FOOL CONFERENCE CALL SYNOPSIS*
By Debora Tidwell (MF Debit)

Sun Microsystems, Inc.
2550 Garcia Avenue
Mountain View, CA 94043-1100
(415) 336-2288
http://www.sun.com

UNION CITY, Ca., January 17, 1997/FOOLWIRE/ --- Sun Microsystems released their Q2 1997 results on January 15th after the market close. Sun's fiscal second quarter results set several new records. In summary, revenues were $2.082 billion, an increase of nearly 19% from Q2 a year ago. Net income was $178.3 million, an increase of more than 41%, and earnings per share was $0.46, up 41% compared with Q2 last year. Common stock equivalents at the end of Q2 were 388.7 million shares, a decrease of nearly 1.4 million shares from the prior quarter.

Bookings for the quarter at $2.146 billion were up over 16% compared with the year-ago quarter. They ended the quarter with $470 million in backlog, up from $406 million in Q1. For the second quarter, revenue growth by geography was highest in North America, which posted a 22.6% gain over the prior year quarter. Europe posted a 13.9% revenue growth while the rest of the world category posted a 17.3% revenue growth. Japan, which continues to dominate the rest of the world category experienced a strong quarter in local currency, but not when translated into US dollars in light of the recent strength of the dollar.

Gross margin was 50.4% of revenues. Gross margin was up 270 basis points sequentially and up 590 basis points compared to the year-ago quarter. The high gross margins reflect the strength and competitiveness of their product line through volume shipments of mid-range and high-end Ultra SPARC desktops, servers, and storage arrays.

OPERATING EXPENSES. R&D expense was 9.7% of revenue. SG&A was 20.4% of revenue. As they previously indicated, they expected to make key investments to grow the business. These investments include growth in their enterprise level field sales, service, and support organizations, demand creation programs, application performance tuning and software partners relationships, as well as their own internal business profit simplification efforts. Operating income was $255.8 million, or 12.3% of revenues -- a new high for Sun in about 10 years.

ASSET MANAGEMENT. Inventory turns for Q2 was 10.7 and days sales outstanding was 60 days. Stockholders equity was $2.304 billion and their book value per share was $6.26. Headcount at the end of Q2 was 19,356, up sequentially by 1,168.

Sun feels it is more useful to evaluate their results over a longer period of time than just one quarter and highlighted some of those more useful longer-term comparisons in their comments.

ORDER GROWTH STRONG. They are quite pleased with the positive book-to-bill ratio and the overall growth rate in orders compared to a year ago. During Q2 last year, they introduced the Ultra SPARC desktop, hence their year-over-year comparison was fairly difficult. On a six month to-date basis, their orders are up over 18%. Over the past six months, essentially the only new products introduced were related to the Java stations. Sun expects significant impact on their topline from the Java station announcements during fiscal 1998. Thus, from that perspective, they feel pretty good about order growth in the first half of the year. They do expect a much more active second half of the year from a product announcement standpoint. Since January 1st, they have already announced an improved low-end product -- the upgraded 170 mHz version of the SPARCstation 5 and an upgrade to 250 mHz UltraSPARC 2 processors for their server line. They are announcing another product family later in January which they believe will put them in the position to compete very effectively in another new segment of the market in which they have not played in the past.

REVENUE. From a revenue standpoint, essentially they see the same in terms of revenue growth. On a six month to-date basis, revenues are up over 21% versus the six months a year ago. They are not seeing much of a change in the overall revenue mix from a company standpoint. All of the businesses are growing essentially as planned. The external, or non-inner-company revenues from SunService, Sun Microelectronics, SunSoft, SunExpress, and JavaSoft continue to grow at above the SMI average rate. Sun Microsystems computer company is still the largest business and is also growing quite well, so they have not really seen a noticeable shift in the overall business mix.

REVENUES BY GEOGRAPHY. From a geographical standpoint, the US turned in the strongest year-over-year performance as their revenues were up a bit in terms of the overall mix. They have gotten some indication earlier in the quarter that this was happening as during Q2 the US business was tracking to a higher degree of linearity than in their recent past. Essentially, this continued throughout the quarter. They did not see anything new or unusual in the rest of the geographies. Parts of Europe were stronger than others. Most noteably, the UK was the strongest and France was the weakest relative to the prior year. Again, this is not unlike their experience in the past few quarters. Their business in Japan also grew at a very healthy rate in local currency, right around the corporate average. But, the strength of the dollar continued to reduce this when translated into dollars. However, they are quite aware of the macroeconomic picture in Japan and continue to monitor their business and investment profile carefully.

