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Comprehensive Problem: Sun Microsystems

Comprehensive Problem: Sun Microsystems


A complete analysis conducted on the financial statements and status of Sun Microsystems exposed key
issues determined to be of great import to shareholders. After examining the research findings and
analysis, it seems that Sun Microsystems finances have not maintained a steady incline. In fact, it had
definitely experienced some highs and lows in its return on investment and stockholders equity over a
four- year evaluation spanning the years 1998 through 2001. In an effort to decipher the problems
within the companys operations, data from the following reports and ratios offered considerable clues.
To collect relevant data, the annual percentage change in net income per common share diluted, net
income/net revenues, the major income statement accounts to net revenues, return on stockholders
equity, the price/earnings (P/E) ratio, and the book values per share for each year numbers were
examined. In order for Sun Microsystems to see a greater return in its bottom line assets, it must
consider an alternative approach in operating its organization.
The following is a comprehensive view of the finances of Sun Microsystems from 1998-2001. Sun
Microsystems has experienced significant fluctuations in performance. The annual percentage change in
net income per common share diluted and profit margins were as follows:
Table 1
Percentage change in net income per common share-diluted
1999 $ .31 2000 $ .55 2001 $ .27
1998 $ .24 1999 $ .31 2000 $ .55
$ .07 $ .24 $-.28
+29.2% +77.4% -50.9%

Table 2
Profit Margin
1998 1999 2000 2001
7.66% 8.72% 11.79% 5.08%

Sun Microsystems saw tremendous growth in net income between 1999 and 2000 leading up to a sharp
decline between 2000 and 2001. The income statements show increased revenues in 2001,
contradicting the data above. Further analysis provides an explanation for the deceleration of income
growth in spite of increased revenue. The ratios of several expenses to net revenues were taken for
2000 and 2001.
Table 3
Percent of net revenue
2000 2001
Net revenues $15,721 $18,250
Cost of sales $7,549 48.02% $10,041 55.02%
Research and development 1,630 10.37 2,016 11.05
S, G, and A 4,072 25.90 4,544 24.90
Provision for income taxes 917 5.83 603 3.30


The main contributing factor to the decline in the return on stockholders equity (25.37% to 8.73%) was
the decline in the profit margin (11.79% vs. 5.08%). The decrease in asset turnover (1.11 to 1.00) made a
small contribution to the decline, as did the decline in the debt ratio (48.4% to 41.8%).
Ratios for return on assets and return on equity offer support for the loss in stockholders equity. Return
on assets went from 13.1 in 2000 to 5.1 in 2001 and return on equity dropped from 25.4 in 2000 to 8.7
in 2001. Return on equity represents return on assets divided by the difference of 1 and debts/assets.
This supports the conclusion that cost of sales, a reflection of asset investment, is most responsible for
the lackluster net income of 2001. The price/earnings (P/E) ratio further demonstrates the fluctuation in
value to stockholders from 1998 to 2001.
Table 4
P/E = Stock price/net income per common share-diluted (EPS)
1998 1999 2000 2001
P/E 46.9 54.0 51.8 35.2

The sharp decline in performance caused investors to pay a lower multiple for the stock. The lower P/E
in 2001 suggests again that the return on stockholders investment is small for revenue generated in
that year and stock prices will decline accordingly since P/E multiplied by earnings per share determines
stock price. Finally, consider the ratio of price (stock price) to book value (net worth per share) from
1998 to 2001.

Table 5
Price to book value = Stock price/book value
1998 1999 2000 2001
P/BV 9.53 10.81 12.45 2.91

