October 14, 1998

A Trip to the Sun
A Motley Fool Interview with Sun Microsystems
by Greg Markus (TMF Boring@aol.com)

PALO ALTO, Calif. -- After the market closes on October 15, Sun Microsystems (Nasdaq: SUNW) will report results for its fiscal 1999 first quarter, which ended September 30. According to First Call, analysts expect the company to have earned $0.49 per share, up 20% from the year-ago period.

Ahead of that earnings release, I visited Sun headquarters in Palo Alto, to speak with the company's director of investor relations, Mark Paisley. Sun was observing its pre-release "quiet period" and so Paisley was not about to tell me how the quarter went. I was able to learn something about Sun's overall strategy for the coming year, however, and especially about how its investor relations department... well, relates to investors.

I also got to see a sample of CEO Scott McNealy's famous -- or infamous, depending on who you ask -- sense of humor. Standing right at the front door of Sun Corporate HQ is a huge doghouse emblazoned with the name of the company's mascot: the Greater Swiss Mountain Dog, "Network."

A Glance at Sun

In a feature story published in Fortune on Oct. 13, 1997, the legendary Silicon Valley venture capitalist and longtime Sun board member, John Doerr, described Sun as "the last standing, fully integrated computing company adding its own value at the chip, OS [operating system] and systems level." Or, roughly translated, Sun is equal parts of Intel (Nasdaq: INTC), Microsoft (Nasdaq: MSFT), and Hewlett-Packard (NYSE: HWP) all rolled into one.

Sun was launched in 1982 by McNealy, Andy Bechtolscheim, Bill Joy, and Vinod Khosla with the goal of making and selling high-performance computer workstations based on a model that Bechtolsheim had built for Stanford's computer network. (The company's name is an acronym for Stanford University Network.) That workstation, the SUN-1, was the first of its kind to be based on readily available components and the UNIX operating system.

Sun has gone on to become a leading supplier not only of computer hardware -- including workstations, servers, and storage subsystems -- but also operating software (the Solaris version of UNIX) and software development languages (SunWorks, Java), the UltraSPARC microprocessors inside its computers, and a full range of technical services and support.

Sun has differentiated itself from competitors by its commitment to networked computing (as opposed to stand-alone PCs) and its open-systems architecture. "The network is the computer" is how McNealy articulated the concept back in 1987, the year after the company went public, and that basic idea has remained Sun's motivating vision ever since.

Perhaps nowhere is that vision exemplified more than in Sun's Java language. Java debuted in 1995 as the first universal software designed from the ground up to enable Internet and corporate intranet developers to write applications that run on any computer, regardless of microprocessor or operating system. "Write once, run anywhere," claims Sun, although some critics say that, at least in its current form, Java is more like "write once, debug everywhere."

Either way, Java jolted Bill Gates, according to recently revealed internal memos that circulated within rival Microsoft. Gates saw that Sun's new language offered the potential of breaking Microsoft's stranglehold on desktop operating systems. The perhaps inevitable outcome of the rivalry has been a suit filed by Sun alleging that Microsoft sought to undermine Java's platform independence by adding its own "features" to Java. For its part, Microsoft has counter-sued, claiming, more or less, that it's only trying to improve Java for everyone.

Its battle with Microsoft aside, Sun has in the past year extended Java to small consumer-oriented devices, such as smart cards and television set-top boxes. A number of Sun's recent acquisitions of small companies, such as Chorus Systems and Diba Inc., have been intended to advance Sun's push into the consumer market.

In recent years, Sun has devoted around 10% of total revenues to research and development of new products and processes, not counting various purchases of small companies so as to acquire their "in-process" technology R&D.

For the fiscal year that ended June 30, 1998, Sun posted revenues of $9.8 billion, up 14% from the previous year despite unfavorable foreign exchange rates and financial turmoil in Japan and much of the rest of Asia. (A bit less than half of Sun's total revenues come from outside the U.S.) Net revenues from product sales increased 11%, to $8.6 billion, while services net revenues rose 40%, to $1.2 billion. Net income increased 23% to $906 million, excluding certain one-time items, as gross margins on both products and services increased. Earnings per share rose 22% to $2.30.

Operating activities generated $1.5 billion in cash and cash equivalents in fiscal 1998, and as of June 30, 1998, the Sun's cash, cash equivalents, and short-term investments totaled $1.3 billion.

