Sun A CEO's Last Stand

Talk with ever-voluble Sun Microsystems CEO Scott McNealy, and you may hear
one of his favorite quips: "Conventional wisdom doesn't contain a whole
lot of wisdom." He believes it because of his own experience. Consider
1995: All of Sun's competitors - Hewlett-Packard, IBM, and Digital Equipment
Corp. - were busy developing new servers to run the next version of Microsoft
Corp.'s Windows software. Wall Street pundits begged McNealy to show some
common sense and do the same. But he refused, instead cranking up his investment
in Sun's own software, called Solaris. What happened next made McNealy look
brilliant. Rivals couldn't match the speed, reliability, and security of Sun's
servers. As the tech boom took off, Sun's boxes became the must-have gear for
thousands of Internet startups and financial firms. Sales soared; profits
exploded.

Six years later, as the boom of the late 1990s came to a crashing end, Wall
Street had more advice for McNealy: Batten down the hatches for the storm ahead;
slash research; lay off staffers; and get serious about low-cost products. Once
again, McNealy held his ground. But this time, he was dreadfully wrong. Sun's
sales have tumbled 48% in the past three years, it has lost a third of its
market share-and it continues to head south even as its rivals ride the
economic recovery. Its stock, which reached $64 in 2000, trades at about $4. No
other major player has been weakened as much during the tech downturn.
"Right now it looks pretty grim," says Geoffrey A. Moore, author of
several tech-industry books, including Crossing the Chasm.

It's a classic management tragedy, and to a striking degree the
responsibility lies with the 49-year-old McNealy. His greatest strengths-the
uncompromising determination, sharp-tongued irreverence, and unblushing idealism-turned
out to be critical flaws. Through interviews with 38 current and former Sun
executives, including nine departees on the record, BusinessWeek has learned
that as Sun's situation deteriorated, McNealy was bucking not just the counsel
of outsiders but also that of his own lieutenants. After the tech industry went
into its long slide in late 2000, virtually his entire management team,
including Chief Scientist Bill Joy and President Edward J. Zander, pleaded with
McNealy to scale back his vision and adjust to meaner times.

Time and again, McNealy refused. An economics major during his days at
Harvard University, he was convinced that the economy would snap back quickly
from its slump, insiders say. Plus, he believed that the Net was so critical to
companies that they couldn't hold off buying gear for long. "The Internet
is still wildly underhyped, underutilized, and underimplemented," he said
in early 2001. "I think we're looking at the largest equipment business
in the history of anything. The growth opportunities are stunning."
Preparing for the next upturn, he felt, was much more important than whittling
expenses for a brief lull.

'I'm Not Going Away'

As the tech wreck went from bad to worse, McNealy's contrarian instincts
kicked in. After all, he had been right to ignore the consensus within Sun's
ranks before. In the 1980s, he overruled execs who were skittish about dropping
Motorola Inc.'s microprocessors for chips developed by Sun-a move that paid
off in a big way. This time, as his team urged him to cut back, he felt the
stakes were even higher. He was determined to fight off what he thought were
short-term thinkers, particularly on Wall Street, so that Sun could be preserved
as an innovative force. Although he had thought about quitting during the boom,
McNealy recommitted himself to Sun in late 2001, convinced that his credibility,
experience, and sheer nerve were what the company needed during its darkest
days. "I'm here, and I'm not going away. This is a really tough
situation, and we're going to get through this," he told staffers at the
time, according to former Executive Vice-President Larry Hambly.

It would be nice to think that McNealy was doing the right thing. After all,
here was a chief executive who was taking the heat to protect his employees,
fund R&D, and plan for the long term. Alas, it was not to be. He badly
underestimated the severity of the downturn and dismissed customers' desire
for low-end servers. As time wore on, the losses piled up, and McNealy's
high-minded resolve began to look to others like simple-minded obstinacy. One by
one, his team lost faith and departed. All told, almost a dozen of McNealy's
most trusted lieutenants have left over the past three years, including Zander,
Joy, and John Shoemaker, chief of the server business. Like many others, Masood
Jabbar, Sun's longtime sales chief who retired in 2002, says he admires
McNealy's courage. But the standoff became counterproductive. "The fight
just didn't seem worth it anymore," says Jabbar. "It was an
untenable situation."

