甲骨文 (ORCL) 2005 Q4 法說會逐字稿

Good afternoon.

My name is Michael and I will be your conference facilitator today.

At this time I would like to welcome everyone to the Sun Microsystems fiscal year 2005 and Q4 earnings conference call.

[OPERATOR INSTRUCTIONS]

Thank you, ladies and gentlemen.

I would now like to turn the call over to Mr. Jeff Boldt, Director of Investor Relations for Sun Microsystems.

Good afternoon.

Thank you for joining the Sun Microsystems quarterly conference call.

With me today is Scott McNealy, Sun's Chairman and Chief Executive Officer, Jonathan Schwartz, Sun's President and Chief Operating Officer and Steve McGowan, Sun's Chief Financial Officer and Executive Vice President, Corporate Resources.

The purpose of today's call is to discuss the results of Sun's fiscal year 2005 and fourth quarter which ended on June 30, 2005.

During the last hour, we e-mailed a copy of the operations analysis data sheet with nine quarters of financial and operations information, including the quarter just completed.

If you have not received the earnings announcement or the detailed financial data sheet for any reason, or you wish to hear a live broadcast of this conference call, you may log on to our website at sun.com/investors.

We have posted slides you can view on the web which should accompany our prepared remarks.

These slides maybe viewed at the same URL, sun.com/investors.

Simply click on the link marked "earnings releases".

Finally, we will also post the earnings conference call script on our website.

The prepared remarks for our call today will last about 30 Q&A session.

During the course of this conference call, we will make projections or other forward-looking statements.

Such statements are just predictions and involve risks and uncertainties such that actual results may differ materially.

I'd like to refer you to Sun's [inaudible] reports that are filed from time to time with the Securities and Exchange Commission, including the company's annual report and Form 10-K for the fiscal year ended June 30, 2004, and Form 10-Qs for the quarters ended September 26, 2004, December 26 2004, and March 27, 2005.

These documents contain and identify important factors that could cause actual results to differ materially from those contained in our projections.

In addition, during the course of the conference call, we will describe certain non-GAAP financial measures which should be considered in addition to, and not in lieu of comparable gap financial measures.

Please refer to our website at sun.com/investors for the most directly comparable GAAP financial measure and related reconciliation.

Now for the financials.

Revenues were $2.975 billion, a decrease of 4.3% as compared to the $3.110 billion in revenues reported for the fourth quarter fiscal year 2004.

We had a favorable currency impact on revenue of approximately 2.1% year-over-year, and an unfavorable impact of approximately 1.6% sequentially.

The gross margin was 41.4% of revenue an increase of 2 points over the gross margin for the fourth quarter fiscal year 2004.

R&D and SG&A expenses were $1.248 billion, a decrease of $119 million year-over-year.

We recorded a $190 million net tax benefit during Q4.

Included in this amount was a tax expense of $82 million on income generated in certain foreign jurisdictions and adjustments for the difference between estimated amounts recorded and actual liabilities resulting from the filing of prior periods' tax returns.

This expense was more than offset by a $249 million tax benefit arising from adjustments to our income tax reserves, resulting from the June 2005 conclusion of both a previously disclosed U.S. and a foreign income tax audit, and a $23 million net beneficial correction to the valuation allowance on deferred tax assets and prior years' state and foreign tax provisions.

Net income for the fourth quarter of fiscal year 2005 was $121 million, which rounds to net income of $0.04 per share, as compared to the net income of $783 million and net income per share of $0.23 for the fourth quarter fiscal year 2004.

The fiscal 2004 fourth quarter results included $1.6 billion of other income related to a legal settlement with Microsoft.

Excluding a charge of $84 million for workforce and real estate restructuring, and the related tax benefit of $6 million, and a $1 million loss in equity investments, net income for Q4 fiscal 2005 on a non-GAAP basis was $200 million, or a net income of $0.06 per share.

Services revenues totaled $1.47 billion, and we're up 0.3% year-over-year and up 11% sequentially.

Within services revenue, support service revenues were $778 million, down 1.8% year-over-year and up 6% sequentially, while client solutions and knowledge services revenues totaled $269 million, up 6.7% year-over-year and up 21.8% sequentially.

Products revenues totaled $1.928 billion, down 6.7% year-over-year and up 14.6% sequentially.

Within products revenues, computer systems products revenues were $1.577 billion, a decrease of 3.8% year-over-year and an increase of 13.4% sequentially.

Network storage products revenues were $351 million, down 17.8% year-over-year and up 22.2% sequentially.

U.S. revenues were $1.177 billion, down 13.2% year-over-year and up 20% sequentially.

Europe revenues totaled $1.64 billion, and were up 3.7% year-over-year and up 13.4% sequentially.

Japan revenues were $158 million, down 11.2% year-over-year and down 20.6% sequentially.

And rest of world revenues were $576 million, up 4.7% year-over-year, and up 13.2% sequentially.

Ending sales channel inventory was $375 million, or 5.7 weeks of supply, which is within the desired levels.

We ended the quarter with a cash and marketable debt securities balance of $7.524 billion.

Please note that the results discussed today are just preliminary and include a total of approximately $45 million in cumulative accounting adjustments, decreasing fourth quarter net income.

These reflect a variety of items detected during the Company 's routine quarterly accounting reviews.

The two principle items are an increase in both revenue reserves and cost of goods sold.

The Company does not believe that they are material to any prior periods.

Nevertheless, the Company has not completed its review of this matter.

Depending upon the outcome of that review, the Company may conclude that these adjustments could result in restatements of prior period financial statements.

Should the Company reach that conclusion, the impact would be to improve the fourth quarter results reported today with the corresponding reduction in various prior period results.

The Company expects to complete this process prior to filing its Form 10-K.

With that, I'll turn it over to Steve.

Great.

Thanks, Jeff, and welcome everyone.

Let me start with a brief review of the financial progress we have achieved this year.

First, we stabilized revenue, ending the year at approximately $11.1 billion.

We improved gross margin dollars on a non-GAAP basis by greater than $129 million or 1.6 percentage points.

And we dramatically improved productivity by reducing our R&D and SG&A expenses by over $0.5 billion or 11%, while achieving the $4.7 billion guidance that we provided.

