<PAGE>   1

                                  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 December 31, 2000

                                       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)

                                 (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 ( )

                      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.

               CLASS                         OUTSTANDING AT DECEMBER 31, 2000
  Common Stock - $0.00067 par value                 3,259,867,598



<PAGE>   2

                                      INDEX


<TABLE>
<CAPTION>
                                                                              PAGE
                                                                              ----
<S>                                                                           <C>
  COVER PAGE                                                                    1

  INDEX                                                                         2

  PART I - FINANCIAL INFORMATION

        Item 1 - Financial Statements:
                 Condensed Consolidated Statements of Income                    3
                 Condensed Consolidated Balance Sheets                          4
                 Condensed Consolidated Statements of Cash Flows                5
                 Notes to Condensed Consolidated Financial Statements           7

        Item 2 - Management's Discussion and Analysis of
                 Financial Condition and Results of Operations                  16

        Item 3 - Quantitative and Qualitative Disclosures About
                 Market Risk                                                    31


  PART II - OTHER INFORMATION

        Item 1 - Legal Proceedings                                              33
        Item 4 - Submission of Matters to a Vote of Security Holders            33
        Item 5 - Other Information                                              34
        Item 6 - Exhibits and Reports on Form 8-K                               35

  SIGNATURES                                                                    36
</TABLE>


                                       2
<PAGE>   3

                         PART I - FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

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

<TABLE>
<CAPTION>
                                                           Three Months Ended              Six Months Ended
                                                      ----------------------------    ---------------------------
                                                      December 31,    December 26,    December 31,    December 26,
                                                          2000            1999            2000            1999
                                                       ----------      ----------      ----------      ----------
<S>                                                    <C>             <C>             <C>             <C>
Net revenues:
    Products                                           $    4,317      $    2,997      $    8,660      $    5,665
    Services                                                  798             557           1,500           1,035
                                                       ----------      ----------      ----------      ----------
Total net revenues                                          5,115           3,554          10,160           6,700
Cost of sales:
    Cost of sales - products                                2,153           1,370           4,306           2,578
    Cost of sales - services                                  518             349             980             654
                                                       ----------      ----------      ----------      ----------
Total cost of sales                                         2,671           1,719           5,286           3,232
                                                       ----------      ----------      ----------      ----------
    Gross margin                                            2,444           1,835           4,874           3,468
Operating expenses:
    Research and development                                  497             398             987             755
    Selling, general and administrative                     1,236             941           2,478           1,835
    Purchased in-process research and development              71               -              71               4
                                                       ----------      ----------      ----------      ----------
Total operating expenses                                    1,804           1,339           3,536           2,594
                                                       ----------      ----------      ----------      ----------
Operating income                                              640             496           1,338             874
Gain on sale of investments                                     1               -               1               -
Interest income, net                                           91              32             166              61
                                                       ----------      ----------      ----------      ----------
Income before income taxes                                    732             528           1,505             935
Provision for income taxes                                    309             174             572             310
                                                       ----------      ----------      ----------      ----------
Net income                                             $      423      $      354      $      933      $      625
                                                       ==========      ==========      ==========      ==========

Net income per common share - basic                    $     0.13      $     0.11      $     0.29      $     0.20
                                                       ==========      ==========      ==========      ==========
Net income per common share - diluted                  $     0.12      $     0.10      $     0.27      $     0.19
                                                       ==========      ==========      ==========      ==========
Shares used in the calculation of
    net income per common share -basic                      3,229           3,148           3,217           3,139
                                                       ==========      ==========      ==========      ==========
Shares used in the calculation of
    net income per common share -diluted                    3,430           3,382           3,433           3,368
                                                       ==========      ==========      ==========      ==========
</TABLE>

                            See accompanying notes.


