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 March 29, 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) DELAWARE 94-2805249 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 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 [ ] 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> <CAPTION> CLASS OUTSTANDING AT MARCH 29, 1998 ----- ----------------------------- <S> <C> Common stock - $0.00067 par value 378,811,393 </TABLE> 1
2 INDEX <TABLE> <CAPTION> PAGE <S> <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 10 PART II - OTHER INFORMATION Item 1 - Legal Proceedings 16 Item 5 - Other Information 16 Item 6 - Exhibits and Reports on Form 8 - K 17 Item 7A - Quantitative and Qualitative Disclosures About Market Risk 17 SIGNATURES 18 </TABLE> 2
3 PART I - FINANCIAL INFORMATION ITEM 1 - FINANCIAL STATEMENTS SUN MICROSYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands) <TABLE> <CAPTION> March 29, June 30, 1998 1997 ----------- ----------- (unaudited) <S> <C> <C> ASSETS Current assets: Cash and cash equivalents $ 656,765 $ 660,170 Short-term investments 357,098 452,590 Accounts receivable, net 1,675,899 1,666,523 Inventories 476,471 437,978 Deferred tax assets 315,766 286,720 Other current assets 272,566 224,469 ----------- ----------- Total current assets 3,754,565 3,728,450 Property, plant and equipment, at cost 2,040,090 1,658,341 Accumulated depreciation and amortization (901,382) (858,448) ----------- ----------- 1,138,708 799,893 Other assets, net 277,972 168,931 ----------- ----------- $ 5,171,245 $ 4,697,274 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Short-term borrowings $ -- $ 100,930 Accounts payable 521,938 468,912 Accrued liabilities 993,927 963,012 Other current liabilities 293,981 316,184 ----------- ----------- Total current liabilities 1,809,846 1,849,038 Long-term debt and other obligations 137,637 106,299 Stockholders' equity 3,223,762 2,741,937 ----------- ----------- $ 5,171,245 $ 4,697,274 =========== =========== </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 Nine Months Ended -------------------------- -------------------------- March 29, March 30, March 29, March 30, 1998 1997 1998 1997 ---------- ---------- ---------- ---------- <S> <C> <C> <C> <C> Net revenues $2,360,928 $2,114,618 $6,909,775 $6,055,225 Cost and expenses: Cost of sales 1,101,636 1,053,194 3,300,700 3,058,697 Research and development 252,770 196,151 734,616 583,429 Selling, general and administrative 672,606 585,305 1,984,549 1,701,302 Purchased in-process research and development -- 22,958 162,284 22,958 ---------- ---------- ---------- ---------- Total costs and expenses 2,027,012 1,857,608 6,182,149 5,366,386 Operating income 333,916 257,010 727,626 688,839 Gain on sale of equity investment -- 62,245 -- 62,245 Interest income, net 12,366 9,438 33,134 21,331 ---------- ---------- ---------- ---------- Income before income taxes 346,282 328,693 760,760 772,415 Provision for income taxes 114,273 105,182 270,886 247,173 ---------- ---------- ---------- ---------- Net income $ 232,009 $ 223,511 $ 489,874 $ 525,242 ========== ========== ========== ========== Net income per common share - basic $ 0.62 $ 0.61 $ 1.31 $ 1.43 ========== ========== ========== ========== Net income per common share - diluted $ 0.59 $ 0.58 $ 1.24 $ 1.35 ========== ========== ========== ========== Shares used in the calculation of net income per share - basic 374,524 368,247 373,487 367,915 ========== ========== ========== ========== Shares used in the calculation of net income per share - diluted 394,637 388,364 394,322 389,073 ========== ========== ========== ========== </TABLE> See accompanying notes. 4
5 SUN MICROSYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) (in thousands) <TABLE> <CAPTION> Nine Months Ended ------------------------- March 29, March 30, 1998 1997 --------- --------- <S> <C> <C> Cash flow from operating activities: Net income $ 489,874 $ 525,242 Adjustments to reconcile net income to net cash provided from operating activities: Depreciation, amortization and other non-cash items 292,446 266,069 Tax benefit of options exercised 106,399 39,815 Gain on sale of equity investment -- (62,245) Purchased in-process research and development 162,284 22,958 Increase in accounts receivable (7,025) (214,877) Increase in inventories (32,657) (30,556) Increase in accounts payable 15,353 196,647 Net increase in other current and non-current assets (114,747) (91,890) Net increase in other current and non-current liabilities 54,002 116,271 --------- --------- Net cash provided from operating activities 965,929 767,434 --------- --------- Cash flow from investing activities: Acquisition of property, plant and equipment (571,379) (403,589) Acquisition of other assets (84,918) (27,270) Payment for acquisitions, net of cash acquired (227,655) (22,958) Acquisition of short-term investments (460,278) (473,939) Maturities of short-term investments 571,032 447,574 --------- --------- Net cash used by investing activities (773,198) (480,182) --------- --------- Cash flow from financing activities: Issuance of common stock 58,872 32,482 Acquisition of treasury stock (224,002) (398,267) Proceeds from employee stock purchase plans 61,905 51,287 Proceeds from sale of equity investment -- 62,245 Reduction of short - term borrowings, net (100,930) (44,605) Increase in (reduction of) long-term borrowings 8,019 (34,769) --------- --------- Net cash used by financing activities (196,136) (331,627) --------- --------- Net decrease in cash and cash equivalents $ (3,405) $ (44,375) ========= ========= </TABLE> 5