Clouds over Sun
If Scott McNealy is going to turn around Sun, he has much to fix. Here are his challenges and solutions:
Â		THE PLAN	PROGNOSIS
	Invasion of the Low-cost Computers: Customers have been dumping Sun's pricey homegrown computers for cheaper models based on Intel chips and nearly-free Linux software.	THE PLAN After many false starts, Sun says it's getting serious about the "Lintel" threat. New models equipped with Intel-style chips can run Sun's Solaris, Linux, or even Windows software.	Sales of the new products helped drive 20% unit growth in each of the last three quarters, but they're cannibalizing Sun's more lucrative models. With Sun's heavy R&D load, it will have a hard time competing with Dell's efficiency or IBM's scale.
	The Innovation Drought: Sun won over corporate buyers with visionary products like its Java software. It hasn't advanced its technology enough to stop customers from jumping to low-cost alternatives.	On the high end, Sun is betting on "throughput computing" machines that handle dozens of tasks simultaneously. It's also working on innovative lowend models that include networking features.	Throughput computing is the future, but Sun isn't alone. Intel is working on a similar plan, and IBM may beat them both to market next year. The plan for lower-end models is promising. The question is whether customers will pay any premium.
	The Missing Software Business: Sun has tried to move beyond its Solaris operating software to sell other kinds of Net infrastructure programs. Yet software still accounts for less than 10% of revenues.	Sun has forged its many pieces of software into one integrated package, and offers a $100-per employee annual licensing plan that is cheaper and simpler than rivals' offerings.	Sun remains a distant fourth in corporate infrastructure software, and companies are reluctant to swap their existing programs for a Sunonly approach. Plus, software partners such as BEA and Veritas resent the competition.
	Bloated Cost Structure: McNealy has cut his workforce by 28% in the past three years, but that's far short of the 48% skid in sales. Sun also spends fully 17% of its revenues on R&D.	On April 2, McNealy announced 3,300 job cuts. And Sun is forging development partnerships with Intel, AMD, and Fujitsu for chips and Hitachi in storage.	There may be more cutting to do. While the belt-tightening moves could cut yearly costs by $500 million, Banc of America Securities estimates Sun will have to up sales by more than 13% to break even. Yet most analysts expect flat sales.
	A Damaged Culture: For nearly two decades, Sun was admired for its aggressive salespeople and innovative engineers. But now some insiders say a riskaverse, survival-first attitude has taken root.	Sun is giving extra incentives to the salesforce for selling more than Sun's breadand-butter servers. McNealy brought back Sun co-founder Andreas Bechtolsheim to inspire new design innovations.	Until Sun returns to growth mode and the layoffs end, morale will sag. And Sun has tried sales incentives in the past to spur success in new markets, with minimal success.
	Ongoing Management Turmoil: Once known for its seasoned team, Sun is undergoing its second management makeover in two years. Recent departees include respected services chief Patricia Sueltz.	McNealy has let new President Jonathan Schwartz build his own management team, bumping aside some veteran execs. Others, such as Sueltz, left for new opportunities.	Sun is more dependent than ever on McNealy, while Schwartz' arrogant style and inexperience have made him controversial with some employees and partners. Sun is facing its worst crisis ever with an unproven team and thin bench.
Good Fair Poor

Now some investors believe it's time for McNealy to follow his former execs
out the door, or at least give up the CEO post and retain only a chairman's
role. Says analyst Andrew Neff of Bear, Stearns & Co.: "It's pretty
standard that if the ship keeps going toward the iceberg, you change the
captain."

