Derek Oosterman | Lily Chang | Michael Renery

Moving Sun Microsystems into the Future Prepared for: Sun Microsystems (21 April 2003)

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Table of Contents Executive Summary 2

Company Profile 3

Financials 3

Internal Rivalry 6

Organization 6

Products 7

Services 10

Geography 11

Competition 11

Substitutes & Complements 12

Buyer & Supplier Power 13

Entry 14

Strategy Dilemma 15

Solution 17

Appendix 20

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Executive Summary

Sun Microsystems has suffered disproportionately bad market performance as compared to its closest rivals in recent years. However, Sun’s recent financial statements have demonstrated the effectiveness of Sun’s efforts at fiscal recovery. Sun also demonstrates consistent technological innovation and cutting-edge hardware, software, and services. Finally, Sun is insulated from the threats of entry, buyer and supplier power, and substitutes and complements. This situation leads Blaisdell Consulting to believe that Sun suffers a strategic flaw that is causing the market to be pessimistic with regard to Sun’s performance in the future. Blaisdell Consulting believes that Sun is being squeezed by its competitors from both the top and the bottom, and that Sun faces unique challenges to its software portfolio that stem from the increasing popularity of open-source software. Within major corporations, there is a trend away from rooms full of high-end servers toward mainframe computers, where Sun has no product offerings. Simultaneously, the low-end server market is changing as the result of commoditization and the consequent increasing popularity of Intel-powered systems running Linux. Finally, Linux and other open-source programs are challenging the future profitability of Sun’s proprietary Unix-based operating system, Solaris, as well as the remainder of the Sun ONE software portfolio. This affects Sun’s strongest market segment, mid-range servers running Solaris. In order to combat these market trends and grow market share, Blaisdell Consulting recommends that Sun involve itself in the development of mainframe computers, using for research money that which is saved by diminishing the research funds given to proprietary operating systems and processors, especially in the low-end server market. By adopting Intel processors and Linux operating systems in Sun’s low-end units, Sun will remain technology and cost competitive in this important, introductory market. Furthermore, Sun must be watchful of the progress of Linux in the market and ready to adapt it increasingly in their products as the market necessitates this step. Shifting funds to stimulate software development will allow Sun to be at the forefront of this high-margin market and will allow for the development of programs that integrate many separate functions, creating efficiency gains over less comprehensive and less integrated software package offerings. Furthermore, Sun should create systems that increase the ease with which software is bought and upgraded by corporations. These efficiency gains and novel integrations should continually stave off the competition of open-source offerings and the offerings of rival proprietary software makers, thereby protecting the software division from declining profits and ultimate destruction. Blaisdell Consulting believes that the implementation of these measures will preserve and ultimately grow the market share that Sun has lost in recent years. Furthermore, the adaptation of a realistic and logical strategy for the future should restore market confidence and reward investors.

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Company Profile Sun Microsystems, founded in 1982 with only four employees, has quickly grown to become one of the world’s largest companies, which today holds the 112th position on the Fortune 500 list with FY2002 revenues of $12.5 billion and over 36,000 employees. Sun is involved in the telecommunications, financial services, government, manufacturing, education, retail, life sciences, media and entertainment, and health care industries. It maintains the philosophy that open standards and open programming interfaces increase the value of Net-based solutions and create a larger market for all players. Sun is traded on the NASDAQ National Market under SUNW. Sun is dedicated to producing systems, software and services that are at the leading edge of technology and provide unparalleled efficiency. In systems, Sun sells network servers, data storage systems, engineering workstations, and information appliances for use in a wide range of markets. Sun’s product line stretches from massive, high- integrity systems in configurations costing upwards of $10 million to ultra-thin, rack-mountable servers priced under $1000. Sun software provides all the products needed to create, assemble, deploy, and manage services on demand under the blanket of the Sun Open Net Environment (Sun ONE). The Sun ONE software stack includes identity management, security, integration, Web, application, portal, and messaging programs. Sun’s service branches include consulting, education, and support, which combine to help customers design and support their networks. Sun is dedicated, through all the ir branches, to maximizing uptime, increasing productivity, and controlling costs.

Financials

The industry of which Sun is a part, computer hardware, has suffered a very difficult year, and as a result of this turmoil Sun itself has also struggled. The global economic downturn has clearly hurt nearly every company nationwide. However, additional harm to Sun has been caused by disturbances in the telecommunications industry, collapses in the dot-com sector, national security concerns, and high-profile accounting scandals. These auxiliary difficulties conspired to bring dramatic reductions in capital-equipment spending, which is essential to the business of Sun. i These dilemmas are reflected in the financial statements of the company, which show a clear reduction in revenues and a heavy net loss sustained by Sun during fiscal year 2002, which ended June 30, 2002. Accounting statements for the first quarter of fiscal year 2003 show continued losses. However, the numbers highlight some positive aspects that speak to Sun’s ability to weather this storm and continue to be competitive in the future, when industry demand has recovered.