6 <TABLE> <S> <C> <C> Supplemental disclosures of cash flow information: Cash paid during the period for: Interest $ 606 $ 10,616 Income taxes $ 210,632 $ 248,172 Supplemental schedule of non-cash investing and financing activities: In conjunction with the Company's acquisitions, liabilities were assumed as follows: Fair value of assets acquired $ 284,294 Cash paid for assets (233,111) --------- Liabilities assumed $ 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 quarterly financial information is unaudited, the financial statements included in this report reflect all adjustments (consisting only 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 1997 Annual Report to Stockholders which is incorporated by reference in the Company's 1997 Form 10-K (as amended on Form 10-K/A). INVENTORIES (IN THOUSANDS) <TABLE> <CAPTION> March 29, 1998 June 30, 1997 -------------- ------------- <S> <C> <C> Raw materials $200,258 $236,900 Work in process 66,813 50,577 Finished goods 209,400 150,501 -------- -------- $476,471 $437,978 ======== ======== </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. 7
8 EARNINGS PER SHARE The Company adopted Financial Accounting Standards No. 128 (FAS 128), "Earnings Per Share" in the second quarter of fiscal 1998. Share and per share amounts for all periods presented have been restated to comply with FAS 128. THREE MONTHS ENDED <TABLE> <CAPTION> March 29, 1998 March 30, 1997 --------------------------------- -------------------------------- Net income Shares EPS Net income Shares EPS ---------- ------ --- ---------- ------ --- <S> <C> <C> <C> <C> <C> <C> Basic $232,009 374,524 $0.62 $223,511 368,247 $0.61 Effect of dilutive securities - options and warrants 20,113 20,117 ------- ------- Diluted $232,009 394,637 $0.59 $223,511 388,364 $0.58 ======= ======= </TABLE> NINE MONTHS ENDED <TABLE> <CAPTION> March 29, 1998 March 30, 1997 --------------------------------- -------------------------------- Net income Shares EPS Net income Shares EPS ---------- ------ --- ---------- ------ --- <S> <C> <C> <C> <C> <C> <C> Basic $489,874 373,487 $1.31 $525,242 367,915 $1.43 Effect of dilutive securities - options and warrants 20,835 21,158 ------- ------- Diluted $489,874 394,322 $1.24 $525,242 389,073 $1.35 ======= ======= </TABLE> ACQUISITIONS On August 22, 1997, the Company acquired all of the outstanding stock of Diba, Inc. for $25,000,000 in cash. The transaction was accounted for as a purchase. The excess purchase price over the estimated fair value of net tangible assets has been allocated, based upon an independent third-party valuation, to various intangible assets, primarily consisting of purchased in-process research and development and goodwill. In connection with this acquisition, purchased in-process research and development of $22,300,000, associated with products which had not achieved technological feasibility and for which no alternative uses have been established by the Company, was written off. Intangible assets, including goodwill, are being amortized over their estimated useful lives of three years. The results of operations of Diba, Inc. from the date of acquisition through March 29, 1998 are included in the Company's consolidated statement of income and are not material to the Company. On September 22, 1997, the Company acquired all of the outstanding stock of Integrity Arts, Inc. for $30,200,000 in cash. The transaction was accounted for as a purchase. The excess purchase price over the estimated fair value of net tangible assets has been allocated, based upon an independent third-party valuation, to various intangible assets, primarily consisting of purchased in-process research and development and goodwill. In connection with this acquisition, purchased in-process research and development of approximately $29,900,000, associated with products which had not achieved technological feasibility and for which no alternative uses have been established by the Company, was written off. Intangible assets, including goodwill, are being amortized over their estimated useful lives of three years. The results of operations of Integrity Arts, Inc. from the date of acquisition through March 29, 1998 are included in the Company's consolidated statement of income and are not material to the Company. On October 21, 1997, the Company acquired substantially all of the assets and certain liabilities of Chorus Systems, S.A. and its wholly-owned subsidiaries for approximately $26,500,000 in cash. The transaction was 8
