UNITED STATES
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 October 1, 2006

or

o                                 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)

 

4150 Network Circle, Santa Clara, CA 95054

(Address of principal executive offices with zip code)

(650) 960-1300

(Registrant’s telephone number, including area code)

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  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer”  in Rule 12b-2 of the Exchange Act) (Check one);

Large accelerated filer  x               Accelerated filer  o               Non-accelerated filer  o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    YES  o    No  x

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 practicable date.

 

 

INDEX

PART I — FINANCIAL INFORMATION
Item 1.		Financial Statements:		3
		Condensed Consolidated Statements of Operations		3
		Condensed Consolidated Balance Sheets		4
		Condensed Consolidated Statements of Cash Flows		5
		Notes to Condensed Consolidated Financial Statements		6
		Report of Independent Registered Public Accounting Firm		15
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations		16
Item 3.		Quantitative and Qualitative Disclosures About Market Risk		26
Item 4.		Controls and Procedures		27
PART II — OTHER INFORMATION
Item 1.		Legal Proceedings		28
Item 1A.		Risk Factors		28
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds		28
Item 6.		Exhibits		29
SIGNATURES				30

 

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PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

SUN MICROSYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
(in millions, except per share amounts)

		Three Months Ended
		October 1,			September 25,
		2006			2005
Net revenues:
Products		$	1,959		$	1,704
Services		1,230			1,022
Total net revenues		3,189			2,726
Cost of sales:
Cost of sales-products (including stock-based compensation expense of $3 and $2(1))		1,123			966
Cost of sales-services (including stock-based compensation expense of $8 and $7(1))		678			558
Total cost of sales		1,801			1,524
Gross margin		1,388			1,202
Operating expenses:
Research and development (including stock-based compensation expense of $18 and $17(1))		473			439
Selling, general and administrative (including stock-based compensation expense of $29 and $24(1))		958			828
Restructuring and related impairment of long-lived assets		21			12
Purchased in-process research and development		—			60
Total operating expenses		1,452			1,339
Operating loss		(64		)	(137		)
Gain on equity investments, net		—			13
Interest and other income, net		42			44
Loss before income taxes		(22		)	(80		)
Provision for income taxes		34			43
Net loss		$	(56	)	$	(123	)
Net loss per common share-basic and diluted		$	(0.02	)	$	(0.04	)
Shares used in the calculation of net loss per common share-basic and diluted		3,497			3,407

(1)                For the three months ended October 1, 2006 and September 25, 2005, respectively.

See accompanying notes.

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SUN MICROSYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in millions)

		October 1,			June 30,
		2006			2006
		(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	3,362		$	3,569
Short-term marketable debt securities		609			496
Accounts receivable, net		2,036			2,702
Inventories		584			540
Deferred and prepaid tax assets		214			209
Prepaid expenses and other current assets		747			757
Total current assets		7,552			8,273
Property, plant and equipment, net		1,583			1,812
Long-term marketable debt securities		700			783
Goodwill		2,566			2.610
Other acquisition-related intangible assets, net		848			929
Other non-current assets, net		645			675
		$	13,894		$	15,082
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current portion of long-term debt and short-term borrowings		$	2		$	503
Accounts payable		1,292			1,446
Accrued payroll-related liabilities		661			777
Accrued liabilities and other		1,063			1,190
Deferred revenues		1,695			1,988
Warranty reserve		244			261
Total current liabilities		4,957			6,165
Long-term debt		582			575
Long-term deferred revenues		558			506
Other non-current obligations		1,388			1,492
Stockholders’ equity		6,409			6,344
		$	13,894		$	15,082

 

See accompanying notes.

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SUN MICROSYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in millions)

		Three Months Ended
		October 1,			September 25,
		2006			2005
Cash flows from operating activities:
Net loss		$	(56	)	$	(123	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		123			143
Amortization of other acquisition-related intangible assets		81			46
Stock-based compensation expense		58			50
Purchased in-process research and development		—			60
Gain on investments, net		—			(13		)
Impairment of assets		8			—
Deferred taxes		(3		)	—
Changes in operating assets and liabilities:
Accounts receivable, net		672			449
Inventories		(71		)	67
Prepaid and other assets		36			203
Accounts payable		(151		)	(174		)
Other liabilities		(540		)	(484		)
Net cash provided by operating activities		157			224
Cash flows from investing activities:
Purchases of marketable debt securities		(675		)	(454		)
Proceeds from sales of marketable debt securities		515			2,818
Proceeds from maturities of marketable debt securities		136			75
Proceeds from sales of equity investments, net		7			9
Proceeds from sales (purchases) of property, plant and equipment, net		160			(48		)
Purchases of spare parts and other assets		(34		)	(20		)
Payments for acquisitions, net of cash acquired		—			(3,150		)
Net cash provided by (used in) investing activities		109			(770		)
Cash flows from financing activities:
Proceeds from issuance of common stock, net		27			3
Principal payments on borrowings and other obligations		(500		)	—
Net cash provided by (used in) financing activities		(473		)	3
Net decrease in cash and cash equivalents		(207		)	(543		)
Cash and cash equivalents, beginning of period		3,569			2,051
Cash and cash equivalents, end of period		$	3,362		$	1,508
Supplemental disclosures of cash flow information:
Interest paid (net of interest received from swap agreements of $10 and $20, respectively)		$	30		$	20
Income taxes paid (received) (net of refunds of $14 and $137, respectively)		$	110		$	(76	)
Supplemental schedule of noncash investing activities:
Stock and options issued in connection with acquisitions		—			$	89
Net issuance of nonvested stock awards (restricted stock)		$	5		$	64

 

See accompanying notes.

