A kinder, gentler McNealy? Don't count on it

Scott McNealy--master of the high-tech taunt, the man who labeled Microsoft an evil empire, the bigmouthed promoter of all things Sun--was counseling humility?

Hours after Sun Microsystems reported record results for the June quarter, chief executive Scott McNealy got a call from one of his top salesmen, who was pumped about the stellar numbers. McNealy's response: "Humble, buddy, humble."

Humble? Scott McNealy--master of the high-tech taunt, the man who labeled Microsoft an evil empire, the bigmouthed promoter of all things Sun--was counseling humility?

Surprisingly, yes. Now that Sun's sales are rising faster than those of Microsoft, Intel and even Dell Computer, it's time for Sun to behave more like an industry leader, McNealy says. That means resisting jokes about the competition, doing fewer of his trademark top 10 lists lambasting Bill Gates, and staying above the fray. In short, it means growing up.

"It's always a little harder being the lead dog," says McNealy, 45. "I've taken a much lower profile in the last year. I haven't been running around yak-yakking."

McNealy knows that's a change for the world's fastest-growing maker of servers-- the computers that run Internet sites, corporate databases and telecommunications equipment. His priority is keeping Sun focused, now that it's not fighting a rebel war against archenemy Microsoft. The Redmond, Wash., software giant is now scrambling to catch up with Sun in Internet computing while appealing a court ruling that it's a monopolist.

Sun shines
Stock performance says it all. Shares of Palo Alto, Calif.-based Sun have rocketed 12-fold in two years, to around US$128 this week. In the same period, Microsoft's shares have risen 33 percent, lagging a 46 percent gain for the Standard & Poor's 500 index.

Sun's gross profit margin--the percentage of sales left after subtracting manufacturing costs--was 52 percent in the quarter ending in June. Margins at Hewlett-Packard, the world's second-biggest computer maker, were 30 percent. No. 1 IBM fared better, at 37 percent. Dell, which cuts overhead by building PCs to order and selling on the Internet, had a gross margin of only 21 percent.

Sun outshone rivals in sales growth too. Sales surged 33 percent during the year ending in June, compared with annual sales growth of 7.50 percent for crosstown rival HP and 7.20 percent for IBM.

"Sun's kicking the living tar out of the other guys," says Doug Van Dorsten, an analyst at Thomas Weisel Partners, a San Francisco investment bank. He rates Sun's shares a "buy."

Paying a premium
Investors pay a premium for Sun's performance. Its shares trade at 125 times earnings, compared with 33 times for IBM and 35 for HP.

"All the good news about Sun is embedded in the stock price," said Art Russell, an analyst at Edward Jones and one of just two researchers who has strayed from the fold of "buy" recommendations and put a "hold" rating on Sun. "One misstep, and this stock is going to get cremated," he added.

Price isn't the only issue nagging investors. Sun's competitors have figured out that the Internet is here to stay. That makes Sun, not Microsoft, the company to gun for.

HP, which missed the Net boom, has new computers to run Web sites and a new CEO, named Carly Fiorina, who's flying around the world to sell them--taking a few well-aimed potshots at McNealy and Sun in the process.

IBM is pitching one-stop shopping for everything from supercomputers to PCs. Embattled Microsoft is pushing to sell its new Windows 2000 operating software to computer makers who are challenging Sun.

Has Sun peaked?
Some rivals say Sun has peaked. The company is growing so fast it can't care for its customers, they assert. Its computers are too expensive, they claim. Given advances in Microsoft's operating systems and chips from Intel and IBM, competitors can build cheaper machines that keep pace with Sun's.

"Sun is headed for a fall," says Jim Ewel, a Microsoft vice president. "It's a supernova before it explodes. It burns brightest at the end."

The Internet's latecomers are getting some traction. HP beat Sun for an estimated US$500 million in computer sales to Amazon.com in May. Earlier that month, HP had come close to nabbing online auctioneer eBay, one of Sun's most visible customers, before Sun came in with the winning bid.

In April, IBM bumped Sun out of a multimillion-dollar contract to supply an undisclosed number of computers to Network Solutions, the VeriSign unit that manages the master directory for millions of Web addresses.

"Sun was out there by themselves living on high margins," said Mike Kerr, IBM's vice president of Web server products. "They haven't focused on managing their accounts."

McNealy hopes to stay at the forefront by having his salespeople pay more attention to existing customers, which hasn't been Sun's strong point, analysts say.

He's pounding the table at investor meetings and industry gatherings, insisting the Web should be as reliable as the phone system. He says only Sun--whose machines are homegrown, from microprocessors to e-commerce software--can make it so.

Battling the big boys
Even though his main business is under attack by the likes of IBM and HP, McNealy has picked a fight on a whole new front--with EMC, the world's biggest maker of data-storage systems for corporations. He's got about 1,000 salespeople and experts working on data storage, and in June he unveiled products aimed squarely at EMC.