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Sun’s market performance in recent years has been disastrous. As can be seen, Sun was a benefactor of the technology stock bubble of the late 1990s, and its shares have declined steadily and severely in value since about mid-2001. This timing coincides roughly with the terrorist attacks of September 11, but Sun’s precipitous market decline cannot be blamed solely on this factor. While once commanding a price in excess of $60, shares of Sun now trade in the $3-$4 range. Major competitors to Sun, such as International Business Machines, Dell Computer, and Hewlett-Packard have followed this downward trend. However, these companies have not seen the sheer percentage declines in share price that Sun has seen. This would suggest that something other than simple market downturn is either buoying competitors’ share prices, or causing Sun’s shares to be extraordinarily depressed. Sun’s high beta of 2.5 also shows that Sun’s share prices have a tendency to swing more wildly than the market average. Sun’s price to sales ratio of 0.9x means that Sun trades at a lower multiples of sales than the industry average (1.5x). Sun’s price to book of 1.1x is significantly lower than the industry average of 6.3x. ii This suggests both that Sun’s shares fallen in line with fair value and that the market does not see exceptional growth opportunity in Sun. Sun’s financial statements shed some light on the company’s shifting situation. The chart entitled “selected financial data”iii (Appendix A.1) summarizes Sun’s operations over the

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past five years. As can clearly be seen, revenues in FY2002 declined severely from FY2001, falling by almost $6 billion, or 31.5%. Also, the gross margin has been falling steadily over the past five years, reflecting declining profitability caused by increased price competition within the industry. Despite the economic difficulty, Sun remains dedicated to research and development, reflecting the importance of remaining at the forefront of technology in this industry. The lower operating income, combined with largely unchanged R&D spending, and a one-time $517 million restructuring charge, led to an operating loss of $1.248 billion, despite cost-cutting measures. Due to higher than expected tax rates, Sun’s net loss came to only $587 million. In the consolidated statements of operations iv (Appendix A.2), the most noticeable change is that Sun’s revenues are inc reasingly more dependent on services. In the future, we can expect this high margin area to continue to grow as a percentage of total revenues. On the consolidated balance sheetsv (Appendix A.3), a few figures are salient. First, despite Sun’s FY2002 loss, it still holds a healthy reserve of cash and cash equivalents, over $5 billion. Sun suffered roughly a $1.5 billion reduction in assets. Inventories decreased significantly, reflecting a conscious effort on the part of Sun to save costs. Quarter one of FY2003, ended September 29, 2002, continued Sun’s trend of generating losses. As can be seen on the quarter’s condensed consolidated statements of operations vi (Appendix A.4), year over year net revenues had fallen. Again, services accounted for a greater portion of total revenues. The gross margin improved, reflecting cost-cutting efforts, and operating expenses declined, again reiterating the effectiveness of these efforts. While losses are still being incurred, these losses have been reduced across the board, implying an eventual return to profitability. On the balance sheetvii (Appendix A.5), assets and liabilities again decreased year over year, showing that this slump is not over. The most recent available numbers show that, year over year, total revenue declined by 6 percent, the result of product revenue declining by 11 percent while service revenue increased by 6 percent. However, compared to quarter one of FY 2003, revenue has grown 6 percent, indicating a recovery. The gross margin is up 6.7 points over one year previous, and up 2.1 points over the previous quarter, suggesting continually increasing efficiency gains. Divided into products and services, there are increased margins in both segments, both year over year and sequentially. Operating expenses are down 8 percent over a year ago and down 3 percent over the previous quarter. This has been accomplished through a reduction in the number of employees and through lower discretionary spending. Operating loss for quarter two of FY2003 is $2.504 billion dollars. The vast majority of this loss is due to unusual expenses. Excluding goodwill impairments ($2.027 billion), intangible impairments ($98 million), and restructuring and IPRD charges ($361 million), operating loss would only be $18 million. viii While Sun’s financial strength has been diminished by the global economic downturn, the position it is in at the present is not a weak one. On the contrary, Sun still harbors a

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lot of financial strength, and the numbers suggest that the measures Sun is taking to restore profitability are working. Nonetheless, Sun remains in the red, and must continue to be cautious and vigilant in order to get back into the black. The challenges that Sun faces in the market will be covered in the following sections.