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SUN MICROSYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. DESCRIPTION OF BUSINESS

Sun Microsystems Inc. (Sun) provides network computing infrastructure solutions that include Computer Systems (hardware and software), Data Management (hardware and software) and Support Services and Client Solutions and Educational Services. Sun’s solutions are based on Sun technology innovations such as the Java technology platform, the SolarisTM Operating System, Sun JavaTM products and the UltraSPARC® microprocessor technology, as well as other widely deployed technologies such as the Linux operating system and AMD OpteronTM microprocessor-based systems. Our network computing infrastructure solutions are used in a wide range of technical/scientific, business and engineering applications in industries such as telecommunications, government, financial services, manufacturing, education, retail, life sciences, media and entertainment, transportation, energy/utilities and healthcare. We sell complete networking solutions, including products and services, in most major markets worldwide through a combination of direct and indirect channels. In the first quarter of fiscal 2006, we completed the acquisition of Storage Technology Corporation (StorageTek) which allowed us to broaden our offerings of storage products, services and solutions.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Fiscal Year

Sun’s first three quarters in fiscal year 2007 end on October 1, 2006, December 31, 2006, and April 1, 2007. In fiscal year 2006, the quarters ended on September 25, 2005, December 25, 2005, and March 26, 2006. The fourth quarter in all fiscal years ends on June 30.

Basis of Presentation

The accompanying condensed consolidated financial statements (Interim Financial Statements) include the accounts of Sun and its subsidiaries. Intercompany accounts and transactions have been eliminated.

These Interim Financial Statements have been prepared in accordance with generally accepted accounting principles in the United States (U.S. GAAP) for interim financial information and the rules and regulations of the Securities and Exchange Commission (SEC) for interim financial statements and accounting policies, consistent, in all material respects, with those applied in preparing our audited consolidated financial statements included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2006, filed with the SEC on September 8, 2006 (2006 Form 10-K). These Interim Financial Statements are unaudited but reflect all adjustments, including normal recurring adjustments management considers necessary for a fair presentation of our financial position, operating results and cash flows for the interim periods presented. The results for the interim periods are not necessarily indicative of the results for the entire year. The condensed consolidated balance sheet as of June 30, 2006 has been derived from the audited consolidated balance sheet as of that date. The information included in this report should be read in conjunction with our 2006 Form 10-K.

Computation of Net Income (Loss) per Common Share

Basic net income (loss) per common share is computed using the weighted-average number of common shares outstanding (adjusted for treasury stock and common stock subject to repurchase activity) during the period.

Diluted net income (loss) per common share is computed using the weighted-average number of common and dilutive common equivalent shares outstanding during the period. Dilutive common equivalent shares consist primarily of stock options and nonvested stock awards. Due to our net loss for all periods presented, all of our outstanding options and nonvested stock awards were excluded from the diluted loss per share calculation because their inclusion would have been anti-dilutive.

If we had earned a profit during the three months ended October 1, 2006 and September 25, 2005, we would have added 26 million and 4 million common equivalent shares, respectively, to our basic weighted-average shares outstanding to compute the diluted weighted-average shares outstanding.

Recent Pronouncements

In May 2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections” (SFAS 154), which replaces Accounting Principles Board Opinions (APB) 20 “Accounting Changes” and SFAS 3, “Reporting Accounting Changes in Interim Financial Statements — An Amendment of APB Opinion No. 28.” SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the earliest practicable date, as the required method for reporting a change in accounting principle and restatement with respect to the

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reporting of a correction of an error. Our adoption of SFAS 154 in the first quarter of fiscal 2007 did not have a material impact on our results of operations and financial position.

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 (FIN 48), which clarifies the accounting for uncertainty in tax positions. This Interpretation requires that we recognize in our financial statements, the impact of a tax position, if that position is more likely than not to be sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective in the first quarter of fiscal 2008, with the cumulative effect, if any, of the change in accounting principle recorded as an adjustment to opening retained earnings. We are currently evaluating the impact of adopting FIN 48 on our consolidated financial statements.

In September 2006, the SEC released Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (SAB 108). SAB 108 provides interpretive guidance on the SEC’s views regarding the process of quantifying materiality of financial statement misstatements. SAB 108 is effective for fiscal years ending after November 15, 2006, and early application for the first interim period of the same fiscal year is encouraged. The application of SAB 108 in the first quarter of fiscal 2007 would not have a material effect on our results of operations or financial position.

In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements” (SFAS 157). SFAS 157 defines fair value, establishes a framework and gives guidance regarding the methods used for measuring fair value, and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We are currently evaluating the impact of adopting SFAS 157 on our consolidated financial statements.

In September 2006, the FASB issued Statement No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (SFAS 158). SFAS 158 requires companies to recognize the overfunded or underfunded status of a defined benefit post-retirement plan as an asset or liability in their balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income, effective for fiscal years ending after December 15, 2006. SFAS 158 also requires companies to measure the funded status of the plan as of the date of its fiscal year-end, with limited exceptions, effective for fiscal years ending after December 15, 2008. We are currently evaluating the impact of adopting SFAS 158 on our consolidated financial statements.

