甲骨文 (ORCL) 2008 Q3 法說會逐字稿

Good afternoon.

I will be your conference facilitator.

At this time, I would like to welcome everyone to the Sun Microsystems fiscal year 2008 third quarter results conference call.

After the speakers' remarks there will be a question and answer period.

(OPERATOR INSTRUCTIONS).

Thank you, ladies and gentlemen.

I would now like to turn the call over to Mr.

Ron Pasek, Vice President and Treasurer for Sun Microsystems.

Good afternoon.

Thank you for joining the Sun Microsystems quarterly conference call.

I'm Ron Pasek, Sun's Corporate Treasurer.

With me today is Jonathan Schwartz, Sun's CEO; and Michael Lehman, Sun's Chief Financial Officer and Executive Vice President of Corporate Resources.

The purpose of today's call is to discuss the results of Sun's fiscal year 2008 third quarter, which ended on March 30, 2008.

During the last hour, we published a copy of the operations analysis data sheet with nine quarters of financial and operations information, including the quarter completed on March 30, 2008.

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

We have also posted slides you can view on the Web, which accompany our prepared remarks.

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

After the prepared remarks of our call today, we will devote the remaining time to Q&A.

During the course of this conference call, we will be making projections and other forward-looking statements regarding expected future financial results and business opportunities.

Our actual results may be very different from our current expectations.

We encourage you to read the 10-K's and 10-Q's that we file periodically with the SEC.

These documents contain a discussion of the risks facing our business, including factors that could cause these forward-looking statement not to come true.

We do not currently intend to update these forward-looking statements.

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

Please refer to the [ops] as posted on our Website at sun.com/investors for the most directly comparable GAAP financial measures and related reconciliation.

Now let's go to the financials.

Sun's total revenues for the third quarter of fiscal 2008 were $3.266 billion, a decrease of 0.5%, as compared with $3.283 billion in the revenue reported for the third quarter of the fiscal 2007.

Total gross margin was 44.9% of revenue, an increase of 0.4 percentage points over the gross margin for the third quarter of fiscal 2007.

Total R&D and SG&A expenses were $1.446 billion, a decrease of $25 million year-over-year.

In the third quarter of fiscal 2008, we recorded a $52 million tax provision.

GAAP net loss for the third quarter of fiscal year 2008 was $34 million or a loss per share of $0.04, as compared with net income of $67 million, or earnings per share of $0.07 for the third period fiscal year 2007.

Q3 product revenues totaled $2.003 billion, a decrease of 2.8% year-over-year.

Within products revenues, computer systems product revenues was $1.473 billion, an increase of 1.8% year-over-year.

Storage products revenue was $530 million, a decrease of 5.4% year-over-year.

Q3 services revenue totaled $1.263 billion, up 3.3% year-over-year.

Within services revenue, support services revenue was $961 million, up 1.2% year-over-year.

Revenue from professional services and educational services totaled $302 million, an increase of 10.6% year-over-year.

We ended the quarter with cash and marketable debt securities balance of $3.801 billion and generated positive cash flow from operations of $329 million.

During Q3 '08, we repurchased 17.5 million shares of our common stock, which equates to $300 million.

Shares were repurchased at an average price of [$17.16].

There our currently $500 million of the $3 billion share repurchase program we announced in Q4 '07.

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

Great.

Thanks, Ron.

First, let me start with the obvious.

Our third quarter was challenging one, in which U.S.

macro factors impacted our overall performance and really overshadowed the progress we've made in other parts of the world.

Our teams delivered growth in 12 out of 16 selling geographies during the quarter, with double-digit performance in a number of emerging markets.

That being said, I'm disappointed and I'll spend time today talking you through various factors that came into play throughout the quarter that caused us to come in below our own expectations.

I'll then turn it over to Mike, who will walk through the various operational adjustments we'll be making to best position Sun for efficiency and growth moving forward.

To start, I want to recognize that it was a seasonally challenging quarter.

This was expected.

However, in addition, during March, we saw a substantive change in U.S.

sentiment, along with change in orders mix and closings.

With purchase decisions postponed on the basis of macro economic uncertainty.

In terms of the U.S.

vertical performance during the third quarter, our financial services business, specifically in the Northeast, was solid and on plan.

While the majority of weakness came in our government vertical, as well as industries with significant consumer exposure, including retailers and the telecommunications sector.