We achieved a non-GAAP net income of $184 million or $0.05 which is $975 million improvement over fiscal year 2004.

And finally, we generated over $369 million of cash flow from operations, our sixteenth consecutive year of generated positive cash flow from operations.

Let's take a look at the quarter in a little more depth.

We'll start with slide four in our demand metrics.

In Q4, our book-to-bill ratio was 1.03, up from 0.97 in Q3.

And in fact this is the highest Q4 book-to-bill ratio since Q4 of fiscal year 2000.

Additionally, Q4 bookings were very linear throughout the quarter.

Our combined products and services backlog at quarter-end totaled $1.453 billion, up $124 million sequentially.

And our quarter-end deferred revenue balance was $2.191 billion, an increase of 1% year-over-year.

In fact, this deferred revenue was made up of $540 million of products and $1.651 billion.

This is our highest level of deferred revenue ever.

Turning to the revenue on slides five and six.

We'll start with services.

And looking at the service revenue, it grew approximately 3% fiscal year 2005 over fiscal year 2004, led by a 10% growth in our client solutions and knowledge services business.

For the quarter, services revenue was up slightly year-over-year, while support services revenue declined about 2%.

Support services contract penetration rate however, increased 4 points to 53%.

In the quarter, our client solutions and knowledge services revenue grew 7% year-over-year, which we believe is an indicator of progress we're achieving with our solutions selling model.

This growth was led by our client solutions identity management and managed services practices.

Overall, Sun services has delivered a very solid performance this year.

They've made excellent progress in increasing the number of systems under contract, improving productivity, driving cost efficiencies, and improving gross margins.

Turning to products, total product revenue declined approximately 3% fiscal year 2005 over fiscal year 2004.

However, within products revenue, computer systems revenue at $5.8 billion was level with fiscal year 2004.

In this computer systems performance, we did see a continued shift from the data center and enterprise systems to entry level service.

Specifically, approximately 65% of server revenue is now derived from our one- to eight-way offerings.

And more importantly, we grew the non-GAAP product margins by 0.5 point to 42.2% as we benefited from the sale of full systems and the continued improvements in our supply chain.

We shipped approximately 331,000 computer system server units in the year, with almost 50,000 being x86 servers.

This is a 7% year-over-year increase in total service shipments and a 117% increase year-over-year on x86 server shipments.

Our network storage business revenue was down 13% for fiscal year 2005.

For the quarter, total products revenue declined 7% year-over-year, with computer systems revenue down about 4% and network storage products revenue down approximately 18%.

Product categories which grew, however, year-over-year, sequentially and full-year 2005 over 2004 include -- x86 servers; four- to eight-way SPARC servers, mid-range storage arrays and our software line of products.

Java enterprise systems subscribers climbed 43% sequentially for 186,000.

And we're delighted to report the cumulative Java ES count is now up to 619,000 subscribers.

Of this 619,000, 77,000 of Java ES suite subscribers, these suites, announced this past spring, are comprised of five solution sets that target customer's most critical business needs and are attractively priced at $50 per employee per year.

And finally, shipments were relatively linear within the quarter with no significant component issues.

Turning to revenue by geography in slide nine.

For the U.S, revenue was down 8% fiscal year 2005 over fiscal year 2004, and down 13% Q4 '05 over Q4 '04.

However, our U.S. demand indicators stabilized in Q4.

The U.S. product book-to-bill ratio was 1.18 versus 1.06 one year ago.

And U.S. product backlog was $358 million versus $301 million one year ago.

Looking at the verticals in the U.S., a bright spot was a relative strength with our Wall Street financial customers, as revenue grew in this segment on a full-year over full-year basis.

However, both our communications and government verticals continue to decline.

To address this decline in the government business, we've reestablished some federal business organization to bring more focus to this important vertical.

Europe continued to perform well from both their revenue and profit perspective.

We're delighted that European revenue increased 5% on both products and services for the full fiscal year 2005 as compared to 2004.

And for the quarter, increased 4% on a year-over-year basis.

Countries in which revenue grew year-over-year sequentially and full fiscal year include Italy, Portugal, Belgium, Denmark, Sweden and Austria.

And looking at Japan, revenue for the full-year decreased by 4% on a full-year over full-year basis.

A significant part of this decline is directly attributed to the change in our relationship with Fujitsu, resulting from our previously announced partnership.

However, the overall benefits from this partnership more than offset the specific revenue decline in Japan.

Given this, Japan's underlying revenue has stabilized.

And finally, looking at the rest of the world from a geography perspective, rest of world revenue grew 6% for the full year.

This is our strongest growth region for both products and services.

And we're delighted with the continued progress in this region.

Areas that grew year-over-year sequentially and full-year over full-year include Canada, Latin America, Australia , India, and Singapore.

Now let's move forward and take a look at gross margins on slides ten and 11.

Product gross margin for the quarter was 41.4%, a seasonal sequential decline of 0.7 points.

This decline was due to the following unfavorable variances.

Approximately 3 points for pricing and discounting actions, and approximately 1.7 points for other costs that includes channel program-related cost and reserves.

These unfavorable variances were partially offset by approximately 3.5 points of favorable impact due to material cost reductions and 0.5 point favorable impact due to mix.

These material cost reductions were mainly due to lower component costs, including memory and our continued focus in operational efficiencies in our supply chain, while the favorable mix impact was driven by the strength in our software and our four- to eight-way SPARC server business.

Services margin for the quarter was 41.5%.

We recorded a seasonal sequential margin increase of 1.4 points.

This increase was due to approximately 1.8 points in cost reductions and efficiencies, and the combined impact of approximately 1.6 points due to increased volume and favorable pricing.

These favorable impacts were partially offset by 1.8 points of impact due to mix attributed to the stronger growth in our client solutions business.

Improved efficiencies reflect the results of our drive to provide service by a variable cost business model focusing on technology and process efficiencies.

Now moving to slide 12 and 13.

R&D and SG&A.

These expenses for the quarter were $1.248 billion, a decrease of $119 million year-over-year.

This decrease was primarily attributed to our many ongoing cost reductions and productivity improvement initiatives.

For the quarter, R&D and SG&A expenses did increase the anticipated $66 million sequentially, due to four extra days of compensation expense in Q4 and due to the prototype spending associated with new product development.