But this captain likely will remain at the helm for the foreseeable future.
Two Sun directors who agreed to interviews for this article, M. Kenneth Oshman
and Naomi O. Seligman, say the board is squarely behind McNealy. "There's
no plan for Scott to step down. I think we've got a great leader," says
Oshman, CEO of networking player Echelon Corp.

As for McNealy, he says he still has what it takes to bring Sun back.
"Maybe it's time to get rid of me," he says. "But this company
has a lot invested in training and developing me. I have 20 years' experience.
I'm 49 years old. I'm in good shape. Healthy. Lot of energy. Lot of wisdom.
Relationships around the world." He seems remarkably unperturbed by the
withering criticism of the past few years. Although he admits to some mistakes,
he's just as acerbic and cocky as ever. He's not prone to self-doubt, or
even much self-reflection. "I don't do feelings," he has said.
"I'll leave that to Barry Manilow."

Instead, McNealy is focused on turning Sun around with what he calls
"disruptive innovation," the same approach that has saved it so many
times before. While most rivals make plain-vanilla computers and slug it out on
price, Sun's plan is to change the rules of the game. At the high end of the
server market, Sun is developing "throughput computing" chips that can
handle dozens of tasks at the same time. At the low end, Sun servers built
around Advanced Micro Devices's inexpensive chips will handle not only
processing tasks but also the basic networking that rivals' boxes can't. And
its pricing approach is something no server company has dared try before: It's
planning to give away low-end servers to customers that agree to buy its
software for several years. "We have a maverick strategy," says
McNealy. "I think there's a huge opportunity right now."

He insists that concerns about Sun's future are vastly overblown. He points
out that unit sales of the company's servers have risen more than 20% in each
of the past three quarters. Despite huge write-offs, Sun has $7.5 billion in
cash and investments, including nearly $2 billion from a landmark settlement
with Microsoft in April. And he pledges that he's getting serious about
whacking away at Sun's bloated costs, having laid off 28% of his workforce in
three rounds.

While McNealy's plan may look good on paper, it will be difficult to pull
off. The new strategy calls for Sun to move in two directions at once: build
bare-bones servers while also inventing cutting-edge technologies. Those are
diametrically opposed pursuits, like trying to be Wal-Mart and Gucci at the same
time. McNealy contends that Sun is more focused than major rivals. Dell, for
instance, sells printers and digital music players, while IBM gets half its
revenues from services. "We're not doing digital cameras. We're not
doing printers," says McNealy. "We're fundamentally focused, much
more so than any company I see out there."

No Way Out?

But Sun's competitors are focused in other, potent, ways. Dell
concentrates on efficiency and low costs, spending a mere 2% of sales on
R&D. That'll cause trouble in basic hardware for Sun, which invests 17% in
R&D. At the same time, Sun will struggle to out-innovate larger, and
deeper-pocketed, rivals such as IBM. And Sun's track record of diversification
is lousy. The reality is that every major initiative to move beyond high-end
servers over the past decade has failed. "Scott's a smart guy, but I don't
see a way out for Sun," says Kevin B. Rollins, chief executive of Dell.
"Will they disappear? No. But most of the customers we talk to are looking
for reasons to use less of their products."

The Javafix

The bottom line is that McNealy's moves probably come too late to
resurrect the icon-turned-also-ran. When the company reports earnings for the
fourth fiscal quarter on July 20, analysts expect slight improvements, including
stronger low-end sales and narrower losses, excluding special charges. But
revenues are forecast to be about 5% below the year-earlier quarter. And for the
fiscal year ended June 30, analysts expect revenues to have slipped 4%, to $11
billion, and net losses to have hit $1.2 billion, excluding any gain from the
Microsoft settlement. Most industry experts expect larger and stronger
competitors, including ibm, Dell, and Hewlett-Packard, to continue making off
with blue-chip customers, relegating Sun-and McNealy-to side stage.
"Scott is kind of like Moses," says Paul Saffo, director of the
Institute for the Future, a Menlo Park (Calif.) think tank. " led the
world to the land of milk and honey, but he got left behind."

