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SUN Microsystems announces fourth-quarter results on Tuesday; 21 brokers currently provide ratings on the shares: 15 say "hold" and a further five say "underperform".

Posted on: Monday, 21 July 2003, 06:00 CDT

SUN Microsystems announces fourth-quarter results on Tuesday; 21 brokers currently provide ratings on the shares: 15 say "hold" and a further five say "underperform". They are looking for revenue for the period ending June 2003 of $11.5bn, down 8% on the same period last year ($12.4bn). They also expect a significant improvement in earnings before interest, tax, depreciation and amortisation to $761.5m from a loss of $239m.

Prudential Financial initiated coverage on the shares just a week ago. It says "hold" with a $4.50 target price, 5% lower than the current $4.75 share price. Prudential believes Sun's only path ahead lies in fully embracing open systems hardware. Sun has clearly established itself as a leader in today's UNIX systems market. However, the broker believes that a reluctance on the part of IT managers to pursue proprietary technology has led to compound annual UNIX revenue growth forecasts for 2002-07 of just 1.5%. This is extremely modest when compared to the 7% and 28% revenue forecasts for Windows and Linux systems respectively.

Sun has experienced a deterioration of its core customer base during the current economic downturn although it now appears to be turning a corner. Following seven consecutive quarters of operating losses, Prudential forecasts a slight operating profit in the June quarter of 0.9%. Additionally, Sun has recently undergone two rounds of headcount reduction and management is attempting to address "cost- structure challenges". During the first three quarters of this fiscal year, sales, general and admin costs declined 14% from a year ago. At the same time, revenue declined by just 7%. However, Prudential thinks Sun still has more work to do, given that the current sales run rate is more than 40% below peak levels.

Until Sun can take greater control of costs and alter its underlying emphasis on UNIX and associated high R&D expenses, the broker "is not favourably inclined towards the stock".

Morningstar believes "Sun still isn't cheap enough to justify the risks". If the shares fell below $2.50 they would be trading at around book value. Given the difficulties in estimating Sun's value above this, that is the level at which Morningstar would consider buying the shares.

Competition for the few IT dollars that are being spent is intense. Sun faces two big risks: uncertainty about the timing of an IT spending turnaround and increased competition from IBM and Dell. The broker's fair value target might be $5 but, given the lack of visibility over any IT spending recovery, the broker remains uncomfortable recommending the stock.

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