1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended December 27, 1998 or [ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from ______ to _______ Commission file number:0-15086 SUN MICROSYSTEMS, INC. (Exact Name of registrant as specified in its charter) <TABLE> <S> <C> DELAWARE 94-2805249 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) </TABLE> 901 SAN ANTONIO ROAD PALO ALTO, CA 94303 (Address of principal executive offices with zip code) Registrant's telephone number, including area code: (650) 960-1300 N/A (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS: Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. YES [X] NO [ ] APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date. <TABLE> <S> <C> CLASS OUTSTANDING AT DECEMBER 27, 1998 Common Stock - $0.00067 par value 385,264,651 </TABLE>
2 INDEX <TABLE> <CAPTION> PAGE ---- <S> <C> <C> COVER PAGE 1 INDEX 2 PART I - FINANCIAL INFORMATION Item 1 - Financial Statements Condensed Consolidated Balance Sheets 3 Condensed Consolidated Statements of Income 4 Condensed Consolidated Statements of Cash Flows 5 Notes to Condensed Consolidated Financial Statements 7 Item 2 - Management's Discussion and Analysis of Results of Operations and Financial Condition 11 PART II - OTHER INFORMATION Item 1 - Legal Proceedings 24 Item 4 - Submission of Matters to a Vote of Security Holders 24 Item 5 - Other Information 25 Item 6 - Exhibits and Reports on Form 8 - K 25 Item 7A - Quantitative and Qualitative Disclosures about Market Risk 25 SIGNATURES 26 </TABLE> 2
3 PART I - FINANCIAL INFORMATION ITEM 1 - FINANCIAL STATEMENTS SUN MICROSYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands) <TABLE> <CAPTION> December 27, June 30, 1998 1998 ----------- ----------- (unaudited) <S> <C> <C> ASSETS Current assets: Cash and cash equivalents $ 669,862 $ 822,267 Short-term investments 902,929 476,185 Accounts receivable, net 2,108,237 1,845,765 Inventories 363,664 346,446 Deferred tax assets 373,541 371,841 Other current assets 327,461 285,021 ----------- ----------- Total current assets 4,745,694 4,147,525 Property, plant and equipment, at cost 2,593,985 2,257,228 Accumulated depreciation and amortization (1,141,377) (956,616) ----------- ----------- 1,452,608 1,300,612 Other assets, net 363,218 262,925 ----------- ----------- $ 6,561,520 $ 5,711,062 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Short-term borrowings $ 12,351 $ 7,169 Accounts payable 611,412 495,603 Accrued liabilities 1,230,718 1,166,491 Income taxes payable 205,340 188,641 Other current liabilities 288,169 264,967 ----------- Total current liabilities 2,347,990 2,122,871 Deferred income taxes and other obligations 112,527 74,563 Total stockholders' equity 4,101,003 3,513,628 ----------- $ 6,561,520 $ 5,711,062 =========== =========== </TABLE> See accompanying notes 3
4 SUN MICROSYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME (unaudited) (in thousands, except per share amounts) <TABLE> <CAPTION> Three Months Ended Six Months Ended ------------------------ ------------------------ December 27, December 28, December 27, December 28, 1998 1997 1998 1997 ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> Net revenues: Products $2,384,740 $2,161,992 $4,540,858 $4,009,880 Services 399,700 288,251 734,766 538,967 ---------- ---------- ---------- ---------- Total net revenues 2,784,440 2,450,243 5,275,624 4,548,847 ---------- ---------- ---------- ---------- Cost and expenses: Cost of sales-products 1,121,500 997,301 2,109,737 1,858,628 Cost of sales-services 225,710 174,329 453,810 340,436 Research and development 303,482 259,228 586,762 481,846 Selling, general and administrative 747,603 696,450 1,459,191 1,311,943 Purchased in-process research and development 12,000 110,100 92,000 162,284 ---------- ---------- ---------- ---------- Total costs and expenses 2,410,295 2,237,408 4,701,500 4,155,137 Operating income 374,145 212,835 574,124 393,710 Interest income, net 20,306 10,197 35,661 20,768 ---------- ---------- ---------- ---------- Income before income taxes 394,451 223,032 609,785 414,478 Provision for income taxes 133,364 73,600 234,824 156,613 ---------- ---------- ---------- ---------- Net income $ 261,087 $ 149,432 $ 374,961 $ 257,865 ========== ========== ========== ========== Net income per common share - basic $ 0.68 $ 0.40 $ 0.99 $ 0.69 ========== ========== ========== ========== Net income per common share - diluted $ 0.64 $ 0.38 $ 0.93 $ 0.65 ========== ========== ========== ========== Shares used in the calculation of net income per share - basic 382,547 373,875 379,883 372,968 ========== ========== ========== ========== Shares used in the calculation of net income per share - diluted 405,288 393,231 401,445 394,165 ========== ========== ========== ========== </TABLE> See accompanying notes. 4
5 SUN MICROSYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (in thousands) <TABLE> <CAPTION> Six Months Ended --------------------------- December 27, December 28, 1998 1997 --------- --------- <S> <C> <C> Cash flows from operating activities: Net income $ 374,961 $ 257,865 Adjustments to reconcile net income to operating cash flows: Depreciation and amortization 313,370 183,472 Tax benefit of options exercised 96,740 74,466 Purchased in-process research and development 92,000 162,284 Net (increase) decrease in accounts receivable (258,651) 16,004 Net increase in inventories (17,218) (15,765) Net increase in accounts payable 114,749 14,414 Net increase in other current and non-current assets (87,687) (97,594) Net increase in other current and non-current liabilities 143,529 19,301 --------- --------- Net cash provided from operating activities 771,793 614,447 --------- --------- Cash flows from investing activities: Acquisition of property, plant and equipment (360,322) (410,453) Acquisition of spare parts and other assets (68,481) (49,080) Payments for acquisitions, net of cash acquired (31,269) (227,655) Acquisition of short-term investments (935,266) (305,738) Sale of short-term investments 235,617 224,309 Maturities of short-term investments 252,268 214,122 --------- --------- Net cash used by investing activities (907,453) (554,495) --------- --------- Cash flows from financing activities: Issuance of common stock, net 92,228 37,189 Acquisition of treasury stock (164,286) (140,537) Proceeds from employee stock purchase plans 58,529 50,649 Net reduction of short-term borrowings and other obligations (3,216) (94,155) --------- --------- Net cash used by financing activities (16,745) (146,854) --------- --------- Net decrease in cash and cash equivalents (152,405) (86,902) --------- --------- Cash and cash equivalents, beginning of period 822,267 660,170 --------- --------- Cash and cash equivalents, end of period $ 669,862 $ 573,268 ========= ========= </TABLE> 5
6 SUN MICROSYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) (unaudited) (in thousands) <TABLE> <CAPTION> Six Months Ended --------------------------- December 27, December 28, 1998 1997 --------- --------- <S> <C> <C> Supplemental disclosures of cash flow information: Cash paid during the period for: Interest $ 745 $ 388 Income taxes $ 58,448 $ 55,503 Supplemental schedule of non-cash investing activities: Stock issued in conjunction with an acquisition $142,028 -- Fair value of assets acquired $198,629 $ 284,294 Cash paid for assets $ 35,684 $ 233,111 Liabilities assumed $ 20,737 $ 51,183 --------- --------- </TABLE> See accompanying notes. 6
7 SUN MICROSYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) BASIS OF PRESENTATION The consolidated financial statements include the accounts of Sun Microsystems, Inc. ("Sun" or the "Company") and its wholly-owned subsidiaries. Intercompany accounts and transactions have been eliminated. Certain amounts from prior years have been reclassified to conform to current year presentation. While the interim financial information is unaudited, the financial statements included in this report reflect all adjustments (consisting of normal recurring accruals) that the Company considers necessary for a fair presentation of the results of operations for the interim periods covered and of the financial condition of the Company at the date of the interim balance sheet. The results for the interim periods are not necessarily indicative of the results for the entire year. The information included in this report should be read in conjunction with the 1998 Annual Report to Stockholders which is incorporated by reference in the Company's 1998 Form 10-K . INVENTORIES (IN THOUSANDS) <TABLE> <CAPTION> December 27, 1998 June 30, 1998 ----------------- ------------- <S> <C> <C> Raw materials $127,115 $ 92,197 Work in process 40,577 58,765 Finished goods 195,972 195,484 -------- -------- $363,664 $346,446 ======== ======== </TABLE> INCOME TAXES The Company accounts for income taxes under the liability method of Statement of Financial Accounting Standards No. 109. The provision for income taxes during the interim periods considers anticipated annual income before taxes, earnings of foreign subsidiaries permanently invested in foreign operations, and other differences. RECENT PRONOUNCEMENTS The Company adopted SOP 98-1 "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" effective July 1, 1998. The adoption of SOP 98-1 did not have a material effect on the Company's consolidated financial position or operating results. In June 1998, Financial Accounting Standard No. 133 ("FAS 133"), "Accounting for Derivative Instruments and Hedging Activities" was issued and is effective for all fiscal years beginning after June 15, 1999. FAS 133 requires the Company to recognize all derivatives as either assets or liabilities and measure those instruments at 7