And looking at restructuring activities in Q4, they totaled $84 million with $40 million associated with previously announced restructuring plan.

This $40 million is comprised of $33 million related to real estate portfolio actions and $7 million in workforce reductions and previously announced outsourcing activities.

In a continuing effort to improve our cost structure we expect to shortly announce a plan to reduce our property portfolio capacity at a cost of approximately $180 million.

This will take place over the next several quarters and I'll update you regularly on the specific charges on future earning calls.

Additionally, we initiated a plan to reduce our workforce by approximately 1,000 people at a cost of approximately $100 million.

We took $44 million of this charge for the workforce rebalancing effort in Q4, fiscal year 2005, and expect the remaining $56 million over the course of the next four quarters.

In looking at taxes, we recorded $190 million net tax benefit during Q4.

Included in this amount was the tax expense of $82 million in income generated in certain foreign jurisdictions and adjustments for the differences between estimated amounts recorded and actual liabilities resulting from the filing of prior periods' tax returns.

However this expense was more than offset by $249 million tax benefit arising from adjustments to our income tax reserves resulting from the June 2005, favorable conclusion to two significant income tax audits that have been in process for a number of years.

The previously disclosed audits were in both the U.S. and foreign jurisdictions covering the period 1997 through 2000, and 2000 through 2004, respectively.

We're delighted with the outcome of these audits.

Finally, we had a $23 million net beneficial correction to the valuation allowance on deferred tax assets and prior years' state and foreign tax provisions.

Now, turning to slide 16 on the four balance sheet items.

We generated $195 million in cash flow from operations in the quarter and $369 million for the year.

Again, our sixteenth straight year of positive cash flow from ops.

We improved our cash conversion cycle by 11 days, ending the year at 29 days, which was six days better than our guidance.

We managed capital spending very carefully by investing $80 million in capital and spares for the quarter and $347 million for the year.

And finally, we ended the quarter with a cash and marketable securities balance of over $7.5 billion.

Finally, let me close with some comments on FY '06.

The comparison of fiscal year 2006 performance to fiscal year 2005 will be challenging, due to the anticipated close of the Storage Tech and SeeBeyond acquisitions in the early fall, and the inclusion of equity-based compensation expense associated with the adoption of FAS 123R.

Therefor I'll provide fiscal year 2006 guidance without these three events at this time.

In FY '06 we've planned and goaled the organization for growth, profitability, and positive cash flow from operations.

And specifically, we anticipate R&D and SG&A spending to be flat to slightly up from the FY '05 level and for Q1, FY '06 to be approximately $1.6 billion.

We anticipate a tax provision of approximately 200 to $250 million.

Capital and spares, we would approximate at $400 million or investment for the year, including an increase in our Sun Grid investment.

And a cash conversion cycle, a three day improvement to approximately 26 days.

You'll note that the impact of the acquisition of Storage Tech and SeeBeyond will be provided after their close expected again in the early fall.

Now, we adopted FAS 123R share-based payment on July 1, 2005 and will be including stock-based compensation expense in our Q1 fiscal year 2006 results from operations.

FAS 123R will have a material impact on our results of operations.

However, our future stock-based compensation strategy and variables such as future stock price, make it difficult to determine whether the stock-based compensation expense that we will incur in future periods will be similar to the current pro forma expenses disclosed in our 10-Q and 10-K filings.

Therefore we'll provide more details on the impact of stock option expensing by the end of the quarter.

And with that let me turn it over to Scott.

Thanks, Steve.

So, I'd like to kind of review the quarter and the year a little bit and then talk about some of the tuneups and strategies, some of the product plans we have going forward.

And then kind of what we're really focused on for the next fiscal year.

So let me just crank through that.

Big-time progress I think, in '05 on a number of fronts and sure feels nice to make money.

That always feels good.

We spent the last year getting in shape and succeeding in a lot of fronts and really setting the Company up to have a very successful '06.

At least that's how it feels to us.

There's kind of a little battle going on out there among microprocessors, operating systems, middleware and storage all of the rest of it's service [inaudible], but we're going to play the game at a higher level also at the system's level and the utility computing level, so we like our position.

We feel like we're one of the few remaining major companies doing large scale multi-billion dollar R&D investment in this systems technology.

And we believe we've done what we need to do to drive this Company into growth mode.

On the financials front, we're going to continue to be a cash Company.

Accounting gets more complicated, not less, but cash is very simple, sixteenth straight year cash flow positive from operations and we're at more than $7.5 billion.

We stabilized revenue, grew gross margin dollars by over $129 million.

We met our $4.7 billion spending target that we committed a year ago.

So again, reflective of the discipline and management focus and leadership that I think this Company has from a fiscal perspective.

And quite impressive on $11 billion run rate, was improving the non-GAAP net income by $975 million year-over-year.

Any company would love to improve by nearly $1 billion on an $11 billion run rate.

So the team, I believe, financially, delivered quite nicely on the fiscal year from a financial perspective, given where we were.

We tuned up the strategy.

We have made huge incremental strides in the open source software arena and we certainly have delivered a big fish with Solaris 10.

We have over 2 million downloads in registration so far.

And we've clearly established credibility and position in the x64 marketplace over the last 12 months. 70 or 80% of those downloads are for non-SPARC Intel and AMD machines, so that's pretty exciting and -- as a nice tuneup on the strategy.

We created CDDL with OSI approval, in terms of a licensing mechanism that marries the best of community development with inventor-owned innovation.

We think that's going to be a very powerful mechanism to continue to drive community development.

We initiated a true utility computing strategy with transparent pricing, $1 a CPU hour.

We still don't see anybody responding to that and we feel like we have the low cost provider position in that strategy, so stay tuned, you'll see a lot more interesting stuff there.

On the partner front, a big expansion of our relationship with Fujitsu and you'll see APL-based product in the next calendar year.

We enlisted IBM for ten more years of Java, plus they're doing Solaris 10 on SPARC and x86 -- x64 as a Tier One port for all of their software.

It's kind of over now.

We added EMC so the world is now supporting Solaris 10 and our x64 boxes.

People are asking us where's the beef on the Microsoft partnership and we had our year one update with wonderful progress on single sign-on and directory interoperability storage and systems management interoperability.

