Does Sun, Burned by Competition, Need a New Business Model?

The clouds over Sun Microsystems are thickening as the company continues to struggle against competition from cheap, open systems offered by Dell, and from IBM and Hewlett-Packard in high-end business systems.

 

The Santa Clara, Cal.-based manufacturer of servers and proprietary networking software, which developed the Java language that allowed computers to communicate across different operating systems, is suffering more than other tech companies in the current drought of corporate information technology spending.

 

But its reliance on big, powerful machines is holding Sun back against other competitors as the industry moves to using more microprocessors, according to Wharton faculty and analysts.

 

Last year, Sun suffered an 8.5 % decline in revenues. Since 2001, sales are down 37% and Sun’s headcount has dropped from 43,000 to 35,000 workers. Sun’s share price, which hit a record three years ago of $64.31, is now trading at around $3.30.

 

The latest blow came at the end of the first quarter in September when Sun announced it would take a $1.05 billion non-cash charge in the fourth quarter, which ended June 30. The charge was due to expectations of lower tax assets in the first quarter. The company warned its first-quarter loss would be $0.70 to $0.10 per share, or $235 million to $230 million. Thompson First Call analysts’ consensus was for a loss of $0.02 per share.

 

“Sun has reached a point of crisis,” wrote Merrill Lynch analyst Steve Milunovich in an unusual open letter to the company and its board after the figures came out. “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.”

 

Hewlett Packard responded in its own way, offering Sun customers a bounty of free consulting services valued at $25,000 to come over to its side.

 

“The high-end server and Java language space is getting more and more crowded,” says Raphael Amit, professor of entrepreneurial management at Wharton. “They are having a harder time standing out.” This is an old story in any technology business, he adds. “The trick for every CEO and management team is to anticipate that kind of trajectory and to always be ahead of the market.”

 

David Croson, a former Wharton professor of information strategy, suggests that Sun license out some of its technologies to third parties. “Sun seems to be allergic to adopting licensing as its primary strategy, and the market isn’t valuing its technological advances as much as it should, or as much as Sun hoped it would when these projects were started.”  

 

Where Sun excels, he notes, is in developing stable operating systems and cross-platform languages like Java. “Sun will eventually be forced to focus on what it does best … It’s better to adopt this strategy before the market does it forcefully.”

 

Croson says the company is at risk of repeating the mistake that Apple Computer made when it bundled “so-so” hardware with its world-class software. Apple was trounced by Microsoft’s low-tech, low-cost Wintel platform. “Sun should switch to an R&D/licensing model immediately focusing on what they do best, and forget about competing with Microsoft and Intel. I’m scratching my head as to why this hasn’t happened already.”

 

Sun did form a licensing arrangement with Microsoft to support Java but now says Microsoft misused that deal to link Java to its own platforms. Sun has filed a series of anti-trust suits against Microsoft although the two warring companies recently signed a truce to extend the agreement for nine months beyond its scheduled expiration in January 2004 to give clients more time to move to new systems.

 

Too Much R&D?

Milunovich and others have criticized Sun for its unusually high research and development spending of 15% of sales, up from what had historically been about 5%. Last fall, Sun CEO Scott McNealy pledged to spend $10 billion over the next three to five years.

 

Milunovich also said Sun should de-emphasize development of its SPARC microprocessors since they do not have a strong place in the market, and he suggested the company spin off Java.

 

Since it was founded in 1982, Sun has grown to become one of Silicon Valley’s signature companies, shipping more than one billion systems by 1993. In 1995, 100 Sun systems were used to create the images for the movie Toy Story.

 

Indeed, Sun’s success may now be weighing it down, suggests Harbir Singh, Wharton professor of management. “This is a large corporation. In a sense, when you reach a particular scale because of prior success and making the right strategic calls, then market analysts will look for a continuation of that.

 

“When the source of success is eroding it means decline can be sudden,” he continues. “This is a fast-moving business. There are new products and new services to replace what has become outmoded. Maybe that explains why they are pushing the R&D pedal a bit harder.”

 

But Sun has not come up with new must-have products. “Ideally those products should have been there” had the company innovated successfully while it was growing, Singh adds.

 

Joseph Beaulieu, who follows Sun for Morningstar, says the company has not presented a clear strategy to dull the criticism. “Their response has been all over the place.” Sun, he adds, was slow to concede to the low-cost competition and offer Linux and Window-based systems. Now it is offering these systems on a range of products while continuing to push its proprietary high-end systems.

 

“All this is causing them a little bit of a headache. There’s no easy solution. That’s why they are in such a tough situation. They have been throwing ideas against the wall to see what sticks.”

 

Sun’s problems go deeper than the cyclical downturn that is hurting all technology companies. “They have been losing money for a long time and it’s not clear when they’re going to become profitable again,” says Beaulieu, who adds that the competitive environment for Sun has changed and the company is not positioned to ride an IT spending resurgence.

 

Milunovich suggests that Sun cut 5,000 to 7,000 jobs, a move he estimated would improve earnings by 10 to 15 cents per share. Sun, he adds, should focus on becoming a niche player by developing specialty computing systems.

 

A Defiant CEO

In the face of all this criticism CEO McNealy, 48, is defiant. In an interview following the backlash to Sun’s earning’s announcement, he called the unsolicited advice “boring.” “We’re not very fashionable right now, are we? We have a pretty controversial investment strategy … and people are skeptical of it and we will have to prove them wrong.”

 

That attitude might have been expected.

 

“It does seem to be the general view out there that senior management has not come to grips with this problem,” says Singh. “That often happens in companies that have been highly successful. The people who are on top basically were responsible for the success in the technology that got them there. Maybe they are not open to the idea of radically different technologies or business models so we see a response that says, ‘We don’t have a problem.’”

 

Beaulieu suggests that McNealy’s style works well when a company is on the rise. “When a company is seemingly falling behind, that kind of brashness doesn’t play very well.” It is unlikely Sun’s board will replace McNealy, Beaulieu adds. To do so would probably cost Sun its entire layer of top management at a time when many managers have already left the company. If McNealy were to exit, that could signal a takeover, he says.

 

Still, Sun is sitting on $5.7 billion in cash and securities. That’s enough to keep the company afloat for several more years, according to Beaulieu. The company throws off enough cash that it is not overly dependent on its stock price. “The only sense that the clock is ticking is in terms of how the company would be valued in an acquisition. If this goes on longer, then that value could be less.”

 

In the end, Sun is likely to be acquired, Beaulieu states, adding that there is not an obvious strategic partner who would benefit from Sun’s technology because most of the other players have similar products themselves. A buyer would only be after Sun’s customer lists. He named IBM or Hewlett-Packard as possible acquirers.

 

“The question is how much is someone willing to pay for what they’re going to get which, in the long-term, is going to be Sun’s customers,” says Beaulieu. The acquirer would “then slowly transition [these customers] onto their own platform.”

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