3. BALANCE SHEET DETAILS

Inventories

Inventories consisted of the following (in millions):

 

Warranty Reserve

We accrue for our product warranty costs at the time of shipment. These product warranty costs are estimated based upon our historical experience and specific identification of product requirements and may fluctuate based on product mix.

The following table sets forth an analysis of warranty reserve activity (in millions):

 

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4. GOODWILL AND OTHER ACQUISITION-RELATED INTANGIBLE ASSETS

Information regarding our goodwill by reportable segment is as follows (in millions):

 

Information regarding our other acquisition-related intangible assets is as follows (in millions):

		Gross Carrying Amount									Accumulated Amortization									Net
		June 30,						October 1,			June 30,						October 1,			October 1,
		2006			Additions			2006			2006			Additions			2006			2006
Developed technology		$	889		$	—		$	889		$	(471	)	$	(38	)	$	(509	)	$	380
Customer base		650			—			650			(204		)	(39		)	(243		)	407
Trademark		63			—			63			(10		)	(1		)	(11		)	52
Acquired workforce and other		94			—			94			(82		)	(3		)	(85		)	9
		$	1,696		$	—		$	1,696		$	(767	)	$	(81	)	$	(848	)	$	848

 

Amortization expense of other acquisition-related intangible assets was $81 million and $46 million for the three months ended October 1, 2006 and September 25, 2005, respectively. Our acquisition-related intangible assets are amortized primarily over periods ranging between one and five years on a straight-line basis.

Estimated amortization expense for other acquisition-related intangible assets on our October 1, 2006 balance sheet for the fiscal years ending June 30, is as follows (in millions):

 

5. RESTRUCTURING CHARGES AND RELATED IMPAIRMENT OF LONG-LIVED ASSETS

In accordance with SFAS 112, “Employers’ Accounting for Post Employment Benefits” (SFAS 112) and SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146), we recognized a total of $21 million and $12 million in restructuring and related impairment of long-lived assets in the three months ended October 1, 2006 and September 25, 2005, respectively. The determination of when we accrue for severance costs and which standard applies depends on whether the termination benefits are provided under a one-time benefit arrangement as defined by FAS 146 or under an on-going benefit arrangement as described in FAS 112.

We estimated the cost of exiting and terminating our facility leases or acquired leases by referring to the contractual terms of the agreements and by evaluating the current real estate market conditions. In addition, we have estimated sublease income by evaluating the current real estate market conditions or, where applicable, by referring to amounts being negotiated. As of October 1, 2006, our estimated sublease income to be generated from sublease contracts not yet negotiated approximated $24 million. Our ability to generate this amount of sublease income, as well as our ability to terminate lease obligations at the amounts we have estimated, is highly dependent upon the commercial real estate market conditions in certain geographies at the time we perform our evaluations or negotiate the lease termination and sublease arrangements with third parties. The amounts we have accrued represent our best estimate of the obligations we expect to incur and could be subject to adjustment as market conditions change.

Restructuring Plan VI

In May 2006, we implemented a plan to better align our resources with our strategic business objectives (Restructuring Plan VI). As part of this plan, we expect to reduce our workforce by approximately 4,000 employees across certain business functions, operating units and geographic regions as

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well as implementing other expense reduction measures. Through the first quarter of fiscal 2007, we reduced our workforce by approximately 1,700 and recognized cumulative expenses relating to severance and benefit costs of $165 million, primarily in workforce reduction charges associated with Restructuring Plan VI.

Restructuring Plan V

In June 2005, we implemented a workforce reduction and in July 2005, we committed to a facility exit plan (Restructuring Plan V). This plan included reducing our workforce across all levels, business functions, operating units and geographic regions. Through the first quarter of fiscal 2007, we reduced our workforce by approximately 1,400 employees, and recognized cumulative expenses relating to severance and benefit costs of $94 million, associated with Restructuring Plan V. As of October 1, 2006, all employees to be terminated as a result of Restructuring Plan V had been notified in accordance with local employment laws. All facilities relating to the amounts accrued under this restructuring plan were exited by October 1, 2006 in accordance with SFAS 146.

In the fourth quarter of fiscal 2006, we committed to the closure of our Newark, California campus and as a result recognized an impairment loss of approximately $80 million in accordance with FAS 144. We completed the sale of our Newark, California campus in the first quarter of fiscal 2007 and received approximately $213 million, net of $1 million in closing costs, which is included in the “Proceeds from sales of property, plant and equipment, net” in our Condensed Consolidated Statements of Cash Flows.

Restructuring Plans Prior to Phase V

Prior to the initiation of Restructuring Plan V, we implemented certain workforce reduction and facilities exit actions. As of June 30, 2006, all employees to be terminated under these plans had been notified and all facilities relating to the amounts accrued under these restructuring plans were exited by June 30, 2005.