We licensed the remote display protocol for our Thin clients and Solaris technologies.

And we certified Windows on all of our x64 boxes.

So lots going on on the partnering front out there.

Organizationally, the team created our client services organization and that has created a very modular and extensible organization structure to allow us to integrate things like Storage Tech and SeeBeyond seamlessly into our field portfolio.

Demand indicators in the U.S. have improved nicely as you heard on the numbers.

Business grew 20% sequentially and our services business continues to perform very well with solid 3% year-over-year growth.

We were active in the M&A front as the $7.5 billion of cash is not needed for the survivability conversation but now we're actually putting it to work.

Procom beefed up our NAS offerings very nicely and the 3150 is a very competitive product.

We bought Tarantella have along with the RDP license gives us interoperability out the wazoo.

I'm not sure that's a financial term, but it gives us the ability to basically tie anything to everything out there in the marketplace.

We announced the definitive agreement to acquire SeeBeyond, which really delivers a Java-based service-oriented architecture and allows the customer to build these new composite applications in a very nice way.

We also open sourced the JBI, the Java Business Integrations services bus.

And I've got to say at this point, as we execute on all of this, we are SOA now, and it's all Java-based.

We also announced a definitive agreement to acquire Storage Tech with 17,000 customers and 36% of the world's archive data running on the Storage Tech tape libraries.

How you may have seen their numbers, if you read Storage Tech's numbers you might actually think that tape is a growth business.

But we'll let you make your own judgments based on how they did in their June quarter.

But it gives us huge interoperability with a whole bunch of data center environments, especially IBM and Microsoft.

And as we add in the JES capabilities around security and access and identity, we believe we can deliver ILM, information lifecycle management with security and identity as a real value-add in the marketplace.

We got tons of cash;

I should be more accurate.

We have $3-plus billion of cash after acquisitions and Storage Tech and Sun are both generating cash with about $1.1 billion in debt.

We will continue to act as a consolidator on an opportunistic basis out there in the marketplace.

We do not believe we have used up our capacity to go be that consolidator.

Quick review of the year from key product rollouts and customer momentum.

In Q1 of last year, we did the Take Back Wall Street campaign, that was very successful.

We've got big wins with ABN Amro, DE Shaw, JP Morgan.

A terrific move into that vertical market and it's paying off.

And we grew our Wall Street business year-over-year.

So when we focus and with the new strategies we can execute.

Q2 we unveiled the new Solaris 10 operating system and we've got more than 1450 applications on SPARC and more than 1000 applications certified on x64.

Dozens of positive product reviews and performance and price performance records out there.

Customers are using this in big-time ways, the Philadelphia Stock Exchange, DE Shaw, HPCVL, and we have over 40 additional proof of concept trials going on around the world with the likes of JP Morgan and others.

It's down to Solaris, Windows and probably Red Hat out there in the surviving long term OSs, in our view.

We're pretty excited about it.

Q3 was all about the Sun Grid launch. $1 per CPU hour and $1 per gigabyte month.

Huge interest with financial services, biotech, educational communities.

I talked to major University has a beta project has up and running on the Grid.

There will be more manufacturing, energy, research and technology sectors are all very interested.

The backlog of activity is just huge and we are going to be investing aggressively in capital and R&D on this grid utility computing model.

We got some great relationships.

EZ (ph) Qual allows ISVs to remotely qualify their applications on Solaris 10 using the Sun Grid computing utility.

So you're going to see a lot of new and innovative uses of the grid that we don't necessarily even plan for that just start to show up.

Q4, we did the Microsoft announcement.

I talked about that and we highlighted our EDS Sun partnership big-time and all of the new systems integration partnerships we have with like, NEC and Netcetera and others.

And we have demonstrated the new single sign-on environment specifications.

And you'll see more of the integration of .NET and the Java enterprise systems web services stack going forward.

We went live on June 14 with the Solaris open source code on openSolaris.org and you will continue to see us open source other technologies as we open sourced our application server platform, edition 9.O, and we open sourced the business integration Java enterprise server bus.

We had ten years of JavaOne -- or of Java, and JavaOne this year celebrated a big birthday, 2.5 billion Java devices, 700 million Java phones, big partnerships.

Anybody who was there, I believe walked away thinking that we have a big huge business that's got a ton of vitality and energy.

Storage, we saw real solid momentum in the mid-range with our 6920 bringing high-end capabilities to the mid market and we're seeing very interesting activity and wins in the media and high performance technical computing marketplace.

Regarding our key communities -- SPARC platform server CPU shipments exceeded the competition since IDC began tracking them and our new SPARC Niagara CMT chips have been quite positive.

Niagara two and Rock will take out this fiscal year and you'll see all SPARC IV+ and IIIi+ ship in this fiscal year also.

So SPARC is continuing to ramp up and break some new ground as we move forward.

Solaris 10 rocks on.

I mentioned the downloads, keep watching 70+% are on the x64 marketplace.

Java is accelerating.

You will continue to see us drive more Java community process development with more JSR's and more new design wins.

The one I particularly like is that Blu-ray has adopted a Java platform, which would put the Java virtual machine on the next-generation DVD players and you would see Java code showing up on all of the DVDs that are Blu-ray compatible.

That's a big win.

Java enterprise systems skyrocketed to 619,000 subscribers.

That's 104% increase, FY '05 over '04 and when you start putting this stuff together, JES, the SeeBeyond potential opportunity Solaris, and Java studio, we become the price performance leader in the complete web service and stack.

Take a look at the numbers.

Take a look at the charts on our website.

It's pretty impressive and I just thought I might take two seconds out and let Jonathan talk about something that's already happened here in this fiscal year, since I'm only talking about last quarter I'll let him talk about this quarter.

Jonathan maybe you could give us a little update on JES?

Sure, and I think we had a reasonably good quarter in Q4 in terms of the deals we got closed.

There are obviously a few that we didn't get done that we wanted to get done within the first few weeks of Q1.

We have closed and we'll be announcing tomorrow that General Motors which, last I checked is a Fortune 5 company, will be adopting the Java enterprise system across their enterprise for service-oriented architectures.

And as importantly, they will also be running those components on the standardized operating system across General Motors which will be Solaris 10.

So I think there's just a ton of momentum there.

