Life After Dot-Coms Sun Microsystems liked to boast that it was the "dot in dot-com." The dirty little secret was that it had become the "o" in "old" economy, which is a good thing to be right now.
By Eric Nee

(FORTUNE Magazine) – Welcome to the new new economy. Less than three miles from Sun Microsystems' headquarters is the Santa Clara Convention Center. It usually plays host to one of Silicon Valley's seemingly daily technology confabs, but on April 18, in a Spartan ballroom set off to one side, it was the site of an old-fashioned auction. On the block were enough Sun servers, Cisco routers, Dell PCs, and other high-tech gear to run a decent-sized company. In fact, several decent-sized companies--TargetFirst, Lifespire,,, and to own the stuff. Much of the equipment was barely used, some had never even left the box, and all of it was selling for a song. Here, at ground zero of the Internet revolution, were the grim vestiges of the technology buying binge that had swept through America just a short while ago.

Few companies benefited more from that spending spree than Sun Microsystems. During the past two years Sun's revenues climbed 60%, to $15.7 billion, while its profits jumped a stunning 150%, to $1.9 billion. At the peak of the tech boom last September, the company was valued at a heady $210 billion, which worked out to more than ten times revenues and roughly 100 times earnings.

Under the banner WE'RE THE DOT IN DOT-COM, the company rode the Internet craze for all it was worth. Whether it was e-commerce firms, telecommunications service providers, or traditional companies, if there was a Web application to run, the odds were that a Sun computer was running it. But now, of course, many dot-coms are dead or dying, the telecom sector is a bloody mess, and most other corporate customers are in the midst of what some in Silicon Valley are calling a "buyer's strike." To top it off, billions of dollars of gear that once belonged to the dot-coms is coming back on the market for bargain-basement prices at auctions just like the one in Santa Clara.

Not surprisingly, the sudden collapse of the IT market has led to a dramatic reversal of fortune for Sun and its brethren. In the first three months of 2001 (Sun's third fiscal quarter), the company's revenues grew a paltry 2% over the previous year, while profits were down 43%. More alarming, revenues fell 20% from the previous quarter--and Sun does not expect sales to improve much, if at all, in the near future. "We're taking a meat cleaver to our fourth-quarter and fiscal 2002 estimates," Merrill Lynch analyst Thomas Kraemer wrote in a recent report about Sun. As a result of all this, the company's stock has plummeted by some 70%. Clearly Sun's days of hypergrowth and outsized stock valuations are over, possibly for good.

So why on earth does Scott McNealy seem so darned chipper? "I was on the golf course this weekend. And someone said to me, What are you doing on the golf course--you should be working," Sun's boss tells FORTUNE. "Why should I?" he laughingly recalls telling the person. "No one is buying anything." Ah, that's just the sort of wisecrack people have come to expect from the technology industry's answer to Henny Youngman. Can you imagine another CEO happily moving his corporate headquarters into a former state insane asylum, as McNealy did last year?

But don't let his demeanor fool you. To the outside world McNealy, 46, often seems like the class clown, but inside Sun he's anything but. "He's very strategic and very, very smart," says Sun's chief scientist, Bill Joy, who's no intellectual slouch himself and who founded Sun back in 1982 along with McNealy, Andy Bechtolsheim (now at Cisco), and Vinod Khosla (now at Kleiner Perkins Caufield & Byers).

The reasons for McNealy's optimism in the face of such tough times are twofold. First, Sun has so far avoided any serious missteps as it slims down operations to match lower revenues. Second, the company has actually emerged from the dot-com boom in a much stronger position than it held going in. In fact, some analysts argue that Sun may be poised to dethrone IBM as king of corporate computing.

Before we get to the story of how Sun gained so much traction in corporate computing during the past few years, let's look at how the company is coping with the downturn. If McNealy and gang don't handle this right--if they are forced to gut their work force, slash R&D, or lower their level of service--many of the gains of the past few years may have been for naught.

To appreciate how well Sun is doing, compare the company's performance with that of its cross-town neighbor, Cisco Systems. The two firms face similar predicaments. Both were highfliers during the Internet mania, and both have seen sales dramatically decline as the spending spigot was turned off.