The following table sets forth an analysis of our restructuring accrual activity for the three months ended October 1, 2006 (in millions):

		Restructuring Plans
		VI						V						Prior to V
		Severance			Facilities			Severance			Facilities			Severance			Facilities
		and			Related			and			Related			and			Related
		Benefits			and Other			Benefits			and Other			Benefits			and Other			Total
Balance as of June 30, 2006		$	132		$	—		$	21		$	1		$	6		$	300		$	460
Severance and benefits		23			—			—			—			—			—			23
Accrued lease costs		—			—			—			1			—			5			6
Property and equipment impairment		—			8			—			—			—			—			8
Provision adjustments		(4		)	—			(8		)	—			(4		)	—			(16		)
Total restructuring charges		19			8			(8		)	1			(4		)	5			21
Cash paid		(52		)	—			(13		)	—			(2		)	(20		)	(87		)
Non-cash		—			(8		)	—			(1		)	—			—			(9		)
Balance as of October 1, 2006		$	99		$	—		$	—		$	1		$	—		$	285		$	385

 

The above restructuring charges are based on estimates that are subject to change. Changes to the previous estimates have been reflected as “Provision adjustments” on the above table in the period the changes in estimates were made. Accrued lease costs include accretion adjustments associated with the passage of time.

The remaining cash expenditures relating to workforce reductions are expected to be paid over the next few quarters. Our accrual as of October 1, 2006 for facility-related leases (net of anticipated sublease proceeds) will be paid over their respective lease terms through fiscal 2023. As of October 1, 2006, $156 million of the total $385 million accrual for workforce reductions and facility-related leases was classified as current accrued liabilities and other and the remaining $229 million was classified as other non-current obligations.

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We anticipate recording additional charges related to our workforce and facilities reductions over the next several quarters, the timing of which will depend upon the timing of notification of the employees leaving Sun as determined by local employment laws and as we exit facilities. In addition, we anticipate incurring additional charges associated with productivity improvement initiatives and expense reduction measures. The total amount and timing of these charges will depend upon the nature, timing, and extent of these future actions.

Acquisition-related Restructuring Costs

As a result of our acquisition of StorageTek, we have recorded acquisition-related restructuring costs associated with the costs of integrating the operating locations and activities of StorageTek with those of Sun and eliminating duplicative activities. U.S. GAAP (EITF 95-3, “Recognition of Liabilities in Connection with Purchase Business Combinations”) requires that these acquisition-related restructuring costs, which are not associated with the generation of future revenues and have no future economic benefit, be recorded as assumed liabilities in the allocation of the purchase price. As a result, during the year ended June 30, 2006, we recorded approximately $172 million of restructuring costs in connection with the StorageTek acquisition, which are based upon plans committed to by management. To estimate restructuring liabilities, management utilized assumptions of the number of employees that would be involuntarily terminated and of costs associated with the disposition of duplicate or excess acquired facilities. Decreases to the estimates of executing the currently approved acquisition related restructuring plans are recorded as an adjustment to goodwill indefinitely, whereas increases to the estimates are recorded as an adjustment to goodwill during the purchase price allocation period and as operating expenses thereafter. The following table sets forth an analysis of the acquisition-related restructuring liabilities for StorageTek for the three months ended October 1, 2006 (in millions):

 

As of October 1, 2006, our estimated sublease income to be generated from sublease contracts not yet negotiated approximated $11 million. The balance of the StorageTek severance accrual at October 1, 2006 is expected to be utilized during the remainder of fiscal 2007 and 2008 due to legal restrictions imposed in certain European countries and is expected to be funded through cash flows from the combined operations.

6. COMPREHENSIVE LOSS

The components of comprehensive loss were as follows (in millions):

 

The components of accumulated other comprehensive income were as follows (in millions):

 

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7. INCOME TAXES

For the first quarter of fiscal 2007, we recorded an income tax provision of $34 million, as compared with $43 million for the first quarter of fiscal 2006. These tax provisions are primarily based on income generated in certain state and foreign tax jurisdictions. The tax provision for the first quarter of fiscal 2007 also includes a benefit of $14 million for the reduction in accrued withholding taxes on unremitted foreign earnings as a result of restructuring some of our European subsidiaries during the quarter.

We currently have provided a full valuation allowance on our U.S. deferred tax assets and a full or partial valuation allowance on certain overseas deferred tax assets. We intend to maintain these valuation allowances until sufficient positive evidence exists to support reversal of the valuation allowance in a specific taxing jurisdiction. Likewise, the occurrence of negative evidence with respect to certain of our foreign deferred tax assets could result in an increase to the valuation allowance. Our income tax expense recorded in the future will be reduced or increased to the extent of offsetting decreases or increases to our valuation allowance.

During the third quarter of fiscal 2006, we received a revenue agent report from the Internal Revenue Service relating to their examination of our tax returns filed for fiscal years 2001 and 2002. Pursuant to the report, the Internal Revenue Service has proposed various adjustments resulting in a tax assessment of approximately $27 million. On April 17, 2006, we filed a protest with the Internal Revenue Service to contest several items. Although the ultimate outcome is unknown, we believe that we have adequately reserved for these potential adjustments and the final outcome will not have a material adverse affect on our results of operations.

We are currently under examination by the IRS for tax returns filed in fiscal years 2001 through 2005. Although the ultimate outcome is unknown, we have reserved for potential adjustments and we believe that the final outcome will not have a material affect on our results of operations.