9 accounted for as a purchase. The excess purchase price over the estimated fair value of net tangible assets has been allocated, based upon an independent third-party valuation, to various intangible assets, primarily consisting of purchased in-process research and development and goodwill. In connection with this acquisition, purchased in-process research and development of $13,100,000, associated with products which had not achieved technological feasibility and for which no alternative uses have been established by the Company, was written off. Intangible assets, including goodwill, are being amortized over their estimated useful lives of three years. The results of operations of Chorus Systems, S.A. from the date of acquisition through March 29, 1998 are included in the Company's consolidated statement of income and are not material to the Company. On November 24, 1997, the Company acquired substantially all of the assets of Encore Computer Corporation's storage products business for approximately $186,000,000 in cash. The transaction was accounted for as a purchase. The excess purchase price over the estimated fair value of net tangible assets has been allocated, based upon an independent third-party valuation, to various intangible assets, primarily consisting of purchased in-process research and development and goodwill. In connection with this acquisition, purchased in-process research and development of $97,000,000, associated with products which had not achieved technological feasibility and for which no alternative uses have been established by the Company, was written off. Intangible assets, including goodwill, are being amortized over their estimated useful lives of three years. The results of operations of the storage products business of Encore Computer Corporation from the date of acquisition through March 29, 1998 are included in the Company's consolidated statement of income and are not material to the Company. REGISTRATION STATEMENT 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 $1,000,000,000. On October 24, 1997, the Registration Statement became effective, so that the Company may now choose to offer, from time to time, the debt securities and common stock 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. 9
10 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 net revenues: <TABLE> <CAPTION> Three Months Ended Nine Months Ended ---------------------- ---------------------- March 29, March 30, March 29, March 30, 1998 1997 1998 1997 ------ ------ ------ ------ <S> <C> <C> <C> <C> Net revenues 100.0% 100.0% 100.0% 100.0% Cost of sales 46.7 49.8 47.8 50.5 ------ ------ ------ ------ Gross margin 53.3 50.2 52.2 49.5 Research and development 10.7 9.3 10.6 9.6 Selling, general and administrative 28.5 27.6 28.7 28.1 Purchased in-process research and development -- 1.1 2.4 .4 ------ ------ ------ ------ Operating income 14.1 12.2 10.5 11.4 Gain on sale of equity investment -- 2.9 -- 1.0 Interest income, net 0.6 0.4 0.5 0.4 ------ ------ ------ ------ Income before income taxes 14.7 15.5 11.0 12.8 Provision for income taxes 4.9 4.9 3.9 4.1 ------ ------ ------ ------ Net income 9.8% 10.6% 7.1% 8.7% ====== ====== ====== ====== </TABLE> The following sections contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve risks and uncertainties such that actual results may vary materially. Certain factors that may affect the Company's results and financial condition over the next few quarters are discussed under the caption "Future Operating Results" below. Other factors that may affect such results and financial condition are set forth in the Company's 1997 Annual Report to Stockholders which is incorporated by reference in the Company's Form 10-K (as amended on Form 10-K/A), and the Company's Form 10-K, as amended. RESULTS OF OPERATIONS NET REVENUES Net revenues were $2.361 billion for the third quarter and $6.910 billion for the first nine months of fiscal 1998, representing increases of 11.6% and 14.1%, respectively, over the corresponding periods of fiscal 1997. 10
11 The growth in revenues resulted primarily from increased demand for workgroup and enterprise servers, and from high-end storage, memory and related products. The remaining increase reflects growth in revenues from other Sun businesses, primarily customer services. Domestic net revenues increased by 17.8% and 17.9% while international net revenues (including United States exports) grew 6.0% and 10.4% in the third quarter and first nine months of fiscal 1998, respectively, compared with the corresponding periods of fiscal 1997. In US dollars, European net revenues increased 19.9% and 16.6%, Japanese net revenues decreased 12.2% and 2.6% and net revenues in Rest of World decreased 3.8% and increased 10.6% in the third quarter and first nine months of fiscal 1998, respectively, when compared with the same periods of fiscal 1997. The increase in European