I think the industry is looking to General Motors maybe to lead the way in cost reduction and they're certainly starting off with their middleware and getting a lot of efficiency out of it.

I love Detroit iron and my GMC custom van that I drive my boys in, so I had to throw that one in there.

Thank you General Motors.

The x64 business is booming.

We saw huge gains. 117%, Steve I think mentioned on our x64 business.

And while total servers across-the-board grew 7%, and that's before we launched the new Galaxy line which everybody is very excited about and launched the new SPARC chip, so stay tuned.

And again, storage is up with terabytes to storage shipped within servers went up by more than 50%.

Looking forward let me just quickly review where I see the team focused.

We are planning and goaling our team on growth and profitability in FY '06.

And included as part of the goal set for the variable compensation is cash generation, too.

We have a nice start to FY '06 with solid Q4 bookings and an increase in deferred revenue and some nice wins like the General Motors win already this fiscal quarter.

We have a full product calendar ahead as I mentioned with just about every system product and software product due for a major update or enhancement this fiscal year.

The $2 billion R&D budget says that there are very, very few, if any product holes in our product calendar going forward.

We have a big task of integrating our big acquisitions into Sun, driving the synergies and leverage.

But we're very excited about Storage Tech bringing enormous field strength to our quite competitive storage offerings today.

The Sun Grid and Java enterprise system pipelines are very strong and active.

Our challenge is to monetize those and bring the orders in.

We will continue to invest in R&D with a plan for more than $2 billion investment in FY '06 with a basic statement that our customers can feel confident in our commitment to innovation going forward.

And we will again maintain our commitment to lead this organization with transparency, quality, and fiscal discipline, while never losing our focus on the customer.

Jeff, back to you.

Thanks, Scott and Steve.

Now we'll take your questions.

Michael, will you please start the question and answer session?

Ladies and gentlemen, we will now begin the question and answer portion of today's call.

[OPERATOR INSTRUCTIONS]

Your first question comes from Brent Bracelin with Pacific Crest Securities.

Thank you.

Actually I had a question on the backlog, highest level here in several years, 15% sequential growth, 13% year regrowth.

Could you provide a little more color on what's the composition of the backlog from a product standpoint, and then to give us a little better driver -- understanding of what the growth drivers there are?

Right.

Brent, there's a couple different metrics, first of all, when we look at the backlog, the book-to-bill, the deferred revenue.

There's a nice uptick we're seeing in deferred revenue.

It's up 1 point, it's 2.191 billion, 500 -- the breakdown that I gave there was 540 was product and 1.650 billion was services, so that's pretty much how we sort of split that one down.

The overall products and services backlog, which we've got detailed in the ops analysis is 1.453 billion, so it's 124 million up sequentially.

So we're seeing some good upticks in our -- in the demand.

That's why I wanted to provide that sort of perspective.

That sort of wrapped in the envelope of the book-to-bill at 1.03, gives some pretty, what I'll call, solid demand metrics as we exited Q4 and as we start to look forward to this fiscal year.

Sure.

I guess my point was more on -- you did indicate that 65% of kind of the server units were coming from that one- to eight-way space.

Is that product backlog -- does that consist of mostly one- to eight-way product or are you seeing kind of a resurgence and interest in more of the larger higher end UNIX systems?

As far as I know there's nothing unique about what's on backlog versus what we have been shipping over the last few quarters.

And we have seen, definitely, a bit of a resurgence on the high end, on the data center side.

So I think especially with the evolution of Solaris 10, the new ultra SPARC IV bus systems coming out and also the high end on the storage side, we're definitely seeing interest, there.

Okay.

Great and any update on the number of service contracts for Solaris 10 since we're now kind of two quarters into it ?

We're still driving the volume of downloads on licenses, and we'll hopefully have an update for you pretty soon on the actual number of subscribers.

But again for now, we're really driving the download volume.

That for us, proceeds the conversion through subscriptions.

There's a six to 12 month development certification and deployment kind of lag anyhow, so we didn't expect much at this point.

And the best leading indicator is just download volume.

People don't download what they're not ultimately going to license.

Thank you.

Next question, please?

Your next question comes from Richard Chu with SG Cowen.

Yes, just following up on the previous question.

Can you be a little bit more specific on data sent through server trends Q4 versus Q3, and versus a year ago, whether you just think of it as an uptick?

And then second, on operating expense guidance for fiscal '06, I'm a little bit surprised that you're not targeting further reductions, especially with the weaker dollar.

Why not?

And if -- does this reflect an increased commitment to investment opportunities and if so, where?

Field, R&D, are you moving [inaudible] in R&D offshore?

Could you comment on that please?

Yeah, okay.

Richard, let me start and we'll both take a shot at that.

The one thing I want to do is on the R&D, SG&A guidance for '06 and for Q1 in particular, it was 1.2 billion is what we're targeting for Q1.

I think I may have said 1.6.

I want to make sure that's clear.

As far as the backlog, we don't assume there's any significant shift in the mix of the backlog.

You'll notice in the slide tech this time, we put a -- the one- to eight-way and the enterprise in the data center servers.

And you've seen that sort of slow shift from 45%, one- to eight-way, 55% data center and enterprise and it's shifted sort of inexorably over time, this thing has kept moving where now we're 65%, one- to eight-way, 35% enterprise and data center.

The good news about that is, sort of the myth that we broke along the way, is that our margins would deteriorate and that Sun would be caught in this sort of vicious vise of declining product margins.

And in fact our product margins have actually gone up because of the improvements in the supply chain that we've put in place, because of the the benefits of selling the system.

So although I'm not going to give on the call the explicit breakdown between one- to eight-way and data center and enterprise.

You can be assured we carefully look at what our product margins are going to be and what the profitability is from them.

As far as the R&D SG&A for next year's guidance, we are planning for growth and profitability and cash generation.

So that, when I said approximately flat, that's 4.7ish, 4.8ish kind of R&D, SG&A, keep in mind that would assume we achieve all of our goals and objectives during the year.

We achieve the revenue growth and the profitability and only under those terms would we fundamentally spend that amount of money.

Any bonuses or other things associated in that number are going to be a function of us achieving the goals we've set out for FY '06.

If we don't achieve them, then the number would come down appropriately.

So to be a little more specific, we are planning a fully funded variable compensation plan for our employees for FY '06.