Collectively, this slowing had the most pronounced impact on the higher end of our system-product sales, from high end tape libraries to enterprise servers.

The net result was a gap in U.S.

performance, which given its prominence in our overall business, typically around 40% of total revenue, had a significant affect on our overall results.

as Mike will review in a moment, we're going to be making some prudent steps to adjust our spending profile, positioning us for continued profitability and again, improving financial performance.

It's important to note, we're continuously making choices to align strategically, geographically and operationally, with our plan for long-term growth this year will be no different.

Turning our to progress in the quarter.

We continued to see the market align with our investments around high-performance computing, open source innovations, eco-efficiency and most importantly, on using technology and network computing as a source of competitive advantage.

As I mentioned earlier, we continue to see very strong growth in key markets outside of the U.S., namely across EMEA, Asia Pacific and the international Americas.

More specifically, we see the emerging markets across these geographies as key components to our growth strategy, as evidenced by 20% year-over-year growth in Brazil.

30% year-over-year growth in India.

8% growth in China.

Growth in Korea and Russia.

And 18% growth in the Middle East, Africa and eastern Mediterranean region.

We're committed to making the necessary investments to support and fuel the momentum we see driven by our open source platform from MySQL to open Solaris, to our newly announced open storage platforms, alongside our ultra-efficient Niagara and x86 system.

Turning to products, those Niagara platforms once again grew billings at an impressive clip of 110% up year over year to approximately $300 million.

As productivity and efficiency remained among the highest priorities for our customers across the world.

Our X86 systems business also continued to advance and we're seeing strong growth in our Blades platforms and wins in the burgeoning high-performance computing sector.

Our disc space storage business was up 6% within the quarter.

And although we saw declines in libraries and high end storage systems, we have a great variety of new open storage innovations to deliver to the market within the next few quarters.

Leveraging our open source [DFS] system to deliver differentiation, performance and efficiency to a market we've historically been unable to reach.

As for a few other highlights during the quarter, we signed a landmark collaboration agreement with the People's Republic of China, Ministry of Education to cultivate integrated circuit engineering talent and industry development based upon our open source silicon platform.

This endorsement will introduce a generation of Chinese students to Sun and our innovation, while providing China with the foundations of its own indigenous microelectronics capabilities.

Secondly, we announced an award from the Defense Advanced Research Project Agency, know as DARPA, for research focused on microchip inter-connectivity via on-chip optical networks, enabled by silicon photonics and proximity communications.

This work will create more opportunity and differentiation for Sun in the construction of very high capability and productivity data center facilities.

And finally, we announced the closing of two critically important acquisitions, furthering our presence in the open source software marketplace.

First, was Innotech, who's virtual box products provide free desktop virtualization, especially to developers with multiple run-time operating environments on their laptops.

And then MySQL, the world's most popular open source database.

The integration of these acquisitions continues to go well.

And with MySQL, in particular, we've found enormous receptivity to the technology and value proposition from among a broad spectrum of our customers who are already signing Sun services agreements.

Just a sampling of these customers, ranging from Web2.0 startups to large enterprises, companies include Thomson Reuters, [Classes] Direct, Newforma and ScienceLogic.

I'm also pleased to report that the MySQL team has performed on behalf Sun from the minute we closed the deal this quarter.

In closing, although this was a tough quarter, considering the various factors I just reviewed, we feel the opportunity before us remains as strong as ever.

From providing the world's first open-storage platform, to deliver solutions based on the number one open source database, and continuing the ramp of open Solaris on Sun and un-Sun hardware, we remain confident in the durability of our business and our ability to improve operational discipline and in the important product and go-to market investments that we're making.

With that, I'd now like to pass it over to Mr.

Lehman for more details and specifics on our results and a detailed look at the cost structure initiatives underway.

Thanks, Jonathan.

I'm going to provide a bit more detail about our Q3 results, but also talk about our current view of Q4, and the steps we are taking to enable us to make improvements in our business during next fiscal year.

As Jonathan mentioned earlier, our revenues came in substantially less than we had expected.

This quarter's results truly reflect that one major geography, the U.S., did not meet expectations.

At our analysts' meeting in February, I stated that we expected revenue growth in the second half of this fiscal year of at least 5% and that we did not expect all of that growth to occur in Q4.

During the first week of March, we began to get signals from our larger U.S.

channel partners that they were not seeing the sell-through of products that they had expected.

In each of the remaining weeks of March, we experienced a significant number of deferrals of purchases from many of our large U.S.

end user customers as well.