revenues was principally due to the continued strengthening of the markets and producer acceptance. The decrease in Japanese net revenues primarily reflects the macroeconomic issues in that country. The decrease was also reflected in local currency. The decrease in Rest of World net revenues was primarily the result of decreases in Korea and other South East Asian country net revenues, offset partially by increases in net revenues generated from markets in China, Australia and Latin America. The Company generally manages currency exposure through the use of simple, short-term forward foreign exchange and currency option contracts, the objective of which is to minimize the impact of currency fluctuations on the results of operations. As the Company utilizes projected data as a basis for its forward foreign exchange and currency option contracts, variances which result from forecasting differences and the extent of currency movement during the quarter could have a material adverse effect on the results of operations and cash flows. GROSS MARGIN Gross margin was 53.3% for the third quarter and 52.2% for the first nine months of fiscal 1998, compared with 50.2% and 49.5%, respectively, for the corresponding periods in fiscal 1997. The increase in gross margin for the periods compared reflects principally the effects of increased revenue generated from sales of higher margin servers and storage products, as well as decreases in the cost of key components, including chips, memory and storage. The factors described above resulted in a favorable impact on gross margin for the third quarter and first nine months of fiscal 1998. 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 were $252.8 million in the third quarter and $734.6 million for the first nine months of fiscal 1998, compared with $196.2 million and $583.4 million, respectively, for the same periods of fiscal 1997. As a percentage of net revenues, R&D expenses increased to 10.7% for the third quarter and 10.6% for the first nine months of fiscal 1998, from 9.3% and 9.6% ,respectively, for the corresponding periods of fiscal 1997. These increases reflect the increased expenditures focused on the development of hardware and software products which utilize the Java architecture, as well as the continued development of UltraSPARC systems, storage products and further development of products acquired through acquisitions, and increased compensation due primarily to an increase in personnel. 11
12 SELLING, GENERAL AND ADMINISTRATIVE Selling, general and administrative (SG&A) expenses were $672.6 million in the third quarter and $1,984.5 million in the first nine months of fiscal 1998, compared with $585.3 and $1,701.3 million, respectively, for the same periods of fiscal 1997. As a percentage of net revenues, SG&A expenses were 28.5% and 28.7% in the third quarter and first nine months of fiscal 1998, respectively, and 27.6% and 28.1%, respectively, in the corresponding periods of fiscal 1997. The dollar increases are primarily attributable to increased compensation resulting from higher levels of headcount (principally in the sales organization) in addition to marketing costs related to demand creation programs. The increase is also due to costs associated with the Company's ongoing efforts to improve business processes and cycle times. The Company expects to continue to focus on expansion of its demand creation programs and support organizations. PURCHASED IN - PROCESS RESEARCH AND DEVELOPMENT Purchased in-process research and development represents the write-off of purchased in-process research and development associated with the Company's acquisitions of Diba, Inc., Integrity Arts, Inc., Chorus Systems, S.A., and the storage products business of Encore Computer Corporation in fiscal 1998 and Longview Technologies, LLC in the third quarter of fiscal 1997. GAIN ON SALE OF EQUITY INVESTMENT The gain on sale of equity investment represents the net proceeds from the sale of the Company's equity investment in Iona Technologies, plc. during the third quarter of fiscal 1997. INTEREST INCOME, NET Net interest income was $12.4 million for the third quarter and $33.1 million for the first nine months of fiscal 1998, compared with $9.4 million and $21.3 million, respectively, for the corresponding periods in fiscal 1997. The increase for the third quarter of fiscal 1998 is 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 for the third quarter and first nine months of fiscal 1998 was 33% before a $19.8 million tax charge resulting from a non-recurring write-off of in-process research and development associated with the acquisitions of Diba, Inc. and Integrity Arts, Inc. during the first quarter of fiscal 1998. The effective income tax rate including such tax charge was 36%. The effective income tax rate for the third quarter and first nine months of fiscal 1997 was 32%. The increase in the overall effective tax rate to 33% for fiscal 1998 is attributable to an increase in anticipated worldwide earnings without offsetting tax credits or other tax savings. FUTURE OPERATING RESULTS The market for Sun's products and services is 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 in many segments of the network computing market across a broad spectrum of customers. The Company expects the markets for its products and technologies, as well as its competitors within such markets, will continue to change as the trend in enterprise computing 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 its competitors, principally Hewlett-Packard Co., International Business Machines Corporation, Digital Equipment Corporation, and Silicon Graphics, Inc., aggressively position 12