8 fair value. It further provides criteria for derivative instruments to be designated as fair value, cash flow and foreign currency hedges and establishes respective accounting standards for reporting changes in the fair value of the derivative instruments. Upon adoption, the Company will be required to adjust hedging instruments to fair value in the balance sheet and recognize the offsetting gains or losses as adjustments to be reported in net income or other comprehensive income, as appropriate. The Company is evaluating its expected adoption date and currently expects to comply with the requirements of FAS 133 in fiscal year 2000. The Company does not expect the adoption will be material to the Company's financial position or results of operations. COMPREHENSIVE NET INCOME As of July 1, 1998, the Company adopted Financial Accounting Standards No. 130 ("FAS 130") , "Reporting Comprehensive Income." FAS 130 establishes new rules for the reporting and display of comprehensive net income and its components, however, it has no impact on the Company's net income or stockholders' equity. FAS 130 requires foreign currency translation adjustments and changes in fair value for available for sale securities, which prior to adoption were reported in stockholders' equity, to be included in comprehensive income. The components of comprehensive net income, net of tax, are as follows: <TABLE> <CAPTION> Three Months Ended Six Months Ended ------------------------ ------------------------ December 27, December 28, December 27, December 28, 1998 1997 1998 1997 ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> Net income $ 261,087 $ 149,432 $ 374,961 $ 257,865 Unrealized gain (loss) on securities (6,513) 9,406 (20,637) 9,592 Change in cumulative translation adjustment 242 7,515 2,201 (1,622) --------- --------- --------- --------- Comprehensive net income $ 254,816 $ 166,353 $ 356,525 $ 265,835 ========= ========= ========= ========= </TABLE> ACQUISITIONS On August 28, 1998 the Company acquired all of the outstanding capital stock of NetDynamics, Inc. ("NetDynamics") by means of a merger transaction pursuant to which all the shares of NetDynamics capital stock were converted into the right to receive Sun common stock based upon an agreed-upon exchange ratio which was calculated using an agreed-upon average market price for Sun common stock. The Company issued 2,746,785 shares of Sun common stock (with a fair market value of $48.26875 per share) as the consideration for the acquisition. The transaction was accounted for as a purchase and the excess purchase price over the estimated fair value of net tangible assets has been allocated to various intangible assets, primarily consisting of developed technology ($20 million) and goodwill ($36.2 million), customer base ($10 million) and assembled workforce ($2 million). In addition to the intangible assets acquired, the Company recorded an $80 million charge, representing the write-off of in-process research and development ("IPRD"). On September 28, 1998 the Company acquired all of the outstanding capital stock of i-Planet, Inc. ("i-Planet") by means of a merger transaction pursuant to which all the shares of i-Planet capital stock were converted into the right to receive cash. The transaction was accounted for as a purchase and the excess purchase price over the estimated fair value of net tangible assets has been allocated to various intangible assets, primarily consisting of developed technology ($3.3 million) and goodwill type assets ($18.3 million). In addition to the intangible assets acquired, the Company recorded an $8.4 million charge, representing the write-off of IPRD. 8
9 On October 16, 1998, the Company acquired all of the outstanding capital stock of Beduin Communications Incorporated ("Beduin") by means of a share purchase transaction pursuant to which all the shares of Beduin capital stock were converted into the right to receive cash. The transaction was accounted for as a purchase and the excess purchase price over the estimated fair value of net tangible assets has been allocated to various intangible assets, primarily consisting of developed technology ($3.1 million) and goodwill type assets ($1.4 million). In addition to the intangible assets acquired, the Company recorded an $3.6 million charge, representing the write-off of IPRD. For financial reporting purposes, the Company is required for each acquisition to determine the fair value of all identified intangible assets acquired and expense the fair value associated with IPRD for which there is no alternative future use. The allocation of $80 million, $8.4 million, and $3.6 million of the purchase price to IPRD in the case of the NetDynamics, i-Planet and Bediun acquisitions, respectively, represents the estimated fair value based on risk adjusted cash flows related to each incomplete project. The Company believes that such fair values do not exceed the amount a third party would pay for each such in-process technology. At the date of each of the acquisitions, the projects associated with the IPRD efforts had not yet reached technological feasibility and the in-progress technology had no alternative future use. Accordingly, these costs were expensed. In making its purchase price allocations for the NetDynamics, i-Planet, and Bediun acquisitions, the Company considered present value calculations of income, an analysis of project accomplishments and completion costs, an assessment of overall contribution, as well as project risks. The values assigned to IPRD related to each acquisition were determined by estimating the costs to develop the purchased in-process technology into commercially viable products, estimating the resulting net cash flows from each project, excluding the cash flows related to the portion of each project that was incomplete at the acquisition date, and discounting the resulting net cash flows to their present value. Each of these forecasts were based upon future discounted cash flows, taking into account the state of development of each in-process project, the cost to complete that project, the expected income stream, the life cycle of the product ultimately developed, and the associated risks. Projected future net cash flows attributable to the in-process technology, assuming successful development of such technologies, were discounted to their present value using a discount rate which was derived based on the Company's estimated weighted average cost of capital plus a risk premium to account for the inherent uncertainty surrounding the successful completion of each project and the associated estimated cash flows. The values assigned to developed technologies related to each acquisition were based upon future discounted cash flows related to each of the existing products' projected income stream. The values of the customer bases were determined based upon the value of existing relationships and the expected revenue stream. The value of the assembled workforces were based upon the cost to replace that workforce. Intangible assets, including goodwill, are being amortized over their estimated useful lives, generally two to five years. 9
10 SUN MICROSYSTEMS, INC. AND AMERICA ONLINE, INC. STRATEGIC DEVELOPMENT AND MARKETING AGREEMENT On November 23, 1998, Sun and America Online, Inc. ("AOL") entered into a Strategic Alliance consisting of several agreements between the parties, including the Strategic Development and Marketing Agreement ("SDMA"). A copy of the SDMA has been filed as exhibit 10.93 to this Form 10-Q and is incorporated herein by reference. Under terms of the SDMA, AOL and Sun committed to collaboratively develop, market and sell client and server software and collaboratively develop an AOL specific Java environment that will enable AOL services to be accessed through a variety of hardware devices. The SDMA provides that over a three year period, AOL will develop and market, together with Sun, client software and network application and server software based in part on the Netscape Communications, Inc. ("Netscape") code base, on Sun code and technology, and on certain AOL services features to business enterprises. In addition, AOL and Sun have agreed to coordinate their sales efforts and share revenues with respect to designated collaboratively developed client software and network application and server software and associated services. Under the terms of the SDMA, Sun has committed that the total revenue earned by AOL from certain existing Netscape contracts, the sale or license of certain AOL and Netscape software and services, the sale or license of certain collaboratively developed software products and services and the license to Sun to distribute commercially existing Netscape software will not be less than $312 million, $330 million and $333 million in the first, second and third years of the SDMA's three year term, respectively; for these purposes a portion of the total revenue is determined as a percentage of the gross margin or net of sales commissions earned by Sun. In addition, Sun will pay to AOL approximately $275 million in licensing and other fees in connection with licenses granted to Sun by AOL. In a separate transaction, AOL signed a definitive agreement to acquire Netscape (the "Merger"). The SDMA provides that in the event the Merger is not consummated by June 30, 1999, AOL and Sun will negotiate in good faith for a period of 30 days thereafter in an effort to agree to alternative terms, and either party may terminate the SDMA if the parties fail to agree on alternative terms during that period. SUBSEQUENT EVENTS On January 21, 1999 the Company announced a two-for-one stock split (to be effected in the form of a stock dividend) to stockholders of record as of the close of business on March 18, 1999. This dividend is subject to stockholder approval of an increase in the number of authorized shares of the Company's Common Stock to 1.8 billion shares which will be sought at the Company's Special Meeting of Stockholders on March 17, 1999. On January 22, 1999, the Company acquired all of the outstanding capital stock of Maxstrat Corporation ("Maxstrat"), by means of a merger transaction pursuant to which all of the shares of Maxstrat capital stock were converted into the right to receive cash. The transaction will be accounted for as a purchase, and the purchase price will be allocated to tangible and intangible assets and IPRD. 10