                                       3
<PAGE>   4

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


<TABLE>
<CAPTION>
                                                       December 31,     June 30,
                                                          2000           2000
                                                       ----------      ----------
                                                       (unaudited)
ASSETS
Current assets:
<S>                                                    <C>             <C>
        Cash and cash equivalents                      $    1,403      $    1,849
        Short-term investments                                737             626
        Accounts receivable, net                            3,215           2,690
        Inventories                                           792             557
        Deferred tax assets                                   808             673
        Prepaid expenses and other current assets             785             482
                                                       ----------      ----------
               Total current assets                         7,740           6,877
Property, plant and equipment, net of accumulated
  depreciation of $1,796 and $1,597 as of
  December 31 and June 30, respectively                     2,382           2,095
Long-term investments                                       5,302           4,496
Intangible assets, net                                      2,110             205
Other assets, net                                             546             479
                                                       ----------      ----------
                                                       $   18,080      $   14,152
                                                       ==========      ==========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
        Short-term borrowings                          $        2      $        7
        Accounts payable                                    1,219             924
        Accrued payroll-related liabilities                   621             751
        Accrued liabilities and other                       1,718           1,366
        Deferred revenues and customer deposits             1,454           1,289
        Income taxes payable                                  134             422
                                                       ----------      ----------
               Total current liabilities                    5,148           4,759
Long-term debt and other obligations                        2,183           2,084
Total stockholders' equity                                 10,749           7,309
                                                       ----------      ----------
                                                       $   18,080      $   14,152
                                                       ==========      ==========
</TABLE>



                             See accompanying notes.


                                       4
<PAGE>   5

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

<TABLE>
<CAPTION>
                                                                        Six Months Ended
                                                                   December 31,     December 26,
                                                                      2000             1999
                                                                   ----------       ----------
<S>                                                                <C>              <C>
Cash flows from operating activities:
  Net income                                                       $      933       $      625
  Adjustments to reconcile net income to net cash provided by
     operating activities:
     Depreciation and amortization                                        445              357
     Tax benefits from employee stock plans                               621              261
     Purchased in-process research and development                         71                4
     Gain on sale of investments                                           (1)               -
     Changes in operating assets and liabilities:
          Accounts receivable, net                                       (516)             278
          Inventories                                                    (233)            (251)
          Other current and long-term assets                             (462)            (210)
          Accounts payable                                                292              (83)
          Other current and long-term liabilities                         106              183
                                                                   ----------       ----------
Net cash provided by operating activities                               1,256            1,164
                                                                   ----------       ----------

Cash flows from investing activities:
  Purchases of investments                                             (5,646)          (4,199)
  Proceeds from sales and maturities of investments                     4,676            2,534
  Acquisition of property, plant and equipment                           (572)            (432)
  Acquisition of spare parts and other assets                             (54)             (45)
  Payments for acquisitions, net of cash acquired                         (24)             (75)
                                                                   ----------       ----------
Net cash used in investing activities                                  (1,620)          (2,217)
                                                                   ----------       ----------

Cash flows from financing activities:
  Proceeds from issuance of long-term debt                                  -            1,500
  Decrease in borrowings and other obligations                            (15)             (18)
  Proceeds from issuance of common stock, net                             124               32
  Acquisition of treasury stock                                          (311)            (389)
  Proceeds from employee stock purchase plans                             120              138
                                                                   ----------       ----------
Net cash (used in) provided by financing activities                       (82)           1,263
                                                                   ----------       ----------

Net (decrease) increase in cash and cash equivalents                     (446)             210
Cash and cash equivalents, beginning of period                          1,849            1,101
                                                                   ----------       ----------
Cash and cash equivalents, end of period                           $    1,403       $    1,311
                                                                   ==========       ==========
Supplemental disclosures of cash flow information:
Cash paid during the period for:
        Interest                                                   $       56               $-
                                                                   ==========       ==========
        Income taxes                                               $      331       $      226
                                                                   ==========       ==========
</TABLE>


                             See accompanying notes.


                                       5
<PAGE>   6

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

<TABLE>
<CAPTION>
                                                                 Six Months Ended
                                                            ----------------------------
                                                            December 31,    December 26,
                                                                2000            1999
                                                            ------------    ------------
<S>                                                         <C>             <C>
Supplemental schedule of non-cash investing activities:
  In conjunction with the Company's acquisitions,
    liabilities were assumed as follows:
      Fair value of net assets acquired                      $    2,055       $       84
      Cash paid for assets                                          (29)             (75)
      Stock issued and vested options assumed                    (2,024)              (1)
                                                             ----------       ----------
      Liabilities assumed                                    $        2       $        8
                                                             ==========       ==========
</TABLE>

                            See accompanying notes.


