The Company

The News

Investors showed a much sunnier disposition toward

Sun Microsystems

After the markets closed Monday, the Santa Clara, Calif.-based company posted a profit of $329 million, or nine cents a share, for the three months ended June 30, beating analysts' consensus estimate of five cents a share. During the same quarter last year, Sun reported a loss of nine cents a share. Top-line growth, however, was far from shiny with quarterly revenue coming in at $3.8 billion, pretty much flat with last year's sales figures.

Investors seemed to ignore those top-line figures, though. Instead, they were much more fixated on the company's operating margins, which far surpassed Sun's earlier goals. Through cost cuts and lower-than-expected expenses for memory components like dynamic random access memory, or DRAM, Sun's operating margins came in at 8.5% in the latest quarter a huge reversal from the negative 8.8% operating margins it reported last year. Even more encouraging was the fact that the operating margins were more than double the 4% operating margin goal that management laid out earlier this year, a sign that Sun might be well on its way toward reaching its target of 10% operating margins by 2009.

"It's clearly very encouraging," says Brent Bracelin, an analyst at Pacific Crest Securities. "That said, there are still some uncertainties around growth drivers to this model. Less than 1% growth isn't something to get too excited by." (Pacific Crest makes a market in Sun's shares.)

The Analysis

For investors who've stuck by the once highflying Sun for years, any sign that the company is moving in the right direction is a good excuse to be ecstatic. After all, this quarter marks Sun's third profitable quarter in a row following years of losses.

But investors shouldn't get too excited about Sun's latest news. As analysts like Bracelin explain, Sun's impressive operating margin improvements may not be sustainable for too much longer. Part of that reason is that the company received an added boost from weakened prices for memory components like DRAM, which saw prices decline by more than 50% during the June quarter.

"They will have to get a little more aggressive on reducing their operating expenses because they probably won't get the same benefit on memory and DRAM," says Bracelin. "I think the September, December, March quarters will be very important barometers of how well Sun tracks toward these 10-plus operating margins."

Even while the company could continue to improve its cost-cutting for the next several quarters, its lack of sales growth should remain a concern, he says. In particular, there are concerns about the company's storage business. Tape-based storage products like the ones Sun sells are being replaced by disk-based technologies. "It's in a secular decline," he explains.

Citigroup analyst Richard Gardner describes the storage business as "disappointing at best" and notes that the company likely lost substantial market share to rival IBM. He notes that in the typically difficult U.S. market, IBM saw a 6% increase in storage sales year over year, while Sun saw a 2% decline. (Citigroup has conducted both investment banking and noninvestment business with Sun over the past 12 months. The firm also makes a market in Sun's shares.)

Other parts of Sun's business will also struggle as it phases out its old legacy UNIX-based servers for virtual-based servers. "Over half of Sun's revenue still comes from these legacy products," says Bracelin. "As they transition, it will limit the amount of upside that there will be near-term."

The Bottom Line

There will be cloudy days ahead for investors who bet that Sun's stock will surge further anytime soon.

Citigroup's Gardner predicts that the company will fail to achieve its goal of 10% operating margins by 2009. Gardner, who has a Sell rating and a 12-month price target of $5.25 on Sun's shares, says he "would be more interested in the shares below $4."

Bracelin is a little more optimistic. "If we start to see growth improve and margins improve, you can start to make the case for a higher valuation," he says. "But for at least six to nine months, we think $6 is an appropriate and fair value."

At that level, the shares, which recently changed hands at $5.21, are a far cry from their 52-week high of $6.78 hit Feb. 5 a boost that came after Sun's finance chief, Mike Lehman, announced that the company's financial woes had finally "turned the corner."

What investors should learn here is that Sun has plenty more corners to turn before it's a safe and fruitful investment again.