11 ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The following table sets forth items from the Condensed Consolidated Statements of Income as a percentage of total net revenues: <TABLE> <CAPTION> Three Months Ended Six Months Ended -------------------------- -------------------------- December 27, December 28, December 27, December 28, 1998 1997 1998 1997 ----- ----- ----- ----- <S> <C> <C> <C> <C> Net revenues: Products 85.6% 86.5% 86.1% 88.2% Services 14.4 13.5 13.9 11.8 ----- ----- ----- ----- Total net revenues 100.0 100.0 100.0 100.0 ----- ----- ----- ----- Cost of sales: Products 40.3 40.7 40.0 40.8 Services 8.1 7.1 8.6 7.5 ----- ----- ----- ----- Total cost of sales 48.4 47.8 48.6 48.3 ----- ----- ----- ----- Gross margin 51.6 52.2 51.4 51.7 Research and development 10.9 10.6 11.1 10.6 Selling, general and administrative 26.8 28.4 27.7 28.85 Purchased in-process research and development 0.4 4.5 1.7 3.6 ----- ----- ----- ----- Operating income 13.4 8.7 10.9 8.7 Interest income, net 0.8 0.4 0.7 0.4 ----- ----- ----- ----- Income before income taxes 14.2 9.1 11.6 9.1 Provision for income taxes 4.8 3.0 4.5 3.4 ----- ----- ----- ----- Net income 9.4% 6.1% 7.1% 5.7% ===== ===== ===== ===== </TABLE> The following sections contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve risks and uncertainties, and the cautionary statements set forth below, specifically those contained in "Future Operating Results" identify important factors that could cause actual results over the next few quarters to differ materially from those predicted in any such forward-looking statements. Such factors include, but are not limited to, adverse changes in general economic conditions, including adverse changes in the specific markets for the Company's products, adverse business conditions, decreased or lack of growth in the computing industry, adverse changes in customer order patterns, increased competition, lack of acceptance of new products, pricing pressures, lack of success in technological advancements, risks associated with foreign operations (including the downturn of economic trends and unfavorable currency movements in the Asia Pacific and Latin American marketplace), 11
12 risks associated with the Company's efforts to comply with Year 2000 requirements, risks associated with the Company's new business practices, processes and information systems, and other factors, including those listed below. Other facts that may affect such results and financial condition are set forth in the Company's 1998 Annual Report to Stockholders which is incorporated by reference in the Company's Form 10-K. RESULTS OF OPERATIONS NET REVENUES Net revenues were $2,784.4 million for the second quarter of fiscal 1999 and $5,275.6 million for the first six months of fiscal 1999, representing increases of 13.6% and 16.0%, respectively, over the corresponding periods of fiscal 1998. Sun's products net revenues were $2,384.7 million for the second quarter of fiscal 1999, an increase of $222.7 million or 10.3% over the second quarter of fiscal 1998. Net product revenues were $4,540.9 million for the six months ended December 27, 1998, an increase of $531.0 million or 13.2% over the corresponding period of fiscal 1998. More than 50% of the growth in products revenues for the quarter ended December 27, 1998 resulted from strong demand for low-end desktop products and workgroup servers, and to a lesser extent from increased revenues generated by richly configured enterprise servers. More than 50% of the growth in products revenues for the six month period ended December 27, 1998 resulted from strong demand for low-end desktop products and workgroup servers and to a lesser extent, the Company's storage products. The growth in product revenues in both the quarter and year to date periods was partially offset by a decline in high-end desktop product volumes as the result of a shift in customer purchasing patterns towards low-end desktop products and workgroup servers. Sun's services net revenues were $399.7 million for the second quarter of fiscal 1999, an increase of $111.4 million or 38.6% over the second quarter of fiscal 1998. Net revenues from services were $734.8 million for the six months ended December 27, 1998, an increase of $195.8 million or 36.3% over the corresponding period of fiscal 1998. The increases in services revenues are primarily the result of a larger installed product base due to increased product unit sales, as well as increased revenues associated with Sun's professional and educational services. Domestic net revenues increased by 10.1% and 14.9 % in the second quarter and first six months of fiscal 1999, respectively. International net revenues (including United States exports) grew 17.2% and 17.1% in the second quarter and first six months of fiscal 1999, respectively, compared with the corresponding periods of fiscal 1998. In US dollars, European net revenues increased 22.7% and 28.7%, Rest of World (ROW) net revenues increased 7.1% and 10.8%, and Japanese net revenues increased 13.8% and decreased 3.3%, in the second quarter and first six months of fiscal 1999, respectively, when compared with the corresponding periods of fiscal 1998. The increases in Europe and the ROW are due to continued market acceptance of Sun's network computing products and services primarily in the United Kingdom and Germany. The Company attributes the increase in Japanese revenues in the second quarter to increased demand within the region for Sun's products, rather than a sign of strengthening in the Asian economies. Sun remains cautious with regard to the Japanese market and does not expect the current Japanese Macroeconomic trends to change significantly or materially in the near term. The foregoing is a forward-looking statement that is subject to risks and uncertainties, and actual results may differ materially from those set forth in such statement as the result of a number of factors. In particular, if the economic trends in Japan significantly worsen in a quarter or decline over an extended period of time, the Company's results from operations and cash flows would be adversely affected. A portion of the Company's operations consists of manufacturing and sales activities in foreign jurisdictions. As a result, the Company's results could be significantly adversely affected by factors such as changes in foreign currency exchange rates or economic conditions in the foreign markets in which the Company distributes its 12
13 products. The Company is primarily exposed to changes in exchange rates on the Japanese yen, British pound sterling, French franc and German mark. When the U.S. dollar strengthens against these currencies, the U.S. dollar value of non-U.S. dollar-based sales decreases. When the U.S. dollar weakens against these currencies, the U.S. dollar value of non-U.S. dollar-based sales increases. Correspondingly, the U.S. dollar value of non-U.S. dollar-based costs increases when the U.S. dollar weakens and decreases when the U.S. dollar strengthens. Overall the Company is a net receiver of currencies other than the U.S. dollar and, as such, benefits from a weaker dollar, and is adversely affected by a stronger dollar relative to major currencies worldwide. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, may adversely affect the Company's consolidated sales and gross margins as expressed in U.S. dollars. To mitigate the short-term effect of changes in currency exchange rates on the Company's non-US dollar-based sales, product procurement, and operating expenses, the Company regularly hedges its net non-U.S. dollar-based exposures by entering into foreign exchange forward and option contracts to hedge transactions. Currently, hedge contracts do not extend beyond three months. Given the short-term nature of the Company's foreign exchange forward and options contracts, the Company's exposure to risk associated with currency market movement on these instruments is not material. GROSS MARGIN Total gross margin was 51.6% for the second quarter of fiscal 1999 and 51.4% for the first six months of fiscal 1999, compared with 52.2% and 51.7%, respectively, for the corresponding periods of fiscal 1998. Products gross margin was 53.0% in the second quarter of fiscal 1999 and 53.5% for the first six months of fiscal 1999, compared with 53.9% and 53.6%, respectively, for the corresponding periods of fiscal 1998. The decrease in the products gross margin for the second quarter of fiscal 1999 reflects the effects of increased volumes of lower margin low-end desktop products, partially offset by higher margin servers and reduced component costs across product lines. There could be a further impact upon products gross profit margins as the result of any continued shift in customer purchasing patterns towards low-end desktop products and workgroup servers. The foregoing is a forward-looking statement that is subject to risks and uncertainties, and actual results may differ materially from those set forth in such statement as the result of a number of factors. Services gross margin was 43.5% for the second quarter of fiscal 1999 and 38.2% for the first six months of fiscal 1999, compared with 39.5% and 36.8%, respectively, for the corresponding periods of fiscal 1998. The increases in services gross margin reflect increased market penetration in Enterprise datacenter accounts, increased enrollment in datacenter training courses and other offerings, and continued growth in professional services offerings. These increases have been partially offset by increased investment by the Company in its services business. The Company continuously evaluates the competitiveness of its product offerings. These evaluations could result in repricing actions in the near term. Sun's future operating results would be adversely affected if such repricing actions were to occur and the Company were unable to mitigate the resulting margin pressure by maintaining a favorable mix of systems, software, service, and other products and by achieving component cost reductions, operating efficiencies and increasing volumes. RESEARCH AND DEVELOPMENT Research and development (R&D) expenses increased to $303.5 million in the second quarter of fiscal 1999, compared with $259.2 million for the second quarter of fiscal 1998. R&D expenses were $586.8 million for the first six months of fiscal 1999, compared with $481.8 million for the corresponding period of fiscal 1998. As a percentage of total net revenues, R&D expenses increased to 10.9% and 11.1% for the second quarter and first six months of fiscal 1999, respectively, compared with 10.6% in each of the corresponding periods of fiscal 1998. Both the dollar and percentage increase in R&D expenses in the second quarter and first half of fiscal 1999 over the corresponding periods in fiscal 1998 primarily reflect increased expenditures focused on the development of hardware and software products which utilize the Java (TM) platform and new server and storage products. The remaining increase in R&D expenses is due to 13