On to the Interview

Mark Paisley has been with Sun since 1990, having had experience on the financial side of many of Sun's operations, including engineering, marketing, international sales, and manufacturing, supplier management and logistics. He began managing Sun's IR department in October 1996 and became its director in February 1998.

Paisley said that Sun's three-person IR department focuses on educating the investment community about Sun's business, strategy, direction, and financial performance. The department monitors analysts' expectations about the company's performance and keeps Sun's executives apprised of the Street's sentiments. IR also coordinates meetings of Sun executives with portfolio managers all over the country to communicate Sun's story. Company representatives have also been increasingly speaking to groups of individual investors at "retail" investment seminars and even meeting with local investment clubs.

Finally, Sun uses its Website (http://www.sun.com) to showcase how Internet technologies can be employed as an efficient and effective vehicle for corporate communications.

Sun understands the value of having a fair-sized chunk of its stock distributed across many individual shareholders -- who tend to invest for the long term -- rather than passing constantly through the hands of a few momentum-oriented fund managers. Volatility in its stock price complicates a company's financial planning and can be a distraction to employees. That's particularly true for technology companies, where executives and even many lower-level workers may receive a substantial amount of their total compensation packages in the form of stock options. Paisley said that the proportion of Sun's stock held by individual investors has increased over the past couple of years as the fraction held by large institutions has declined from about 70% to 57%.

Sun shines in terms of the wealth of information it provides current and potential shareholders through its IR department and Website. Sun's current policy regarding full disclosure of the information it shares with analysts and institutional investors in quarterly conference calls isn't quite as "open systems" as the company's products are, however.

Interview Excerpts

Q. Sun can be a complicated company to understand -- you're in everything from the microprocessor to the hardware, to the software, to services. Do you have any advice as to how an individual investor can get his or her arms around all of that and develop an understanding about Sun?

A. It is difficult -- and not only for individual investors. When an analyst initiates coverage of Sun, it takes a while for that person to come up the learning curve. We offer a lot of information at our Website. The 10-Qs and 10-Ks, the annual reports, and the press releases we issue periodically are all worth reading. If you're in a reasonably large investment club or group, it might be possible to get a Sun representative to visit with your group. Norelle Tavrow is the primary contact for individual investors in our department. She spends a lot of time on the phone answering questions -- but you should look first at our Website, because chances are that the answer you need is already there.

We also have an extensive fax-on-demand system: 1-800-801-SUNW. If you need any literature on Sun, you can walk through the menu and get articles, press releases, updates on products and services, eight-quarters of rolling financial information in an operations analysis statement, and more -- sent straight to your fax machine.

Q. I know that you're in a "quiet period" right now, but could you say something about what some of the important strategic themes are for Sun in the coming year?

A. Network computing is the theme. Ever since Sun became a public company in 1986, "the network is the computer" has been our tag-line. With the Internet explosion and the Web, and now with Java, that's more true than ever -- for businesses and individuals alike.

Sun's bread-and-butter has been selling workstations and servers and data storage to large enterprise customers who run their mission-critical operations on them. In the past year, we've extended Java to the consumer space. For example, Motorola (NYSE: MOT) has licensed Java to embed it in cell phones, pagers, and other products so that consumers can, for example, access the Internet from anywhere. The TV set-top box market is another area where Sun has a growing presence, through an agreement with TCI (Nasdaq: TCOMA).

Q. And what are the main challenges for Sun in the coming year?

A. The challenge is always the same: execution. The company's fundamental strategy has always been the same: every device anywhere in the network should be able to access information located in the network from anywhere. So the challenge is to continue to execute to advance that strategy. For example, Sun focuses its R&D on Java, the Solaris operating system, and the SPARC microprocessor in order to bring out the right kind of next-generation products and services to advance our core strategy. Executing -- doing the research and getting the right products to market quickly -- is everything.

That may sound a little boring in some ways, since Sun's mission and strategy have basically stayed the same. But if you've got the right strategy, it makes sense to stick with it.

Certainly some things change. For example, some people were concerned -- although I don't hear it as much now -- that the "Wintel" crowd would knock out the UNIX vendors. With the delays in NT 5.0 from Microsoft and the delays in Merced, the next-generation chip from Intel, it's left a big window of opportunity for Sun. Our next-generation operating system is to be announced very soon, and our next-generation microprocessor is on track to come out well ahead of Merced.