                                       6
<PAGE>   7


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

1. DESCRIPTION OF BUSINESS

Sun Microsystems, Inc. ("Sun" or the "Company") is a provider of products,
services, and support solutions for building and maintaining network computing
environments. Sun sells scalable computer systems, high-speed microprocessors,
and a line of high-performance software for operating networks, computing
equipment, and storage products. Sun also provides a full range of services
including support, education, and professional services. The Company markets its
products primarily to business, government, and education customers and operates
in various product segments across geographically diverse markets.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Fiscal Year

Sun's first three quarters in fiscal 2001 end on October 1, December 31 and
April 1 (in fiscal 2000 the quarters ended on September 26, December 26 and
March 26). The fourth quarter ends on June 30.

Basis of Presentation

The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries. Intercompany accounts and transactions have been
eliminated. Certain amounts from prior years have been reclassified to conform
with the current year presentation.

On December 5, 2000, the Company effected a two-for-one split of its common
stock paid in the form of a stock dividend. All share and per share data herein
has been adjusted to reflect the split for all periods presented.

While the quarterly financial information is unaudited, the financial statements
included in this report reflect all adjustments (consisting of normal recurring
adjustments) 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 condensed consolidated balance sheet as of June 30, 2000 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 the
Company's Annual Report on Form 10-K for fiscal 2000.



                                       7
<PAGE>   8


Derivative Financial Instruments

The Company uses derivatives to moderate the financial market risks of its
business operations. Derivative products, such as forward and option contracts,
are used to hedge the foreign currency market exposures underlying certain
assets and liabilities and forecasted transactions with customers and vendors.
The Company also enters into interest rate swap agreements to modify the
interest characteristics of its outstanding long-term debt. The Company's
accounting policies for these instruments are based on its designation of such
instruments as hedging transactions. An instrument is designated as a hedge
based in part on its effectiveness in risk reduction and one-to-one matching of
derivative instruments to underlying transactions. The Company records all
derivatives on the balance sheet at fair value.

For derivative instruments that are designated and qualify as a fair value hedge
(i.e., hedging the exposure to changes in the fair value of an asset or a
liability or an identified portion thereof that is attributable to a particular
risk), the gain or loss on the derivative instrument as well as the offsetting
gain or loss on the hedged item attributable to the hedged risk are recognized
in earnings in the current period. For derivative instruments that are
designated and qualify as a cash flow hedge (i.e., hedging the exposure of
variability in expected future cash flows that is attributable to a particular
risk), the effective portion of the gain or loss on the derivative instrument is
reported as a component of Other comprehensive income (OCI) in stockholders'
equity and reclassified into earnings in the same period or periods during which
the hedged transaction affects earnings. The remaining gain or loss on the
derivative instrument in excess of the cumulative change in the present value of
the future cash flows of the hedged item, if any, is recognized in current
earnings during the period of change. For derivative instruments not designated
as hedging instruments, changes in their fair values are recognized in earnings
in the current period.

For currency forward contracts, effectiveness is measured by using the
forward-to-forward rate compared to the underlying economic exposure. For
currency option contracts, effectiveness is measured on an intrinsic basis using
only the current forward rate and the strike price for both the currency option
contract (either put or call option) and the underlying transaction. All time
value and volatility changes are deemed ineffective and are immediately
recognized in earnings. For interest rate swap agreements, the Company assumes
no ineffectiveness as each interest rate swap meets the short-cut method
conditions required under Statement of Financial Accounting Standards No. 133
(SFAS 133), "Accounting for Derivative Instruments and Hedging Activities" (see
Note 5, "Derivative Financial Instruments").

Computation of Net Income Per Common Share

Basic net income per common share is computed using the weighted average number
of common shares outstanding during the period. Diluted net income 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.