Internal Rivalry Sun falls under the Computer Hardware sub- industry of the Technology sector. Given the breadth of Sun products and services, no single standard industry classification (SIC) code can encompass all of Sun’s offerings. Sun lies primarily within SIC code 3571, electronic computers; however, the company also falls within SIC codes 3572, 3575, 3577, 3578, 3579, 7372, and 7373, which, respectively, are computer storage devices, computer terminals, computer peripheral equipment, calculating and accounting equipment, office machines, prepackaged software, and computer integrated systems design. The Computer Hardware industry generated roughly $300 billion in revenues in 2002. The following section describes the wide variety of products and services sold by Sun. Organization Within its product offerings, Sun sells software, servers, storage, desktops and workstations, and networking equipment. Sun sells primarily to large, institutional customers and some private small businesses, avoiding entirely the home computing market. Sun has focused their organization on the following products and services businesses. Each group provides products and services for commercial and technical computing. The primary competitive differentiators for these products in the marketplace are their price/performance, scalability, and reliability. Enterprise Systems Products The Enterprise Systems Products group provides an integrated family of mid-range and high-end enterprise server systems for mission critical and high-performance computing environments. These products run application environments, directories, databases, websites and many other applications. Volume Systems Products The Volume Systems Products group provides entry enterprise servers, blade computing (management of a pool of modular, single board servers as one computing environment, which allows companies to allocate and re-allocate resources to changing workloads) and workstations with low price points and high computing density for horizontally scalable

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environments (large computing environments composed of clusters of smaller servers). The entry servers deliver network computing in a compact package. Processor and Network Products The Processor and Network Products group develops UltraSPARC microprocessors, associated companion application-specific integrated circuits, and Network and Cryptographic products and technologies. They are at the heart of all Sun systems. Network Storage The Network Storage group directly, and through third party relationships, provides complete storage solutions from the operating system to servers, storage, software, services, and support. Software The Software group designs, develops and brings to market the Sun ONE software offerings, including the Solaris Operating Environment, the Java platform, Sun ONE middleware, their core technologies for consumer and embedded markets which utilize the Java technology, Jini network technology, software development tools and their StarOffice application software, which are based upon open source standards, including XML technology. Sun Services The Sun Services group provides a broad range of worldwide services for their network computing environment. These services include design, implementation and operation of enterprise and Internet computing environments, systems integration and support, professional services and education. Products Sun products are all designed, developed, and produced for the network computing environment. This affirms the Sun motto “The Network is the Computer.” Enterprise Systems Products In the arena of data center and high-performance computing servers, Sun offers the Sun Fire 15K, the Sun Fire 10K, and the Sun Enterprise 10000 servers. These servers are UNIX platform-based, very scalable, and incorporate Sun’s own UltraSPARC processors. They are designed to offer greater performance and lower total cost of ownership than mainframe products.

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In the mid-range server group, Sun offers nine products: The Sun Fire 3800, 4800, 4810, and 6800; the Sun Fire 880R; and the Sun Enterprise 3500, 4500, 5500, and 6500. Midrange servers provide reliability, availability, and scalability to address the needs of data centers and enterprise-scale network computing at a moderate cost. Volume Systems Products In the entry servers group, Sun offers four high-end products and ten low-end products. The high-end line includes the Sun Fire 880 and 480R, the Sun Enterprise 420R, and the Netra t 1400/1405 servers. The low-end line includes the Sun Fire V100, V120, and 280R, the Sun Enterprise 250, and the Netra 120, t1 200/205, t1120/1125, 20, CT400, and CT800. These servers deliver network computing in a compact, low-cost package. Recently, Sun introduced their first line of entry level X86 servers, the Sun LX50, which provide high density scalable solutions for Solaris and the Linux operating environments. This line is in addition to the Sun Linux-based Cobalt Appliance Servers, which have been designed to run Internet-related applications including file serving and web hosting, and support software applications such as electronic mail and electronic commerce. In the workstations group, Sun has the Sun Blade 100 and 2000 workstations. The Sun information appliances group includes the Sun Ray 100 and 150 enterprise appliances. These workstations represent the product most similar to a home computer, only with slightly less processing power but much more network compatibility. Processor and Network Products Sun manufactures its proprietary line of UltraSPARC processors for use in its own hardware products. This processor architecture is utilized throughout Sun’s entire hardware range. Sun’s Network and Cryptographic portfolio includes solutions based on technologies such as Ethernet, secure socket layer, and virtual private network, enabling high speed, secure network solutions. Network Storage In the high-end data center storage group, Sun, through an agreement with Hitachi Data Systems, offers the Sun StorEdge 9900 series. They provide a platform for direct attach storage or storage area network solutions. The midrange storage group offers the StorEdge 6900 and 3900 series, as well as the Sun StorEdge T3 and A5200 arrays. This series supports high-performance computing and enterprise storage area network implementations, as well as storage virtualization technology.