14 further development of products acquired through acquisitions and increased compensation due primarily to higher levels of R&D staffing. The increase in R&D expenses reflects the Company's belief that to maintain its competitive position in a market characterized by rapid rates of technological advancement, the Company must continue to invest significant resources in new systems, software products and microprocessor development, as well as enhancements to existing products. The Company continues to expect the level of R&D expenses to be in the range of 10 to 11% of revenue for fiscal 1999. SELLING, GENERAL AND ADMINISTRATIVE Selling, general and administrative (SG&A) expenses increased to $747.6 million in the second quarter of fiscal 1999, compared with $696.5 million for the second quarter of fiscal 1998. SG&A expenses were $1,459.2 million for the first six months of fiscal 1999, compared with $1,311.9 million for the corresponding period of fiscal 1998. As a percentage of total net revenues, SG&A expenses decreased to 26.8% and 27.7% in the second quarter and first six months of fiscal 1999, respectively, from 28.4% and 28.8%, respectively, in the corresponding periods of fiscal 1998. Overall SG&A spending increased by approximately $51.1 million or 7.3% in the second quarter of fiscal 1999 in comparison with the same period of fiscal 1998. For the six month period ended December 27, 1998, overall SG&A spending increased by approximately $147.2 million or 11.2% in comparison to the corresponding period of fiscal 1998. The dollar increases in fiscal 1999 are primarily attributable to increased compensation resulting from higher levels of headcount, principally in the sales organization, annual salary adjustments and to a lesser extent marketing costs related to promotional programs. The dollar increase also reflects investments aimed at improving Sun's own business processes. The Company expects to continue to hire personnel, although at a lower rate than in fiscal 1998 and early 1999, to further expand its demand creation programs and support organizations. PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT NETDYNAMICS, INC. On August 28, 1998, the Company acquired all of the outstanding capital stock of NetDynamics by means of a merger transaction pursuant to which all the shares of NetDynamics capital stock were converted into the right to receive shares of Sun common stock based upon an agreed-upon exchange ratio which was calculated using an agreed-upon average market price for Sun common stock. The Company issued 2,746,785 shares of Sun common stock (with a fair market value of $48.26875 per share) as the consideration for the acquisition. The transaction was accounted for as a purchase and the excess purchase price over the estimated fair value of net tangible assets has been allocated to various intangible assets, primarily consisting of developed technology ($20 million), goodwill ($36.2 million), customer base ($10 million) and assembled workforce ($2 million). In addition to the intangible assets acquired, the Company recorded an $80 million charge, representing the write-off of IPRD. At the acquisition date, NetDynamics was conducting development, engineering, and testing activities associated with the completion of a new enterprise application platform product scheduled to be released in mid calendar 1999. It is anticipated that this new product offering ("NetDynamics New Product Offering") will employ a new server-side component model, based on the Enterprise JavaBeans (TM) ("EJB") architecture, which will allow business logic to reside in the middle tier of the enterprise computing model independent of the client presentation layer and independent of legacy and database systems. This architecture is significantly different than the business logic architecture in NetDynamics' existing product offering in which the server components are tightly integrated with the presentation interface. The EJB architecture will allow for the development of more robust applications with improved reusability, better connectivity to a wide variety of data sources, and a more-industry standard interface through the use of Java enterprise application 14
15 programming interfaces. Other new features include significant security enhancements and performance and scalability improvements and the addition of new platform adaptor components for legacy systems integration. At the acquisition date, NetDynamics was in mid-stages of development and substantial progress had been made in the areas of specifications, design, and implementation. Remaining efforts necessary to complete the NetDynamics New Product Offering relate primarily to coding, testing, and addressing additional implementation issues. The Company anticipates that the NetDynamics New Product Offering will be complete by the end of the Company's fiscal year ending June 30, 1999, after which the Company expects to begin generating economic benefits from the value of the completed development associated with the IPRD. The Company continues to expect expenditures to complete the NetDynamics New Product Offering to total approximately $5.7 million in fiscal 1999 of which $2.4 million has been incurred. The preceding two sentences are forward-looking statements that are subject to risks and uncertainties and actual results may differ materially from those set forth in such sentences as a result of a number of factors. In particular, there can be no assurance that the NetDynamics New Product Offering will be completed by the end of the Company's fiscal year ending June 30, 1999, that it will meet either technological or commercial success or that the Company will receive any economic benefit from the NetDynamics New Product Offering. In addition, the expenditures related to completing the NetDynamics New Product Offering may exceed the Company's current estimates as a result of delays in the development of the technology, the complexity of the technology, changes in customer needs, or for other reasons. I-PLANET, INC. On September 28, 1998 the Company acquired all of the outstanding capital stock of i-Planet by means of a merger transaction pursuant to which all the shares of i-Planet capital stock were converted into the right to receive cash. The transaction was accounted for as a purchase and the excess purchase price over the estimated fair value of net tangible assets has been allocated to various intangible assets, primarily consisting of developed technology ($3.3 million) and goodwill type assets ($18.3 million). In addition to the intangible assets acquired, the Company recorded an $8.4 million charge, representing the write-off of IPRD. At the acquisition date, i-Planet was conducting development, engineering, and testing activities associated with the completion of a new Java technology-based remote Internet access product scheduled to be released in early calendar 1999. It is anticipated that this new product offering ("i-Planet New Product Offering") when combined with a new Sun software product will be designed to allow cost-effective, secure, and ubiquitous internet access for applications such as remote access to corporate intranets, supply chain management and commerce applications. At the acquisition date, i-Planet was in mid-stages of development and substantial progress had been made in the areas of specifications, design, and implementation. Remaining efforts necessary to complete the i-Planet New Product Offering relate primarily to coding, testing, and addressing additional implementation issues. The Company anticipates that the i-Planet New Product Offering will be complete by the end of the Company's third quarter of fiscal 1999, after which the Company expects to begin generating economic benefits from the value of the completed development associated with the IPRD. Expenditures to complete the i-Planet New Product Offering are expected to total approximately $6 million in fiscal 1999. The preceding two sentences are forward-looking statements that are subject to risks and uncertainties and actual results may differ materially from those set forth in such sentences as a result of a number of factors. In particular, there can be no assurance that the i-Planet New Product Offering will be completed by the end of the Company's fiscal year ending June 30, 1999, that it will meet either technological or commercial success or that the Company will receive any economic benefit from the i-Planet New Product Offering. In addition, the expenditures related to completing the i-Planet New Product Offering may exceed the Company's current estimates as a result of delays in the development of the technology, the complexity of the technology, changes in customer needs, or for other reasons. BEDIUN COMMUNICATIONS INCORPORATED On October 16, 1998, the Company acquired all of the outstanding capital stock of Beduin by means of a share purchase transaction pursuant to which all the shares of Beduin capital stock were converted into the right to receive cash. The transaction was accounted for as a purchase and the excess purchase price over the estimated fair value of net tangible assets has been allocated to various intangible assets, primarily consisting of developed technology ($3.1 million) and goodwill type assets ($1.4 million). In addition to the intangible assets acquired, the Company recorded an $3.6 million charge, representing the write-off of IPRD. At the acquisition date, Bediun was conducting development, engineering, and testing activities associated with the completion of a suite of products ("Bediun New Product Offerings") which included: Lifestyle Manager Personal Information Manager ("PIM") (a next generation PIM targeted at smart devices incorporating Java technology), and email Client (a next generation email client specialized to take advantage of the benefits of 15
