Over the past 12 months many astute investors have turned their backs on US equities due to the deterioration in house prices, the economy and the dollar. Even Warren Buffett has been cutting his exposure and increasing his overseas interests. I agree with this view, especially for domestic consumer-dependent stocks. But I wouldn’t write off Wall Street entirely. There are compelling long-term buys among US large-caps, particularly those with solid balance sheets, substantial foreign operations and growth opportunities.
Sun Microsystems (Nasdaq:JAVA), rated a BUY by Bank of America
One such buy is Sun Microsystems. Founded in 1982, Sun Microsystems develops software services and hardware for enterprise computing networks, such as servers, storage applications and disk and tape systems for data centres. Around 65% of turnover comes from outside America, while it had net funds of $1.75bn (equal to $2.20 a share) at the end of March. It is also a pioneer of open-source software, allowing users free downloads of its Java platform, OpenOffice system (a Microsoft rival) and MySQL database package.
Giving away one’s best applications might seem daft, but the commercial logic is sound. By not charging for downloads, Sun Microsystems believes it can rapidly penetrate its target markets. And the strategy seems to be working. The Java suite now powers more than 4.5 billion devices globally, including about 800 million PCs, 1.5 billion mobile phones, 2.2 billion smartcards and other items, such as printers and SatNavs. MySQL is used by more than 11 million firms and about 1 million copies of OpenOffice are downloaded each week.
The trick for Sun Microsystems is to monetise this vast user base by selling them other products, such as hardware and maintenance services. A full 39% of turnover is now generated by such services, with 76% of this coming from recurring maintenance and support deals. This trend should continue as many influential firms (including Vodafone, DoCoMo and China Mobile) insist that their suppliers have global support deals in place if they choose to benefit from Sun Microsystem’s free software.
So why is the share price at near five-year lows? Simple. Two weeks ago, the firm shocked Wall Street with an ugly profits warning at its third quarter results, ended in March (Q3’08). It said it would shed 1,500-2,500 jobs and forecast a worsening outlook for the next two years. Revenues were down 0.5%, due to a 10% drop in America, offset partly by overseas expansion. The stock plunged 20% on the day.
Analysts have slashed estimates and expect sales and underlying earnings per share (EPS) of $13.9bn and $0.85 respectively for this year, rising to $14.2bn and $1.08 next. I reckon the bar has now been lowered to relatively undemanding levels, with the implied 2009 operating margin (EBIT) only 7%. This looks too low for such a hi-tech firm, particularly once it exploits its massive installed base. It should be able to generate sustainable EBIT margins of at least 10% by 2010, which would equate to an adjusted EPS of more than $1.50 – in which case the stock is trading on a 2010 p/e multiple of less than nine.
There are risks, such as growing competition in the arena of servers from the likes of IBM at the high end and Dell at the low end, putting pressure on prices and profits. The jury is also still out on whether the free software model will eventually bear fruit. Sun Microsystems also derives a large proportion of turnover from telecom and financial services and is vulnerable to IT cut-backs in these sectors. But the sell-off looks way overcooked. In the near-term, the firm may even become a target for a larger IT player.
Recommendation: GOOD VALUE at $13.46
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments