Merrill to Sun: 'Cut and Focus' or Be Acquired

A prominent technology analyst for Merrill Lynch is urging Sun Microsystems (Quote, Chart) to slash as much as 15 percent of its workforce and focus on being a niche player in mission-critical computing -- or risk joining the "carcasses" of formerly-great companies DEC and Data General at the bottom of a tech "ravine."

In an open letter to Sun's chief executive Scott McNealy urging the company's board to take action, Steven Milunovich wrote that "Sun faces a crisis. It's necessary to cut expenses to assure profitability and narrow the product focus to reestablish a clear value proposition."

If the company stays on its current course, the note continued, "we believe Sun is likely to suffer further share and financial losses, become irrelevant to most users, and eventually be acquired for its installed base."

The research note comes on the heels of a warning by Sun on Monday that it would have to report an even bigger loss -- between 7 and 10 cents per share -- than it expected in the most recent quarter. Analysts were expecting a loss of about 2 cents per share. The news drove down Sun's price the next day by as much as 15 percent.

Following the Merrill Lynch research note Thursday, which contained the open letter to the company, Sun's shares were off by as much as 3 percent to $3.16 during the midday trading session.

Despite a concerted effort to expand its support for Linux across more of its product lines, the systems vendor still finds itself on the defensive about its support for Linux in relation to its high-end Solaris operating system, while trying to withstand intensifying competition from IBM and HP and a tech recession that has wrought two years of declining revenues at Sun.

The Merrill Lynch note urged the Santa Clara, Calif., company to drop some product lines and cut its costs by reducing headcount between 5,000 and 7,000. It also urged Sun to "focus on creating mission-critical computing systems where it can add value through innovation.

"That includes operating systems (Solaris, Orion), system architecture (blades), systems management (N1), and services."

The note continued: "Solaris is critical to why users like Sun. Being late to Linux is unforgivable both because Linux is a kissing cousin to Unix and because Linux is a disruptive threat to Microsoft.

"Sun needs to convince users that Linux is a subset of Solaris and push two messages: (1) if you're doing Linux, go to the Unix expert, and (2) use Linux on the edge, but when you need mission-critical capability it's time to graduate to Solaris. Linux is not associated with Sun, so at this point the best Sun can do is make clear it aggressively supports Linux."

Michael Hakkert, director of communications for Sun, said while the company is in a quiet period ahead of its next earnings release, Sun "welcomes Steve [Milunovich] to visit the company, meet with executives" and hear more about how it is "driving back to profitability."

Namely, Hakkert pointed to Sun's fiscal 2003 results, which showed that Sun improved its margins by close to 5 percent on servers, and 1.9 percent in services, while cutting $477 million from its administrative and overhead costs during the year.

The note also said it was "tempted to advise giving up on middleware, but the sedimentation trend of middleware moving into the OS [operating system] and the disruptive pricing of Orion (Java Development System) may be a hand worth playing though the selling model is unclear. Sun has made strides in improving its maintenance contract attach rates but may need to invest more in consulting/systems integration (though we don't see a major acquisition)."

It also urged the company to de-emphasize its SPARC processor system and save the roughly $200 million to $300 million that Sun spends on research and development for the processor systems.

"At the same time, Sun can't just dump SPARC outright given the size of the installed base and importance of migration paths," Milunovich wrote. "Customers must be assured that there will be multiple generations of SPARC to support their needs, especially high-end customers, much as HP has had to do with PA-RISC. The pure Solaris/SPARC story would be gone, but it already is."

The note was also hard-hitting about Sun's Java strategy, urging the company to spin off its Java division, asserting that "Java has been a technology success, a so-so branding effort, and a financial failure."

The note apparently kept its powder dry for perhaps the hardest-hitting suggestions to "bring in a COO" and to "Give Scott a makeover," referring to McNealy, also one of the company's founders.

"Scott's brash and contrarian personality have been synonymous with the company's image and success. Unfortunately, the act is getting old," Milunovich wrote. "Sun does need to make contrarian bets but must do so in ways palatable to conservative CIOs. Sending a clear message with a more pragmatic tone could help. More (some) respect for the competition and for different viewpoints is needed. In addition, Scott should not be the only face of Sun (we consider the brilliant Jonathan Schwartz cut from the same cloth), which is why a strong COO could balance yin with yang."

The note urged Sun to "return to its roots while looking to the future." Sun is an innovator, it continued, "but even IBM became selective about its R&D efforts when the red ink flowed. [Sun's]Solaris, Linux, Orion, Mad Hatter, N1, SPARC, x86, storage, Java-'The Network is the Computer' tent is bursting at the seams," he wrote of some of Sun's main product and services lines.

Hakkert declined comment on the suggestions, but stressed that "Sun is focused on executing on its strategies," with a strong management team in place and a pipeline filled with new products and aggressive pricing models for both high-end and lower-priced Intel-based server systems. In addition, he noted that Sun has reduced corporate spending, paid down $200 million in debt and ended the year with $5.7 billion in cash and securities, while working its way back to profitability.

But Milunovich wrote that a large installed base of customers and strong balance sheet will only act as brakes on a "slippery slope to the bottom of [a] ravine filled with carcasses such as DEC, Data General, Compaq, and others."

"We have an open invite for Steve to come to talk with us" about the company's focus, Hakkert added. Sun will release its earnings for its fiscal first quarter of 2004 on October 16th.

I can't find the open letter on the web, but I have a copy of it in PDF.

The highlights section at the top reads:

• We write an open letter to CEO Scott McNealy and the board urging action now.

• Sun faces a crisis. It’s necessary to cut expenses to assure profitability and narrow the product focus to reestablish a clear value proposition.

• On its current course, we believe Sun is likely to suffer further share and financial losses, become irrelevant to most users, and eventually be acquired for its installed base.

• To avoid this fate, Sun should accept being a successful niche company in mission-critical computing. It faces much larger competitors in IBM, HP, and Dell.

• Sun must become profitable quickly, so headcount reductions are unavoidable; 5,000- 7,000 seems a ballpark number.

• As important, Sun must prioritize its investments and clarify its message. We think there is a place for Sun as a mission-critical computing vendor adding value in operating software as well as in systems architecture and management.

• What doesn’t fit? SPARC, Mad Hatter, Java, and an attitude that makes partnering difficult.

• We can’t become more positive on the stock until we see management act on our advice.

The complete section on Java reads:

Spin off Java. Java has been a technology success, a so-so branding effort, and a financial failure. Sun deserves to be a proud father, but Java now belongs to the masses. IBM likely invests more in Java than Sun does. Yes, it’s Sun that hosts the Java Developer Conference, but it’s hard to figure a financial model where Sun gets direct benefit from Java, and it doesn’t need to own it to get indirect benefit (selling the infrastructure behind Java-enabled devices). Sun, IBM, Oracle and others could jointly own and support Java development, perhaps including the open source community as well.

I suggest that MSFT make a tender offer for the entire U.S. equity market at a premium of 500% above previous market value.

Everone will be rich overnight. The Dow will soar to 45,000. Even SUNW will be worth over $20.00 per share.

Although MSFT only has 50 billion in cash for this takeover, the Board has authorized the issuance of more than 173.5 trillion new shares and to accept replacing the FED as the source of all new corporate financing.

The New York MOMD [MicroSoft Open Market Desk] will issue an additional 94.2 quadtrillon in 7 day Microsoft Treasury Notes, and pay off the entire U.S. Federal Debt overnight. These will carry a new rate of interest demoninated in the new U.S. currency: $MSFT.

$MSFT will yield new MSFT shares at the rate of 3 new shares for each $1,000 invested each day.

The NYSE and the NASDAQ will be trading over 356 trillion MSFT shares each day and we will all become wealthy.

You can visit MCD for a Happy Meal for only a few $MSFT. A new GM "Softy" will be at your disposal, with 0% interest forever. The "Softy" will run on veggie-burgers instead of oil.

The middle east problem will be solved overnight. Everyone in "The Region" will now work for MSFT selling its stock. Even Iraq will stop kiling American soldiers each day and be busy building millions of golden arches on each corner to sell the new MSFT cous-cous delux.

As you all can see this ultimate merger will bring prosterity to everyone around the globe.

Thanks-be to the wonders of capitalism!

For some applications, serious computing is needed, but with the MBAs pushing their corporations towards commodity computing, the problem is that few businesses care anymore about objectives like this.

Maybe you're right - maybe not. But Sun has got to price their stuff at a point the customers are willing to pay, and that doesn't seem to be the case right now.