All of this means a brand-new set of challenges for McNealy as he grapples with Sun's transformation from underdog to top dog. The biggest one may be keeping up with demand. Order backlog for all Sun products more than doubled to US$1.8 billion in the June quarter, from US$825 million a year earlier.

Some companies say the abundance of orders has made Sun cocky, and its overtaxed sales force is doing little to retain customers who decide to buy from a competitor.

Bruce Chovnick, a general manager at Network Solutions, says Sun didn't push to change his mind when he planned to replace Sun with IBM for new machines.

So far, the encroachments by Big Blue and the others haven't made much of a dent in Sun's bottom line.

McNealy showed his dominance when Sun reported earnings for the fiscal fourth quarter ending June 30: Sales rose 42 percent to US$5.02 billion from a year earlier--Sun's best growth rate in the past decade.

Net income climbed 82 percent to US$720.4 million, including a pretax gain of US$95.8 million from the sale of investments. And per-share earnings excluding the gain and acquisition costs rose to 39 cents, topping the 33-cent average forecast by analysts from First Call/Thomson Financial.

Bragging rights
McNealy--the ice hockey-playing father of three young boys, Maverick, Dakota, and Colt--earned the right to gloat. Sun started life as a maker of workstations--high-powered machines used for computer-aided design and other jobs.

Stanford University graduate student Andy Bechtolsheim had assembled a powerful, inexpensive computer to connect to Stanford's new computer network, attracting the attention of Vinod Khosla, a Stanford MBA.

The pair agreed to work together, and Khosla recruited his friend McNealy--another Stanford MBA--to join them during lunch at a nearby hamburger place.

The threesome convinced Berkeley software expert Bill Joy to come on board, and in 1982 they founded Sun, the name an acronym for Stanford University Network.

Growing pains

McNealy took over as CEO in 1984, when Khosla, now a partner in Silicon Valley venture powerhouse Kleiner Perkins Caufield & Byers, left. Four years later, Sun reached US$1 billion in annual sales, placing it among the fastest-growing companies in the valley's history.

The mid-1990s weren't as kind. Compaq Computer, HP, and IBM started making workstations with Intel's souped-up Pentium Pro processor and Microsoft's Windows operating system.

The machines performed like many Sun computers but at a lower price. In October 1996, Compaq unveiled the US$6,700 Professional Workstation, which used Wintel parts, and showed off data indicating it could do the same job as a US$29,995 Sun machine.

McNealy was preaching that the PC would become a dinosaur as Sun's servers stored and distributed information over a vast web of connected computers. The message was largely lost on the masses, and few seemed to get Sun's tag line: "The network is the computer."

Gates, meanwhile, held onto his notion of the PC as the center of computing. Sales of Windows 95--and personal computers based on the operating system--soared.

"A lot of analysts said Sun needed to get on the Wintel bandwagon before it was too late," says Tom Henkel, an analyst at research firm Gartner Group, who worked at Sun at the time.

McNealy held his ground, a lone voice warning that Microsoft and Intel would hollow out the big computer companies, making them little more than resellers of Wintel products.

Wintel threat
HP and others didn't listen, and they cut back spending on Unix, a more expensive operating system developed by AT&T 30 years ago.

Sun kept pouring money into Solaris, its own type of Unix. The investment paid off when Unix machines, including those running on the popular Unix offshoot, Linux, proved more reliable than Windows for Internet sites.

Sun also spent more research dollars on Java, the now-popular language used for writing programs that will run on any computer system.

"We took a big hit through all of the '80s and all of the '90s because we invested," says McNealy.

Sun's fortunes improved in October 1998. The company reported a 19 percent gain in sales in its fiscal first quarter, helped by the thing that McNealy and Sun managers had been betting on: the Internet. Orders rose 32 percent, surprising many analysts.

Companies big and small had started spending millions on machines to get online, buying Sun boxes because they were designed from the outset to run networks--unlike Wintel rivals.

Sun shares took off after the sales report and haven't slowed.

Business booms
Business is so good that Sun is trying to move production of its cheaper workstations to outside suppliers to make room in its plant in Newark, Calif., south of Oakland, to build more Enterprise 10,000s, which look like big purple refrigerators. Sun sold almost 500 of the million-dollar-plus "E10Ks" in the June quarter. It sold about 100,000 servers altogether.

Microsoft, by contrast, has suffered sales-slowing delays on new versions of Windows and has seen some of its best talent bail.

Microsoft has made life miserable for Sun at times, but McNealy has gotten a lot of free marketing by poking fun at Chairman Bill and Windows, which McNealy calls the "hairball on the desktop."

Cable gambit
Microsoft's brash move into other businesses even helped push customers into McNealy's hands. In December 1997, John Malone, then CEO of cable company TCI, was deciding if he should use Sun's Java or Microsoft's Windows CE to run at least 5 million new television set-top boxes. Sun pursued the account because it would be a boost for Java, which didn't have many mass-market uses at the time.