So far, Sun seems to be handling the slowdown a lot better than Cisco. It has not had any layoffs, while Cisco was forced to eliminate 8,500 jobs. Sun's inventories are a manageable $900 million, while Cisco's stand at a bloated $1.6 billion--and that's after writing off $2.5 billion in inventories. Moreover, Sun cut its sales, marketing, and overhead expenses by $40 million in the last quarter of 2000, and another $247 million in the first quarter of this year. By contrast, Cisco's sales and overhead expenses were up $70 million in the quarter ended Jan. 27, 2001.

"You can't just say, 'I can close my books every day,' " says McNealy, in a pointed reference to Cisco, which claims to be able to do just that. "You gotta have a team that can react to the dynamics of the industry." To use a golf analogy, if this were the Ryder Cup, McNealy's team would have a Tiger Woods-like lead. But they have yet to play the challenging back nine. If revenues don't pick up soon, Sun may still be forced to lay off employees, write down inventory, or take some other drastic action.

So why does Sun seem to be dealing with the downturn so much better? (Besides the fact that Golf Digest ranked McNealy the No. 1 golfer among U.S. CEOs last year.) One reason is that Sun has played this course before; Cisco hasn't. Cisco had enjoyed uninterrupted growth since its founding in 1984--until now, that is. By contrast, Sun has had its share of ups and downs over the years. In fiscal 1989, and again in 1992 and 1993, earnings declined significantly when the company stumbled. Sun's sales record has been patchy as well. As recently as 1998, just before Internet sales began to rocket, the company posted a modest 14% gain in revenues.

Because Sun had run into financial problems before, McNealy was ready to hunker down when the first signs of an economic slowdown began showing up. McNealy says he and Sun President Ed Zander "both started to put on the air brakes" last fall. He uses "air brakes" deliberately to suggest that it wasn't an immediate halt as much as a gradual slowing of outlays. Discretionary spending like travel was tightened, hiring cut back, and construction of new facilities postponed. Duplicative research projects also have been canceled, and free doughnuts dropped from the break rooms. Most recently Sun imposed a mandatory week off for most employees in July.

Some of the credit for Sun's early and quick reaction has to go to McNealy's buddy Jack Welch, who put McNealy on General Electric's board two years ago. "He gets a pretty good early warning signal here," says Welch. Does he ever. GE is so diverse, selling everything from light bulbs and jet engines to television advertising time and insurance, that it is almost a microcosm of the economy. "We were talking about the downturn at the October board meeting," recalls Welch. "In the fourth quarter Scott was acknowledging what the situation was. When we were talking about our issues, he was talking about the same sort of issues. Scott's a pretty pragmatic guy."

McNealy may be the one who receives the heads-up and sets Sun's overall strategy, but it's up to "Eddie," as the 54-year-old Ed Zander is known, to make sure it gets carried out inside the company. All of Sun's operations report to Zander, who's also COO, while the corporate side reports to McNealy. "He's McNealy's consigliere," says Howard Anderson, chairman of the Yankee Group. That's not a bad image--consigliere. Throughout his interview, Eddie carried around a dark-green aluminum Easton baseball bat--sometimes pounding it on his office floor when he was sitting on the couch or occasionally standing up and giving the bat a few good swings. Eddie hails from the Bensonhurst neighborhood of Brooklyn (the Jewish, not the Italian, side), so he's not unfamiliar with the tough-guy role. No doubt the bat comes in handy at Sun's budget meetings these days when Eddie's asking employees to tighten belts.

And tighten they must, because as bad as things are now for Sun, they could get worse before they get better. Not only have sales slowed, with no signs yet of an uptick, but prices are under mounting pressure. That's because vendors like Sun are desperate to hang on to their customers, and the customers know it. For the first time in years, it's a buyer's market, and customers are using that power to exact price cuts from everyone. What's more, the competition Sun faces from previously owned Sun servers being sold at all those dot-com bankruptcy auctions certainly hasn't helped on the pricing front.

In a recent survey by Merrill Lynch of 65 CIOs, 75% said they were pressuring vendors to lower prices, and 80% of them said they were succeeding. As a result, profit margins for technology companies are plummeting. Sun's gross margins on hardware dropped from 50% to 43% last quarter and show few signs of recovering soon. Margins for service, which account for 20% of Sun's revenues, have held steady at 35%, but even they may come under pressure as corporate customers play vendors off against one another.