16 these smart devices). The Lifestyle PIM and the email client were scheduled to be released in the second quarter of calendar year 1999. It is anticipated that these Bediun New Product Offerings will provide the core functionality for smart devices incorporating Java technology and enable more efficient communication, regardless of time, location or type of device. These Bediun New Product Offerings are designed to integrate and synchronize communications and data processing systems to enable communications across time and space. At the acquisition date, Bediun was in mid-stages of development and substantial progress had been made in the areas of specifications, design, and implementation. Remaining efforts necessary to complete the Bediun New Product Offerings relate primarily to coding, testing, and addressing additional implementation issues. The Company anticipates that the Bediun New Product Offerings will be complete during the fourth quarter of the Company's fiscal year ending June 30, 1999, after which the Company expects to begin generating economic benefits from the value of the completed development associated with the IPRD. Expenditures to complete the Bediun New Product Offerings are expected to total approximately $1 million in fiscal 1999. The preceding two sentences are forward-looking statements that are subject to risks and uncertainties and actual results may differ materially from those set forth in such sentences as a result of a number of factors. In particular, there can be no assurance that the Bediun New Product Offerings will be completed by the end of the Company's fiscal year ending June 30, 1999, that it will meet either technological or commercial success or that the Company will receive any economic benefit from the Bediun New Product Offerings. In addition, the expenditures related to completing the Bediun New Product Offerings may exceed the Company's current estimates as a result of delays in the development of the technology, the complexity of the technology, changes in customer needs, or for other reasons. VALUATIONS OF IPRD For financial reporting purposes, the Company is required to determine the fair value of all identified intangible assets and expense the fair value associated with IPRD for which there is no alternative future use for each of its acquisitions. The allocation of $80 million, $8.4 million, and $3.6 million of the purchase price to IPRD in the case of the NetDynamics, i-Planet and Bediun acquisitions, respectively, represents the estimated fair values based on risk adjusted cash flows related to each incomplete project. The Company believes that such fair values do not exceed the amount a third party would pay for each such in-process technology. At the date of each of the acquisitions, the projects associated with the IPRD efforts had not yet reached technological feasibility and the R&D in progress had no alternative future uses. Accordingly, these costs were expensed. Forecasts of future results that management believes are likely to occur were the basis for assigning value to IPRD. For the NetDynamics, i-Planet, and Bediun acquisitions, the values assigned to IPRD were determined by estimating the costs to develop the purchased in-process technology into commercially viable products, estimating the resulting net cash flows from each project, excluding the cash flows related to the portion of each project that was incomplete at the acquisition date, and discounting the resulting net cash flows to their present value. Each of these forecasts were based upon future discounted cash flows, taking into account the state of development of each in-process project, the cost to complete that project, the expected income stream, the life cycle of the product ultimately developed, and the risks associated with successful development and commercialization of each project. Projected future net cash flows attributable to the in-process technology, assuming successful development of such technologies, were discounted to their present value using a discount rate which was derived based on the Company's estimated weighted average cost of capital ("WACC") plus a risk premium to account for the inherent uncertainty surrounding the successful completion of each project and the associated estimated cash flows. The discount rates used in valuing the net cash flows from each purchased in-process technology were 20% for the NetDynamics acquisition, 25% for the i-Planet acquisition, and 40% for the Bediun acquisition. These discount rates are higher than the WACC due to the inherent uncertainties in the estimates described above, including the uncertainty surrounding the successful development of the purchased in-process technologies, the useful life of such technologies, the profitability levels of such technology and the uncertainty of technological advances that are unknown at this time. The estimates utilized in the valuation of the IPRD charges are subject to change, given the uncertainties of the development process, and no assurance can be given that deviations from these estimates will not occur. Management expects to continue its development each project and believes that there is a reasonable chance of successfully completing such development. However, there is risk associated with the completion of the in-process projects and there can be no assurance that any project will meet with either technological or commercial success. Failure to successfully develop and commercialize these in-process projects would result 16
17 in the loss of the expected economic return inherent in the fair value allocation. Additionally, the value of other intangible assets acquired may become impaired. The foregoing statements in this paragraph are forward-looking statements that are subject to risks and uncertainties, and actual results may differ materially from those set forth in such statements as the result of a number of factors, including those stated in this paragraph. Purchased IPRD of $110.1 million and $162.3 million in the second quarter and first six months of fiscal 1998, respectively, represent the write-off of purchased IPRD associated with the Company's acquisitions of Chorus Systems S.A., and the storage products business of Encore Computer Corporation in the second quarter of fiscal 1998 and Diba, Inc. and Integrity Arts, Inc. in the first quarter of fiscal 1998. INTEREST INCOME, NET Net interest income was $20.3 million for the second quarter and $35.7 million for the first six months of fiscal 1999, compared with $10.2 million and $20.8 million, respectively for the corresponding periods in fiscal 1998. The increases in 1999 are primarily the result of higher interest earnings due to a larger average portfolio of cash and short-term investments. INCOME TAXES The Company's effective income tax rate was 33% for the second quarter and first six months of fiscal 1999, before non-recurring tax charges of $3.2 million resulting from a write-off of IPRD associated with the acquisition of i-Planet in the second quarter of fiscal 1999 and $30.4 million resulting from a write-off of IPRD associated with the acquisition of NetDynamics in the first quarter of fiscal 1999. The effective tax rate including such charges for the second quarter and six months ended December 27, 1998 was 33.8% and 38.5%, respectively. The Company's effective income tax rate for the second quarter and six months ended December 28, 1997 was 33% before a tax charge of $19.8 million resulting from a write-off of IPRD associated with the acquisitions of Diba Inc. and Integrity Arts, Inc. in the first quarter of fiscal 1998. The Company currently expects its effective tax rate to remain at 33% for the balance of fiscal 1999, exclusive of any acquisition- related charges. FUTURE OPERATING RESULTS COMPETITION The markets for Sun's hardware and software products and services are intensely competitive and subject to continuous, rapid technological change, short product life cycles and frequent product performance improvements and price reductions. Due to the breadth of the Company's product lines and the scalability of its products and network computing model, Sun competes principally with Hewlett-Packard Company, International Business Machines Corporation, Compaq Computer Corporation, Silicon Graphics, Inc. and EMC Corporation, in many segments of the network computing market across a broad spectrum of customers. The Company expects the markets for its products, technologies, and services, as well as its competitors within such markets, will continue to change as the rightsizing trend shifts customer buying patterns to network-based systems which often employ solutions from multiple vendors. Competition in these markets will also continue to intensify as Sun and many of its competitors, aggressively position themselves to benefit from this shifting of customer buying patterns and demand. The Company is also facing competition from certain systems manufacturers, including Dell Computer Corporation and certain of its competitors listed above, whose products are based on microprocessors from Intel Corporation coupled with Windows NT operating system software from Microsoft Corporation. These products demonstrate the viability of certain networked personal computer solutions and have increased the competitive pressure, particularly in the Company's workstation and 17