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The workgroup storage group includes the Sun StorEdge T3, D2, and A1000/D1000 arrays, which are flexible, compact, and cost-effective. The tape backup and restore group offers Sun StorEdge tape automation products for all capacity demands. They include tape autoloaders, small- footprint libraries, and large-capacity, fast-access tape backup and restore systems. The storage software group has implemented Storage ONE, an automated storage management family. These products, individually, are the Sun StorEdge Availability Suite, Performance Suite, Resources Management Suite, and Utilization Suite. The Sun storage area network (SAN) solutions group offers the Sun StorEdge Open SAN Architecture set of products to help ease SAN management and to allow the consolidation of storage resources on the network. Products include the Sun StorEdge Network 2Gb FC Switch-16, 2 Gb PCI Fiber Channel Network Host Bus Adapter, and Traffic Manager and Diagnostic Expert software. Software As a result of Sun’s dedication to open-source software, deciphering their software strategy can be confusing. Sun’s overall goal is to network-enable every device on the planet, from automotive systems to vending machines to airplane seatbacks. Doing so creates more demand for server-side infrastructure needed to track the information that these units generate. The core of network-enabling these devices is the Java pla tform, with its open and collaborative standards. Key parts of the Sun ONE portfolio, therefore, are compatible product implementations of the Java technology standards. The core of Sun’s software revenue, however, is not isolated to the Sun ONE products but is instead the integration of all these technologies and products into a holistic solution that enables customers to use technology to solve business problems. ix Sun produces a wide variety of software, all under the Sun ONE platform. The Solaris Operating Environment product line includes desktop, intranet, Internet Service Provider (ISP) and enterprise operating environments for SPARC and Intel platforms. The most recent version, Solaris 9, was introduced in FY2002. Java technology is one of the first widely accepted application environments to allow development of application software independent of the underlying operating system or microprocessor. Sun expanded the definition and availability of the Java platform with the Java 2 Platform, Micro and Enterprise Editions, in addition to the Standard Edition. Jini Network Technology is an open architecture that enables developers to create network-centric services. The Jini Starter Kit and the Jini Core Platform Compatibility Kit are available. The StarOffice Productivity Suite is an office suite that runs on most major operating environments and platforms including Solaris, Windows, Linux, OS/2 and Java. Its fully

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integrated applications provide word processing, spreadsheet, graphic design, presentations, database access, HTML editor, mail/news reader, event planner, and formula editor tools. FY2002 saw the launch of StarOffice 6.0. Sun ONE Developer Tools are designed to aid in application development and integration. Sun ONE Middleware products include Sun ONE Directory Server, Identity Server, Meta-Directory Server, Integration Server, Portal Server, Web Server, Application Server, Calendar Server, Messaging Server, and others to enable enterprises to transmit their information and applications into services offered on intranets and the Internet. These products support Solaris, Windows NT, HP-UX, AIX, and Linux operating systems. Services The Sun Services team provides expertise in network computing through a broad range of global services, including support services (systems support for hardware and software), professional services (IT consulting, systems integration and system/network management), and educational services (education consulting, skills migration and training). Sun assists both technical and commercial customers, supporting more than 1.6 million systems in more than 100 countries, training more than 400,000 students annually, and providing consulting, integration and operations assistance to information technology organizations worldwide. Support Services The SunSpectrum support services product offerings allow customers to customize their support services contracts. Customers can choose form four levels of support that range from mission-critical to self-support. This service is sold separately or packaged with hardware, software and peripherals in a single price support service. Professional Services Sun Professional Services provides a suite of technical consulting and systems integration services to help customers plan, implement, and manage complex distributed network computing environments. The professional services teams specializes in providing customers with advanced systems, storage, and network architecture design consulting, platform integration, enterprise systems management and operation, and advanced Sun ONE and Java software integration. Educational Services Sun Educational Services group develops and delivers learning solutions for enterprises, information technology organizations, and individual information technology