We did not pay out at the targeted level in FY '05 but we are planning and that is a $250 to 300 million fully funded plan for the next fiscal year.

So that's significantly more than what was paid out in this year, so that's a big chunk of why, our actual spending on non-variable comp is just down year-over-year with the 4.8 billion plan.

So we are --

Is there some front end loading on the accruals for that, why the [inaudible] Q1?

No, and you know as we do a bridge on Q1 and we'll talk more about that when we end the quarter.

The last year, if we think about Q1 it was a little bit of a stub period so there may be a day or two extra that's in this Q1.

Secondly, we put a focal or a pay increase in during the year so that obviously shows up in this Q1.

There's a couple different events that the additional things that Scott mentioned, the exciting new products that we're looking at both in the x64 and the SPARC area, there's prototype investments in Q1.

So there's some items like that that we will have in our Q1 and we're giving you our best guidance on that right now.

Okay, thank you.

Thanks, Richard.

Next question, please?

Your next question comes from Laura Conigliaro with Goldman Sachs.

Yes, thank you.

A couple of things.

Since you indicate that you're -- you directionally -- you ended with some positive indications about demand, should we be thinking therefore that first quarter demand won't necessarily reflect normal seasonality of minus 15%?

That's the first thing.

Secondly, why shouldn't we be thinking about your taxes in the just reported quarter, as being a number that doesn't include some of those one-time benefits such as the $249 million and there was another item as well and therefore, it gets you a different kind of an earnings number?

And then thirdly, do your orders -- does your backlog include any Galaxy in it?

Okay.

So we got a couple of different pieces there.

One, Laura, on the guidance in terms of the quarter, we weren't trying to signal any change in how you'll forecast what you think Q1 is going to be.

We just wanted to provide as complete a picture as we could about what it looked like from each of the different demand components we look at.

There's obviously seasonality in Q1 over Q4, and I wanted you to have as full a picture as we have and you can make your best assessment there.

As far as tax, you're absolutely right.

From a tax standpoint, the guidance that I gave was what I'll call our sort of operational tax provisions.

We did have some special one-time tax benefits this year.

We've explained what they were from and some cases we were addressing and resolving tax issues that went back to '9.7 So the good news is we finally got many of those cleared up, but those are not going to be repeatable obviously, on a quarterly or even annual basis.

So that tax guidance I gave's operational.

And then as far as galaxy products --

On both the seasonality question and the backlog question, there's no Galaxy systems in the backlog.

And with respect to the demand metrics, I think the one interesting change for us is certainly a stabilization in the U.S.

As well as some growth year-over-year on the backlog side as well as just heightened interest in what we're up to.

So I think the team there is definitely executing pretty well.

Solaris 10 is helping to drive a lot of interest and conversation around both Galaxy as well as Niagara, as well as the storage systems for that matter.

So again, would that suggest that perhaps normal seasonality won't necessarily be the case?

I think your guess is as good as ours at this point.

Next question, please?

Your next question comes from Kevin Hunt with Thomas Weisel Partners.

Okay, thank you.

And I had a couple of questions.

One, wonder if you can give us any update on the timing of the Galaxy products, since people seem to interested in that?

And also curious, can you help me understand a little bit on -- you talked about, I think Jonathan, saying the high end looks stronger but then also if you kind of just do the math with the one- to eight-way getting as high as it is as a percentage of the mix, that obviously implies that your high end was not so strong.

And clearly wasn't as strong as the numbers IBM reported last week.

So maybe you can kind of talk a little bit about competitive dynamics, there and maybe the same on the storage side, since that also doesn't seem to be making that much progress despite your positive commentary about it.

I think when you look inside any of these overall numbers, I think on the storage side we saw growth in Sun intellectual property and the softening we saw and some of the deals that fell out of the quarter were on the very high end, the Hitachi systems we're partnering with Hitachi.

So the growth that we saw based on unit volumes, the next generation 6920 we introduced, the new NAS offerings, we are obviously on a smaller base and didn't make up for any of the softening or weakness we saw in the very high end.

On the server side of this, we obviously have seen a continued growth and a pretty aggressive growth, frankly on just raw unit volumes in the UNIX base.

And with some of the decisions that HP has made around PA-RISC, that's kind of taken that out of contention in some of the customer situations.

We've seen more of a stabilization on the high end than any return to growth there.

And I think certainly, the new introductions of the Panther systems UltraSPARC IV+ as well as the release of Solaris 10 into deployment, is giving us some new opportunities.

But obviously we've still got a lot of execution to do.

Regarding Galaxy, we won't announce exactly when we're going to announce, but we do have early access machines in customer sites and it is going through the normal pre-production ramps and the customer interest is high on that.

But I can't say anymore than that right now.

Okay, thanks guys.

Next question, please?

Your next question comes from Harry Blount with Lehman Brothers.

Hi, guys.

A couple quick questions.

Steve, just on the -- going back to the 200 to $250 million tax provision.

What are you assuming in terms of NOLs and effective tax rate in that number?

And then secondly, I don't mean to nit on this backlog and momentum issue, but if -- I'm looking at the supplemental disclosures here, your -- it looks like your product backlog is still down on a year-over-year basis, and so I'm trying to understand if you had linearity in the quarter, where you're seeing that momentum from?

Okay, so let's do the tax one first.

Harry, the best way to look at it is, I gave you what I'll call our operational tax provision that we would plan for for FY '06.

Now we've got a number of moving pieces as we go into this year and one of them which -- where the profits actually will be.

We're in a tax paying position in foreign jurisdictions and we're not in the U.S. right now.

So it depends where those actual -- where the business actually falls, number one.

Number two, is we look at the acquisitions that we are focusing on.

We will obviously have some tax -- situation to use some of the NOLs you're talking about, again based on where the profits are going to be.

Because those NOLs are effectively sitting in the U.S.

Then as far as the backlog that we gave you for the 805 which you're picking up on the Q4 backlog versus the 834, I'm trying to give you each of the different pieces, there's backlog, there's deferred revenue, don't forget the difference between a backlog and deferred revenue.

Backlog, there's still something we've got in-house, deferred revenue we've already shipped and it's up on the balance sheet so it's already sitting at the customer site and we're going to take it down as soon as we meet the deliverables with the customer.