As a result, the U.S.

revenues decreased approximately 10% during Q3 on a year-over-year basis.

With the U.S.

traditionally being approximately 40% of our business, we were not able to offset that decrease by the growth in the remaining geographies.

We do not believe that much of this business was lost to competitors, as many of the deals and projects that we were tracking are still active in our pipeline today.

However, our experience with such deferrals is that they don't all come back immediately and become additive to the next quarter.

The overall revenue decrease in Q3 was experienced in both computer systems and storage.

In systems, the shortfall was most noticeable at the high end of the product line, in storage, the shortfall was principally in the high end tape, library and drive products.

In fact, both computer systems and storage missed our internal expectations by roughly the same amount, more than $100 million each in the quarter.

The fact that the shortfall was in the higher end of both product lines is the principal reason for the sequential drop in products gross margin, which was 3.6 points percentage decrease from Q2 to Q3.

Our services business, despite challenges associated with the implementation of new systems for quoting, billing and managing support, essentially met our expectations from both a revenue and margin standpoint.

There are always difficulties when bringing up new systems and this was no exception.

Our professional and educational services practices, which principally assist customers with the design and implementation of Sun-based intellectual property, showed good year-over-year revenue growth in Q3, more than 10%.

At the highest level, even with Q3 revenues that were more than $200 million below our internal expectations, and a pronounced mix shift towards the mid-range and lower-end product sets; we improved our product gross margin slightly on a year-over-year basis.

Our services margins are quite volume sensitive and we also delivered a modest improvement in year-over-year service gross margins in Q3.

As we said last quarter, currency continues to provide a positive impact to our EMEA and APAC based revenues, as the U.S.

dollar continued to weaken.

Generally speaking, our results include some benefit from exchange rate movements in both the revenue and gross margin lines.

As in the past, such benefits are largely offset by the negative impact of such currency movements on our operating expenses, as local-currency-based expenses are converted to U.S.

dollars.

We also continue to make progress towards another longer-term goal.

that of a more durable and predictable business model.

An increasing amount of deferred revenue is the proxy for that goal, as it provides a stable base for future quarters' results.

In Q3, deferred products revenue increased by approximately 28% on a year-over-year basis.

This primarily reflects the timing of installation and/or acceptance of a broader set of products, which often has ancillary benefit to us in terms of additional professional services.

Our deferred service revenue was down 1% on a year-over-year basis in Q3.

This is one area in which the system conversion did have a nominal impact on our balance sheet.

Due to the timing of receipts of a number of purchase orders late in the quarter, we were able to process only a portion of the service contracts for these customers.

We were able to record the appropriate amount of revenue for the quarter but were unable to record the entire value of such contracts, which would have been deferred revenue.

We expect that these contracts will be fully processed in Q4.

The amount of unbilled and deferred revenue associated with these contracts at the end of Q3 was not significant.

Turning to operating expenses.

Total R&D and SG&A expenses were down $25 million in Q3 on a year-over-year basis.

This is due to continued savings from real estate consolidations, reduction of certain incentive payments and a variety of other factors.

I would point out that headcount is up approximately 1,100 sequentially.

We added approximately 600 people from the acquisitions of MySQL, Innotech and Vaau.

And as we had previously indicated, we believe we have opportunity to grow revenues in a number of emerging markets, and accordingly have added approximately 300 people in our global sales organization.

Additional headcount was added in engineering and IT.

We will continue to hire in areas where there are near-term growth opportunities, as well as where we can find and when we can find key engineering skills.

I would like to summarize the impact of the MySQL acquisition on the results of the quarter.

As most of you know, this transaction closed in late February.

Our income statement reflects the results of the revenues and operating expenses of that business, as well as a one-time charge for in-process R&D of approximately $22 million, as well as one month's amortization of certain acquired intangible assets.

In short, as we had expected, the overall impact of this acquisition on our Q3 income statement was a decrease of approximately $30 to $35 million of net income, or approximately $0.04 per share.

From an integration standpoint, things are going well.

Our teams are operationally connected already and customer response has been great.

In Q4, the impact of MySQL is currently estimated to be in the same overall range as in Q3.

This will reflect the near term full quarter impact of the stand-alone business and ongoing amortization.

In Q1, we began reporting a non-GAAP measure that we entitled adjusted EBITDA.