We have also provided amounts for other anticipated tax audit adjustments in the U.S., state and foreign tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes and interest may be due. In addition, although specific foreign country transfer pricing exposures have not been identified, the risk of potential adjustment exists. If our estimate of the federal, state and foreign income tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result. If events occur which indicate payment of these amounts is unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary.

8. STOCK-BASED COMPENSATION

We have a stock-based compensation program that provides our Board of Directors broad discretion in creating employee equity incentives. This program includes incentive and non-statutory stock options and nonvested stock awards (also known as restricted stock and restricted stock units that are settled in stock). These awards to employees are granted under various plans, the majority of which are stockholder approved. Stock options are generally time-based, vesting 20% on each annual anniversary of the grant date over five years and expire eight years from the grant date. Nonvested stock awards are generally time-based and vest 50% in two tranches within a five year period from the grant date. We also have a Directors’ Stock Option Plan that provides for the automatic grant of stock options to non-employee members of our Board of Directors on the date such person initially becomes a director, and on the date of each annual meeting of stockholders. Additionally, we have an Employee Stock Purchase Plan (ESPP) that allows employees to purchase shares of common stock at 85% of the fair market value at the date of purchase. Shares issued as a result of stock option exercises, nonvested stock awards and our ESPP are generally first issued out of treasury stock. As of October 1, 2006, we had approximately 382 million shares of common stock reserved for future issuance under our stock option plans and ESPP.

On July 1, 2005, we adopted the provisions of SFAS 123R, requiring us to recognize expense related to the fair value of our stock-based compensation awards. We elected to use the modified prospective transition method as permitted by SFAS 123R. Under this transition method, stock-based compensation expense after adoption includes compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of July 1, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. Stock-based compensation expense for all stock-based compensation awards granted subsequent to July 1, 2005 was based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R. We recognize compensation expense for stock option awards on a straight-line basis over the requisite service period of the award.

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The following table sets forth the total stock-based compensation expense resulting from stock options, nonvested stock awards, ESPP and options assumed as a result of our acquisitions included in our Condensed Consolidated Statements of Operations (in millions):

 

Net cash proceeds from the exercise of stock options were $38 million and $3 million for the three months ended October 1, 2006, and September 25, 2005, respectively. No income tax benefit was realized from stock option exercises during the three months ended October 1, 2006, and September 25, 2005. In accordance with SFAS 123R, we present excess tax benefits from the exercise of stock options, if any, as financing cash flows rather than operating cash flows.

The fair value of stock-based awards was estimated using the Black-Scholes model with the following weighted-average assumptions for the three months ended October 1, 2006 and September 25, 2005, respectively:

 

Our computation of expected volatility for the quarter ended October 1, 2006 is based on a combination of historical and market-based implied volatility. Our computation of expected life is based on historical exercise patterns. The interest rate for periods within the contractual life of the award is based on the U.S. Treasury yield curve in effect at the time of grant.

Stock option activity for the three months ended October 1, 2006, is as follows (in millions, except per share amounts):

 

The aggregate intrinsic value in the table above represents the total pretax intrinsic value (i.e., the difference between Sun’s closing stock price on the last trading day of our first quarter of fiscal 2007 and the exercise price, times the number of shares) that would have been received by the option holders had all option holders exercised their options on October 1, 2006. This amount changes based on the fair market value of Sun’s stock. The total intrinsic value of options exercised was $18 million and nil for the three months ended October 1, 2006 and September 25, 2005. respectively. The total fair value of options vested was $53 million and $52 million for the three months ended October 1, 2006 and September 25, 2005, respectively.

As of October 1, 2006, $302 million of total unrecognized compensation cost related to stock options is expected to be recognized over a weighted-average period of 2 years.

The following table summarizes our restricted stock and restricted stock unit activity for the three months ended October 1, 2006 (in millions, except per share amounts):

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As of October 1, 2006, we retained purchase rights to 8 million shares issued pursuant to stock purchase agreements and other stock plans at a weighted-average price of approximately $0.01.

As of October 1, 2006, $112 million of total unrecognized compensation costs related to nonvested stock is expected to be recognized over a weighted-average period of 4 years.

9. OPERATING SEGMENTS

We design, manufacture, market and service network computing infrastructure solutions that consist of Computer Systems (hardware and software), Data Management (hardware and software), Support Services and Client Solutions and Educational Services. Our organization is primarily structured in a functional manner. During the periods presented, our current Chief Executive Officer was identified as our Chief Operating Decision Maker (CODM) as defined by SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information” (SFAS 131).

Our CODM manages our company based primarily on broad functional categories of sales, services, manufacturing, product development and engineering and marketing and strategy. Our CODM reviews consolidated financial information on revenues and gross margins for products and services and also reviews operating expenses, certain of which has been allocated to our two operating segments. Our Product Group segment comprises our end-to-end networking architecture of computing products including our Computer Systems and Data Management systems product lines. Our Services Group segment comprises a full range of services to existing and new customers, including Support Services and Client Solutions and Educational Services. StorageTek’s former storage and services segments have been included in our Product Group and Sun Services segments, respectively.