Wall Street is now coming to realize that networked computing is complicated stuff. The idea that Microsoft would be able to go from stand-alone desktops to learning how to do networked computing and scale it up into the enterprise, or that Intel could crank out anything like Sun's UltraSPARC microprocessor -- well, it's just not all that easy, and the other companies are now discovering that.

We're pleased, for example, that Intel recently came to Sun and asked that we port the Solaris operating system to their Merced chip when it does finally come out. That's a great market-expansion opportunity for Sun, and it will encourage developers to write more applications that will run on Solaris on both SPARC and Intel chips.

As for NT, the industry analysts all agree that Solaris is two to three years ahead of NT in terms of functionality and robustness -- Solaris won't crash all the time, it can scale up to 64 CPUs. Sun has a 16-year lead on Microsoft in networked computing, and even though Microsoft has a lot of cash in the bank, this is about having the right kind of really high-quality engineers on the software side.

From my understanding, Microsoft is scaling back on some of their commitments as to what would be in NT 5.0. But whatever Microsoft does, Sun has two goals: first, to stay two to three years ahead in our operating system -- its features, its robustness; and second, to work on our strategy for interoperability with NT, so that when it finally does come out, Sun can "embrace and extend" to it. We're never going to put a Sun workstation on everyone's desktop, and it's a mistake to try to convince customers that desktop computers are "wrong." So it makes sense to adapt to the heterogeneous computing environments that are out there, an environment that includes Sun workstations, Wintel desktops, next-generation network computers, and everything else.

Sun's new Cascade product, slated to come out this winter, is an example of providing that kind of interoperability. We believe we can incorporate NT servers and clients as "full citizens" in a networked environment -- and better than NT can do it.

Q. One of the participants in The Motley Fool posted a note asking that I ask you about Sun's relationship with a neighbor of yours -- Silicon Graphics (NYSE: SGI). Are there any chances of Sun acquiring SGI or establishing some kind of strategic partnership with them?

A. We would, of course, never talk in public about any ongoing discussions of acquisitions, but in general I don't see that there would be much in the way of synergy for Sun to acquire SGI. Just to expand on that, the high-end server that Sun has now -- the 64 CPU Starfire server, the only UNIX-based server with that kind of capacity in the world -- was technology from the former Cray Supercomputer Inc. that SGI sold to us when they acquired Cray. SGI sold it to Sun because the Cray predecessor to the current Starfire used SPARC microprocessors and the Solaris operating system, and so it was unlikely that SGI would ever want to offer customers a machine that was so closely linked to Sun.

I wonder whether SGI ever questions their decision to sell that technology to Sun rather than simply burn it or destroy it, because it's been a phenomenal success for us. In one year alone, Sun sold 500 Starfires at about $1 million a pop. This machine took Sun directly into mainframe accounts virtually overnight, because the Starfire is the first UNIX server that has mainframe capabilities. Talk about a great return on investment!

Q. Sun recently participated in the NationsBanc Montgomery conference in San Francisco. Individual investors have the impression that information is sometimes conveyed to institutional investors at those kinds of conferences that they, the individual investors, don't have access to. What about that?

A. As far as Sun is concerned, there is nothing that we state at a conference that an individual investor couldn't find at our Website. We may package the information or highlight parts of it in ways that are tailored to a particular conference, but the information is all publicly available. We want analysts to have a positive outlook on the company and the stock, and so we certainly aren't shy about, for example, talking about what we are doing well in a particular market. But we never "hype" the company artificially.

Q. You have an earnings report scheduled for Thursday -- with a conference call to follow, I presume. Will there be a taped replay of the call available for individual shareholders to listen to?

A. Our current policy is that we don't publish the number for the taped replay. If an individual investor calls us up to request the number, we would more than likely give it to him. But we do that on a case by case basis. Our legal department is of the view that if the information discussed on the call were freely available to people who don't follow Sun closely, those people could misinterpret what was said. That said, I personally believe that the individual investor is becoming much more savvy and that we've got to be more open to catering to their needs and helping them to understand the company and its strategies better. We're getting there.

Q. And we'll continue to encourage you. Thanks very much for taking time to talk with us.

A. You bet.