Sun will not escape the MS trap

I posted on GNC today about Sun selling Microsoft Server on their commodity boxes. This is on top of them recently signing with Intel to use their chips as well as the AMD's they have from the past. In thinking about this I wanted to expand a bit on the details of how this will effect both their brand and their ability to compete.

As I said in the GNC article, a lot of what Sun is is due to the vision of Scott McNealy. The Brand image of the company was built around technical snobbery. Engineers that were experts on Sun equipment considered themselves an elite group amongst their peers, and to a lesser extent their peers agreed with this. A lot of the anti-Microsoft stance that the company took was around fostering this elite Brand image. This included McNealy testifying against Microsoft in their anti-trust trial.

The issue that has has faced this decade, is that their core Unix business and platform is a closed technology competing against an open one. An open technology spreads its R&D load across multiple companies, allowing it to develop quicker and cheaper. At some point in 2003, and Intel processor passed the Sparc in chip to chip performance, and has continued to accelerate past. While they were able to hold ground against Microsoft (itself a closed technology), the greater acceptance and reliability of Linux allowed competition from a completely open platform, that is cheaper and better performing. The only reason Sun still have a Unix market at all is a mix of elitism and good service.

Scott McNealy and his team recognised this and tried a number of tactics to change the market (N1, thin client, etc) before giving in to the inevitable and entering the commodity market. They managed to do this while maintaining their elitist Brand image. Firstly they used Linux, then they used the AMD processor only to maintain a Geek cred. Finally their release marketing was squarely aimed at denigrating the leading commodity supplier of the time, Dell.

Sun have been allowing customers to install Windows on their AMD hosts for some time, but officially supporting it, and factory installing it is completely different from a Brand perspective. It goes beyond a tacit acceptance and becomes an endorsement. To continue to hold themselves above a platfomr that they endorse will be viewed by all but the true fanboys to be hypocritical. To consider themselves to be in the commodity server market though, they need to be able to conform to a new market dynamic that they are unsuited for.



The table above gives a look at some select pieces of Sun financials from their latest full year results, compared to those from alternative commodity suppliers. This table shows for each company the gross profit on the product sold, and the cost of selling that product, which results in a net profit. These are across all product lines so there is some uncertainty in direct comparison, but they give a very good indication of what is happening.

While Sun make a large profit on their cost of materials, their cost of sale is huge compared to other players in the market. Wintel servers are a cost game though. He with the lowest costs will win. In terms of hardware costs for an Intel or AMD server, there is not much difference for all the players. We can assume that Sun will drop its profit on the hardware down to the same level as its competitors. The cost entailed by the company to sell those servers though is orders of magnitude above its competitors. The figures for Dell give an indication of what the best cost model in the commodity space looks like. But Dell is a volume player and cannot at this time offer anything like the level of service Sun does.

Even against similar companies though (HP and IBM) which both have large services divisions and renowned support quality, they have double the cost of sale. As Sun start selling more commodity, their existing customers will drag the sales in. It will become increasingly difficult for them to drive these customers to the more expensive products due to competitive pressures and their depleting Brand image. The competitive foils of their competitors will become harder to deflect as they start to look less differentiated. In order to compete they are going to have to cut their costs which will reduce even further their Brand identity.

The new management team look as if they have been doing a good job since Scott McNealy left. They have recovered from $800M loss last year to a $473M profit this one, a turn around of $1.2 Billion (link to financial release). Looking into the details, almost all of this difference can be account for by a reduction in costs from the StorageTek merger and in incentive options (maybe Scott's?). I cannot see any inherent or long term improvements to the fundamentals of their busienss model. This combined with their depletion of thier own Brand value spells not good things for Sun. I wonder who will buy them?

Pseudo legal notice - I'm not a financial advisor, this is not advice for your own finances.