GROSS MARGINS. The gross margin was 50.4%. They said that this was a bit higher than even Sun had thought going into the quarter. They made a fairly sizeable series of price cuts in mid-quarter, up to 38% in some cases, that impacted their desktop product line and some of the memory and storage products. They continue to see very strong growth in their servers across the entire product line from low-end departmental ones to the high-end enterprise 6000s. They are also continuing to derive increasing amounts of revenue from their storage products, from Java licensing, from professional services, and the like. While they don't have accurate competitive information, based on some preliminary industry information they have seen they appear to be taking marketshare away from some of their traditional UNIX competitors. They continue to work on their cost structure and have seen continued benefits from pricing of components including memory, CPUs, and some other commodities. All of those factors combined resulted in the highest gross margin rate they can recall over the past ten years.

It just comes in as an arithmetic sum of all the different business units and so they don't really manage gross margin. They think they are in a very nice position to be fairly aggressive in those parts of the marketplace where they need to gain share or grow unit volume or deal with some particular competitive threat. Then there are other parts of the marketplace where they have such a strong position that they are actually spewing gross margin in a pretty aggressive and positive manner. They don't know if they expect gross margin to stay at that level. They are really trying to make sure they are managing the company from a contribution margin as opposed to a gross margin and continue to bring money to the bottom line. One of the areas they want to continue to focus on and the management incentive program rewards is driving growth at the topline. For the first half, revenue has grown quite nicely. They wouldn't mind seeing it go higher and could deal with it going lower, but they are going to continue to motivate the management team to crank out revenue. They have a strong product position and think they have a market position right now where some of their competitors just aren't necessarily executing or delivering on the client or the server side, so they think there are some big market opportunities for them.

PRICING ACTIONS. They hope that the results of the past quarter demonstrate that they have a strong business model that allows them to continue to price their products from a position of strength. Not all price cuts are made because of competitive pressure. Their philosophy has been and will be putting further significant price cuts in their product lines as they go forward. As an example, many have seen the introductions of SPARCstation 5, model 170 which has essentially twice the performance of its predecessor model at a price that is approximately 30% less.

HIRING. They continue to monitor carefully the balance between short-term profits and longer term opportunities. They have repeatedly mentioned that, aside from great products and technologies, the biggest single levers that they have to accelerate their growth are in the field. This includes sales people and accompanying system engineers, service and support people, professional services staff, and the like. They hired very aggressively during Q2. This represents some of the hiring that was originally planned for the second half of the fiscal year. During the quarter they added over 1,100 people. Of these, more than half were in the demand creation area, including the sales, SEs, and field marketing staff. They also added to their professional service and support areas, and nearly 150 engineering professionals principally in JavaSoft and SME. They have also added in other areas including operations inside of SMCC and information resources. Some of the increased information resources headcount is devoted full time to the major re-engineering projects they have been referring to for the past few quarters which are aimed at reducing cycle times and costs in some of their largest processes. They will continue to grow the company's headcount in selected areas. Their emphasis will continue to be on the areas that are driving the topline and developing products and techhologies. They will attempt to limit the growth in the support functions as much as possible.

BALANCE SHEET. They have managed their inventory levels reasonably well and are comfortable with their receivables position and other balance sheet metrics. On the cash front, they now have a systematic repurchase plan in effect. They will be in the market each quarter now versus some of the larger one-time share buybacks they have done in the past. In the second quarter, they repurchased approximately 1.9 million shares of their stock for around $58 million. They have targeted up to $150 million per fiscal year for this program. Finally, they purchased the second phase of their Menlo Park, California campus during Q2 for approximately $100 million. This portion of the campus had been off balance sheet during the construction phase prior to that time.

WILL THEY COMPETE WITH NT. Many people have asked them if the whole Wintel juggernaut is going to bowl them over. They don't think you can just take general purpose momentum like that and answer the question without dissecting the problem a little more precisely. Sun really looks at the marketplace in 6 different segments -- 3 client side and 3 server side segments. On the client side there is the embedded market, the volume desktop market (PCs), and the power desktop market (workstations). On the server side there is the workgroup server (file/print/Novell's market), the midrange/minicomputer/departmental server, and the enterprise world. When you look at NT and Intel in each of those different areas, they are winning some, they're not playing in some, and they are challenging in others. When you look at UNIX and SPARC/Solaris in particular in those areas, they are winning some, not playing in some, and emerging and challenging in some new ones.

VOLUME DESKTOP MARKET. Wintel is doing quite well in the volume desktop market. There are 4 strategies to go at that market. First is to ignore it, second is resell it, third is to try and "out-fat-client" Wintel (the Apple strategy, and the fourth strategy is to change the rules. Sun is doing a little bit of the third strategy and a lot of the fourth strategy and are changing the rules by going to this zero administration, thin client, Java station architecture. They think longer term that is the right answer. That doesn't mean they are giving up on their fat clients in the volume desktop arena because they make money on those and are happy to ship those.

