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Technology > Tech Biz
House of the rising Sun
Shares of Sun Microsystems have enjoyed a nice pop lately. Is the worst finally over?
September 14, 2004: 1:10 PM EDT
By Paul R. La Monica, CNN/Money senior writer

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NEW YORK (CNN/Money) - Investors are once again betting on a comeback for Sun Microsystems, with shares up some 23 percent in the past month.

Granted, the stock only needed to move from $3.31 to $4.10 to accomplish such a gaudy gain. And shares of Sun (SUNW: Research, Estimates) are still more than 30 percent off their 52-week high and 90 percent below the all-time peak they hit during the glory days of 2000.

But is all the talk of a turnaround for real this time? It could be.

Sure, I've had some harsh words for Sun in prior columns. It has had its share of head-fake rallies before. Remember some of the takeover rumors that lifted the stock last year?

But there have been some encouraging signs lately.

In the company's fiscal fourth quarter, which ended in June, Sun reported its first year-over-year sales increase since 2001. And thanks to a nearly $2 billion settlement of all outstanding litigation with long-time rival Microsoft in April, Sun posted a profit for the quarter as well.

(The company announced in a filing on Monday, however, that it was lowering earnings for the quarter by $12 million due to an accounting change for the settlement.)

What's more, recent reports from two tech research firms -- Gartner and IDC -- both indicated that Sun posted the highest level of growth in server shipments during the second quarter, outpacing rivals IBM, Hewlett-Packard and Dell.

If you can't beat 'em, join 'em

Sun is in the process of a necessary transformation: from a company that prospered by selling proprietary high-end servers to one that can capitalize on a move toward lower-cost servers.

It's been a volatile year for Sun. Can shares build on recent momentum?  
It's been a volatile year for Sun. Can shares build on recent momentum?

For example, Sun has begun selling low-end servers running on chips made by Advanced Micro Devices instead of relying exclusively on its own Sparc line of processors.

Of course, the move to lower-priced servers could pressure profits. But Brent Bracelin, an analyst with Pacific Crest Securities, said that's better than sitting by and doing nothing.

"Sun would rather cannibalize its own high-end sales than lose business," Bracelin said.

Mark Stahlman, an analyst with Caris & Co. thinks that there are more good times ahead for Sun. He said that the company's largest customer base, the telecom sector, has been on the rebound and that should lead to healthy gains in server sales in the next two quarters.

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"Telecom is the largest piece of Sun's business and that has gone from being a negative to an increasing positive. Telecoms are back in an infrastructure build mode," said Stahlman.

Analysts are predicting a 7 percent year-over-year revenue increase in Sun's first quarter, which ends in September, and a 3 percent gain in the second quarter. But Stahlman thinks Sun could wind up doing better than that.

"There are a bunch of value investors who put Sun on their radar screens and have figured out that Sun is going to have a better-than-expected September quarter and potentially a blowout December quarter," Stahlman said.

Getting in touch with its software side

But perhaps the best thing Sun has going for it is that it is slowly but surely trying to emphasize its software business. Sun has been widely praised for its Java software and Solaris operating system.

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Sun Microsystems Incorporated
Computing and Information Technology
By Paul R. La Monica

Sun clearly recognizes that its future lies more with higher-margin software than with the commodity hardware business. Sun even promoted its software guru Jonathan Schwartz to president and chief operating officer in April.

"Sun is ill equipped to be the low-cost hardware provider. It's the right move to move towards software," said Dion Cornett, an analyst with Decatur Jones Equity Partners.

Yes, Sun still has many challenges. Competition in the server business will probably intensify and it remains to be seen whether or not the increased emphasis on software will really translate into consistent benefits to the bottom line.

Sun is expected to report a loss of three cents per share in the second quarter and a profit of just two pennies a share for all of fiscal 2005 and 11 cents in 2006. So Sun is trading at the not exactly cheap level of 37 times 2006 earnings estimates.

But Bracelin said investors wouldn't be paying much attention to valuation right now because Sun is a turnaround story.

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"This is a stock that is not going to trade based on a relative valuation. It's going to trade more on clearing hurdles. As the company successfully clears them, the stock will react," Bracelin said.

So as long as Sun can keep reporting gains in server sales and progress on the software side of the business, then Sun is probably in good shape.

And Stahlman said that Sun is a classic case of a misunderstood company that's primed for a breakout. He thinks it could double within the next year or so.

"People gave up on Sun. There's not a whole lot of people who have spent time on the new story," he said. "Wall Street hasn't bothered because Sun was left for dead."

Analysts quoted in this story do not own shares of Sun and their firms have no investment banking ties to the company.

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