18 lower-end server product lines. Finally, the timing of introductions of new products and services by Sun's competitors may negatively impact the future operating results of the Company, particularly when such introductions occur in periods leading up to the Company's introduction of its own new enhanced products. The Company expects this pressure to continue and intensify throughout fiscal 1999. While many other technical, service and support capabilities affect a customer's buying decision, the Company's future operating results will depend, in part, on its ability to compete with these technologies. PRODUCT DEVELOPMENT The Company's future operating results will depend to a considerable extent on its ability to rapidly and continuously develop, introduce, and deliver in quantity new systems, software, and service products, as well as new microprocessor technologies, that offer its customers enhanced performance at competitive prices. The development of new high-performance computer products, such as the Company's recent development of the UltraSPARC microprocessor is a complex and uncertain process requiring high levels of innovation from the Company's designers and suppliers, as well as accurate anticipation of customer requirements and technological trends. Once a hardware product is developed, the Company must rapidly bring such products to volume manufacturing, a process that requires accurate forecasting of volumes, mix of products and configurations, among other things, in order to achieve acceptable yields and costs. Future operating results will depend to a considerable extent on the Company's ability to closely manage product introductions in order to minimize unfavorable patterns of customer orders, to reduce levels of older inventory and to ensure that adequate supplies of new products can be delivered to meet customer demand. The ability of the Company to match supply and demand is further complicated by the Company's need to adjust prices to reflect changing competitive market conditions as well as the variability and timing of customer orders with respect to the Company's older products. As a result, the Company's operating results could be materially adversely affected if the Company is not able to correctly anticipate the level of demand for the mix of products. Because the Company is continuously engaged in this product development, introduction, and transition process, its operating results may be subject to considerable fluctuation, particularly when measured on a quarterly basis. MANUFACTURING AND SUPPLY Sun uses many standard parts and components in its products and believes there are a number of competent vendors for most parts and components. However, a number of important components are developed by and purchased from single sources due to price, quality, technology or other considerations. In some cases, those components are available only from single sources. In particular, Sun is dependent on Sony Corporation for various monitors and on Texas Instruments Incorporated for different implementations of SPARC(TM) microprocessors. Certain custom silicon parts are designed by and produced on a contractual basis for Sun. The process of substituting a new producer of such parts could materially adversely affect Sun's operating results. Some suppliers of certain components, including color monitors and custom silicon parts, require long lead times such that it can be difficult for the Company to plan inventory levels of components to consistently meet demand for Sun's products. Certain other components, especially memory integrated circuits such as DRAMs, SRAMs, and VRAMs, have from time to time been subject to industry wide shortages. Future shortages of components could negatively affect the Company's ability to match supply and demand, and therefore could materially adversely impact the Company's future operating results. The Company is increasingly dependent on the ability of its suppliers to design, manufacture, and deliver advanced components required for the timely introduction of new products. The failure of any of these suppliers to deliver components on time or in sufficient quantities, or the failure of any of the Company's own designers to develop advanced innovative products on a timely basis, could result in a material adverse impact on the Company's operating results. The inability to secure enough components to build products, including new products, in the quantities and configurations required, or to produce, test and deliver sufficient products to meet demand in a timely manner, would materially adversely affect the Company's net revenues and operating 18
19 results. To secure components for development, production, and introduction of new products, the Company frequently makes advanced payments to certain suppliers and often enters into noncancelable purchase commitments with vendors early in the design process. Due to the variability of material requirement specifications during the design process, the Company must closely manage material purchase commitments and respective delivery schedules. In the event of a delay or flaw in the design process, the Company's operating results could be materially adversely affected due to the Company's obligations to fulfill such noncancelable purchase commitments. SALES, DISTRIBUTION AND MARKETING Generally, the computer systems sold by Sun, such as products based on UltraSPARC (TM) processors, are the result of hardware and software development, such that delays in the software development can delay the ability of the Company to ship new hardware products. In addition, adoption of a new release of an operating system may require effort on the part of the customer and porting by software vendors providing applications. As a result, the timing of conversion to a new release is inherently unpredictable. Moreover, delays by customers in adopting a new release of an operating system can limit the acceptability of hardware products tied to that release. Such delays could materially adversely affect the future operating results of the Company. A significant portion of the Company's revenues is derived from international sales and is therefore subject to inherent risks related thereto, including the general economic and political conditions in each country, currency exchange rate fluctuations, the effect of the tax structures of various jurisdictions, changes to and compliance with a variety of foreign laws and regulations, trade protection measures and import and export licensing requirements. There can be no assurance that the economic crisis and currency issues currently being experienced in certain parts of Asia will not have an adverse effect on the Company's revenue or revenue growth rates in the future. The impact of any of the foregoing factors could have a material adverse effect on the Company's future financial condition and operating results. Seasonality also affects the Company's operating results, particularly in the first and third quarter of each fiscal year. In addition, the Company's operating expenses are increasing as the Company continues to expand its operations, and future operating results will be adversely affected if revenues do not increase accordingly. Additionally, the Company plans to continue to evaluate and, when appropriate, make acquisitions of complementary technologies, products or businesses. As part of this process, the Company will continue to evaluate the changing value of its assets, and when necessary, make adjustments thereto. Acquisitions may involve amortization of acquired intangible assets in periods following such acquisitions. In addition, acquisition transactions are accompanied by a number of risks, including, among other things, those associated with integrating operations, personnel, and technologies acquired, and the potential for unknown liabilities of the acquired business. One customer accounted for more than 10% of revenues in fiscal 1998. Any termination by a significant customer of its relationship with the Company or material reduction in the amount of business such a customer does with the Company could materially adversely effect the Company's business, financial condition or operating results. BUSINESS PRACTICES, PROCESSES AND INFORMATION SYSTEMS In order to remain competitive in a rapidly changing industry, the Company is continually improving and changing its business practices, processes, and information systems. In this regard, during fiscal 1999 the Company implemented a number of new business practices and a series of related information systems across the enterprise that affect numerous operational and financial systems and processes. Although the systems were fully operational by the end of the second quarter of fiscal 1999, these systems will be further tested in the second half of the Company's fiscal year, and in particular, the fourth quarter to the extent that the Company 19
20 experiences higher volumes of orders and shipments as it has typically experienced during these periods. In addition, during the balance of fiscal 1999, the Company expects to continue its efforts to optimize usage of systems capabilities, enhance user skills surrounding system features, and reduce runtime errors. However, there can be no assurance that the system will be able to support the increased volume of activities expected at the Company's fiscal year end. The time period in which the new business practices and related information systems will be fully tested and leveraged are forward-looking statements subject to risks and uncertainties, and actual results may differ materially from those set forth above as a result of a number of risk factors. In particular, the ability to fully leverage systems capabilities are subject to a number of risks, including the complexity of the new systems themselves and the need for substantial and comprehensive employee training in connection with the adoption of such new business practices and information systems. While the Company has tested these new systems and processes in advance of their implementation and continues to monitor the systems and processes ability to support increased volumes of transactions, there are inherent limitations in the Company's ability to simulate a full-scale operating environment in advance of actual transaction volumes. Any increase in the volume of orders and shipments of products during the last half of the fiscal year may have a material adverse effect on the Company's business and operating results, if the systems and processes are unable to support the increased volume of activity. In addition, to the extent that the Company encounters problems with these new systems and practices that prevent or limit their full utilization, there could be a material adverse impact on the Company's operating results. YEAR 2000 COMPLIANCE Many currently installed computer systems and software products are coded to accept only two digit entries in the date code field. As the Year 2000 approaches, these code fields will need to be able to distinguish years beginning with "19" from those beginning with "20." As a result, in less than a year, computer systems and/or software products used by many companies may need to be upgraded to comply with such Year 2000 requirements. The Company is currently expending resources to review its products and services, as well as its internal use software in order to identify and modify those products, services and systems that are not Year 2000 compliant. The Company believes that the vast majority of these costs are not incremental to the Company but represent a reallocation of existing resources and include regularly scheduled system upgrades and maintenance. In addition, the Company is working to make