This New Pick Still Has Room to Run

We are initiating an 800-share position in Sun Microsystems (SUNW) . The stock was recently trading at $6.32, and we believe that despite Sun's latest run-up, shares have at least 20% to 25% appreciation over the next 12 months.

We recently wrote about Sun Microsystems in November, saying that its risk/reward was not favorable because of slowing growth in its core server market. At that time we believed that demand for Solaris, Sun's operating system, would not be enough to offset this decline, and that the company's restructuring efforts were already factored into the share price.

But after three months of outstanding execution, our opinion on the company has changed. Sun's restructuring program is on pace to lower annual operating costs by more than $500 million, and Solaris sales are growing faster than expected. Software now accounts for 15% of Sun's total revenue, and it appears that the company's market-share losses in the server sector have bottomed. These catalysts are largely responsible for the recent climb in the share price, but future catalysts -- which were addressed at Sun's analyst day meeting Feb. 6 -- are the reasons behind our change in sentiment.

At the analyst meeting, management reiterated its plans to achieve 10% operating margins in 2009 -- up from the 3% it reported last quarter -- which seemed overly optimistic when we first wrote about the company. Sun's first step is to drive top-line growth through new products and by expanding sales of its Solaris operating system, which now has 7 million licenses downloaded as a result of open sourcing. (Open-source software makes the underlying programming code available to users, allowing them to change it.) Other initiatives include reducing material costs and lowering operating expense as a percentage of sales.

Based on the success of Sun's restructuring effort, we believe management will be able to cut costs further to meet goals. As for its expansion of Solaris, Sun's recent deal with Intel (INTC) highlights its potential.

On Jan. 22, Sun agreed to buy Intel chips for use in its server systems. This deal gives Intel a competitive edge over rival Advanced Micro Devices (AMD) , but could be an even greater plus for Sun if Intel endorses Solaris' operating system. Sun now has partnerships with both Intel and AMD, which gives Solaris a platform on the two major server vendors.

Also, on Jan. 23, private-equity firm Kohlberg Kravis Roberts (KKR) invested $700 million in Sun in the form of convertible notes. In return, KKR gets one board seat and the right to convert the $700 million in loans into an equity stake of 5% of the company. The deal was headline news and sparked takeover speculation.

However, we do not believe that this is the first step in a potential buyout, but rather just a solid investment by one of the oldest and most-profitable private-equity firms in the world. Based on the terms of the deal, Sun's share price will have to top $7.21 (which is a gain of 15% from today's price) for the investment to start making money. But based on KKR's stellar track record of creating value for shareholders, we do not believe the firm made this investment for only a 15%, or even 25%, gain.

At first glance, Sun shares look expensive. On a price-to-earnings basis, Sun trades at 40 times next year's analyst estimates, according to Capital IQ. This is high, considering that IBM (IBM) trades at 15 times and Hewlett-Packard (HPQ) trades at 17 times next-year's estimates. However, Sun's last two quarters were well ahead of forecasts, and analysts are beginning to raise full-year estimates, which will push its multiple down to a more respectable level.

Also, Sun is projected to grow at a faster pace than its competitors over the next three years. Its revenue increased for the first time in five years during fiscal 2006. In addition, the company is projecting operating profits this year for the first time since 2002, and its balance sheet is very strong with more than $5 billion in cash and only $1.3 billion in debt.

Based on the recent ramp-up in its core server business and the growth in its software division, we believe Sun has more room to run. Further restructuring initiatives will continue to benefit the bottom line, and as the company approaches its 10% operating margin goal, we could see additional analyst upgrades throughout the year. We also view KKR's investment as a catalyst and believe other private-equity funds could flow into Sun in the short term, based on the company's latest turnaround initiatives and future objectives.

Given the success of its turnaround, we believe that Sun's troubles are now behind it, and shares offer a favorable risk/reward over the next 12 to 18 months.

Frank Curzio is a research associate at TheStreet.com.

TheStreet.com is a publisher and a registered investment adviser. TheStreet.com Stocks Under $10 contains the authors' own opinions, and none of the information contained therein constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. You further understand that the Stocks Under $10 Investment Team will not advise you personally concerning the nature, potential, value or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter. To the extent any of the information contained in TheStreet.com Stocks Under $10 may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person.

Past results are not necessarily indicative of futureperformance. Investing in the stocks chosen forTheStreet.com Stocks Under $10 model portfolio is riskyand speculative. The companies may have limited operatinghistories and little available public information, and thestocks they issue may be volatile and illiquid. Trading insuch securities can result in immediate and substantial losses of the capital invested. You should use only risk capital, and not capital required for other purposes, such as retirement savings, student loans, mortgages or education. As an editorial employee of TheStreet.com, Curzio is restricted from owning individual securities other than stock or options in TheStreet.com, Inc.

-----------------------------------------------------------Visit the TheStreet.com Stocks Under $10 site (available to subscribers ONLY) by clicking here: http://www.thestreet.com/k/su/index.html

To view TheStreet.com Stocks Under $10 portfolio on theWeb, click here:http://www.thestreet.com/k/su/portfolio.html

For customer service on your account please visit:https://secure2.thestreet.com/cap/selfserve/

-----------------------------------------------------------

(c) 2007 TheStreet.com, Inc., 14 Wall Street, 15th Floor,New York, NY 10005, Attention: Customer Service Department