We believe that it is important to look closely at our Company's fundamental value, in addition to ways reported under generally accepted accounting principals.

The principal measure that we use at Sun is adjusted EBITDA, as that measure more effectively depicts the cash generating capability of our quarterly results.

During Q3, our adjusted EBITDA was $230 million or 7% of revenues, an increase of 7.5% on a year-over-year basis.

Looking at Q4 and beyond, there are a number of factors that we are looking at.

We continue to focus on revenue growth as a top priority and we are taking action to improve the level of profitability.

In Q4, we intend to take a restructuring charge between $130 and $220 million.

The actions include a reduction in force of approximately 1,500 to 2,500 people.

We expect that this will result in a more efficient coverage model, with the resources aligned to growth opportunities, as well as a more focused and effective demand creation capability.

We expect that this restructuring will lower our annual operating expenses by approximately $100 to $150 million on an annual basis.

We expect the majority of this run rate benefit will be reflected in our income statement by Q2 next fiscal year.

Given our Q3 experience in the U.S., we have revised our view of Q4 revenues.

There still appear to be a number of customers who's spending plans are uncertain.

We now view that our Q4 revenues will be roughly flat on a year-over-year basis.

We still plan to complete the conversion of a number of our EMEA channel partners to sell out, as we did with our U.S.

and China partners in Q2.

The impact of that change, which will be in the range of a $20 to $40 million reduction in revenues in Q4, is contemplated in the above statement.

We do expect a sequential increase in gross margin for both products and services due to improved mix and volume respectively.

Excluding the impact of MySQL and the restructuring charge, we expect to be solidly profitable in Q4 at the revenue level noted above.

Our previously-stated guidance ranges for the full fiscal year 2008, for R&D SG&A of $5.7 to $5.9 billion; stock-based compensation of $215 to $240 million; amortization of intangibles to $250 to $300 million; and a tax provision of $200 to $250 million are all still in effect.

Net interest income is now expected to be $150 to $170 million for the full fiscal year 2008.

As we look at next fiscal year, the same uncertainties are on our minds.

We had previously stated that we were targeting, prior to the MySQL acquisition, a GAAP operating income of at least 10% next fiscal year and we're targeting a 9% level after this acquisition.

As I spoke about this, I articulated that we were basing this on a combination of revenue growth, gross margin expansion and operating expense reduction.

It is clear that the single biggest inhibitor to our ability to achieve such results is in fact what we are seeing now, a major economy in some difficulty.

We believe that we are on the right track, we are making the right investments and disinvestments and plan to improve our profitability next fiscal year on an annual basis.

At the highest level, we intend to grow our revenues, maintain annual gross margins and reduce both R&D and SG&A in absolute dollars next fiscal year.

We intend to capitalize on the previously identified opportunities to grow our business due to the acquisition of MySQL.

We are currently targeting a GAAP operating margin, including the impact of MySQL, of at least 7% in FY '09.

In our June quarter conference call, we will talk more about next year but I wanted to at least give you a sense of where we were headed at this time.

With that, I will turn it back to Ron.

Thank you, Mike and Jonathan.

I need make one correction, computer systems product revenue was $1.473 billion, it's a decrease of 1.8% year-over-year.

Before we begin the question-and-answer session, I'd like to request that each of you ask just one question, consisting of one part.

This way we hope to get through most of the questions in queue today.

If there's time remaining, we will be happy to take your follow-up questions.

Operator, will you please start the question-and-answer session?

(OPERATOR INSTRUCTIONS).

We'll take our first question from Richard Gardner from Citigroup.

Thank you very much.

You talked about the weakness primarily being in the United States but Europe also experienced a pretty sharp deceleration in local currency.

And all of the signs from your distribution partners point to further deceleration in Europe.

So I'm wondering if you can talk a little bit about what you're seeing in Europe?

Whether you have seen any slowdown in business there toward the end of the quarter and what you think the outlook there is for the next quarter or two?

Thank you.

Richard, this is Jonathan.

For the most part, we haven't seen a similar slowdown or anything even close to what we saw in the U.S.

Interactions with our partners and customers from Europe has been as strong as ever.

Again, if anything they're probably a little more focused on energy efficiency and moving toward open source.

And so I think we remain pretty confident and pretty optimistic about the opportunity in Europe.

Operator, next question?

Our next question comes from Shannon Cross of Cross Research.

Hi, yes, good afternoon.

Can you talk a little bit more specifics about the restructuring?