Once again, the sharp fall off in price to book value between 2000 and 2001 can be attributed to the
decline in performance (and the impact on the stock prices). Book value was going up, but the ratio
declined sharply due to the declining stock prices. The price/book ratio shows that the stock at Sun
Microsystems was not as highly valued in the market in 2001. The difference between the net worth per
share of the company and what the company is able to sell shares for greatly decreased. Changes in the
industry as a whole or changes in consumer habits could be contributing factors to the change in stock
values experienced at Sun Microsystems. Internally, Sun Microsystems needs to explore ways to
maximize profit and minimize costs of producing goods.
Business Alternatives
Looking at the financial statement analysis for Sun Microsystems, one can definitely see the companys
strengths and their needs. The balance sheet indicates what the firm owns and how these assets are
financed in the form of liabilities or ownership interest and the statement of income is the major device
for measuring the profitability of a firm over time (Block and Hirt, 2005, p.25, 28). The financial
statements analysis shows that Sun Microsystems has done very well and made it through the challenge
from 2000 to 2001. The stock prices dropped drastically from 2000 to 2001 and there was a huge
increase in cost of sales resulting in the recommendation to outsource some of their employees to
compensate for some deficit. Sun Microsystems is a very aggressive company and the employees have
fought to bring the costs down as they continued to bring exciting new products to the market (Block
and Hirt, 2005, p. 82). Outsourcing will allow Sun Microsystems to put more concentration into the
products that they have while they make sure they have all their finances in order for the years to come.
The revenue growth of 16% for Sun Microsystems was very significant for the business (Block and Hirt,
2005, p.82). Outsourcing some employees gives Sun Microsystems an opportunity to have a consulting
firm come in and evaluate their business plan. This business plan will potentially lead Sun Microsystems
to long lasting success. A business plan renews their vision, strategic focus and adds value to their
target market segments. It also provides the systematic plan for improving sales, gross margin, and
profitability (Bplans.com, 2007).
Conclusion
Sun Microsystems needs to implement a new plan quickly to save its company from going under as its
stockholders equity continues to decrease. It has experienced a decline in its net income between 2000
and 2001. The P/E in 2001 determined that the return on stockholders investment was rather small
when compared to the amount of revenue it generated. Stock prices also declined. Not all changes were
specific to Sun Microsystems, as some of these changes were industry wide. If Sun Microsystems was to
outsource some of its employees, the money saved overall would appeal to its stockholders.
Consequently, outsourcing will allow for more emphasis and focus on product development, which can
ultimately increase revenue. Sun Microsystems should consider bringing in a consulting firm to look at
its current business plan. Potentially, by doing so, the consulting firm can sift through possible problems
and replace them with solutions. Restructuring the business plan will bring a newfound energy to the
company by renewing its vision and focusing on the appropriate market segment.

References
Block, S. B., & Hirt, G. A. (2005). Foundations of Financial Management. [University of Phoenix Custom
Edition e-text]. New York: McGraw-Hill. Retrieved April 26, 2007, from University of Phoenix, rEsource,
MBA503-Introduction to Finance and Accounting Course Web site.
Bplans.com. (2007). Executive summary. Retrieved May 5, 2008, from http://www.bplans.com

CP 3-2. Sun Microsystems is a leading supplier of computer related products, including servers,
workstations, storage devices, and network switches.

In the letter to stockholders as part of the 2001 annual report, President and CEO Scott G. McNealy
offered the following remarks?

Fiscal 2001 was clearly a mixed bag for Sun, the industry, and the economy as a whole. Still, we finished
with revenue growth of 16 percentand thats significant. We believe its a good indication that
Sun continued to pull away from the pack and gain market share. For that, we owe a debt of gratitude to
our employees worldwide, who aggressively brought costs downeven as they continued to bring
exciting new products to market.

The statement would not appear to be telling you enough. For example, McNealy says the year was a
mixed bag with revenue growth of 16 percent. But what about earnings? You can delve further by
examining the income statement in Figure 1. Also, for additional analysis of other factors, consolidated
balance sheet(s) are presented in Figure 1.

Sun Microsystems, Inc.

Summary Consolidated Statement of Income (in millions)

2001

Dollars 2000

Dollars 1999 Dollars 1998 Dollars

Net revenues $18,250 $15,721 $11,806 $9,862

Costs and expenses:

Cost of sales 10,041 7,549 5,670 4,713

Research and development 2,016 1,630 1,280 1,029

Selling, general and administrative 4,544 4,072 3,196 2,826

Goodwill amortization 261 65 19 4

In-process research and development 77 12 121 176

Total costs and expenses 16,939 13,328 10,286 8,748

Operating income 1,311 2,393 1,520 1,114

Gain (loss) on strategic investments (90) 208 -- --

Interest income, net 363 170 85 48

Litigation settlement -- -- -- --

Income before taxes 1,584 2,771 1,605 1,162

Provision for income taxes 603 917 575 407

Cumulative effect of change in

Accounting principle, net

(54)

--

--

--

Net income $ 927 $ 1,854 $ 1,030 $ 755

Net income per common share

Diluted

$ 0.27

$ 0.55

$ 0.31

$ 0.24

Shares used in the calculation of

Net income per common share

Diluted

3,417

3,379

3,282

3,180

CP 3-2. Continued

Sun Microsystems, Inc.

Consolidated Balance Sheets (in millions)

2001 2000

Assets

Current assets:

Cash and cash equivalents $ 1,472 $ 1,849

Short-term investments 387 626

Accounts receivable, net of allowances of $410 in 2001

and $534 in 2000

2,955

2,690

Inventories 1,049 557

Deferred tax assets 1,102 673

Prepaids and other current assets 969 482

Total current assets 7,934 6,877

Property, plant and equipment, net 2,697 2,095

Long-term investments 4,677 4,496

Goodwill, net of accumulated amortization of $349 in 2001

and $88 in 2000

2,041

163

Other assets, net 832 521

$18,181 $14,152

Liabilities and Stockholders Equity

Current liabilities:

