Can Sun Microsystems rise from the dead?

By Jon Markman

Sun Microsystems might very well be the most hated $15 billion company on Planet Earth these days. And that could spell an opportunity for investors whose time horizon is longer than the next 15 minutes.

Sunny Mike, as the network computing giant is known on Wall Street, is not hated for dishonest accounting, defective merchandise or plumes of pollution. It has been maligned, dismissed and left for dead by virtually every major brokerage because it has spent the last six years as the epitome of everything that went wrong with tech stocks following the rally in the late 1990s.

It is hated as a memory of mistakes long past. It is hated mostly for what it was then, not for what it is now -- a lost soul on the comeback trail.

Burned believers

Back in the day, Sun Microsystems (SUNW, news, msgs) was a king of Silicon Valley. It boasted that its high-end, super-expensive hardware, software and services supplied "the dot in dot-com." Its proprietary Solaris chips and Sparc workstations, running a proprietary version of the UNIX operating system, were the mainstays of the server room in every self-respecting Internet startup, not to mention large, complex, transaction-oriented industrial companies. Its co-founder and chief executive, Scott McNealy, was the brazen cover boy of the Internet revolution, verbally jabbing rivals such as Microsoft (MSFT, news, msgs) and Intel (INTC, news, msgs) at every opportunity. (Microsoft is the publisher of MSN Money.)

Analysts loved Sun shares as they peaked (along with record earnings) at $65 in the fall of 2000. And they blew kisses at McNealy even as Sun shares crashed 95% to near $2 over the next two years, buying his story that the next chapter of growth was right around the corner.

True believers among the company's shareholder base were burned by the bushel, and soon the crying gave way to whimpers, and then silence. And now? Maybe opportunity.

After all, expectations for Sun today are less than zero. Growth investors have vanished, and over the past two years Sun's ownership rolls have changed dramatically. It is now held almost exclusively in large-cap value funds run by the canny investors at Brandes Investment Partners, Wellington Management, Dodge & Cox and Harris Associates.

Angry former shareholders refer to these kinds of investors as vultures who dine on their dead bodies. But really, they are simply thoughtful managers who buy broken things with hidden strengths and wait patiently for a doctor to come along and fix them.

Heads have rolled

These investors prefer strengths that you can take to the bank, and they like to see discredited former managers pushed out the door. That is where Sun gets a little more interesting, because the company is carrying around 19% of its value in cash -- 87 cents out of the recent $4.42 closing price -- and McNealy finally hit the road last month. Now running the company is Jonathan Schwartz, whose ponytail and no-nonsense approach helps him straddle the worlds of hip Sun customers and skeptical institutional investors.

Schwartz is not a slash-and-burn outsider, unfortunately. But the former chief operating officer has started gaining credibility with the Street by taking a machete to the headcount and real-estate portfolio, announcing last week a plan to fire up to 13%, or 5,000, of the company's 37,000 workers and close several campuses. To make a point about shared sacrifices, he is doubling up in an office with the company's chief financial officer. And he has staked out a bold promise of double-digit revenue growth, 4% operating margins next year and 10% in three years.

Predictably, brokerage analysts who adored the stock in the $60s were not impressed, stating that savings of up to $590 million and the profitability goals were too little, too late. Most seem to want to see the company slash headcount by at least 20%, halt at least half its research and development efforts and sell much more real estate. They say that Sun's core market of expensive servers running UNIX is not growing because the world has changed.

Information technology managers, indeed, are now content to use a handful of cheap Hewlett-Packard (HPQ, news, msgs) or Dell (DELL, news, msgs) sever "blades" -- running Intel or Advanced Micro Devices (AMD, news, msgs) chips -- in applications for which they used to use Sun boxes exclusively. Analysts complain that IT departments at large companies simply won't pay up for a little more quality anymore, and have become accustomed to making budget by mixing and matching commodity parts, which, frankly, run at scorching speeds these days. Said one: "Sun has to prove that innovation is something that customers will pay for."

The company has not stuck its head in the mud. It has developed a low-end line called Niagara that has been met with enthusiasm, begun to do a better job of monetizing its terrific Java platform, launched a strong bid to use cheap AMD chips in certain applications and announced a plan to move powerfully into the more profitable storage and security business with the purchase last year of industry stalwart StorageTek. The big idea is to wrap high-profit-margin storage, software and services around low-cost Niagara boxes -- sort of the way that a ballpark makes more money on its food and beer than its tickets.

Street skepticism

Is that enough to move the needle? It just might work, and what's very interesting is that the analyst community -- which represents the bulk of retail investors in many ways -- hates the idea. Needham & Co.'s technology analyst summed up the sentiment best in a remarkably acerbic report last week when the analyst said, "In a market where customers are obsessed with the savings that can be realized from buying commodity hardware, we found Schwartz's comments bordering on the delusional."

Well, it's one thing to be an analyst and just talk all day. It's quite another to put real money on the line. And that is why I was most impressed to discover, while prowling the SEC database, that in the first quarter Jeffrey L. Gendell purchased 35.7 million shares of Sun -- about 1% of the company, probably at prices ranging from $4.10 to $4.30.

Old-line value investors do make mistakes and can get trapped in misfit companies for years. But Gendell, head of the hedge fund Tontine Partners, is one of the new breed of extremely successful value managers who doesn't tend to wait a long time for a payoff. I'm told by a source that he thinks Schwartz and the new chief financial officer, Michael Lehman, can shrink the company to a size that will make it attractive as a buyout candidate to a larger entity like IBM (IBM, news, msgs), Hewlett Packard or Fujitsu of Japan that wants access to its client base. I was unable to reach Gendell for comment.

My guess is that Gendell and the other value guys are going to have the last laugh on the skeptics. Sun can probably eke out a loss of just 2 cents next year. If the layoffs and real-estate sales go as planned, and the company gets a lift out of its new sales strategy, it could earn as much as 12 cents to 15 cents in 2008. If that materializes, which is admittedly a stretch, the stock could be worth as much as $5.50 next year. In a buyout it could be worth as much as $7. With expectations so low, if the stock gets down as low as the mid-$3s over the summer, it's certainly worth a shot.

Fine Print

Forbes magazine last month ran a good interview with Schwartz. Read it here. … To learn more about Sun, visit its Web site. … To remind myself how meaningless past earnings are, I have kept a link to the press release Sun published in October 2000 just as its fortunes were about to collapse. View it here. ... Jeff Gendell is notoriously secretive and very little has been written about him or his fund. According to Institutional Investor, he personally earned $215 million last year, thanks to a 38% return. That followed 100% returns in 2003 and 2004, according to Institutional Investor. He graduated two years after I did at Duke University, in 1981, and recently made a $2.5 million gift to the school for an energy and environment program.

Jon D. Markman is editor of the independent investment newsletters Strategic Advantage and Trader's Advantage. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, Markman owned shares in the following company mentioned in this column: Dell.