That's a far cry from a year ago, when Sun was selling truckloads of computers to spendthrift dot-coms and telecoms, neither of which seemed to care how much they paid. They only wanted to know how soon the gear could be delivered. Laura Conigliaro, an analyst at Goldman Sachs, estimates that dot-coms and service providers accounted for 10% and 35% of Sun's sales, respectively, at their peak last year. Overall, Morgan Stanley reckons the dot-com bubble inflated sales of IT equipment by as much as $34 billion.

Was it a mistake for Sun to sell so much gear to all these flaky companies, many of which are no longer around? McNealy doesn't think so. "What was I supposed to do, turn down the POs?" he says. If he did, Lou Gerstner and Carly Fiorina would have been happy to take them off his hands. In fact, IBM and Hewlett-Packard were frantically trying to entice those very same companies to buy their computers, with much less success. That's because in the past couple of years Sun came on like gangbusters in the server market. Last year, when the overall server market grew just 7%, Sun's server revenues were up 42%, vaulting the company from fourth place to second place, behind only IBM. Even more remarkably, in the $1 million-plus server market, which IBM has ruled for decades, Sun grew 84% last year, to $2.1 billion, while IBM fell 7%, to $4.3 billion. With the demise of the dot-coms and the tumbling of telecom, Sun's server market share will undoubtedly fall this year.

For all the problems created by this roller-coaster ride, the Internet provided at least one important long-term benefit to Sun--it got the company in the door of FORTUNE 500 data centers. Large companies, afraid of being "Amazoned," turned to Sun for help in building their Web businesses. "CIOs looked forward to that meeting with Sun," says Sam Reese, a former VP of sales at Corporate Express and now CEO of Miller Heiman, a Reno firm that provides sales force consulting to technology firms. Because of that, "Sun formed tight relationships with the CIOs at major companies," he adds.

Despite Sun's boast about being "the dot in dot-com," the dirty little secret is that its computers were increasingly gobbled up by large corporations to perform critical tasks. Sun didn't talk about those sorts of applications much. After all, "we're the "o" in old economy" wouldn't have sounded quite so sexy. But traditional firms became a larger and larger part of Sun's business, and with the dot-coms mostly gone now, they're even more vital to the company's future.

Take Ford Motor's financial arm, which provides credit for people who buy Ford cars. The automaker began using Sun systems in 1995 to create an application for its dealers that was written in Sun's Java computer language to run on Web browsers. Today Sun servers are used for a broad range of tasks. "They got their foot in the door," says Paul Nussbaum, VP of IT for Ford Financial. And it's not just Sun's speedy servers that Nussbaum likes. It's also the company's service organization. "If I call them [Sun] with a problem, in an hour they'll have a topflight guy in here," he says. "I can name three other vendors that take days to get someone here. They have saved my bacon several times."

Sun wasn't always so good at this sort of handholding. For many years the company was known for shabby service--or no service. When Sun was a bunch of geeks selling computers to other geeks--Unix programmers, engineers, scientists, and the like--it could get away with that. "Back then customers rarely asked for help," says Larry Hambly, executive VP of services at Sun. That's because most of Sun's users could handle any problems themselves, and when the computer did go down, it affected only a handful of people. Today that's all changed.

Visa's credit card system handles 4,000 transactions per second, 35 billion transactions per year. If it fails, half the retailers in the U.S. might have to shut down. Because of that, "we have zero tolerance for downtime," says Scott Thompson, executive VP of systems development at Visa. When a retailer sends a credit card transaction to Visa for authorization, it goes first to a cluster of Sun E10000 servers, which read the message and route it to the appropriate server. Then IBM mainframes handle the actual financial transaction and communicate the result to the banks. Sun's servers are as fast and reliable as IBM mainframes, says Thompson. The reason they don't handle the entire process is that the software that manages Sun systems isn't as sophisticated as it needs to be. "That's the one thing that differentiates the IBM mainframe class of technology from Sun's," says Thompson.

Sun's move into mission-critical-type applications has not been entirely smooth. The most dramatic failure occurred on June 10 and 11, 1999, when for 22 hours eBay's site went down. There were many reasons for the failure, but the Sun servers powering the site were partly to blame. Zander recalls getting a call from eBay CEO Meg Whitman informing him that the site was not working. It wasn't a pleasant conversation. "eBay was a great wake-up call," he says.