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professionals. Their learning solutions include education consulting services, learning management technologies, and professional certifications. Geography Sun has approximately 140 sales and service offices in the United States and 150 sales and service offices in 45 other countries around the world. Additionally, Sun uses independent distributors in over 100 countries, adding to their market penetration. Revenues from outside of the United States accounted for approximately 54% of total revenues in FY2002, a 1 percentage point increase over FY2001 and a 6 percentage point increase over FY2000. Japan represents the largest portion of international sales, accounting for 9 percent of total revenue in FY2002. Sun owns property primarily in the United States, most notably in Santa Clara, Newark and Menlo Park, all in California. Other significant locations include Broomfield, Colorado and Burlington, Massachusetts in the United States. Outside of the United States, Sun holds significant properties in Bagshot, England; Farnborough, England; and Linlithgow, Scotland. Competition Sun’s competitors are some of the largest, most successful companies in the world. They include International Business Machines, Hewlett-Packard, which now owns Compaq, EMC Corporation, Fujitsu, and the Fujitsu-Siemens joint venture company. They also compete with distributors and resellers of systems based on microprocessors manufactured by Intel Corporation and the Windows family of operating systems software developed by Microsoft Corporation. These competitors include Dell Computer Corporation and HP, in addition to Intel and Microsoft. This competition creates heavy pressure, including pricing pressure on their workstations and certain server product lines. This competitive pressure is expected to continue to intensify during FY2003, stemming from the release of new products from Sun’s competitors. Sun competes in the hardware and software products and services markets. Sun’s competitors compete with them primarily on price, service, warranty and product performance. These markets are intensely competitive. If Sun fails to compete successfully in these markets their resulting loss of competitive position could result in price reductions, fewer customer orders, reduced revenues, reduced margins, reduced levels of profitability and loss of market share. Sun has encouraged the use of SPARC technology as a standard in the computer marketplace by licensing much of the technology, and promoting open interfaces to the Solaris Operating Environment, as well as by offering microprocessors and enabling technologies to third party customers. As a result, several licensees, including Fujitsu and the Fujitsu-Siemens joint venture company, also offer products based on the Solaris Operating Environment and the SPARC architecture that compete directly with Sun’s products. Sun has also worked to make their Java programming language a standard for

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complex networks. They develop applications, tools and systems platforms as well as work with third parties to create products and technologies, in order to continue to enhance the Java platform’s capabilities. As part of this effort, Sun licenses Java technology which widely encourages competitors to also develop products competing with these applications, tools, and platforms. Sun’s business therefore particularly depends on being able to compete effectively here. Overall server market share sees a toss up for the lead between IBM and HP, both with slightly less than 30 percent. Sun, Dell, Fujitsu and Fujitsu Siemens essentially gobble up the rest, although Sun, with 19 percent of the total market, is considerably larger than Dell, and Fujitsu and Fujitsu-Siemens put together roughly equal the market share of Dell. Sun possesses a disproportionately large percentage of larger, Unix-based servers, generally battling with HP for the top position in this segment, where both have slightly more than 30 percent of the market by revenue, although this number varies considerably by quarter. In Intel- and Linux-based systems, HP holds the market share lead with roughly 35 percent, while Dell has a disproportionately large market share in this segment, holding 22 percent. Year-over-year, total sales of Unix servers declined 10 percent, while Linux- and Intel-based systems gained 26.7 percent and 3.2 percent, respectively. x Since Sun currently focuses on Unix-based systems, this trend is not encouraging.

Substitutes and Complements

There are few, if any, substitutes to the products that Sun and other competitors build. Large network machines are specialized in their operation, enormously complex, and very expensive. No alternative computing machine, such as desktop and laptop computers, cellular phones, personal digital assistants, etc. could replace the function of network servers, storage, interconnects, and workstations. Moreover, as computing power continues to become more and more essential to the efficient operation of all types of businesses, no non-computing alternative can even be considered. Likewise, there are no substitutes to the network services provided by Sun, given the highly specialized nature of the information necessary to effectively operate networks. The main complement to network hardware is the operating environment that coordinates and simplifies the function of all the interconnected components. Here we see an interesting market. Sun programs and markets its own Solaris Operating Environment, which is advantageous to the company as it is able to develop its software to maximize and exploit the physical boundaries of its own hardware. However, major competitors also play in this market, notably Microsoft with its Windows NT operating environment, and Linux, an open-source operating environment developed without charge by programmers connected to the Internet from all over the world and distributed through both major corporations, like IBM, as well as smaller technology firms. Further complements include the information technology staff necessary to operate, upgrade, and maintain network systems. The ability of information technology staff to integrate and

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understand new products as they are released and consumed by businesses lowers the implementation costs of that technology to those businesses. Finally, electricity needed to power these machines is also a complement, although less directly so. Efficiency gains in this area are most valuable if the consumer faces the prospect of having to power them during interruption of the general electrical supply, forcing the purchase of expensive generators or electricity on the spot market. Given the importance of a knowledgeable information technology staff, the primary complement to network services is schooling in the information necessary to operate networks. Sun trains over 400,000 students every year, making sure that the resources are available to operate as many networks as Sun is able to manufacture and install.