McNealy's willingness to buck popular opinion dates back to his days
growing up outside Detroit. His father was vice-chairman of American Motors
Corp., and Scott was an accomplished kid - honors student, standout
clarinetist, captain of the tennis team. One summer, he worked in an auto-parts
factory. When the United Auto Workers at the plant went on strike, McNealy didn't
think twice about crossing the picket lines - despite bomb threats and jeers
from angry union members. "It seemed incredibly stupid," he said.
"I couldn't see how highly paid uaw workers were helping their
cause" by losing the company money.

He didn't rush to Wall Street or a tech giant after getting his MBA from
Stanford, either. Instead, after "majoring in beer and golf," as he
describes it, he helped found Sun in 1982, taking on the workaday manufacturing
duties, while Joy and others cooked up the sizzling technology. After being
named CEO in 1984, McNealy quickly showed a bent for making brash bets to stave
off disaster. Boosting investments in Sun's Solaris software in 1995 was the
boldest. Then, as the Net boom began, McNealy helped turn Java into Sun's own
tsunami. Because Java makes it possible to write Net programs that run on any
kind of hardware, developers jumped on the bandwagon, seeding the market for Sun's
gear.

The result was a frenzy of sales. By 2000, Sun was turning in scorching
growth of 50% a quarter - faster than Microsoft, Intel, or Dell. It racked up
gaudy profits, nearly $2 billion in 2000. For that short-lived era when quality
was an imperative and price was no concern, Sun ruled.

But Sun's success laid the seeds for the trouble that would follow. The
company poured billions into R&D for a mind-numbing galaxy of projects -
from UltraSPARC chips for closet-size servers to software for smart credit
cards. Sun hired 7,000 new staffers in the year ending July, 2001, and opened a
600,000-square-foot headquarters in a refurbished 19th century mental-health
facility.

Even inside Sun, though, McNealy was repeatedly warned about the company's
"soft underbelly." Three insiders recall a planning session in 1997,
when several engineers made a presentation about the increasing power of
low-cost chips from Intel. Gene Banman, an exec who had just returned from
running Sun's business in Japan, argued that Sun could get a chip from Intel
for 30% less than it cost Sun to make an equally powerful SPARC chip. Chet
Silvestri, who ran chip design, shot back that his staff would never let that
happen. After a 20-minute debate, McNealy put an end to the meeting. "I don't
see the problem here," he said, according to one insider. Then he laid down
his orders: For the time being, no Sun computers would have Intel inside. Today,
Intel's processors are twice as fast as SPARC chips, and McNealy admits that
his biggest regret is "not putting Solaris on six or
seven years ago."

Instead, McNealy continued to insist that Sun rely on its own innovation. A
classic example was the September, 2000, purchase of Cobalt Networks Inc. By
this time many Sun customers were asking Sun for cheaper servers based on Intel
chips and Linux, the increasingly popular open-source software. Zander persuaded
Sun's board to O.K. the $2 billion acquisition of Cobalt, which had figured
out how to make hefty 51% margins selling specialized "Lintel" servers
costing just $1,500. With the help of Sun's 8,000 salespeople, Zander felt he
could turbocharge Cobalt's sales and learn how to compete with commodity
products.

It never happened. From the beginning, Cobalt was attacked by the heads of
Sun's old-line server businesses, who didn't want Sun to invest in the very
technology that was threatening their livelihoods. Stephen W. DeWitt, Cobalt's
boyish chief executive, became known derisively as the "$2 billion
blond." When it came time to set budgets, Cobalt's was cut repeatedly,
crippling product development. "The work didn't get done," says
former sales chief Jabbar. "The company religion didn't allow it."
McNealy says the acquisition was a mistake. "There were some other people
who thought it was a good idea, and I trusted them," he says.