13 themselves to benefit from this shifting of customer buying patterns and demand. The Company is also facing competition from these competitors, as well as other systems manufacturers, such as Compaq Computer Corporation and Dell Computer Corporation, with respect to products based on microprocessors from Intel Corporation coupled with the 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 lower-end server product lines. Additionally, 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 the remainder of fiscal 1998 and into 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. 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, storage, 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 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 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. 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 significant 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 adversely affect the Company's net revenues and operating 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 Company's design process, the Company's operating results could be adversely affected due to the Company's obligations to fulfill such noncancelable purchase commitments. Generally, the computer systems sold by Sun, such as the UltraSPARC-based products, 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, 13
14 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 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 an adverse effect on the Company's future financial condition and operating results. Seasonality also affects the Company's operating results, particularly in the first 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. 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, the Company has begun to implement a number of new business practices and a series of related information systems; such activities are currently planned to be fully operational in the first half of fiscal year 1999. Implementing a number of new business practices and information systems is a complex process, affecting numerous operational and financial systems and processes as well as requiring comprehensive employee training. While the Company tests these new systems and processes in advance of implementation, there are inherent limitations in the Company's ability to simulate a full-scale operating environment in advance of the system cutover. To the extent that the Company encounters problems after introduction of 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. Many 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 accept four digit entries to distinguish years beginning with "19" from those beginning with "20" dates. As a result, in less than two years, 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 significant resources to review its products and services, as well as its internal management information systems in order to identify and modify those products, services and systems that are not year 2000 compliant. The Company expects such modifications will be made on a timely basis and does not believe that the cost of such modifications will have a material effect on the Company's operating results. There can be no assurance, however, that the Company will be able to modify timely and successfully such products, services and systems to comply with year 2000 requirements, which could have a material adverse effect on the Company's operating results. Based on the Company's assessment to date, most newly introduced products and services of the Company are year 2000 compliant, however some of the Company's customers are running product versions that are not year 2000 compliant. The Company has been encouraging such customers to migrate to current product versions. In addition, the Company 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 the year 2000 requirements. 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, there can be no assurance that these or other factors relating to the 14