Buyer and Supplier Power Sun, as a benefit of its size and importance in the server market, carries considerable weight. Due to the sheer volume of units produced and sold by Sun, the company is able to demand reasonable prices from its suppliers. However, as elaborated upon below, most of the products with which Sun is supplied are produced in highly competitive industries where excess profits already do not exit; therefore, this advantage is unnecessary and redundant. Sun, when compared to its competitors, is in a unique position in that many of the parts supplied, especially those sensitive to price and supplier power, are actually produced in-house. While other manufacturers face strong supplier power when purchasing processors from Intel, Sun builds its own line of UltraSPARC processors for all of its machines, obviating the influence of Intel over their business. Similarly, in operating environments, Sun developed and continuously updates its Unix-based Solaris Operating Environment. Microsoft, another monopolistic giant that wields considerable supplier power, is again unable to leverage Sun, since all of Sun’s units ship either with a version of Solaris or with the free operating environment, Linux. Other components, such as hard drives, memory, and hundreds of smaller switches and transistors, are built in highly concentrated industries, and thus are priced competitively. Producers of these parts do not wield any influence over Sun. Supplier power, therefore, is not an important consideration to the business of Sun. Sun does face considerable buyer power given that its clientele consists almost entirely of large, institutional customers and some smaller businesses. Especially with regard to Sun’s institutional customers, their orders can be of such a magnitude that generous prices are demanded. However, since there are very few firms that compete with Sun in its businesses, the result is situation of oligopoly in which profit is maintained. As evidenced by Sun’s margins, which are in excess of 40 percent, profit has not been squeezed out of the server market either through buyer power or competition. Furthermore, while price competition is fierce in low-end servers, Sun’s emphasis on

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high-end product insulates the company from this pricing pressure. Therefore, while buyer power exists in the server market, it is not utilized to the great disadvantage of Sun.

Entry Sun provides a comprehensive array of network products and services. However, their reach is not so broad as to say that it is unlikely that another company could come to comprehensively compete with them. Their product line is logically arranged and demonstrates a high degree of interconnectivity and synergistic possibility. The market capitalization of Sun, even after the market downturn, currently stands at roughly $10.2 billion, which classifies Sun as a large-capitalization stock. Sun’s primary competitors, notably IBM, HP, and Dell have market capitalizations of $130.3 billion, $50.3 billion, and $60.2 billion, respectively. Clearly, none of these companies could be considered a boutique producer. The industry is highly capital intensive, given the hugely complex nature of network machines and the physical resources necessary to build them. Furthermore, and perhaps more importantly than capital considerations, since any level of capital can be raised with a solid business plan, there exists an enormous and continuously evolving knowledge base under the creation of network machines. This kind of intellectual capital is both expensive to attain and extremely rare. To partially avoid these constraints, it is possible for niche producers to enter into Sun’s hardware and software domains by focusing on one product specifically, for example application servers or tape backup systems. While there are fewer capital and intellectual constraints to challenging Sun at a very narrow level, the resources that Sun and the other giants of the industry are able to bring to bear in the fight against a competitor are tremendous and intimidating. In services, Sun has a natural advantage in that it has a first-hand understanding of its products that can only come from proprietary assembly. However, once this information is passed to others, it is not impossible that these students, charged with equivalent intellectual capital, can then compete with Sun in servicing both their products and the products of competitors, most likely competing on price. However, through service contracts integrated into the purchase of products, Sun is able to minimize this risk. The industry as it stands is already highly competitive, and represents a battle ground for some of the world’s most powerful companies. Entry, therefore, of a firm that will comprehensively compete with Sun under these tremendous competitive, capital, and intellectual constraints, seems highly unlikely. Only companies well versed in computer technology and have a specific focus are seen as being potential entrants.

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Strategy Dilemma While the bursting of the market bubble and subsequent economic recession have certainly played a role in Sun’s lackluster performance over the past few years, the extent to which Sun has faltered as compared to its main competitors is indicative of a strategic shortcoming. Financially, Sun’s major losses in recent quarters have certainly been unpleasant; however, increasing margins, increasing revenues, and a large cash reserve suggest that Sun’s current financial position is not hampering its ability to compete effectively in any way. In technology, Sun engineers are roundly acclaimed as talented in producing both cutting-edge hardware and software that admirably perform a wide variety of tasks. Sun systems are both stable and powerful. In services, Sun has the ability to compete on every level; no competitor offers a service for which Sun does not have a directly comparable alternative. Sun’s major strategic shortcoming is its competitive position, which over the years has evolved due to a combination of growing competition from Sun’s major rivals and evolution in the software industry. While Sun once held a nearly unchallenged position in the mid- level to high-end server market, in recent years this position has come under attack from both ends, causing Sun to be squeezed by competitors looking to eventually devour all of Sun’s market share by reaching into the core of mid- level servers. At the top end of the network hardware market, the battle rages between HP, IBM, and Sun. While Sun leads in the manufacture of powerful servers that run the Unix operating system, which account for 60 percent of the $60 billion server market, HP is close behind in this arena, and IBM still has a decided advantage in very powerful mainframe computers. Compounding IBM’s advantage is that there is a growing trend to replace entire rooms full of servers (many of which are made by Sun) with a single, powerful machine (such as an IBM mainframe). The advantages to this are that single, large computers are faster, cheaper, easier to maintain, and more flexible than a room full of smaller computers. Competing with IBM at the top end of the market is difficult, as replacing a mainframe with a high-end Unix server is inherently much harder than replacing many Unix servers with a single mainframe.xi Therefore, Sun’s position at the top end of the server market is under attack, and Sun’s recourse is difficult as it’s technological emphasis is fundamentally not well-suited to the market in which they are trying to compete. This is particularly unfortunate as the high-end market, although not the largest segment, is the most consistent, and high-end customers are more likely to buy expensive ancillary products and services, such as storage systems and consulting services, where Sun also competes. Another attack from above comes through software. Sun lacks adequate product to compete in the current arena of struggle of the big players, middleware. Middleware is a collection of programs which links hardware and software over the internet, and runs web-based applications. Ironically, the necessity of this software was created by Sun’s own vision of network computing. Application servers, the core of middleware, are

