Can Software Stop Sun’s Slide

It’s been a rough year for computer server manufacturer Sun Microsystems
Inc. Its free-spending Internet customers have gone the way of the dodo. The
soft economy has hurt demand across the board.

Most worrisome, it’s losing market share to hard-hitting competitors, such
as Dell Computer Corp. With its troubles mounting, Sun’s stock has plummeted
to less than $5, a 92% drop from its $64 peak in 2000.

So how do Sun execs plan to get out of this pickle? In a word, software.
While a stronger economy will help sales recover somewhat, the company’s top
brass think the hardware giant needs to act more like a software company to
address its long-term challenges. In a move underscoring the importance of the
strategy, Jonathan Schwartz, Sun’s chief competitive officer for the past
three years, took over the newly created position of executive vice-president
for software development on July 1. "Software is right at the center of the
future of this company," says Schwartz.

The software strategy, dubbed SunONE, for Open Net Environment, is designed
to spark sales across the company’s product lines, from servers to
data-storage gear. The idea is to use software, as a Trojan horse to get into
big corporate accounts that will then buy more of everything from Sun. The most
aggressive move is Sun’s decision to give away its entry-level
application-server software, a $3,000-and-up product that handles simple
e-business tasks like e-commerce transactions and runs the software for more
complex e-business functions. Once in the door, Sun figures it will more easily
sell additional software for things like controlling employee access to
networks. That should allow the company to grab a slice of the $28 billion
infrastructure-software market–and sell more hardware. To back up the effort,
the company in May set up a 1,000-person sales and service group dedicated to
selling software.

No question, Sun needs to do something about its sagging finances. The Palo
Alto company’s revenues for the fiscal year that ended June 30 are expected to
be about $12.4 billion, down 32% from a year ago. The company’s gross margins
have slipped to an estimated 40% this year, compared with 54% last year.
Although it is expected to break even in the June 30 quarter–the first time
that has happened in a year– many analysts question whether the economy alone
can spark renewed growth. "Sun has serious, serious technology and
strategic problems," says Bill Whyman, an analyst at the Precursor Group, a
research firm in Washington, D.C.

The company is being squeezed on both sides. Dell is concentrating on
sub-$10,000 servers and has boosted its share of the overall market to 7.4% in
the first quarter, from 5% in 2000, according to International Data Corp.
Meantime, IBM is a strategic threat at the high end because it can offer big
corporate customers complete, easy-to-use e-business systems with hardware,
software, and everything else they need. The result: Sun’s share of the server
market has dropped to 14.9% in the first quarter, from 17.0% in 2000, IDC says.

How will Sun’s new strategy help? At the moment, software accounts for less
than 5 percent of Sun’s overall revenues, according to Whyman, so even
doubling software sales would do little for top-line growth. Still, the
initiative will give Sun a broader product lineup to compete with IBM, and it
could fatten Sun’s profits. Business software carries gross margins north of
80 percent, compared with about 30 percent for most hardware. Doubling software
sales could add about 500 million dollars in gross profit, compared with 200
million dollars for a comparable revenue increase from hardware products. Sun
won’t specify its targets for software sales or hardware sales driven by
software.

For all its grand plans, Sun faces long odds given its track record. As far
back as 1993, Sun was promising to beef up its software business. Since then, it
has repeatedly tried–and failed–to become a bigger player in the market.
"I respect Sun a great deal," says Alfred S Chuang, CEO of BEA Systems
Inc, "But they have never proven they know how to sell software."

The biggest missed opportunity came in 1998. When America Online acquired Net
pioneer Netscape Communications Corp that year, it handed control over Netscape’s
software to Sun, giving Sun the two top-selling application servers at the time.
Although the market was tiny and fragmented among 40 companies, Sun’s 30
million dollar-plus in app-server sales was 10 percent of the total market,
twice that of its nearest competitor.

But Sun blew its lead. It tried to integrate the two application servers,
stumbled, and didn’t get a new product out the door for nearly two years.
Meanwhile, IBM and BEA introduced upgrades at least once a year. As the
app-server market boomed to 2 billion dollars annually, IBM and BEA dominated,
together selling more than half the app servers in the world. Sun is expected to
slip to a distant third this year, with a 12 percent share of the market,
according to AMR Research Inc. That puts it neck and neck with rival Microsoft
and database giant Oracle Corp.

SunONE is an attempt to take at least part of that market back. In May, Sun
started bundling, for free, its application server with its own Solaris
server-operating system. That’s only a first step. Later this year, the
company will offer the free version of its app-server software for Linux
operating systems and other UNIX programs–and, in a move akin to cats living
with dogs, for Windows. "We don’t think is the wisest
move for many reasons," says Schwartz. "But if that’s what customers
want, we’ll make that available to them." Sun says it is more important
to give customers options and compete on a product-for-product basis, rather
than lock them into a permanent relationship. "Our aim is to win with
innovation and quality," says Sun CEO Scott G McNealy.

And a good sales pitch. McNealy has forced Sun’s more than 300
vice-presidents to master Sun’s new message. He has had each one trained to
explain that Sun can offer complete e-business systems, then videotaped them all
giving a three-minute spiel. That should help execs push additional software to
go with its application-server product. Sun is selling integration software that
ties big computer systems together and works neatly with the application-server
software, directory software that controls the identities of people using a
computer network, and so-called portal software that makes it easier to share
information over a corporate network. Finally, by early next year, Sun will sell
two high-end versions of its app server that address specific needs of big
corporate customers, such as ensuring the reliability of their networks.

Sun’s pitch, that it can offer complete computer systems with hardware and
software, is resonating with some customers. They like the idea that one company
can respond quickly to any complaint.

Sun’s plans for the future could really get some attention. The company is
working on software, called N1, which is similar to the concept of grid
computing. Grid would allow a company to collect huge amounts of computing power
by using the Net to tap unused computers around the country. Sun’s N1 software
would enable grid computing so its customers could grab computing resources
whenever they needed them. The first version of N1 is expected early next year.

Put it all together, and Sun execs think they can finally compete for big
software deals. "Do we wish we could have done this faster? Sure,"
says McNealy. "But we absolutely have the right offerings at the right
place at the right time."

Still, Sun has a tough row to hoe in software. Ask competitors what they
think of Sun, and they don’t bristle–they scoff. "I think they’ve
lost their window. They had an opportunity to create a software business,"
says Scott Hebner, director of marketing for IBM’s app server, called
WebSphere. After years of scuffling, this may be Sun’s last shot to prove it
can get software right.

By Jim Kerstetter in San Francisco in BusinessWeek. Copyright 2002 by The McGraw-Hill Companies, Inc