That's another way to take a look at it.

Secondly, it was really the U.S. that I was trying to give some perspective there in terms of the stabilizing that we saw.

We've been trying to get more and more transparent and granular in terms of the information and giving you the U.S. product backlog up from from 301 to 358 giving you the book-to-bill 1.18 versus 1.06, was trying to let you take a look at the biggest geo -- the biggest country that we have and to say that the Q4 we saw stabilization there.

We're just trying to give you a fuller picture, Harry of what actually transpired in the quarter.

A little more color, Harry.

Just to go back to a recurring theme, around recurring revenue and we're trying to drive our customers and our products and offerings to a recurring revenue model.

Things like JES, things like Solaris support revenues, the client solutions organization, or our old PS, professional service business, the utility compute models.

All of those sorts of things, OEM deals, and we continue to drive this more recurring revenue which shows up more deferred than a product booking number.

So there might be a little bit -- and revenue doesn't necessarily grow as fast as, say profitability does, as we make that transition.

So, I can't tell you how much your guys -- you guys are going to have to do that analysis.

We're trying to watch it and drive it inside but it's kind of hard to say how much is causing what, in these accounts to move.

Right.

I see the short-term deferred's up roughly $30 million year-over-year, the long terms are down slightly.

Okay.

But the additional color is still helpful.

I appreciate it.

Yes, and Harry again, you're looking at -- it's product only.

We're trying to give you product and services backlog.

That was the number I gave, so.

But I think increasingly Harry, I think you're going to see the delineation between some of the product and services, begin to blur because the service licenses on JES and for Solaris 10, it's serviced on a free product but obviously it's based on the conveyance of intellectual property.

So I think the most important top level message is, revenue recognition is increasingly an art form and we're going to focus on getting long term customer wins and make sure that we focus on collecting cash and driving gross margin dollars up.

And we know that investing in technology and making sure that we can be creative with how the customer wants to spend their money is how we're going to win their business.

Great thanks.

Next question, please.

Your next question come from Andrew Neff with Bear Stearns.

Sure.

Can you just give an update with the STK and the SeeBeyond, in terms of where they are in terms of timing and any other issues or [inaudible] at this point?

Yes.

Hi, Andy.

A couple things.

We've cleared with respect to STK, we cleared the HSR waiting period.

We're pleased so far with the progress our integration teams are making at this stage.

STK stockholder meeting is scheduled for August 30, so that's probably all we can say at this time until this is actually closed.

But that will give you an idea of the time frame we're working with.

Will it close right after the shareholder meeting, assuming the vote goes the right way?

Yes, it will.

Great.

Awesome.

So it should be late summer, early fall as we had said and right on target for that.

Your comment was, it would be accretive, any update or anything else you could add to that?

No.

Just that as we said it would be accretive.

I'll keep it right there.

I think they just announced this morning we've been -- we haven't had a chance to dig through it yet but their results are out.

And I think what we just continue to see in the marketplace is customers and their respective sales forces are pretty excited about the opportunities in front of them.

So I think we've definitely collected enough early feedback to know that we're on a good path.

And SeeBeyond?

SeeBeyond, the date for that is 8/25 is their shareholder vote date, so again, on target for late summer, early fall.

And any update on the financial, you said this update is on the financial impact of that?

Yes, no update on that one yet.

No update on those financials.

Okay, thanks a lot.

As soon as we get them, Andy, we'll get you updates to you and the group at the time of close.

Okay.

Thanks.

Next question, please?

Your next question comes from Ben Reitzes with UBS.

Good afternoon.

A couple things just with regard to next year.

Did you say your goal to be profitable is before options or after options, I assume it's before the impact of options, Scott?

And then with regard to the taxes for the quarter just ended, I mean I get all -- using my assumption going into the quarter, I get a loss of $0.01 and I want to take out the tax benefits to get you to $0.06, so I just wanted to clarify if that would be the right number, using a normalized tax rate.

I'll give you my professional and personal view on options.

Professionally, we will report them as an expense.

Personally, I don't have a very strong opinion.

Yes, and Ben, this is Steve.

As I said on the guidance, we have -- what we gave for guidance at this stage does not include STK, SeeBeyond or 123R option expensing.

Okay.

It doesn't include any of that.

But with STK, I would assume that you guys -- do you guys have any idea as to how profitable, or any operating margin you'd like to talk about?

No.

Not yet.

But when we get to the close we'll have more information on both.

And Steve was I in the right direction with regard to a normalized tax rate in the quarter with what the EPS would be?

Yes.

In other words, and I think it probably goes back a bit to Laura's question earlier.

There were some unique items that we have, some tax benefits that were received in Q4 that we described.

The tax provision for this coming quarter and for the year is still -- we'll still put in that target range I gave.

So I think most folks are probably just trying to portion that based on where they see the revenue as it splits during the year.

Thanks.

Next question, please?

Your next question comes from Andy McCullough with CSFB.

Thanks.

Just on the pricing environment, the 300 basis point hit product margins sequentially due to pricing does seem to stick out a bit.

Was this planned going into the quarter or did this occur in response to something you saw either in your business or in the competitive environment during the quarter?

Yes.

It's a -- we pretty much anticipate on the pricing, staying as a price leader we always want to be aggressive on pricing, that we will have price reductions.

Now any quarter in any geo could shift, how much business goes through the channel affects it, but we did anticipate price discounting in that range.

Hence if you look at the cost reductions you'll see that they almost equally offset it.

Because what we do each quarter, is we get a good assessment of where our costs will come in, where the pricing is, do our best cut at mix and geography and we can pretty much start to work with the margins are going to look like.

So yes, yes, expected, yes we assumed cost reductions and supply chain improvements would help offset it.

And that's pretty much how it turned out.

There was nothing unusual in the pricing scenarios out there nor in the cost production scenarios this quarter.

Got it.

Thanks.

Next question, please?

Your next question comes from Tony Sacconaghi, with Sanford Bernstein.

Yes, thank you.

I have three quick things, please.

Firstly, you stated your channel inventory was 5.7 weeks.

I believe it was 4.8 at the end of last quarter.

Can you comment?

Is that seasonal or why that build?

Secondly, your support growth, year-over-year I think was negative for the first time in history.