Where you're targeting, how you think it will roll through?

Anything you can give us just to give a little more clarity since you've obviously been restructuring for awhile.

How you can do this without really impacting your growth revenue opportunities more than they're being impacted right now from the economic standpoint?

So it's Mike Lehman.

And has Jonathan mentioned up front, we are always looking at ways to invest more effectively and disinvest where we can.

And generally speaking, the disinvestments that we will be making will be in areas that we believe will not have an impact on near term and longer term revenues.

So it's not like we haven't been thinking about this, we have been talking about for years the overall intention to reduce absolute dollar R&D and SG&A expense.

There are lots of ways to go and do that.

We have ongoing programs to do that.

And in particular, this particular time around, we are targeting the reductions where we believe there will be not near term impact on revenues.

And maybe just to piggyback on that.

In some of the decisions we make, we decide to concentrate on one investment, rather than two and -- but use that initial investment to go into both markets.

So the example would be, we recently announced a full line-up of open source storage platforms.

Those are now built off of entirely the Solaris operating platform, leverage the open source DFS file system.

So on the one hand we took R&D down, as we removed some of the proprietary technologies that preceded that decision.

But on the other hand, we can now take Solaris, which was historically vectored at computers and begin to use it to build out our storage business.

So that's an an instance, obviously, of doing more with less.

And again, I think that reflects the priorities we hear from our customers, as we move away from proprietary technologies and really begin to eliminate their usage inside of Sun or across the product line, we see our customers doing the same thing.

Operator, next question.

Ben [Risis] of Lehman Brothers, you may ask your question.

Yes, good afternoon.

Could you talk a little bit more about your product line and it's just -- perhaps you saw some weakness at the high end, et cetera?

How do we know it doesn't get worse in this economy?

IBM has a couple of new products coming out or already out and it's increasing competitiveness.

Can you just give us a better feel or why it might not get worse at the high end before it gets better and your confidence?

Yes, Hi, Ben.

Hi.

We're seeing a couple of things.

One, customers are clearly using small numbers -- sorry, large numbers of small computers to replace the need for very large computers.

And that's why we saw our Niagara business grow as rapidly as it did.

And there really is no analogy in our competitors' product lines for what we're doing with Niagara.

It's a -- an eight-core, eight-thread chip, It's the equivalent of a 64-way piece of silicon.

And that obviously allows us to achieve levels of efficiency that our peers can't.

And again, I think that's reflected in the growth.

Secondarily, we actually feel quite good about the competitiveness of our high end.

And some of the decisions we saw in the third quarter were decisions to push out revenue into the fourth quarter.

And we've seen some of those decision now closing in the fourth quarter.

So, we were very careful to go look through and see, are these competitive issues?

Are these distribution issues, are these economic issues or execution issues?

And in every event that we could identify, they were decisions based on; I think I'll exercise some caution and just put off the decision and see how things turn out.

Not surprisingly, there was a notable investment bank on the East Coast that found itself being sold to another investment bank.

Around the time of that transaction, we saw a lot of people wondering what was going to go on in the economy.

And again, there's some level of anxiety building up to that but we see some lightning of that.

And again, we feel very, very good about the competitiveness of our APL product line and the high end in general.

The same thing, by the way, applies to the tape platforms.

Next question.

Our next question comes from Jeff Fidacaro of Merrill Lynch.

Yes, I was wondering if you can give us a little more color of -- the revenues are looking flattish into the fourth quarter, how the regions are looking within that guidance?

And if you can talk a little bit more about some of the deals that got pushed out, via tax rates and the impact there?

So it's Mike Lehman.

And I'm not going to give a forecast by the 16 geographies.

But it's a pretty clear at the highest level, we expect that the U.S.

would still be down slightly year-over-year.

We don't expect it will be down as much as we saw in Q3.

But we still expect, as we look at the overall plat number, the U.S.

would be down a bit, offset by the growth in EMEA and APAC.

And clearly, many of the deals that we're talking about have systems and storage associated with them, absolutely.

They're not separate deals.

The fact that the two numbers were relatively close to each other is not just a coincidence.

There are a lot of them that are linked, that are systems and storage, when I talked about the shortfall.

But they are not all one-for-one but clearly, there's a lot of affinity and a good attach rate.

And I think, just along side that, and just to make sure everybody is aware of this, it's going to be increasingly difficult for us to talk about attach rates, when what is a storage device are exactly the same components and exactly the same operating systems that are used in building out our servers.