Is Sun more stable and reliable? Probably. Is it worth the premium price that they demand? For some, yes, but apparently for the bulk of the market, the answer is no.

Wake up and smell the Java!

Well, it's like this. We can debate all day whether Java is great technologically or not. (I think it's pretty good, but I think .NET is better.) But there's a factor that overshadows that debate.

The guy who wrote this letter is from Merrill Lynch. Now these financial types don't care who wins the technical battles. They have no religious or emotional attachment to any technologies. The only thing they are attached to is making money.

They've rendered their judgement. Sun is down 95% from its peak. BEA about the same. As the guy said in the letter, Java has been a "financial disaster" for Sun. (Only IBM is doing well among the major Java players, and it's hard to tell whether Java helps or hurts them because they're so big.)

Anybody who's concerned about more than just technology has got to worry about jumping into Java right now. Who's going to own it in five years? Will it get the investment to stay leading edge? Has it passed its peak? Are the tools too expensive, and if so, are they ever going to be reasonably priced?

Java's biggest market advantage is a degree of portability. But (1) it's not completely portable in the real world because of different implementations, and (2) the market does not seem to value portability that much.

If you like Java, hey, I'm fine with that. But there's a bigger picture out there, and that's what this Merrill Lynch guy is getting at.

use Linux on the edge, but when you need mission-critical capability it's time to graduate to Solaris.

That's a tactic, not a strategy. The sales force should be running around saying that, but no one in product planning should consider it anything more than a short-term defensive noise.

Expecting linux to stay at the edge is like expecting Intel to stay on the desktop. That's not gonna happen, so don't base a strategy on it. IBM is telling its customers that it will be gradually supplanting AIX with linux, as linux becomes more capable. Any linux that can take the place of AIX can take the place of Solaris as well. Sun should not pretend otherwise. If IBM manages to cut the cost of their bread-and-butter mission-critical OS by sharing development expense with "the community," Sun will be hard-pressed to compete if they are trying to foot the bill for another flavor of UNIX all by themselves.

IBM isn't doing all this linux stuff because they are good guys; they are doing it so they won't have to fund AIX anymore. If even half of their OS development expense is taken care of for them by "the community," that's still a big pile of money and it will turn into a cost advantage in the market. Everything this guy says about getting out of SPARC applies to getting out of Solaris as well. Ultimately, Sun cannot afford to be doing R&D on basic componentry. They aren't big enough to be doing that. All their R&D should be on architeture and integration. The more of that they do, the better they can hide from Dell, and the more likely they are to keep up with IBM in the Enterprise space. If they fall behind there, they are screwed; Sun does not have a cost structure that can play in Dell-space.

Disclaimer: I am surprised that Sun is still alive. They have made so many mistakes that they deserve to be dead a hundred times. Their original business plan was to make workstations for office automation. Their unfair advantage was to be the use of standard components and open standards. That was how they were going to beat Wang, who was the big power in that at the time. Here they are 20 years later, and they've switched places with IBM. Now they sell proprietary hardware running on proprietary software for the glass palaces where the mainframes used to live. And IBM is cleaning their clock with an open source operating system running on Intel chips. How those guys passed in the night without both of them getting killed is a mystery. It just goes to show that reality and theory don't necessarily cooperate. The Merrill Lynch guy might want to remember that. He's only the fortieth guy to write the "Sun is near death" piece, and they are still here. Somehow they always escape from the jaws of death. I guess we're about to find out whether the Houdini was Bill Joy or Scott McNealy.

Is "not taking orders from experts" how he managed to depress the stock price to 5% of it's peak value?

That peak value was highly exaggerated, and you know it.

I can't figure the stock market out. I think it's wacky. I have done well with a long-term strategy and will continue being a long-term investor.
Scott McNealy

Short-termism the perfect recipe for failure in the long run. Too bad it is the dominant approach in too many markets in America. All great success stories are lined with spells of "despair," at least from an outsider's perspective. Henry Ford was a "crazy" loser in the eyes of many before he became a national hero. Churchill was often dismissed as a nut before history proved him right. The "stock price" of the American Revolution would have been pretty low in its early days, had it been "analyzed" by today's short-termists. Columbus's stock could well have been below .0005% of its peak value before he landed!

Sun has got the best people and the best technologies; they're also good enough at marketing themselves. I think their future is bright, provided they continue to be undaunted by the warnings of people who can't see beyond the next minute.

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