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dominated by IBM and BEA. Microsoft is looking to compete as well with its .NET platform. xii Not having a competitive product offering in this area means that Sun is less likely to get software contracts not only in middleware, but also in other areas, since related software tends to have synergistic benefits. This kind of lapse is unacceptable if Sun is to maintain its stated software strategy, with relies on Java-compatible product offerings and the creation of holistic solutions that create value by going beyond simple software packages. As Sun struggles to maintain its grasp of the high-end server market, IBM and HP are simultaneously invading Sun’s hallowed ground, the mid-range Unix server. With new product offerings in this segment that are highly price competitive, Sun finds itself competitively challenged, with the natural erosion of market share being the result. Furthermore, one of the segment’s largest customers, internet firms, have all but disappeared with the technology crash. From below, at the low end of the server market, Sun is facing increasing competition from servers running either Microsoft’s Windows NT software or Linux, which is a free, open-source version of Unix. The trouble here is the advantage of commoditization. Standards-based information technology products are able to be mass produced, and so attract greater research and development spending than do Sun’s customized solutions.xiii Another problem is economies of scale. Companies building servers around Intel’s microprocessors, especially its new Itanium chip, face substantial supplier power, but nonetheless receive a reasonable price given Intel’s production volume. Furthermore, those servers also utilizing Linux have low operating system costs. This puts them at a considerable price advantage to Sun’s Solaris Operating Environment and UltraSPARC processors, for which Sun demands a premium. Furthermore, at the low end of the spectrum, the potential performance benefits of Sun’s proprietary systems are less valuable than they are at the high end; price is the primary consideration in this market. Linux specifically, and open-source software in general, threatens Sun’s position in hardware since Sun’s hardware products are currently optimized to run the proprietary Unix-based Solaris operating environment. However, it also has tremendous implications for Sun’s software, which has always been a lucrative franchise for Sun. While Linux is currently employed only in low-end servers, it is gradually being adapted to handle medium and high-end servers, and in this effort it has the intellectual and financial backing of major corporations, including IBM, which has personally poured $1 billion into the development of Linux. As it stands, Linux now holds 13.7 percent of the server market and is growing fast, while Microsoft’s 59.9 percent market share is predicted to dwindle in the coming years.xiv The continual pressure of Linux also exposes some contradictions in Sun’s strategy, which has always championed open-source, to an extent. On the one hand, Sun loves to use Linux as a weapon against its software archrival, Microsoft. However, as the leading vendor of Unix-based systems, Sun stands to lose big if Linux becomes the standard operating system across the board, from standardized low-end servers to customized mainframes.xv

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While Linux supporters like IBM insist that Sun is scared of Linux and does not support it wholeheartedly, Sun insinuates that companies like IBM are embracing Linux as a marketing ploy to mask incompatible product lines or lack of software knowledge.xvi One thing that IBM and other backers will openly admit is that they hope to undermine the market power of both Microsoft and Sun. If operating systems are commoditized, Linux supporters figure, then companies will spend more money buying their hardware, software, and services. In this same vein, RealNetworks published the source code of its multimedia software as an aggressive move to prevent Microsoft’s domination of this software segment.xvii Despite being in its early stages, the threat of Linux must be counteracted.