We have a Worldwide Operations (WWOPS) organization and a Global Sales Organization (GSO) that, respectively, manufacture and sell all of our products. The CODM held the GSO accountable for overall products and services revenue and margins on a consolidated level. GSO and WWOPS managed the majority of our accounts receivable and inventory, respectively. In addition, we have a Worldwide Marketing Organization (WMO) that is responsible for developing and executing Sun’s overall corporate, strategic and product marketing and advertising strategies. The CODM looked to this functional organization for advertising, pricing and other marketing strategies for the products and services delivered to market. Operating expenses (primarily sales, marketing and administrative) related to the GSO and the WMO are not allocated to the reportable segments and, accordingly, are included under the Other segment reported below.

Segment information

The following table presents revenues, interdivision revenues and operating income (loss) for our segments. The Other segment consists of certain functional groups that did not meet the requirements for a reportable segment as defined by SFAS 131, such as GSO and WMO and other miscellaneous functions such as Finance, Human Resources, and Legal (in millions):

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(1)                Includes restructuring and related impairment of long-lived assets and purchased IPRD, if applicable.

10. LEGAL PROCEEDINGS AND CONTINGENCIES

In fiscal 2005, the General Services Administration (GSA) began auditing our records under the schedule contracts it had with us to verify our compliance with various contract provisions from October 1997 to February 2005. If the audit determines that we did not comply with such provisions, we may be required to pay the GSA a potential settlement. We have made a assessment of our exposure for such amounts potentially due and such assessment is reflected in our fiscal 2006 and 2005 consolidated financial statements. We cannot predict with reasonable certainty when the audit and the subsequent negotiation process will be concluded and it may take several quarters for all issues to be resolved.

In fiscal 2006 as part of a service-based sales arrangement involving a governmental institution in Mexico, we were required to deposit approximately $41 million with a surety company as collateral guaranteeing our performance under the arrangement. As of October 1, 2006 and June 30, 2006, this cash is classified as Other non-current assets, net, in our Condensed Consolidated Balance Sheet.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders, Sun Microsystems, Inc.

We have reviewed the condensed consolidated balance sheet of Sun Microsystems, Inc. as of October 1, 2006, and the related condensed consolidated statements of operations for the three-month period ended October 1, 2006 and September 25, 2005, and the condensed consolidated statements of cash flows for the three-month period ended October 1, 2006 and September 25, 2005. These financial statements are the responsibility of the Company’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the condensed consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Sun Microsystems, Inc. as of June 30, 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended not presented herein, and in our report dated September 1, 2006, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of June 30, 2006, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ Ernst & Young LLP

San Jose, California

October 25, 2006

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following is intended to be an overview of the areas that management believes are important in understanding the results of the quarter. This overview is not intended as a substitute for the detail provided in the following pages or for the condensed consolidated financial statements and notes that appear elsewhere in this document.

Executive Overview

Sun provides network computing infrastructure solutions that include Computer Systems (hardware and software), Data Management (hardware and software), Support Services and Client Solutions and Educational Services. Sun’s solutions are based on major Sun technology innovations such as the Java technology platform, the Solaris Operating System (Solaris OS), Sun Java products and the UltraSPARC microprocessor technology, as well as other widely deployed technologies such as the Linux operating system and AMD Opteron microprocessor-based systems. Our network computing infrastructure solutions are used in a wide range of technical/scientific, business and engineering applications in industries such as telecommunications, government, financial services, manufacturing, education, retail, life sciences, media and entertainment, transportation, energy/utilities and healthcare. We sell complete networking solutions, including products and services, in most major markets worldwide through a combination of direct and indirect channels.

In the first quarter of fiscal 2006, we completed the acquisition of Storage Technology Corporation (StorageTek) which allowed us to broaden our offerings of storage products, services and solutions. Our results of operations for the quarter ended September 25, 2005 included the results for StorageTek from August 31, 2005, the date of acquisition and the beginning of the last month of StorageTek’s fiscal quarter. StorageTek has historically experienced a disproportionately high product revenue volume in the last month of each fiscal quarter. Therefore, the results of operations included for the three months ended September 25, 2005 are not indicative of the results for a full three months. StorageTek’s products revenues are included in Data Management and StorageTek’s services revenues are included in Support Services. Due to certain integration activities, it is no longer possible to accurately separately quantify the results of the former StorageTek business.

During the first quarter of fiscal 2007, we experienced a year over year increase in total net revenues of approximately 17.0%. Our Products net revenue for the first quarter of fiscal 2007 was favorably impacted by storage revenue related to the inclusion of a full quarter of the operations of StorageTek and increased sales of our entry-level and mid-range enterprise servers as a result of our fiscal 2006 introduction of certain UltraSPARC IV+, UltraSPARC T1 and Opteron-based systems. Our Services net revenue for the first quarter of fiscal 2007 was similarly favorably impacted by the inclusion of a full quarter of services revenue related to the operations of StorageTek and SeeBeyond Technology Corporation (SeeBeyond). We experienced a sequential quarterly decrease in total net revenues of approximately 16.7%, which reflects the normal seasonal decline we experience between the fourth quarter of the previous fiscal year and the first quarter of the next fiscal year.

