February 17, 1999
Sun Bear's Den
by Warren Gump ([email protected])
Not at This Price.
First off, let me say that I am an admirer of Sun Microsystems (Nasdaq: SUNW) and have been for years. Since its founding in 1982, the company has emerged as an important innovative force in computer technology and has proven itself to be a solid competitor in the field. That said, I would not purchase this stock at the current price. The problem arises not only from the absolute multiple of earnings that investors must now pay for stock, but also the risk of competitive pressure that could hinder future results at the company.
Sun is the staunchest supporter of the Unix operating system, an operating system competing with Microsoft's (Nasdaq: MSFT) Windows NT and the Linux "freeware" that is spreading like wildfire. Sun is the only major computer maker that has not adopted the Microsoft system in any way, shape, or form. From what I understand, the key advantages of Unix-based systems are their ability to handle vast amounts of data and their higher reliability compared to Windows NT. The current advantage for large-scale tasks still appears to lie in the Unix-based camp.
While Sun is the leader in this field, it faces formidable competition from companies such as IBM (NYSE: IBM) and Hewlett-Packard (NYSE: HWP). These companies have a big stake in the Unix environment and are not going to voluntarily cede market share. When it comes to developing new products, Sun spends aggressively to maintain its cutting-edge position. Last year it spent some $1 billion on research & development (R&D). Because of their greater size, however, IBM and Hewlett-Packard each invested over three times as much money into their R&D efforts. A significant portion of this money is spent on creating enterprise-level computer products that compete with Sun. Certainly, Sun is not a shoe-in to continue dominating this space.
The dynamics in the Unix-Windows NT battle may be about to change as well. Microsoft is planning to release an upgraded version of Windows NT, Windows 2000, that could accelerate the slowdown of UNIX-based systems growth. This upgrade is supposed to be a more stable and scalable version of the current Windows NT software. While Microsoft notoriously introduces a mediocre first version of software, it is usually quite good at improving products in future releases. When this upgraded product is available, Sun's ability to stymie Windows NT's future growth will likely be hindered. Sun has thus far proven resilient, but Microsoft (as well as Intel and the PC makers) may prove to be even more so.
Maintaining a barrier against a dominant software standard involves absorbing significant risks. One need look no further than Apple Computerin the mid-1990s to see what can happen to a company trying to compete against industry standards. Even with the return of the Steve Jobs as CEO and the introduction of the iMac, the company is no more than a niche player.
Moving onto another area of the company, Sun has invested a great deal of money and created enormous hype for the Java and Jini programming language and standards, which are probably discussed in depth in the bull argument. Both offer great promises if the industry accepts them as standards, but it is too early to state that they will definitively be utilized extensively. Until that is done, it is premature to declare victory for these be-all-and-end-all "Microsoft Killers."
Java, which has already emerged as a popular software tool, is facing increasing pressure to be released into a public-standards body before being embraced by the technology community at large. If that were to happen, the revenue that Sun could garner from the software would be limited since it wouldn't hold the proprietary grasp that has propelled Microsoft to its dominance. Jini, on the other hand, was just introduced last month, and it is premature to determine how well it will be accepted by other manufacturers and consumers.
I have spent the time in this argument focusing on risks that Sun faces. I'm sure that Chris did an excellent job of explaining everything going in Sun's favor, but it's important to remember that there are numerous risks. At the current price, trading at around 34x calendar 1999 earnings estimates, investors seem to be envisioning clear sailing for the company. They are not providing any margin of safety for the numerous risks that are inherent in the company. Without such a discount, I'm uncomfortable investing in this company.