Cost-cutting bordered on blasphemy, too. In late 2000, some of McNealy's
top lieutenants began to suggest cutbacks, given that the stock market had been
tumbling since March, and cash-starved dot-coms were imploding. Even Joy, a
devotee of R&D, says he told McNealy to make a bold move. "I thought we
should have cut more sooner," says Joy. "But I could never get the
discussion to go anywhere." Around New Year's Eve, Zander grew concerned
as well. In one meeting with his staff, he said that Cisco Systems Inc. CEO John
T. Chambers had told him Cisco was seeing a large drop in revenues.
"Shouldn't we be equally concerned?" he asked the group. "That's
when the serious discussions began," says Hambly, the former executive
vice-president.

They got a lot more serious on Mar. 8, 2001, when Cisco rocked Silicon Valley
by laying off 18% of its workforce. Quickly, Zander's staffers set down the
broad outlines of a plan. The consensus was that Sun should cut as many as 20%
of its employees, more than 10,000. Many also wanted to jettison the
underperforming storage unit and give up on McNealy's hope of creating a
viable alternative to Microsoft's Office. "When times are hard, you've
got to shoot activities that aren't making money," says Shoemaker, the
former server chief.

A Damaging Exodus

McNealy would have none of it. Time and again, Zander would end staff meetings
by saying: "Well, what do you guys want to do?" says a source who was
in the room. As the execs went around the table expressing their views, it was
clear everyone believed in some sort of austerity plan - except McNealy.

McNealy was convinced that the Internet had fundamentally changed the nature
of the economy. He thought the highs and lows of the business cycle would be far
more extreme and short-lived than in the past, with sharp spikes up and down.
"We don't have rolling waves," he said during a conference call with
analysts in 2001. "We seem to have real edges." If he was wrong, he
promised during one session with his execs, he would "take the heat"
from Wall Street and Sun's board. Today, McNealy declines to discuss those
gatherings in detail but says: "There's a lot of revisionist history out
there."

The executive-suite standoff didn't just cost Sun precious time - it
contributed to a damaging exodus. That had started the previous September, say
sources, when McNealy and Zander met for their yearly talk about their personal
plans. McNealy had been letting Zander run the show, leading the
second-in-command to believe he might soon get the top job. But McNealy said he
planned to remain CEO for a few more years - prompting Zander to decide to
move on, ultimately to the CEO post at Motorola. By mid-2002, half of Sun's
top-level executives had departed.

As Sun's fortunes waned, customers and insiders, including outspoken
software chief Jonathan I. Schwartz, urged McNealy to change course. A key step:
McNealy needed to drop his long-running, and distracting, feud with Microsoft.
Finally, last June, McNealy says the customer requests won him over. He
swallowed his pride and called Microsoft CEO Steven A. Ballmer.

Bill Gates's Bathroom Break

Bringing tech's longest-running feud to a close was not without its funny
moments. Microsoft Chairman William H. Gates III visited Sun's headquarters
the week of July 4, when the office was closed. The famous exec escaped notice,
until he and Sun's chief strategist, Mark Tolliver, went for a bathroom break
and ran into a Sun staffer who had come to the office, dog in tow. "He
looked Gates straight in the eye, and he had the most stunned look on his
face," recalls Tolliver. Still, the meeting stayed secret as negotiations
continued over the next few months. Then, early on the morning of Apr. 2,
McNealy and Ballmer announced the blockbuster deal. Sun would get $1.95 billion
in exchange for calling off two landmark lawsuits. And thanks to a 10-year
technology pact, Sun's servers will be certified to run Windows.

The détente was a public-relations coup, at least temporarily. Sun's
shares jumped 19% during the two days that followed. But internally, reaction to
the day's news was mixed, say insiders. Not only had Sun racked up a net loss
of $750 million for the spring quarter, but McNealy had named Schwartz to be Sun's
new day-to-day chief. Many say that while he is known for his razor-sharp mind,
the ponytailed 38-year-old lacks experience and alienates employees and
customers with his arrogant style. When McNealy told other executives about
Schwartz' promotion the night before the announcement, the silence on the
phone was deafening, according to former execs.