So the industry is converging.

We're one of the drivers of that convergence.

And going forward, we going to be clear about what our overall revenue is and using the intellectual property we have to enter as many markets with that common platform.

Thank you.

Next question.

Thank you.

Our next question comes from Andrew Neff of Bear Stearns.

Andrew Neff, you may ask your question.

Our next question comes from Katie Huberty of Morgan Stanley.

Thanks, good evening.

Mike, can you go back over why product deferred revenues grew so much, given the marked slowdown you saw late in the quarter?

And maybe touch on what you've seen in terms of the deal closings so far in April?

Yes, so again, the growth in product deferred revenues, we've seen actually continue fairly strongly in the last year.

And it is really is a reflection of the packaging of products and services that customers want.

And again, as you saw with our professional services revenue growth of more than 10%, we are participating in the design and build-out of data centers with our customers.

And so there's often a combination of hardware and professional services that results in a longer time for implementation and acceptance.

And that's what we're seeing.

And then, again, I think Jonathan touched on it a bit, we were tracking a pipeline in Q3.

A lot of the deals are still there Some of those have closed but as I said, I don't think it's prudent to assume that all of the deals that got pushed out are going to close in this quarter and then necessarily become additive to the prior run rate.

Which is why we're -- we think prudently just looking at the overall number in Q4 to be relatively flat year-over-year.

And just for a little more insight on the deferreds, we obviously have looked at what's the calendar and the time frame within which we expect those deferreds to convert to revenue.

We've also looked at the overall mix of the deferreds and it tends to be higher end systems and richer configurations because they're parts of higher-value deals.

So again, that's just a little bit of insight into what the future holds for us.

Next question, please?

David Bailey of Goldman Sachs, your line is open.

In addition to the macro environment, could you please give us an update on what's going on in the competitive front?

I think you had said that you didn't move any share but IBM was up 2% in their Unix business this quarter and you were down 2%.

So, if you could give us an update there, it would be great.

You bet.

I don't really know how IBM counts because I think people looked at iSeries as being off, I think, it was 20%-plus.

And it so it's really tough to get it on a unit-by-unit basis.

So, I think the one geography in which we tended to struggle was the U.S.

And again, I don't know how IBM breaks out U.S.

hardware performance specifically, that might be an interesting question to ask.

But broadly speaking, we've seen endorsement and growth in the Solaris platform.

That's both on our own hardware, as well as in the markets that our partners are creating.

And we've continued to sign up OEM's for Solaris.

And the fact that we have an open source operating system really doesn't have an analogy with most of our peers because they don't have operating systems in the open source community.

And I think in terms of the share we're gaining on the Niagara front, we were up 100% year-over-year.

And I think it would be interesting to look at how you measure that.

I think we tend to measure it on the whole and just see ourselves competitively as placed somewhat uniquely, with a very attractive open source operating platform.

And again, one that we can use to enter not only new areas of the server market but we can begin to much more aggressively push out into the storage markets.

Next question, please.

Andrew Neff of Bear Stearns, your line is open.

I wanted to go back to the guidance you were giving.

In the prior -- the last couple of conference calls, you sort of talked about that you would get to the margin guidance and you would take steps, as I recall, to get there regardless.

And now, you seem to be saying, "Well, the economy is what it is.

We just have to bring the guidance down." Why can't you pull additional leverage to get -- to stay with the margin guidance that you gave before?

So I have talked about this long and often and probably in every meeting that I have been in.

And the good news for me is that I keep track of what I say and I have other people help me keep track of it.

I have consistently stated for the last couple of year, that in order to hit the 10% operating income, we needed reasonable but not dramatic revenue growth.

We talked about that being low to mid-single digits for a couple of years, compounded.

That's a big factor.

And while we have made tremendous progress on the gross margin expansion and we will take further action to reduce our operating expenses, at the end of the day, and I have been very clear and consistent about this, meaningful revenue growth for a couple of years compounded is a principal driver.

And absent that, it's going to be very, very difficult.

Because we don't want to make short-term choices to just hit an arbitrary operating income goal that would impact the longer term health of the business.

Next question, please.

Keith Bachman of Bank of Montreal.

Hi, Mike.

I wanted to ask a question about gross margin.

You mentioned that mix negatively influenced gross margin.

Given how you described the environment, as well as the strength in Niagara, will mix continue to be head wind as you look out over the next couple of quarters on gross margin?