Solution Blaisdell Consulting believes that Sun must carve out a sustainable market share in order to continue being competitive in the future. In order to achieve this, it is our recommendation that Sun cut its losses and give into commoditization, especially in low-end servers. In this highly price competitive market, it is essential that Sun both offer products and offer them competitively. Maintaining a strong customer base in low-end servers will ensure that upgrade customers will have accumulated brand loyalty that will play into Sun’s hands as customers move into their dominant mid-grade server range. In order to do this, Sun must consent to offer Linux widely throughout the low-end range to reduce the price of these units. They should also strongly consider offering Intel’s Itanium chip, if this move results in cost savings over their proprietary UltraSPARC chips. Too many computing companies, for example Apple and Silicon Graphics, have fallen into obscurity by insisting on proprietary features. While proprietary features may be viewed as superior, if they are not competitively priced and therefore do not sell, no advantage is gained. At the upper end, if the trend toward mainframes is expected to continue, Sun should devote resources to developing competitive mainframes in addition to their high-end servers. Not only are these products highly profitable in themselves, but have compounded benefits in the associated services and products that are generally purchased with mainframes, areas in which Sun is already very competitive and where the added sales could offset the development cost of mainframes. Regardless of whether or not entering in mainframes is technically feasible, Sun needs to shore up its product line in mid-range servers. It has created too much brand respect and product dominance in this area to allow for invasion from other brands, especially considering Sun’s extensive efforts to network-enable all electronic devices worldwide, which will stimulate demand for servers. Sun has the ability to remain technologically dominant in this area, and should focus resources to ensure that this is the case. With this in mind, it is imperative that Sun remain ever watchful of the development of Linux. If Linux encroaches extensively on Sun’s Solaris Operating Environment, reducing Solaris’

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current technical advantages in mid-range servers and making Solaris’ price premium difficult to justify, it is imperative that Sun embrace this free technology rather than cling to Solaris or try to speed its development to keep it sufficiently ahead. Sun should devote the resources saved through reduced development of its proprietary operating system and microprocessors for low-end servers to software development, specifically middleware currently, but eventually anywhere that their software lags behind the competition. Sun has the coding expertise to create very competitive software in any area, and a knowledge base wide enough to create comprehensive, integrated software which allows increased efficiency. Software, furthermore, is highly profitable, and apart from operating systems, basic database and email programs, is currently impervious to free alternatives. It also serves as a stepping stone to other software purchases, and can easily be bundled with operating systems and other widely distributed software to both increase market share and price discriminate. Developing programs that make the purchase and upgrading of software less complex and more cost efficient will net Sun greater corporate sales and brand loyalty. Continued ingenuity and the integration of programs to reduce complexity will reap benefits and insulate Sun from the effects of niche software producers that cannot offer the price/performance of more comprehensive or bundled software. Increased emphasis on software is also desirable as moving away from proprietary systems will reduce income from hardware. Another area of opportunity to stem the tide of open-source software that threatens Sun is to attack its validity. Open-source software has so far proved to be commercially unviable, and many startups that tried to make money from it have fails or are ailing. In order to recover, many of these companies are offering proprietary hybrids; programs based on open-source code that has been modified somewhat.xviii This notion challenges the very foundation of open-source code, the general public license (GPL). This license dictates that all companies building on top of open-source code must then give away their additions as well. Microsoft and others argue that open-source code destroys the legal notion of intellectual property.xix Since the GPL has never been enforced, Sun could create an alliance with other challengers to question its legality. However, given Sun’s long-time support and utilization of open-source to beat back Microsoft, this would constitute an extreme measure and is a distant second choice to utilizing bundling, ingenuity, and other techniques to maintain the profitability of software. Blaisdell Consulting believes that implementing these measures will allow Sun both to maintain the market share that it currently holds in its dominant area, mid-range servers, while soliciting both new customers and ancillary purchases by increasing its competitive presence both at the low-end and high-end of the server market, and strengthening its software offerings. Furthermore, this can be accomplished without extensive capital investment through the reallocation of resources away from the development of failing areas, namely low-end operating systems and microprocessor development.

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i Standard & Poor’s. “Sun Microsystems.” Stock Reports. 1/18/03. ii Multex Fundamentals. “Sun Microsystems” Company Report. 1/28/03. iii Sun Microsystems. “Annual Report, Fiscal Year 2002.” 9/02. iv Annual Report v Annual Report vi Sun Microsystems. “Form 10-Q for period ended 09/29/02.” 11/13/02. vii Form 10-Q. viii Sun Microsystems. “Q2FY03 Quarterly Earnings Release.” Slides. Retrieved electronically 2/15/03. ix www.sun.com x Singer, Michael. “HP snatches UNIX server lead from Sun.” Internet News. 11/27/02. xi The Economist. “Stealing each other’s clothes.” 10/11/2001. xii The Economist. “Losing his Sparc” 6/20/02. xiii The Economist, 6/20/02. xiv Kerstetter, Jim. “The Linux uprising.” Business Week . 3/3/03. xv The Economist, 10/11/2001. xvi The Economist, 10/11/2001. xvii The Economist. “Going hybrid.” 7/25/2002. xviii The Economist. 7/25/02. xix Kerstetter, Jim.

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Appendix

A.1 Selected Financial Data

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A.2

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A.3

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A.4

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A.5