custom coding enhancements to its internal systems (described in the above paragraphs) so that such systems will be Year 2000 compliant by the end of fiscal year 1999. Although the Company believes that the costs associated with the aforementioned Year 2000 efforts are not material, the Company currently estimates that such costs will be approximately $35 million, of which approximately $5 million has been spent to date. The aforementioned costs are estimates due in large part to the fact that the Company does not separately track the internal labor costs associated with Year 2000 compliance, unless such costs are incurred by individuals devoted primarily to Year 2000 compliance efforts. These cost estimates do not include any potential costs related to any customer or other claim. In addition, these cost estimates are based on the current assessment of the ongoing activities described above, and are subject to change as the Company continuously monitors these activities. The Company believes any modifications deemed necessary will be made on a timely basis and does not believe that the cost of such modifications will have a material adverse effect on the Company's operating results. The Company currently expects the aforementioned evaluation of its products, services, and systems and any remediation necessary will be completed by the end of fiscal year 1999. The Company's expectations as to the extent and timeliness of any modifications required in order to achieve Year 2000 compliance and the costs related thereto are forward-looking statements subject to risks and uncertainties. Actual results may vary materially as a result of a number of factors, including, among others, those described in this section. There can be no assurance however, that the Company will be able to successfully 20
21 modify on a timely basis such products, services and systems to comply with Year 2000 requirements, which failure could have a material adverse effect on the Company's operating results. The Company has established a program to assess whether certain of its products are Year 2000 compliant. Under the program, the Company is in the process of performing tests on its products listed on the Company's price lists. To monitor this program and to help customers evaluate their Year 2000 issues the Company has created a web site at http://sun.com/y2000/cpl.html which identifies the following categories: products that were released Year 2000 compliant; products that require modifications to be Year 2000 compliant; products under review; products that are not Year 2000 compliant and need to be replaced with a Year 2000 compliant product; source code products that could be modified and implemented without Sun's review; and products that do not process or manipulate date data or have no date-related technology. This list is periodically updated as analysis of additional products is completed. Based on the Company's assessment to date, most newly introduced products and services of the Company are Year 2000 compliant, however, there can be no assurance that the Company's current products do not contain undetected errors or defects associated with Year 2000 functions that may result in material costs to the Company. In addition, some of the Company's customers are running products that are not Year 2000 compliant and will require an upgrade or other remediation to become Year 2000 compliant. The Company provides limited warranties as to Year 2000 compliance on certain of its products and services. Except as specifically provided for in the limited warranties, the Company does not believe it is legally responsible for costs incurred by customers to achieve Year 2000 compliance. The Company has been taking steps to identify affected customers, raise customer awareness related to noncompliance of the Company's older products and encourage such customers to migrate to current products or product versions. It is possible that the Company may experience increased expenses in addressing migration issues for such customers or customer dissatisfaction as a result of Year 2000 issues, which may have a material adverse effect on the Company's operating results. The Company also faces risks to the extent that suppliers of products, services and systems purchased by the Company and others with whom the Company transacts business on a worldwide basis do not have business systems or products that comply with Year 2000 requirements. To the extent that Sun is not able to test technology provided by third party hardware or software vendors, Sun is in the process of obtaining Year 2000 compliance certifications from each of its major vendors that their products and internal systems, as applicable, are Year 2000 compliant. In the event any such third parties cannot timely provide the Company with products, services or systems that meet the Year 2000 requirements, the Company's operating results could be materially adversely affected. Furthermore, a reasonably likely worst case scenario would be if one of the Company's major vendors experienced a material disruption in business, which caused the Company to experience a material disruption in business, such a disruption would have a material adverse effect on the Company's business, financial condition and operating results. Should either the Company's internal systems or the internal systems, products or services of one or more of the Company's major vendors fail to achieve Year 2000 compliance, the Company's business, financial position or results of operations could be materially adversely affected. The Company is currently developing contingency plans to deal with potential Year 2000 problems related to its internal systems and products and services provided by outside vendors and expects these plans to be complete by the end of fiscal year 1999. Although the Company believes that the cost of Year 2000 modifications for both internal use software and systems, as well as the Company's products are not material, there can be no assurance that various factors relating to the Year 2000 compliance issues will not have a material adverse effect on the Company's business, operating results or financial position. For example, a significant amount of litigation may arise out of Year 2000 compliance issues and there can be no assurance as to the extent the Company may be affected by any such litigation. Even though the Company does not believe that it is legally responsible for its customer's Year 2000 compliance obligations, it is unclear whether different governments or governmental agencies may decide 21
22 to allocate liability relating to Year 2000 compliance to the Company without regard to specific warranties or warranty disclaimers. Such allocation of liability could have a materially adverse effect on the Company's financial condition and results of operations in any given quarter. Furthermore, it is unknown how customer spending patterns may be impacted by Year 2000 issues. As customers focus on preparing their businesses for the Year 2000, capital budgets may be spent on remediation efforts, potentially delaying the purchase and implementation of new systems, thereby creating less demand for the Company's products and services. These as well as other factors could have a material adverse effect on the Company's revenues or operating results. EURO COMPLIANCE Eleven of the fifteen member countries of the European Union established fixed conversion rates between their existing sovereign currencies and the Euro and adopted the Euro as their common legal currency effective for the initial implementation date of January 1, 1999. The Euro trades on currency exchanges and is available for non-cash transactions, while the legacy currencies will remain legal tender in the participating countries for a transition period between January 1, 1999 and January 1, 2002. During the transition period, cash-less payments can be made in the Euro and parties can elect to pay for goods and services and transact business using either the Euro or the legacy currency. Between January 1, 2002 and July 1, 2002, the participating countries will introduce Euro notes and coins and withdraw all legacy currencies. The Company has expended and continues to expend resources to review and modify its products to support the Euro's requirements, determine pricing strategies in the new economic environment, analyze the legal and contractual implications for contracts, evaluate system capabilities, and ensure banking vendors can support the Company's operations with respect to Euro transactions for the initial implementation as of January 1, 1999 and during the transition period through to January 1, 2002 and thereafter. The Company does not expect that the introduction and use of the Euro will materially affect the Company's foreign exchange and hedging activities, expects that modifications will be made to its business operations and systems, as necessary, on a timely basis and does not believe that the cost of such modifications will have a material adverse impact on the Company's operating results. The Company's expectations as to the extent and timeliness of modifications required to accommodate the conversion to Euro transactions is a forward-looking statement subject to risks and uncertainties. Actual results may vary materially, as a result of a number of factors, including among others, those described in this paragraph. There can be no assurance that the Company will be able to complete such modifications to comply with Euro requirements, which could have a material adverse effect on the Company's operating results. In addition, the Company faces risks to the extent that vendors upon whom the Company relies and their suppliers are unable to make appropriate modifications to support Euro transactions. The Company has not yet completed its evaluation of the impact of the Euro upon its functional currency designations. While the Company cannot predict what effect these various factors may have on its financial results, the aggregate effect of these and other factors could result in significant volatility in the Company's future performance and stock price. LIQUIDITY AND CAPITAL RESOURCES The Company's financial condition strengthened as of December 27, 1998 when compared with June 30, 1998. During the first six months of fiscal 1999, cash flows from operating activities generated $771.8 million in cash and cash equivalents. Non-cash expenses affecting cash provided by operating activities in the first six months of fiscal 1999 included depreciation and amortization expense of $313.4 million, tax benefits of options exercised of $96.8 million and charges for IPRD of $92 million in connection with the acquisitions of 22