But you stated that your penetration in terms of support contracts was actually up 4%.

The implication being that pricing is feeling significant pressure there.

Can you help reconcile those two data points?

And then thirdly, back to your favorite topic, Scott, on stock grants.

Your option grants have been 3% plus as a percentage of shares outstanding.

Historically, that's significantly more than most of your peers.

Can you share a perspective on whether you will continue to issue grants at historically similar levels going forward?

We haven't, I'll do that one first.

We haven't formalized through the board what the plan will be for the next fiscal year.

But we've been bringing that number down fairly relentlessly and gradually over the last few years.

Going back a while it was up to 4.5 or 5%, if I remember correctly, during our higher growth years.

And so that number has been coming down naturally and we're looking at other ways to go generate a fair and equitable compensation strategy for our employees that isn't entirely stock-based.

I think you can plan on that number coming down gradually over the next few years.

I think on the channel side, we've definitely seen that business grow year-over-year and certainly seen the interest from the channel pick up.

We've been investing in the channel to make sure that we can broaden the distribution of our products out in the marketplace and again we've just seen heightened interest in the offerings from Sun and that's just continued to grow.

But Jonathan, would that have changed that much sequentially because the observation's a sequential one, which is 4.8 to 5.7.

Yes.

No, it's within normal range.

Yes, Tony that's -- if you look over time, our channel inventory is six weeks or less.

That's our target.

It does vary, trying to match up what's going to be shipped in in the last couple weeks versus what the anticipated sell out or ship out is, is sometimes a little bit of art as well as science.

So that's well within our desired levels.

Not a concern, not an issue on our part.

And on the services, the contracts are up, the number of contracts with the ASPs obviously would -- the contracts -- if you look at the mix of products that I talked about earlier, the shift we've seen from data center and enterprise we're selling a lot more units and we're selling a lot more one- to eight-ways, so the ASP in the contracts would be coming down just naturally.

Also the other -- and it's really hard to analyze.

We're relying on our partners more.

And so the revenue can come down while the margin percentage can go up and our return on assets and return on expenses can go up.

And I think that's why you see a, kind of a flat year-over-year revenue at Sun is, we're using channel partners more aggressively, we're getting more value for our IP and doing less of the non-value add head count activities.

You can see a natural improvement in the return on assets.

And with our cash conversion cycle down to 29, our cash generation capabilities and a higher gross margin percentage in dollars on a lower expense number.

We can actually be quite competitive and quite partnered, even without the kind of historic revenue growth numbers that you've seen in the past.

And we're clearly focused on sell out and sell through and not selling to the channel.

So again, just to the earlier discussion, it's within normal ranges but the interest level certainly from the channels has been growing as we invest more in the channel.

Thank you.

Next question, please?

Your next question comes from Steve Milunovich with Merrill Lynch.

Thanks.

I wonder if you can talk a little bit more about the competitive situation.

It was pointed out that your computer business was down a bit year-over-year and IBM was up over 30% in UNIX.

So you've had Solaris 10 out a couple quarters.

What do you think you need to do to improve your position in UNIX?

Will we ever see Sun gain share again in UNIX?

I think we're gaining actually extraordinary share in UNIX.

It's just happening with the download of Solaris 10 on to 2 million registered licenses out there.

So, I think we're not only looking at revenue we're also looking at total unit volumes out there, because that's a better predictor for us as long term opportunity.

Now what's interesting to us is the volume of Solaris 10 we've seen downloaded on to IBM x64 systems.

And as Scott mentioned, about 75% of the downloads are on to x86 systems and obviously the bulk of those are not sold by Sun.

That's on the Dell, HP and IBMs.

That's a good leading indicator of opportunity out there for us.

But it also suggests that UNIX is broader than simply SPARC or Power or PA-RISC.

Okay, and Steve, do you have any comment on where gross margin might go going forward?

It sounds like you've got a lot of component cost benefit, which may not continue at the same rate.

Yes, Steve.

I don't want to -- I'm not a seer, I really can't forecast where it's going to go, other than to say we work our supply chain, our productivity, our cost efficiencies hard we're very conscious about driving the gross margin dollars up.

And we're going to stay as focused on those as we can be to keep improving and to make it better.

But I'm not -- I can't give you a percentage.

Too many factors in there.

Thank you.

Next question, please?

Your final question comes from Michael Cohen with Pacific American Securities.

Yes, a couple of questions.

The first one is, Scott mentioned he wants to be a consolidator of the industry going forward.

When looking at potential acquisitions, I was wondering if you could talk at some of the main criteria used when evaluating acquisition candidates?

And the second question is, I was wondering if you could give us some general thoughts on the Opteron.

How it's doing for you?

Maybe contrast it with UltraSPARC and Intel.

We're not going to be specific about the areas of acquisitions, but it's got to be a strategic fit.

We're a very focused Company on delivering the infrastructure to deliver web services out there.

We're very focused on delivering the data center resident technology on an end-to-end solution, and so it's got to be a strategic fit.

It's got to fill out a capability that we need, and it's got to make financial sense.

Those are very broad, probably not terribly helpful comments.

But I'm not going to be a lot more helpful than that until after we announce it and then I'll explain why we did it.

My shareholders appreciate that.

And I think an Opteron is actually a good leading example of that.

If you have differentiating technology, you can go make a lot of progress in the marketplace.

I think the idea that innovation doesn't matter and technology is a commodity is kind of behind us now.

And I think as we see the new markets that we're opening up with Solaris 10 or with JES or with Opteron, or our storage products, for that matter, I think we continue to see IP as the differentiator.

We're looking at total server unit volume growth and we delivered that with the combination of x64 and SPARC.

I think going forward, they are going to target different segments of the marketplace.

I think with the Niagara class systems you're going to see us really target through put oriented performance.

And with the Opteron systems we're going to be driving after price performance with some of the requirements and constraints like power really relaxed.

But again, I think we've got differentiated products on both sides.

I think we've seen a definite performance advantage with Opteron against Intel for example.

I think some of the share numbers you saw recently talking about Opteron's gain in the x64 space is being driven, at least in part, by some success in our x64 products.

And we continue to see the server market is growing and vibrant and our ability to differentiate with our IP is critical to it.

Thank you for joining us today.

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