POWER DESKTOP MARKET. Sun thinks the power desktop market is theirs. They continue to consolidate and gain share. They are the number one UNIX player and outship their next 3 largest competitors combined in that marketplace. It is very profitable for them, is an exciting market, they have lots of value to add, they are adding faster megahertz, better bandwidth, more MP, better graphics, Java extension, and all kinds of good stuff in that marketplace. They think a lot of their traditional competitors are either getting out of that market or not doing as well. Obviously Wintel is coming after them. They believe that Intel has a ways to go on floating point, MMX (Sun thinks Vis is superior and thinks Intel has a long way to go to understand and build in as opposed to adding on graphics). Sun has more than the unit volume they need to get aggressive on pricing wherever they need to. They have the applications, the resellers, and the installed base. That is going to be a very good market and they think that if anybody loses it is not going to be SPARC/Solaris, but maybe some of the weaker players in the workstation marketplace.

EMBEDDED MARKET. In the embedded market, Sun thinks Wintel and Sun are both going at it with different strategies. Microsoft is going at it with CE, which Sun thinks is quite limited in terms of the applications. Sun is going at it with the Java machine and Java chips and have clients like Mitsubishi, NEC, Nortel, Samsung, and a whole host of others who are going to embed these in everything one can imagine. These are the early days and they think it is a fair food fight. Sun likes their chances here. Compelling features of the Java architecture include a small footprint, good security model, object oriented environment, custom silicon around Java chips and the ability to go to very low cost/high performance implementations, the development tools. This is a great new and exciting market that Sun Microelectronics group and JavaSoft are going after and the jury is out on this one, but it's also out for CE too.

MIDRANGE SERVER MARKET. Sun is a client company, but Sun is also a huge server company. If you look at the midrange, clearly that has been Sun's strength and that is where the gross margin moves come from and where a huge hunk of profitability comes from. They are SAP's fastest growing platform. Their Informix business grew 74% year-over-year. Their Oracle business is skyrocketing. Baan, Peoplesoft, all of the key server side enterprise applications have big installed bases on Sun computers. That is their core business and NT is going to have to figure out how to play in that business because there are a lot of gross margin dollars there to be had. Some of the recent trade magazines highlight the challenges folks are having as they are trying to implement NT and Intel machines that don't necessarily scale into this midrange environment. It's hard work. Sun has been working on this for a long time and as people compare NT versus Solaris, they feel very comfortable going with Solaris in this marketplace. Sun runs all the applications, they run them with scalability, they run them with serviceability, reliability, worldwide service and support channel, and are way down the experience curve. Some of the losers here might be some of the proprietary minicomputer environments or some of the lower volume UNIX architectures, but Sun feels that they are only gaining momentum.

WORKGROUP SERVER MARKET. On the workgroup server, this is clearly an NT strength. Wintel with a 4-way P6 and with NT has really taken a chunk out of Novell's hide and probably slowed down OS/2 big-time in the departmental server. Solaris on X86 and some products Sun will introduce before the end of the Spring or Summer is going to go after this market very aggressively. Sun is not going to walk away from it and cede the low-end workgroup, file, print, and small Web server/SOHO server marketplace. They want to play in that market. It is not one that they have been a high volume player in before, but they think they have all the chip technology, operating system technology, the purchasing volumes, the distribution capabilities, the service and support capabilities, and the applications.

HIGH-END SERVER MARKET. In the high-end data center world, Wintel just doesn't play. As far as Sun can tell, Wintel is not going to be a player for quite awhile here. People aren't going to run their major data warehouses, major OLTP environment on Wintel boxes. It just doesn't scale and isn't there yet. This is what Sun will talk about next week. The code name is Starfire and it has something to do with an acquisition they made from one of their competitors recently. This is going to move them into a whole new environment -- a $50 billion market opportunity. This moves them into the high end segment of the server marketplace where they will be competing against some pretty high-price umbrellas and pretty high gross margins where they think they can add some real value. They will be announcing it on January 22nd.

SUMMARY VS. WINTEL. Dissecting each of the areas, they don't take the "Wintel juggernaut" lightly or ignore it, but they have some very good positions in a lot of important segments. They have some open field and some interesting challenges in places like the volume desktop and the embedded marketplace and some pretty interesting answers to those challenges. They think the next few years has great opportunities for Sun.

IBM AND JAVA. Sun is working very closely with IBM and, for example, at Lotus IBM has put hundreds of engineers on building a Java office suite. They have many engineers working to make Java compatible and build 100% pure components for the Notes architecture. Sun has been working with IBM's enterprise software developers very aggressively to put a lot of 100% pure Java applets that IBM has developed in the enterprise arena to provide interoperability into the legacy mainframe world and to provide some of the capabilities -- OLTP and commercial capabilities -- that IBM is so good at and make sure that that industrial strength stuff has been reimplemented in Java. And IBM is also doing their own Java based MCs and other things.

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