Short-term borrowings $ 3 $ 7

Accounts payable 1,050 924

Accrued payroll-related liabilities 488 751

Accrued liabilities and other 1,374 1,155

Deferred revenues and customer deposits 1,827 1,289

Warranty reserve 314 211

Income taxes payable 90 209

Total current liabilities 5,146 4,546

Deferred income taxes 744 577

Long-term debt and other obligations 1,705 1,720

Total debt $ 7,595 $ 6,843

Commitments and contingencies

Stockholders equity:

Preferred stock, $0.001 par value, 10 shares authorized

(1 share which has been designated as Series A Preferred

participating stock); no shares issued and outstanding

--

--

Common stock and additional paid-in-capital, $0.00067

par value, 7,200 shares authorized; issued: 3,536 shares

in 2001 and 3,495 shares in 2000

6,238

2,728

CP 3-2. Continued

Treasury stock, at cost: 288 shares in 2001 and 301

shares in 2000

(2,435)

(1,438)

Deferred equity compensation (73) (15)

Retained earnings 6,885 5,959

Accumulated other comprehensive income (loss) (29) 75

Total stockholders equity 10,586 7,309

$18,181

$14,152

CP Questions

1. Referring to Exhibit 1, compute the annual percentage change in net income per common share-
diluted (2nd numerical line from the bottom) for 1998-1999, 1999-2000, and 2000-2001.

2. Also in Exhibit 1, compute net income/net revenue (sales) for each of the four years. Begin with
1998.

3. What is the major reason for the change in the answer for question 2 between 2000 and 2001?
To answer this question for each of the two years, take the ratio of the following major income
statement accounts to net revenues (sales).

Cost of sales

Research and development

Selling, general and administrative expense

Provision for income tax

4. Compute return on stockholders equity for 2000 and 2001 using data from Exhibits 1 and 2.

5. Analyze your results to question 4 more completely by computing ratios 1, 2a, 2b, and 3b (all
from this chapter) for 2000 and 2001. Actually the answer to ratio 1 can be found as part of the answer
to question 2, but it is helpful to look at it again.

What do you think was the main contributing factor to the change in return on stockholders equity
between 2000 and 2001? Think in terms of the Du Pont system of analysis.

CP 3-2. Continued

6. The average stock prices for each of the four years shown in Exhibit 1 were as follows:

1998 11

1999 16

2000 28

2001 9

a. Compute the price/earnings (P/E) ratio for each year. That is, take the stock price shown above
and divide by net income per common stock-dilution from Exhibit 1.

b. Why do you think the P/E has changed from its 2000 level to its 2001 level? A brief review of P/E
ratios can be found under the topic of Price-Earnings Ratio Applied to Earnings per Share in Chapter 2.

7. The book values per share for the same four years discussed in the preceding question were:

1998 $1.18

1999 $1.55

2000 $2.29

2001 $3.26

a. Compute the ratio of price to book value for each year.

b. Is there any dramatic shift in the ratios worthy of note?

CP Solution:

1. Percentage change in net income per common share-diluted

1999 $ .31 2000 $ .55 2001 $ .27

1998 $ .24 1999 $ .31 2000 $ .55

$ .07 $ .24 $.28

+29.2% +77.4% 50.9%

2. Profit margin

1998 1999 2000 2001

7.66% 8.72% 11.79% 5.08%

3. Percent of net revenue

2000 2001

Net revenues $15,721 $18,250

Cost of sales 7,549 48.02% 10,041 55.02%

Research and

development 1,630 10.37 2,016 11.05

S, G, and A 4,072 25.90 4,544 24.90

Provision for

income taxes 917 5.83 603 3.30

The main problem between 2000 and 2001 was the increase in cost of sales as a percentage of net
revenue (48.02% to 55.02%).

CP 3-2. Continued

4. Return on stockholders equity

2000 2001

Net income $1,854 $ 927

Stockholders equity 7,309 10,586

25.37% 8.76%

5. 2000 2001

1. 11.79% 5.08%

2.a. 13.1% 5.10%

2.b. 11.79% x 1.11 5.08% x 1.00

13.09% 5.08%

3.b.

25.37% 8.73%

The main contributing factor to the decline in the return on stockholders equity (25.37% to 8.73%)
was the decline in the profit margin (11.79% vs. 5.08%). The decrease in asset turnover (1.11 to 1.00)
made a small contribution to the decline as did the decline in the debt ratio (48.4% to 41.8%).

CP 3-2. Continued

6.a. P/E = Stock price/net income per common share-diluted (EPS)

1998 1999 2000 2001

P/E 46.9 54.0 51.8 35.2

b. The sharp decline in performance caused investors to pay a lower multiple for the stock.

7.a. Price to book value = Stock price/book value

1998 1999 2000 2001

P/BV 9.53 10.81 12.45 2.91

b. Once again, the sharp fall off in price to book value between 2000 and 2001 can be attributed to
the decline in performance (and the impact on the stock prices). Book value was going up, but the ratio
declined sharply due to the declining stock prices.