During the first quarter of fiscal 2007, our year over year total gross margin decreased by approximately 0.6 of a percentage point. During the first quarter of fiscal 2007, our year over year Products gross margin decreased by approximately 0.6 of a percentage point due to the unfavorable impact of discounting pricing actions and an unfavorable shift in volume and mix, partially offset by manufacturing and component cost reductions. Our sequential quarterly Products gross margin increased by approximately 1.6 percentage points primarily due to a reduction in discounting actions and a favorable shift in product and volume mix, partially offset by an increase in cost. Our first quarter year over year Services gross margin decreased by 0.5 of a percentage point primarily due to the inclusion of a full quarter of the operations of StorageTek, partially offset by a favorable shift in product volume and mix.  Our sequential quarterly Services gross margin decreased by 1.2 percentage points primarily due to an increase in service costs.

During the first quarter of fiscal 2007, as compared with the corresponding period of fiscal 2006, our research and development expenses increased $34 million and our sales, general and administrative expenses increased $130 million. These increases were primarily due to the inclusion of a full fiscal quarter of StorageTek-related operating expenses and the inclusion of a full fiscal quarter of amortization cost associated with acquisition-related intangible assets, partially offset by savings resulting from our restructuring activities.

In the first quarter of fiscal 2007, we continued to execute on our global workforce and other costs reduction plan announced in fiscal 2006. As a result, we have recorded an incremental $7 million of workforce reduction charges and $14 million of facilities and related asset impairment charges in the quarter.

During the first quarter of fiscal 2007, our operating activities generated cash in-flows of $157 million. Cash management remains a priority and we plan to remain focused on our cash conversion cycle. At October 1, 2006, we had total cash, cash equivalents and marketable debt securities of approximately $4.7 billion. Our cash flows during the first quarter of fiscal 2007 included a $500 million payment to settle a portion of our Senior Notes, partially offset by $213 million in cash proceeds received from the sale of our Newark, California facility.

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Critical Accounting Policies and Estimates

The accompanying discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States (U.S. GAAP). Some of our accounting policies require us to make difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain. We base our estimates and judgments on historical experience and on various other assumptions that we believe are reasonable under the circumstances, however, to the extent there are material differences between these estimates, judgments or assumptions and our actual results, our financial statements will be affected. We believe the accounting policies disclosed reflect our more significant assumptions, estimates and judgments and are the most critical to aid in fully understanding and evaluating our reported financial results. Our senior management has discussed the development, selection and disclosure of these critical accounting policies and related disclosures with the Audit Committee of our Board of Directors.

During the three months ended October 1, 2006, we believe there have been no significant changes to the items that we disclosed as our critical accounting policies and estimates in our discussion and analysis of financial condition and results of operations in our 2006 Form 10-K.

RESULTS OF OPERATIONS

Net Revenues

(dollars in millions, except revenue per employee dollars in thousands)

(1)             Revenue per employee is calculated by dividing the revenue during the period by the average number of employees during the period, including contractors. We use this as a measure of our productivity.

Due to the generally weakened U.S. dollar during the first quarter of fiscal 2007, as compared with the corresponding period of fiscal 2006, our total net revenues were favorably impacted by foreign currency exchange rates. The net foreign currency impact to our total net revenues is difficult to precisely measure. However, our best estimate of the foreign exchange rate impact during the first quarter of fiscal 2007 as compared with the corresponding period of fiscal 2006, was nil on Products net revenue and approximated a benefit of 2% of Services net revenue.

Products Net Revenue

Products net revenue consists of revenue generated from the sale of Computer Systems and Data Management products.

During the first quarter of fiscal 2007, as compared with the corresponding period in fiscal 2006, Computer Systems revenue increased primarily due to increased sales of our entry-level and mid-range enterprise servers based on increased demand resulting from our fiscal 2006 introduction of certain UltraSPARC IV+, UltraSPARC T1 and Opteron-based systems. During the first quarter of fiscal 2007, as compared with the corresponding period in fiscal 2006, Data Management revenue increased primarily due to the inclusion of StorageTek’s high and low-end tape storage product revenue for a full fiscal quarter.

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Services Net Revenue

Services net revenue consists of revenue generated from Support services, Client Solutions and Educational Services.

Support services revenue consists primarily of maintenance contract revenue, which is recognized ratably over the contractual period. During the first quarter of fiscal 2007, as compared with the corresponding period in fiscal 2006, Support services net revenue increased due to the inclusion of a full fiscal quarter of the operations of StorageTek and SeeBeyond.

Client Solutions and Educational services revenue consists primarily of revenue generated from professional services, such as technical consulting that helps our customers plan, implement, and manage distributed network computing environments. The overall increase in Client Solutions and Educational Services revenues during the first quarter of fiscal 2007, as compared with the corresponding period in fiscal 2006, was primarily due to inclusion of the operations of StorageTek and SeeBeyond for a full fiscal quarter, as well as an increase in technical consulting revenue.

Net Revenues by Geographic Area

(dollars in millions)

 

United States (U.S.)

During the first quarter of fiscal 2007, as compared with the corresponding period of fiscal 2006, net revenues in the U.S. increased by $137 million due to the inclusion of the operations of StorageTek for a full fiscal quarter and increased sales of our entry level servers due to increased customer acceptance of certain UltraSPARC T1 based systems introduced in fiscal 2006. During the first quarter of fiscal 2007, we experienced increased demand in certain segments of the educational and state and local government sectors, partially offset by a decline in net revenues in other government and financial services sectors.