23 NetDynamics, i-Planet and Bediun. Favorably impacting cash provided by operations were increases in accounts payable and other liabilities of $114.7 million and $144.5 million, respectively, which reflect the timing of payments for inventory and other items. Offsetting these items, accounts receivable increased $258.7 million which reflects an increase in days sales outstanding. Additionally, other current assets increased due to the timing of payments for insurance and other taxes. Other long-term assets increased primarily due to an increase in intangible assets in connection with the acquisition of NetDynamics. The Company's investing activities used $907.5 million of cash in the first six months of fiscal 1999, an increase of $353 million from the prior year's comparable period. The increase resulted primary from increased acquisitions of short-term investments during the first six months of fiscal 1999, as compared with the prior year's comparable period. Also included in investing activities is capital spending for real estate development, as well as capital additions to support increased headcount, primarily in the Company's engineering, services and marketing organizations. At December 27, 1998, the Company's primary sources of liquidity consisted of cash, cash equivalents and short-term investments of $1,572.8 million and a revolving credit facility with banks aggregating $500 million, which was available subject to compliance with certain covenants. Additionally, on October 16, 1997, the Company filed a Registration Statement with the Securities and Exchange Commission relating to the registration for public offering of senior and subordinated debt securities and common stock with an aggregate initial public offering price of up to $1 billion. On October 24, 1997, the Registration Statement became effective, so that the Company may now choose to offer, from time to time, the securities pursuant to Rule 415 in one or more separate series, in amounts, at prices and on terms to be set forth in the prospectus contained in the Registration Statement and in one or more supplements to the prospectus. The Company believes that the liquidity provided by existing cash and short-term investment balances and the borrowing arrangements described above will be sufficient to meet the Company's capital requirements through fiscal 1999. However, the Company believes the level of financial resources is a significant competitive factor in its industry and may choose at any time to raise additional capital through debt or equity financing to strengthen its financial position, facilitate growth and provide the Company with additional flexibility to take advantage of business opportunities that may arise. 23
24 PART II - OTHER INFORMATION ITEM 1 - LEGAL PROCEEDINGS On October 7, 1997, the Company filed suit against Microsoft Corporation in the United States District Court for the Northern District of California alleging breach of contract, trademark infringement, false advertising, unfair competition, interference with prospective economic advantage and inducing breach of contract. The Company filed an amended complaint on October 14, 1997. Microsoft Corporation filed its answer, affirmative defenses and counterclaims to the amended complaint. The counterclaims include breach of contract, breach of the covenant of good faith and fair dealing, violation of the California Business & Professions Code and declaratory judgment. The Company believes that the counterclaims are without merit and/or that the Company has affirmative defenses and intends vigorously to defend itself with respect thereto. On March 24, 1998 the United States District Court judge ruled in favor of the Company granting a preliminary injunction directing Microsoft Corporation to cease using the Company's Java Compatible Logo(TM) on Microsoft products that failed to pass the applicable test suites from Sun. In addition, on May 12, 1998, the Company filed a second amended complaint alleging copyright infringement by Microsoft and motions requesting further preliminary injunctive relief directed against the planned release by Microsoft of additional products that failed to pass the applicable test suites from Sun. The Court held hearings and arguments on such motions on September 8, 9, and 10, 1998. On November 17, 1998, the District Court issued an Order granting, in substantial part, Sun's request for preliminary injunctions. On December 15, 1998 Microsoft filed notice of its intent to appeal the District Court's Order and on December 18, 1998 Microsoft filed Motions with the District Court to extend the time for compliance with the Order and to clarify or modify the Order. On December 29, 1998 the District Court issued a further Order directing the parties to schedule a settlement conference with respect to certain issues before a designated Magistrate or mutually selected individual. On January 13, 1999, Microsoft filed an appeal to the District Court's Order issued on November 17, 1998. The Company believes that the outcome of this matter will not have a material adverse impact on Sun's financial condition, results of operations or cash flows in any given fiscal year. ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On November 11, 1998 the Annual Meeting of Stockholders of the Company was held in Menlo Park, California. The results of voting of the 313,381,495 shares of Common Stock represented at the meeting or by proxy are described below. An election of directors was held with the following individuals being elected to the Board of Directors of the Company: <TABLE> <CAPTION> Name Shares Voted For Votes Withheld - ---- ---------------- -------------- <S> <C> <C> Scott G. McNealy 314,513,658 1,581,681 L. John Doerr 305,306,845 10,788,494 Judith L. Estrin 314,554,906 1,540,433 Robert J. Fisher 314,551,674 1,543,665 Robert L. Long 314,544,221 1,551,118 M. Kenneth Oshman 314,556,052 1,539,287 A. Michael Spence 314,511,203 1,584,136 </TABLE> 24
25 The seven nominees who received the highest number of votes (all of the above individuals) were elected to the Board of Directors. The stockholders approved an amendment to the Company's 1990 Long-Term Equity Incentive Plan in order to increase the number of shares of Common Stock authorized for issuance thereunder by 18,000,000 shares of Common Stock to an aggregate of 119,400,000 shares. There were 193,531,834 votes cast for the amendment, 121,004,835 votes cast against the amendment and 1,558,670 abstentions. The stockholders approved an amendment to the Company's 1988 Directors' Stock Option Plan in order to decrease the number of shares of Common Stock subject to the one-time automatic nonemployee director grant (granted on the date of the initial appointment of a director who is not affiliated with an entity having an equity investment in the Company) from 80,000 shares to 30,000 shares. There were 259,580,690 votes cast for the amendment, 54,345,777 votes cast against the amendment and 2,168,872 abstentions. ITEM 5 - OTHER INFORMATION a) SCHEDULE OF SALES BY EXECUTIVE OFFICERS DURING THE QUARTER None b) NON-RULE 14a-8 STOCKHOLDER PROPOSALS Proposals of the Company's stockholders that such stockholders intend to present at the Company's 1999 Annual Meeting of Stockholders (the "Annual Meeting"), but not included in the Company's Proxy Statement and form of Proxy related to the Annual Meeting (a "Non-Rule 14a-8 Proposal"), must be received by the Company's Secretary at the Company's offices at 901 San Antonio Road, Palo Alto, California 94303 no later than September 13, 1999 and no earlier than August 12, 1999. In the event that the Company does not receive timely notice with respect to a Non-Rule 14a-8 Proposal, management of the Company would use its discretionary authority to vote the shares it represents as the Board of Directors may recommend. ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K a) EXHIBITS <TABLE> <S> <C> 10.64 Registrant's 1998 Directors' Stock Option Plan as amended on August 12, 1998. 10.66(1) Registrant's 1990 Long-Term Equity Incentive Plan, as amended on August 12, 1998. 10.93+ Strategic Development and Marketing Agreement dated November 23, 1998 by and between America Online, Inc. and the Registrant. 27.0 Financial Data Schedule for the period ended December 27, 1998. </TABLE> + Confidentiality Treatment Requested. (1) Incorporated by reference to Exhibit 4.2 filed as an exhibit to Registrant's Amendment No. 1 to Registration Statement Form S-8/A file number 333-67183 filed with the Securities and Exchange Commission on January 26, 1999. b) REPORTS ON FORM 8-K No reports on Form 8-K were filed during the quarter ended December 27, 1998. ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's market risk disclosures set forth in the 1998 Form 10-K have not changed significantly through the quarter ended December 27, 1998. 25
26 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SUN MICROSYSTEMS, INC. BY /s/ Michael E. Lehman ---------------------------------------- Michael E. Lehman Vice President, Corporate Resources and Chief Financial Officer /s/ George Reyes ---------------------------------------- George Reyes Vice President and Corporate Controller, Chief Accounting Officer Dated: February 8, 1999 26
27 INDEX TO EXHIBITS <TABLE> <CAPTION> EXHIBIT NUMBER PAGE - ------- ---- <S> <C> <C> 10.64 Registrant's 1998 Directors' Stock Option Plan as amended on August 12, 1998. 10.66(1) Registrant's 1990 Long-Term Equity Incentive Plan, as amended on August 12, 1998. 10.93+ Strategic Development and Marketing Agreement dated November 23, 1998 by and between America Online, Inc. and the Registrant. 27.0 Financial Data Schedule for the period ended December 27, 1998. </TABLE> + Confidentiality Treatment Requested. (1) Incorporated by reference to Exhibit 4.2 filed as an exhibit to Registrant's Amendment No. 1 to Registration Statement Form S-8/A file number 333-67183 filed with the Securities and Exchange Commission on January 26, 1999. 27