Recent Pronouncements

In December 1999, the Securities and Exchange Commission (SEC) issued Staff
Accounting Bulletin No. 101 (SAB 101), "Revenue Recognition in Financial
Statements". SAB 101 summarizes certain of the SEC's views in applying generally
accepted accounting principles to revenue recognition in financial statements.
In October 2000, the SEC issued additional written guidance to further
supplement SAB 101. Accordingly, Sun is continuing to evaluate the potential
impact of SAB 101 on the Company's results of operations and financial position.
The Company is required to adopt SAB 101 in the fourth quarter of fiscal 2001.


                                       8
<PAGE>   9

3. BUSINESS COMBINATIONS

Purchase Combinations

The Company completed several acquisitions in fiscal 2001 that were accounted
for under the purchase method of accounting. See the Company's Form 10-Q for the
quarterly period ended on October 1, 2000 for information on acquisitions
completed during the first quarter of fiscal 2001. The Company completed two
acquisitions in the second quarter of fiscal 2001, as discussed below. The
consolidated financial statements include the operating results of each business
from the date of acquisition. Pro forma results of operations have not been
presented because the effects of these acquisitions were not material on either
an individual or a year-to-date aggregate basis.

The Company calculates amounts allocated to in-process research and development
(IPRD) using established valuation techniques in the high-technology industry
and expenses such amounts in the quarter that the related acquisition was
consummated if technological feasibility of the in-process technology has not
been achieved and no alternate future uses have been established. Research and
development costs to bring the products from the acquired companies to
technological feasibility are not expected to have a material impact on the
Company's future results of operations or cash flows. The Company computed its
valuations of IPRD for the acquisitions discussed in the following paragraphs
using a discounted cash flow analysis on the anticipated income stream to be
generated by the IPRD with consideration given to the in-process technology's
stage of completion.

The excess purchase price over the estimated value of the net tangible assets
and IPRD was allocated to various intangible assets, consisting primarily of
developed technology and goodwill, as well as other intangible assets, such as
customer base, trade name or trademark, and assembled workforce. The value of
developed technology was based upon future discounted cash flows related to the
existing products' projected income streams. The value of the customer base was
determined based upon the value of existing relationships and the expected
revenue streams. The value of the assembled workforce was based upon the cost to
replace that workforce. Intangible assets, including goodwill, are being
amortized on a straight line basis over periods not exceeding five years.

On November 7, 2000, the Company acquired all of the interest in grapeVINE
Technologies, LLC (a U.S. limited liability company organized under the laws of
Delaware) (grapeVINE), from grapeVINE Australia Pty. Ltd., a wholly-owned
subsidiary of grapeVINE Technologies, Ltd. (an Australian corporation) for total
cash consideration of $9.4 million. grapeVINE is a producer of collaborative
knowledge management software. This transaction was accounted for as a purchase,
with the excess of the purchase price over the estimated fair value of the net
tangible assets being allocated to various intangible assets, including goodwill
($7.6 million), developed technology ($1.0 million), assembled workforce ($0.3
million) and in-process research and development ($0.5 million).

On December 7, 2000, the Company acquired Cobalt Networks, Inc. and its
wholly-owned subsidiaries (Cobalt) in a stock-for-stock merger. Cobalt is a
provider of server appliances for Internet Service Providers, Application
Service Providers, and small-to medium-sized businesses. Under the terms of the
merger agreement, each share of Cobalt common stock was converted into the right
to receive one share of Sun's common stock. The Company issued approximately
30.5 million shares at a value of $58.302 per share in exchange for all of
Cobalt's outstanding common stock, assumed all of Cobalt's 5.6 million
outstanding options at an estimated fair value of $283.0 million, and incurred
$2.0 million in acquisition costs, resulting in an aggregate purchase price of
approximately $2,061.0 million. This transaction was accounted for as a
purchase, with the excess of the purchase price over the estimated fair value of
the net tangible assets ($93.9 million) being allocated primarily to various
intangible assets, including goodwill ($1,690.0 million), developed technology
($93.5 million), customer base ($41.9 million), assembled workforce ($10.7
million), trade name

                                       9
<PAGE>   10

($5.9 million) and in-process research and development ($70.8 million). In
addition, $54.3 million of the purchase price was allocated to deferred
compensation, which represents the pro-rata portion of the intrinsic value of
Cobalt's unvested options assumed at the date of the acquisition.