The following table sets forth net revenues in those geographic markets that contributed significantly to international net revenues during the first quarter of fiscal 2007 (dollars in millions):

 

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United Kingdom (UK)

During the first quarter of fiscal 2007, as compared with the corresponding period of fiscal 2006, net revenues in the UK increased by $50 million primarily due to the inclusion of StorageTek products and services revenue for a full fiscal quarter, the favorable impact of foreign currency exchange rates and our fiscal 2006 introduction of certain UltraSPARC IV+, UltraSPARC T1, and Opteron-based systems. This increase in demand is partially attributable to improved macroeconomic conditions, particularly in the energy, manufacturing and financial services sectors.

Central and Northern Europe (CNE)

During the first quarter of fiscal 2007, as compared with the corresponding period of fiscal 2006, net revenues in CNE increased by $84 million primarily due to the inclusion of StorageTek products and services revenue for a full fiscal quarter and increased demand for certain entry-level servers including our UltraSPARC T1-based servers.

Japan

During the first quarter of fiscal 2007, as compared with the corresponding period of fiscal 2006, net revenues in Japan increased by $34 million primarily due to the inclusion of StorageTek products and services revenue for a full fiscal quarter and a significant Computer Systems sale. These increases were partially offset by the unfavorable impact of foreign exchange rates and decreases in Data Management and Services revenue. Increased demand in the education and financial services sectors was partially offset by continued competitive pressure in the telecommunications sector.

Germany

During the first quarter of fiscal 2007, as compared with the corresponding period of fiscal 2006, net revenues in Germany decreased by $12 million primarily due a shift in product mix from sales of high-end datacenters to entry-level and mid-range enterprise servers. This decrease was partially offset by the inclusion of StorageTek products and services revenue for a full fiscal quarter and the favorable impact of foreign currency exchange rates.

Gross Margin

(dollars in millions)

 

Products Gross Margin

Products gross margin percentage is influenced by numerous factors including product volume and mix, pricing, geographic mix, foreign currency exchange rates, the mix between sales to resellers and end-users, third-party costs (including both raw material and manufacturing costs), warranty costs and charges related to excess and obsolete inventory. Many of these factors influence, or are interrelated with, other factors. As a result, it is difficult to precisely quantify the impact of each item individually. Accordingly, the following quantification of the reasons for the change in the products gross margin percentage is an estimate.

During the first quarter of fiscal 2007, as compared with the corresponding period of fiscal 2006, our products gross margin percentage decreased by 0.6 of a percentage point due to price reductions and sales discounting actions of approximately 4 percentage points and an unfavorable shift in volume and mix of approximately 1 percentage point, partially offset by manufacturing and component cost savings of approximately 4 percentage points.

Services Gross Margin

Services gross margin percentage is influenced by numerous factors including services mix, pricing, geographic mix, foreign currency exchange rates and third-party costs. Many of these factors influence, or are interrelated with, other factors. As a

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result, it is difficult to precisely quantify the impact of each item individually. Accordingly, the following quantification of the reasons for the change in the services gross margin percentage is an estimate.

During the first quarter of fiscal 2007, as compared with the corresponding period of fiscal 2006, our services gross margin decreased by 0.5 of a percentage point due to an increase in services costs partly as a result of the inclusion of the operations of StorageTek for a full fiscal quarter of approximately 2 percentage points, partially offset by a favorable shift in product volume and mix of nearly 2 percentage points.

Operating Expenses

(dollars in millions)

 

Research and Development (R&D) Expenses

R&D expenses increased by $34 million during the first quarter of fiscal 2007, as compared with the corresponding period of fiscal 2006, primarily due to the inclusion of the expenses associated with the operations of StorageTek and SeeBeyond for a full fiscal quarter, partially offset by savings resulting from our restructuring activities. Included in the $34 million increase was a $36 million increase in compensation costs associated with salaries and bonuses, partially offset by a $6 million decrease in prototype expenses, depreciation expense and outside service costs.

We believe that to maintain our competitive position in a market characterized by rapid rates of technological advancement, we must continue to invest significant resources in new systems, software, and microprocessor development, as well as continue to enhance existing products.

Selling, General and Administrative (SG&A) Expenses

SG&A expenses increased by $130 million during the first quarter of fiscal 2007, as compared with the corresponding period of fiscal 2006, primarily due to the inclusion of the expenses associated with the operations of StorageTek and SeeBeyond for a full fiscal quarter, partially offset by savings resulting from our restructuring activities. Included in the $130 million increase was a $77 million increase in compensation and salaries and bonuses, a $25 million increase in amortization expense, a $23 million increase in facility-related expenses and a $12 million increase in outside services costs.

We are continuing to focus our efforts on achieving additional operating efficiencies by reviewing and improving upon our existing business processes and cost structure.

Restructuring and Related Impairment of Long-lived Assets

Restructuring and related impairment of long-lived assets charges for the three months ended October 1, 2006 were $21 million. These charges included $7 million in net severance and benefit costs, $6 million in accrued lease costs associated with excess facilities and $8 million associated with the impairment of certain long-lived assets.

Restructuring and related impairment of long-lived assets charges for the three months ended September 25, 2005 were $12 million, primarily due to $9 million in severance and benefit costs and $2 million in accrued lease costs associated with excess facilities.

For further detail, refer to Note 5 of our Consolidated Condensed Financial Statements.

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