McNealy wanted a deal with Malone before the Consumer Electronics Show in Las Vegas--less than a month away--where he planned to give a speech. He loaded his team on the corporate jet at 5:30 a.m. on Christmas Eve and flew to Denver.

Sitting in the boardroom at TCI, McNealy asked Malone if he was willing to grant more power to Bill Gates, who had muscled into the cable business with a $1 billion investment in TCI rival Comcast six months earlier. The scare tactic, and a bit of McNealy charm, helped seal a deal in three hours.

"That put Java on the map," says Marge Breya, who helped push Sun into the cable industry and who's now head of marketing at iPlanet, the old Netscape Communications, which America Online and Sun run jointly as an Internet software company.

Now, as the company to beat in Internet computing, Sun regularly takes heat for exerting too much control over Java by refusing to turn it over to an independent standards body.

A bigger challenge was a series of outages last year at eBay. One glitch shut down the site for almost a day, forcing Sun into the headlines. Worse yet, eBay seriously considered buying computers from IBM and HP before deciding to stick with Sun.

Rattled by the incident, McNealy started 14 different initiatives to improve reliability. Sun's people now audit customers to make sure they're using the equipment correctly.

Such steps are necessary because competitors have revived their Unix computers, hoping to ape Sun's success. IBM, for one, recently unveiled a new machine in its RS/6000 S80 line that runs on microprocessors made out of copper.

IBM is undaunted. The company plans to hire 2,000 new people and spend more than US$2 billion in the next two years to design and sell more software for running Web sites.

Too expensive?
Some big companies are using Microsoft rather than Sun to power their Web businesses. Retailer Nordstroms, for one, runs its Web shopping site on Windows.

Dell CEO Michael Dell tossed off a McNealy-style challenge in April, saying that Web servers are "ground zero" for his company, and Dell's performance should be measured against Sun's. He's loading Linux on his machines to make them more attractive for Internet businesses.

Sun executives say they aren't afraid of Michael Dell or the free Linux software. To the contrary, they claim to be thrilled by Linux's popularity because it has revived interest in Unix overall, hurting no one but Microsoft.

So what controversy is McNealy pitching now? He's comparing Sun to something decidedly unsexy: the phone company. He says the Internet should be as reliable and simple as the phone system.

There should be a Web tone, like a dial tone, he says. To make that happen, companies doing business online need to buy computers the way the phone company buys switches: as an integrated unit from one company.

"Big freaking switches"
Many corporations agree and are buying big Sun servers made to order, the way customers buy PCs from Dell.

McNealy calls his systems "big freaking Web tone switches," and he's spent the past decade assembling the parts: the Solaris operating system, Java Internet software, and iPlanet e-commerce code.

McNealy says the strategy is working because companies don't have time to build computer systems with parts from lots of software and hardware makers, the way Microsoft and Intel want them to.

Saying that smart companies don't care about the individual parts of a computer system helps Sun gloss over the fact that its own microprocessor, called UltraSparc II, is aging and that newer ones appear to be late. Talking about processor speeds and other attributes is a losing proposition for Sun right now.

Storage strategy
Another component of the "big freaking switch" that Sun has struggled with is information storage. Discussing it can be soporific, until you come to profits. Storage leader EMC saw the opportunity long before Sun and others, and its second-quarter net income rose 50 percent to US$429 million from a year earlier.

Some companies already are buying more storage machines than servers because of the digital trails that people leave by shopping online, making cell-phone calls, even just stopping at a Web site. Companies hoard every shred of information, often in million-dollar, vending machine-size boxes full of chips, disks, and software made by EMC.

EMC's pitch is that storage systems housing valuable data will form the core of computer systems as the Internet evolves, and servers like Sun's will become commodities that get tacked on as needed. That turns Sun's universe on its head. EMC says it actually looks for companies buying Sun computers because they're an easy sell for EMC storage.

"Every time they sell a server, they increase our market opportunity," says EMC vice president of strategic planning Don Swatik.

Nurturing and managing
McNealy has responded by tapping Janpieter Scheerder, the aggressive Dutchman who developed Solaris. In June, Scheerder unveiled a new device, code-named Purple. Sun's notion is that companies can buy the six-inch-high rectangular devices, stacking them as need be, instead of spending millions on an EMC machine.

McNealy says he's looking forward to the battle with EMC. He couldn't repress his excitement that CEO Michael Ruettgers had mentioned Sun as a competitor in a call with analysts. "We struck a nerve," McNealy laughs.

That kind of glee shows that McNealy hasn't abandoned his wisecracking ways entirely.

It's clearly going to be hard for McNealy to tame his tongue. As an underdog, Sun had a single-minded sense of purpose. As the front-runner, Sun needs to attend to the more complex tasks of nurturing customers and managing size.

Investors, wary of Sun's high price-to-earnings ratio, may look beyond McNealy's gibes and start listening to his rivals. Humble, Scott, humble.

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