4. BALANCE SHEET DETAILS

   Inventories are comprised of the following (in millions):

<TABLE>
<CAPTION>
                        December 31, 2000     June 30, 2000
                        -----------------     -------------
<S>                     <C>                   <C>
   Raw materials            $      339          $      169
   Work in process                 109                  82
   Finished goods                  344                 306
                            ----------          ----------
                            $      792          $      557
                            ==========          ==========
</TABLE>

   Long-term investments are comprised of the following (in millions):

<TABLE>
<CAPTION>
                                       December 31, 2000    June 30, 2000
                                       -----------------    -------------
    <S>                                   <C>                  <C>
    Long-term investments:
      Marketable securities               $    4,882          $    3,961
      Strategic equity investments               420                 535
                                          ----------          ----------
             Total                        $    5,302          $    4,496
                                          ==========          ==========
</TABLE>


Marketable securities consist primarily of corporate bonds, floating-rate notes,
and asset-backed and mortgage-backed securities with original maturities greater
than one year from the balance sheet date. Strategic equity investments consist
of marketable strategic equity securities and preferred stock and other
strategic equity holdings. Marketable strategic equity securities represent
equity holdings in public companies. Preferred stock and other strategic equity
holdings represent equity holdings in nonpublic companies and investments in
venture capital funds.

Marketable securities and marketable strategic equity securities are considered
available-for-sale and are reported at fair value with changes in unrealized
gains and losses, net of applicable taxes, recorded in stockholders' equity.
Gross unrealized gains and losses related to the marketable strategic equity
securities were $19 million as of December 31, 2000 ($210 million as of June 30,
2000). Preferred stock and other strategic equity holdings are carried at the
lower of cost or net realizable value due to their illiquid nature. Realized
gains and losses for all investments are calculated based on the specific
identification method.



                                       10
<PAGE>   11


5. DERIVATIVE FINANCIAL INSTRUMENTS

On July 1, 2000, the Company adopted SFAS 133 which requires that all
derivatives be recorded on the balance sheet at fair value. Changes in the fair
value of derivatives that do not qualify for hedge treatment, as well as the
ineffective portion of a particular hedge, must be recognized currently in
earnings. Upon adoption on July 1, 2000, the cumulative transition adjustment
was insignificant.

Foreign Exchange Exposure Management. The Company has significant international
sales and purchase transactions in foreign currencies and continues its policy
of hedging forecasted and actual foreign currency risk with purchased currency
options and forward contracts that expire within 12 months. These derivative
instruments are employed to eliminate or minimize certain foreign currency
exposures that can be confidently identified and quantified. In accordance with
SFAS 133, hedges related to anticipated transactions are designated and
documented at the inception of the respective hedge as cash flow hedges and
evaluated for effectiveness quarterly. As the terms of the forward contract and
the underlying transaction are matched at inception, forward contract
effectiveness is calculated by comparing the fair value of the contract to the
change in the forward value of the anticipated transaction, with the effective
portion of the gain or loss on the derivative instrument reported as a component
of OCI in stockholders' equity and reclassified into earnings in the same period
or periods during which the hedged transaction affects earnings. Option contract
effectiveness is calculated by comparing the intrinsic value of the instrument
to any degradation of the anticipated transaction against the forward adjusted
strike price with the effective portion of changes in fair value accumulated in
OCI. Any residual change in fair value of the instruments, including option time
value or other ineffectiveness are recognized immediately in Selling, general
and administrative expense. Ineffectiveness in the first half of fiscal 2001 is
not significant.

To meet SFAS 133 entity hedging requirements and to protect U.S. dollar margins,
U.S. dollar functional subsidiaries hedge foreign currency revenues and non-U.S.
dollar functional subsidiaries selling in foreign currencies hedge U.S. dollar
inventory purchases. OCI associated with hedges of foreign currency sales is
recognized in Revenue upon shipment and OCI related to inventory purchases is
recognized in Cost of sales upon shipment. All values reported in OCI at
December 31, 2000 will be reclassified to earnings within 12 months.

