Fitch Affirms Sun Microsystems at BBB

1 January 1970

Fitch Ratings, Inc. has affirmed Sun Microsystems, Inc.'s (Sun) senior unsecured debt rating of 'BBB-'. The Rating Outlook is Stable. Approximately $1.1 billion of public debt securities are affected by Fitch's rating.
The rating considers Sun's strong liquidity as reflected by the company's significant cash and investments position, solid balance sheet with low debt levels, and pressured but still strong market share in the Unix server segment. Sun's recurring revenue base continues to grow and gradually improving financial performance is being driven primarily by ongoing cost-cutting efforts and productivity improvements. Fitch is concerned with Sun's inability to achieve top-line revenue growth, minimal free cash flow generation, improving but existing high-cost structure relative to its competitors, declining overall market share in the server market, and the company's long-term competitive position in the information technology (IT) hardware industry.

The Stable Rating Outlook reflects the significant cash balances, which offset the limited near-term visibility with respect to the success of Sun's various growth initiatives, such as open-sourcing the Solaris 10 operating system to drive future annuity service revenue and the customer adoption rate for the Sun Grid. The Rating Outlook will continue to focus on the extent to which these initiatives are able to drive revenue and, more importantly, free cash flow growth. Free downloads of Solaris 10 have exceeded one million, but Sun's ability to monetize these downloads through future service contracts, as well as cross-sell additional hardware and services remains uncertain. Barring a material decline in IT spending, Fitch expects gradual improvement in Sun's financial performance, driven primarily by ongoing cost-cutting efforts and productivity improvements. Although Sun may experience additional challenges and shortfalls, the company's operations should continue to moderately improve and the investment-grade rating continues to be mainly supported by the company's strong balance sheet and low debt levels.

Strong financial flexibility is provided by more than $7.4 billion in cash and marketable securities. Total debt is approximately $1.1 billion, consisting primarily of $500 million of senior unsecured notes due August 2006 and $550 million due August 2009. Leverage (debt/EBITDA) for the latest 12 months ended March 27, 2005, declined to 1.7 times (x) from 4.7x in the year-ago period, and interest coverage (EBITDA/interest expense) improved to 18.1x from 8.2x one year-ago as a result of Sun's improved financial performance and approximately $350 million of total debt reduction. Fitch does not expect significant improvement in either of these ratios in the near-term as operating profitability and cash flow will remain pressured. However, the company does have a significant net cash balance and any near-term cash usage for working capital investments due to revenue increases is not a concern.

Although revenue has essentially remained flat at $8.1 billion for the first nine months of fiscal 2005 relative to the year-ago period, Sun's ongoing cost-reduction and productivity improvement efforts yielded significant improvement in EBITDA, which increased to $463 million versus negative $67 million, excluding restructuring charges and a $55 million litigation settlement charge for Eastman Kodak Co. in the first quarter of fiscal 2005. Despite the ongoing transformation of Sun's server mix toward low and midrange servers, which carry lower margins than Sun's high-end servers, Sun has thus far been successful at maintaining total gross margins in excess of 40%. For these margins to remain above 40%, Fitch believes the company will have to continue increasing its attach rate on higher margin services and software by selling total solutions rather than selling stand-alone hardware units. On an aggregate basis, SG&A and R&D declined to 42.6% of revenue in the nine months ended March 27, 2005 versus 48% in the corresponding year-ago period, reflecting successful cost-cutting initiatives. Cash flow from operations was $174 million for the first nine months of fiscal 2005 versus $54 million one year-ago, while free cash flow was negative $93 million versus negative $191 million for the same time period.

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Contact:
Fitch Ratings, New York
Nick P. Nilarp, CFA, 212-908-0649
John M. Witt, CFA, 212-908-0673
Brendan Buckley, 212-908-0640
Brian Bertsch, 212-908-0549 (Media Relations)

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Source: Fitch Ratings