Since the eBay debacle, Sun has instituted a wide range of programs to improve service, reliability, and quality throughout the company. Nearly every company talks about improving those sorts of things, but it's often low on the list of priorities. McNealy is determined that this will not happen at Sun, and when he's serious about something, it usually gets done. Part of the reason for McNealy's enthusiasm about making it happen, and his understanding of how important these issues are, goes again to Welch.

Jack is my hero," says McNealy unabashedly. "He's seen all the movies. The best practices we've been able to bring back here are incredible." Sun had already begun a Six Sigma quality program in one part of the company before McNealy joined GE's board, but now the program, dubbed Sun Sigma, is companywide. Another sign of the company's commitment: Forty of Sun's top engineers from Sun Labs have been taken off the development of new products and instead told to devise ways of measuring quality and reliability. They're called--what else?--the Rascals. (If you must know, it stands for reliability, availability, and serviceability, computer analysis laboratory.)

For all the strides Sun has made over the past few years, there are important areas in which it still lags. One of them is software. Sun has turned Solaris into a robust operating system that has garnered strong support among most business software developers. But operating systems are being superseded by a new generation of software, so-called application servers, that run on top of the operating system and provide additional services required for the Internet. It's a bit like Windows, which was introduced to run on top of MS-DOS.

The problem for Sun is that its iPlanet application server ranks a distant third, trailing IBM's WebSphere and BEA Systems' WebLogic, which is No. 1. Looming in the background is Microsoft, which is entering the market with its .Net software. Sun can either continue to compete, hoping to take it all, or throw in the towel and partner with BEA against IBM and Microsoft. Bill Coleman, CEO of BEA and a former Sun executive, hopes McNealy will choose the latter. "I hope what he'll do is determine there's better leverage for BEA and Sun to work together during this shift."

The business in which Sun has the most problems competing is storage--the banks of disk drives that collect the endless stream of data that companies generate. In storage, EMC is the gold standard. "Their [EMC] product is world-class," says Visa's Thompson. When a credit card transaction is sent to one of Visa's data centers, it first passes through a cluster of Sun servers, but a copy of the transaction is kept on EMC's storage systems, not Sun's. Ford Financial prefers EMC systems to store data too. At Ameritrade, which uses Sun servers, "we were using Sun [storage] originally but switched to EMC," says CIO Jim Ditmore.

All told, Sun ranks a distant fourth in the $32 billion storage business, behind EMC, Compaq, and IBM. Since the storage market grew 20% last year, nearly three times the rate of the server market, Sun clearly has a problem. For a long time Sun viewed the storage market as simply an adjunct of the server market, not as a separate specialty. Now Sun is playing catch-up, particularly in the high-end storage business that is EMC's forte. Last month Sun replaced the head of its storage group, naming Mark Canepa the new executive VP of network storage, a move that could presage other changes.

Even in servers, Sun's mainstay business, things will get tougher. During the past few years Sun was lucky. Intel was years late with its 64-bit microprocessor, and Microsoft was slow to upgrade its server operating system, so Sun did not face as much competition from the Wintel duopoly as was expected. That's now changing, as Intel readies its Itanium processor and Microsoft makes headway with its software. Look for Dell and others to take it to Sun at the low and middle range of the server market. And don't forget Linux, the open-source operating system that is catching on even in major corporations. Sun certainly hasn't forgotten it. As a hedge, it recently spent $2 billion to buy Cobalt Networks, a supplier of special-purpose Linux servers.

So make no mistake: The next few years at Sun are going to be a heck of a lot tougher than the past few. Sales to the dot-coms and service providers were so strong that earnings comparisons will continue to suffer through the rest of the year. When revenue growth returns, it won't be at the breakneck rate it once was. But don't worry about Sun's ending up on the auction block along with all its dot-com customers. IT spending is clearly not dead, and neither is the Internet. "It's just not going to transform a bunch of popcorn stands," says Welch in his usual blunt manner. Instead it's going to transform real companies like, well, GE. "We're not going to slow [IT] spending," says Welch. "We'll be up 12% to 15% this year." If the rest of the corporate world does the same, McNealy will have less time for golf--happily.