And I also just wanted to sneak in, if you could give us your views on what you think FX did for you on an annual basis?

Thanks.

So, I'm not going to say anything more than about FX than I have already.

It's not a science in calculating that.

Because the principal thing that FX doesn't take into account is pricing actions and the mix of the products.

So it has a minor impact on revenues and margin positive.

We can see the negative impact on expenses and net-net, it's not a huge number in our overall P&L.

And in terms of the mix, again, many of the customers that we were tracking in our pipeline are the types of customers that were buying the high end systems and tape platforms.

We do expect that a number of those and many of those deals are really pauses and deferrals, as opposed to the fact that they went away.

So we expect that we will see a rebound in the mix.

We typically see a rebound in the mix in the fourth quarter as well.

So some of it's historical but a lot of it is just based upon the deals that we're tracking.

Next question, please.

Next question comes from Lou Miscioscia of Cowen and Company.

Thank you.

If we could just focus more on the product and maybe also on sales, in the sense of, it's been five quarters now where the high end really hasn't really lived up to, I think, the expectation.

I know you have these APL servers out there.

But do you really have to accelerate bringing rock until you sort of get to that or is it really going to be just meandering?

And then alternatively, with -- realize obviously, you're doing very well with Solaris and Niagara but do you have to do something to really get outside of the install base to really sell some more of your high end products to other accounts to get the revenues growing again?

In Q1, 2008, this is Jonathan, we were -- the high end up 24% year over year.

Q2, we were up 8%.

This year, I think we're down.

So it tends to be a pretty lumpy business.

But we're pretty pleased with the performance.

And again, the fact that we have such a large Solaris community to draw from really helps to drive the competitiveness of the platform.

So, we feel pretty good about the high end and our high end is only improving, as we speak.

Now simultaneous to that, we are definitely building our Solaris business outside of our hardware business.

As you know, Intel signed on as a Solaris OEM, DELL signed on as a Solaris OEM and IBM is also now a Solaris OEM.

And we continue -- in fact, we recently signed another systems vendor as an OEM and we continue to work with customers and partners across the world to bring Solaris to every platform on which they run.

And now increasingly, with DFS again, on their storage devices.

So, I think broadly speaking, we're pretty happy with the adoption of the operating system on and off Sun.

In terms of high end opportunities, those aren't going away.

Typically, horizontally scaled systems tend to scale vertically, which is just a polite way of saying when you end up with 500 servers, sometimes they end up with 500 two-ways and 500 four-way.

And then, you end up thinking maybe SMP's are a good idea.

So, we're pretty comfortable.

Next question, please?

Your next question comes from Toni Sacconaghi of Sanford C.

Bernstein.

Thank you.

Mike, I just wanted to follow up on your comments around guidance for 2009.

You and Jonathan had stated right from the beginning that your goal was to set objectives that were achievable and to meet them.

That was basically what you wanted to do.

When pressed on the guidance for 2009 and the 10% operating margin, you basically said, "Well, there were conditions around our meeting that and those conditions don't hold any anymore.

So that guidance doesn't really live up anymore." Can you reconcile this notion between setting targets that basically you're saying we are going to hit and that being a philosophy of yours and Jonathan's?

And accordingly, how do we think about your now fiscal year '09 guidance of 8% operating margin?

Is that also predicated on certain conditions and what kind of confidence can we have on those conditions?

So, Tony, it's Mike.

It's a fair to say that we're disappointed that we're not able to go after the operating income targets that we set a couple of years ago.

We do believe that is largely driven by the U.S.

economy and what's going on in the economy.

We are not the only Company affected by that.

We believe that it's a fairly significant impact and that it would be damaging to the long-term health of the Company to take arbitrary action just to hit that number.

So we believe that in the circumstances, and by the way I previously described those circumstances, that if the macro economic factors went against us, that that might cause us to revisit this area.

So that's in fact what's happened.

So while we're disappointed, we believe it's more prudent to take this action than set new goals for next year, so that people have a sense of how we're looking at the business.

Next question?

Your next question comes from Bill Fearnley of FTN Midwest.

Mike, if I could ask another follow-up question on the restructuring here.

How much of it is outside the U.S.

and does that delay the timing of the actions and the progress?

And to your earlier comment, if the economy does improve, would your restructuring guidelines here -- would the cutbacks get smaller here over the next couple of quarters, if you saw a recovery?

