, QE Oct-06, QE Jan-07, QE Apr-07, QE Jul-07

Exhibit 3: Headcount trends

|QE Sep-05 |QE Dec-05 |QE Mar-06 |QE Jun-06 |FYE Jun-06 |QE Sep-06 |QE Dec-06 |QE Mar-07 |QE Jun-07 |FYE Jun-07 | |Total headcount |38,588 |38,802 |38,312 |38,061 |38,000 |36,250 |34,631 |34,494 |34,219 |34,200 | |y/y growth |18.92% |21.81% |19.73% |22.32% |22.58% |(6.06%) |(10.75%) |(9.97%) |(10.09%) |(10.00%) | |
Source: Gridstone Research.

Assuming that operating leverage is the best tool for driving higher operating margins, JAVA should aim to match the headcount reduction it achieved in FY07.

JAVA has achieved what it had set out to do in Apr-06, largely due to its restructuring efforts. JAVA’s next target is achieving an operating margin of at least 10% by FY09. This seems a little difficult, if one were to extrapolate the decline in Data Management and muted Computer Systems revenue to future revenue from these segments. If JAVA’s strategies of reinventing the company and making new money through open source pay off, it could secure its place among the movers and shakers in the Valley, making its turnaround truly historical.