Today, McNealy is as combative and optimistic as ever. During a series of
interviews, he sketched out bold plans to jump back to the fore of the server
market. Servers based on Sun's throughput computing chips are expected to hit
the market in 2006. Meantime, Sun's experiment with freebie low-end servers
started in June. The idea is that the low-end servers will open the door for Sun
to sell more lucrative software.

Still, McNealy faces a hard slog to win back credibility among customers. For
years corporate buyers bought from Sun in part because it seemed to know where
tech was heading. Now, many believe Sun spent several crucial years with its
head in the sand. "They've always had lots of great things on paper. But
when it comes to execution, they're lacking," says Gary Feierstein,
vice-president for information technology at Premier Inc., a San Diego company
that manages 1,500 hospitals. "They always seem to be behind where they
need to be."

Therein lies the true tragedy in Sun's decline. Throughout the company's
history, McNealy's risk-taking spirit resulted in innovative alternatives to
the offerings of giants such as Microsoft and IBM. Unless he pulls off a
longshot turnaround, it may ultimately be a blow to Silicon Valley and even
America's technological prowess.

By Jim Kerstetter and Peter Burrows

A Tale Of Missed Opportunities

January 27, 1999 Hewlett-Packard announces that it will load Linux
software from leading Linux distributor Red Hat on its servers. Within three
weeks, IBM and Dell announce similar plans. McNealy, who had received his first
report on the Linux threat two years before, refuses to follow suit.

July 20, 2000 Sun reports blowout results for fiscal 2000, with
profits up 49%, to $1.7 billion, as sales hit $16 billion.

September 1, 2000 Stock peaks at $64.

September 19, 2000 Sun spends $2 billion to acquire Cobalt Networks,
which uses Linux in its servers. But with its own pricey servers booming, Sun
never pushes the low-cost models and stifles efforts to use cheaper chips from
Intel.

March 8, 2001 Cisco Systems slashes its workforce by 18%. With Sun's
sales slowing, McNealy's management team begs him to follow suit. No go.

October 5, 2001 McNealy agrees to lay off 3,900 - the last major
tech CEO to call for cuts. By this time, President Ed Zander has decided to
leave after McNealy told him he would stay on as CEO for five more years.

February 7, 2002 McNealy dons a Penguin suit at an analyst meeting to
show his love of Linux. While a new low-end plan is devised to push cheaper
Linux servers, McNealy doesn't force Sun's engineers and salespeople to get
behind it.

May 1, 2002 Sun announces Zander's departure. The company hopes
investors will be happy to hear McNealy is taking a more active role in the
company. Instead, Sun's stock skids 17%.

October 4, 2002 With sales plummeting, shares hit all-time low of
$2.42.

October 16, 2002 McNealy cuts an additional 4,400 jobs, about 11% of
the payroll.

May 19, 2003 Sun revives its Intel server business and, four years
after competitors, starts distributing Red Hat Linux.

June, 2003 McNealy calls Microsoft CEO Steve Ballmer and starts secret
settlement talks.

July, 2003 Microsoft Chairman Bill Gates visits Sun's headquarters
for talks with McNealy and his staff.

September 10, 2003 Co-founder Bill Joy resigns, saying he wants to
take time off before starting a new project.

October 16 2003 Even as rivals show signs of recovery, Sun suffers a
$286 million net loss - evidence that Sun's ailments go well beyond the
economy.

February 10, 2004
McNealy announces that co-founder Andreas
Bechtolsheim is returning to the company to head development of a new line of
servers based on chips made by Advanced Micro Devices.

February 25, 2004
Services chief Patricia Sueltz leaves to become
president of upstart Sales-force.com.

April 2, 2004 McNealy announces a Microsoft détente and anoints
Jonathan Schwartz as president. Sun shares rise 19% over the next two days, to
more than $5. But in the next few weeks, as investors digest the news of the
12th quarter of shrinking sales and a $750 million net loss, the stock falls
back below $4.

April 16, 2004 Schwartz creates distinct divisions for its high- and
low-end businesses. Two more execs, chief strategist Mark Tolliver and volume
systems head Neil Knox, leave.