So as we look at the areas that we're investing and disinvesting, when we make an announcement like this, we intend to make the disinvestments.

Certain of the people affected are outside the U.S..

We will know better about that early next quarter.

At the highest level, there's a pretty good -- a better than a majority that are in areas, and that's why we said we can record the majority of the restructuring charge in Q4.

Next question?

David Wong of Wachovia, you may ask your question.

Thank you very much.

When you were -- I think you said services were pretty much in line with expectations but hardware was quite a bit short for the quarter.

Is there a different customer mix that leads to these results or it is the same people who are finding that they need services but less hardware?

No, this is Jonathan.

Typically what happens is you -- services tends to be a recurring revenue stream, which is on the one hand sensitive to unit volumes going out the door because people have the opportunity to buy services on new systems.

But also, there is that tail to that business because they have an existing install basis systems and they don't want to let them fall out of service or cease being current.

So, this was what we expected when we began to see the decline, which was that the services business would be more predictable and less bumpy than than the sale of new systems.

Next question, please.

Our next question comes from Chris Whitmore of Deutsche Bank.

Thanks, good afternoon.

When you see sharp slowdowns towards the end of the quarter, the channel tends to get caught with excess inventory.

Some contacts have suggested that is the case and there's too much Sun inventory out there in the channel.

Can you comment on channel inventories in both the U.S.

and Europe as you exited the quarter?

Thanks.

Yes, it is Mike Lehman again.

And the good news for us is we have been working very closely with our channel partners over the last six months, nine months as we've talked about, so that we can improve our ability to ship predictably on time with minimal lead times.

And therefore, they have been able to lower the amount of inventory that they have.

And as I mentioned, we have gone to sell-through revenue recognition in the U.S.

and China, We'l' move to that in most of EMEA by the end of Q4.

And so, our view is that frankly the channel inventories are low, continue to be low at reasonable levels, and that's been an effective partnership.

Next question, please.

David Bailey of Goldman Sachs.

I just wanted to follow up on that, with your internal inventory.

It was quite a bit sequentially and I was wondering if you could talk a little bit about the composition, and whether you'll be able to work that down in the fourth quarter?

Yes, it's Mike Lehman.

The answer is yes, it was up a bit sequentially.

That was -- in our view, as I mentioned, we had a revenue shortfall.

We were building inventory for that revenue.

We expect we'll be able to work through that revenue in the fourth quarter with no noticeable impact.

Next question, please?

Our next question comes from Keith Bachman of Bank of Montreal.

Hi.

Thank you for take my follow-up.

Two things on the restructuring, Mike.

Again, I wanted to go back to where the people are coming from because I didn't hear the answer to that?

And then secondarily, if you're taking, I think you said 1,500 to 2,500 people out and expect savings of $100 to $150 million, that seems like a low ratio in terms of the benefit per person.

So again, I am not going to attempt to quantify by geography.

There will be a significant number that are in --.

Not by geography, Mike, I was just thinking about R&D, sales, admin, any kind of categorization by functional area.

So, what I've said, is we're going to take down total R&D spending and SG&A spending.

Some of that will be because of headcount reductions.

Some of it will be programs, as Jonathan alluded to earlier.

So we're not going to, again, forecast a breakdown by function.

Next question, please.

(OPERATOR INSTRUCTIONS).

We'll now take our final question from Bill Fearnley of FTN Midwest.

Yes.

Thanks for the follow-up.

Jonathan, in the past, you've talked about customers replacing existing systems with larger systems during projects like virtualization.

Is that still true?

And what did you see for the trend on the quarter just past and what do you see here for the near-term trend as well?

Thanks.

That is still very much true.

We saw actually outstanding growth on our Blade business.

We saw very good growth on more richly configured Niagara 2 systems.

Again, those were really quite highly in demand.

And so, in some ways, it comes down to your definition of; What's a big system?

With the evolution with of Blades, you can get 48 blades in one rack.

Are they small systems or is that a big system?

So, I -- we still see that trend toward higher value systems and more richly configured systems, as continuing unabated.

I don't think that, frankly at this point, is ever going to slow down.

So we see ample opportunity, not only on the systems front and the store age front, but again, the good news with working in the open Solaris community is the kernel at the heart of Solaris knows that it's scaled to the tallest mountains and biggest systems.

So we can provide an operating system for folks' laptops, for their storage platforms, for their systems platforms, for small systems and big systems alike.

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