15 year 2000 compliance issues, including litigation, will not have a material adverse effect on the Company's business, operating results or financial condition. 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 Total assets at March 29, 1998 increased by approximately $474 million from June 30, 1997, due principally to increases in accounts receivable of $9.4 million, inventory of $38.5 million, other current assets of $77.2 million, property, plant and equipment-net of $338.8 million, and other assets of $109 million offset by a decrease in cash, cash equivalents and short term investments of $98.9 million. The increase in accounts receivable primarily reflects the timing of cash receipts as compared to the fourth quarter of fiscal 1997. The increase in inventory is due to the seasonally lower sales level in the third fiscal quarter relative to the fourth quarter. The increase in property, plant and equipment reflects capital spending for real estate development of the Company's facilities, assets acquired through acquisitions and capital additions to support increased headcount, primarily in the Company's engineering, service and marketing organizations. Other current assets increased due to the timing of payments for insurance and other taxes. Other assets increased due to the recording of goodwill and other intangible assets related to the Company's acquisitions. Total current liabilities decreased $39.2 million from June 30, 1997, due principally to increases in accounts payable of $53 million and accrued liabilities of $30.9 million, offset by decreases in short-term borrowings of $100.9 million and other current liabilities of $22.2 million. The increase in accounts payable reflects increased inventory levels and a payment due on one of the Company's acquisitions. The increase in accrued liabilities is due to increases in warranty and the employee stock participation program. The decrease in short-term borrowings reflects payments related to the debt of subsidiaries and the decrease in other current liabilities primarily reflects the decrease in income taxes payable. At March 29, 1998, the Company's primary sources of liquidity consisted of cash, cash equivalents and short-term investments of $1,013.9 million and a revolving credit facility with banks aggregating $500 million, which was available subject to compliance with certain covenants. 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 $1,000,000,000. On October 24, 1997, the Registration Statement became effective, so that the Company may now choose to offer, from time to time, the debt securities and common stock 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 offering and 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. 15
16 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 granted a preliminary injunction that prevents Microsoft Corporation from using the Company's Java Compatible (TM) logo. 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 5 - OTHER INFORMATION SCHEDULE OF SALES BY EXECUTIVE OFFICERS DURING THE QUARTER The following is a summary of all sales of the Company's Common Stock by the Company's executive officers and directors who are subject to Section 16 of the Securities Exchange Act of 1934, as amended, during the fiscal quarter ended March 29, 1998: <TABLE> <CAPTION> OFFICER/ DATE PRICE NUMBER OF DIRECTOR SHARES SOLD ===================================================================== <S> <C> <C> <C> Alan E. Baratz 2/27/98 $47.625 8,000 2/27/98 $47.5625 8,000 2/27/98 $47.6875 8,000 Lawrence W. 2/27/98 $47.4375 10,000 Hambly 2/27/98 $47.8125 5,000 2/27/98 $48.0625 5,000 Michael E. Lehman 2/25/98 $46.00 20,000 2/26/98 $46.5625 3,420 Michael H. Morris 2/19/98 $46.3125 3,020 Alton D. Page 2/25/98 $46.50 5,000 2/27/98 $47.6875 5,000 Frank Pinto 2/27/98 $48.00 47,000 George Reyes 2/26/98 $46.5625 10,000 Edward Saliba 2/19/98 $46.8750 8,000 </TABLE> 16
17 <TABLE> <S> <C> <C> <C> Janpieter T. 2/13/98 $44.4895 8,000 Scheerder 2/13/98 $44.4895 40,000 John Shoemaker 2/19/98 $46.3375 3,620 A. Michael Spence 2/20/98 $45.8125 7,500 2/25/98 $45.5625 4,500 2/25/98 $45.6250 3,000 William Sutherland 2/24/98 $45.1875 2,400 Kevin Walsh 2/25/98 $46.50 7,000 2/25/98 $46.4375 2,300 2/25/98 $46.3125 5,700 2/26/98 $46.8125 15,000 2/26/98 $47.00 11,600 Edward J. Zander 2/23/98 $46.3125 5,000 2/24/98 $45.00 5,000 2/25/98 $45.25 5,000 2/25/98 $46.00 5,000 2/26/98 $47.00 2,500 2/27/98 $47.875 2,500 </TABLE> ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K a) EXHIBITS 3.1 Registrant's Restated Certificate of Incorporation, as amended February 11, 1998 3.2 Registrant's Bylaws, as amended February 11, 1998 4.3(1) Second Amended and Restated Shares Rights Agreement dated as of February 11, 1998 27.0 Financial data schedule for the period ended March 29, 1998 (1) Incorporated herein by reference to the Registrant's Registration Statement on Form 8-A/A Amendment No. 6 filed on February 13, 1998. b) REPORTS ON FORM 8-K No reports on form 8-K were filed during the quarter ended March 29, 1998. ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's market risk disclosures set forth in the 1997 Annual Report to Stockholders have not changed significantly through the third quarter ended March 29, 1998. 17
18 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: May 6, 1998 18