Additionally, the Company enters into foreign currency forward contracts to
hedge the gains and losses generated by the remeasurement of monetary assets and
liabilities in a non-functional currency. Changes in the fair value of these
fair value hedges (as defined in SFAS 133) are recognized in Selling, general
and administrative expense immediately as an offset to the changes in the fair
value of the assets or liability being hedged.

Interest Rate Risk Management. The Company is exposed to interest rate risk from
both investments and debt. The Company offsets the risk in variable rate
interest earnings from investments by converting the existing fixed rate debt
(with maturities of 3 years, 5 years, 7 years, and 10 years) of $1.5 billion
into variable rate debt with 12 fixed-to-variable interest rate swaps. The
Company assumes no ineffectiveness as each interest rate swap meets the
short-cut method conditions required under SFAS 133 for fair value hedges of
debt instruments. Accordingly, no gains or losses were recorded in income
relative to the Company's underlying interest rate swaps.


                                       11
<PAGE>   12


Accumulated Derivative Gains or Losses. The following table summarizes activity
in OCI related to derivatives held by Sun during the period from July 1, 2000
through December 31, 2000 (in millions):

Cumulative effect of adopting SFAS 133                          $-
Increase in fair value of derivatives                           53
Gains reclassified from OCI, net, into:
     Revenues                                                  (37)
     Cost of sales                                              (9)
                                                        ----------
Accumulated derivative gain, December 31, 2000          $        7
                                                        ==========

6. COMPREHENSIVE INCOME

The components of comprehensive income, net of related taxes, are as follows (in
millions):

<TABLE>
<CAPTION>
                                                  Three Months Ended                       Six Months Ended
                                            December 31,        December 26,        December 31,        December 26,
                                               2000                 1999                2000                 1999
                                            ----------           ----------          ----------           ----------
<S>                                         <C>                  <C>                 <C>                  <C>
Net income                                       $ 423                 $354                $933               $  625
Change in unrealized value of
  investments, net                                (126)                 383                 (76)                 390
Change in unrealized fair value of
  derivative instruments                           (10)                   -                   7                    -
Translation adjustments                            (13)                   2                 (19)                  (5)
                                            ----------           ----------          ----------           ----------
Comprehensive income                             $ 274                 $739                $845               $1,010
                                            ==========           ==========          ==========           ==========
</TABLE>

The components of accumulated other comprehensive income, net of related taxes,
are as follows (in millions):

<TABLE>
<CAPTION>
                                                December 31, 2000      June 30, 2000
                                                -----------------      -------------
<S>                                             <C>                    <C>
Unrealized gain on investments, net                       $ 49                 $125
Unrealized gains on derivative instruments                   7                    -
Cumulative translation adjustments                         (69)                 (50)
                                                    ----------           ----------
Accumulated other comprehensive income                    $(13)                $ 75
                                                    ==========           ==========
</TABLE>


                                       12
<PAGE>   13


7. NET INCOME PER COMMON SHARE

The following table presents the calculation of basic and diluted earnings per
share (in millions, except per share amounts):

<TABLE>
<CAPTION>
                                           Three Months Ended                 Six Months Ended
                                     December 31,      December 26,     December 31,    December 26,
                                          2000             1999            2000             1999
                                      ----------       ----------       ----------       ----------
<S>                                   <C>              <C>              <C>              <C>
Net income                            $      423       $      354       $      933       $      625
                                      ==========       ==========       ==========       ==========
Denominator:
  Weighted average common
  shares - basic                           3,229            3,148            3,217            3,139
  Effect of dilutive securities
  (primarily stock options)                  201              234              216              229
                                      ----------       ----------       ----------       ----------
  Weighted average common
  shares - diluted                         3,430            3,382            3,433            3,368
                                      ==========       ==========       ==========       ==========
Net income per common share -
basic                                 $     0.13       $     0.11       $     0.29       $     0.20
                                      ==========       ==========       ==========       ==========
Net income per common share -
diluted                               $     0.12       $     0.10       $     0.27       $     0.19
                                      ==========       ==========       ==========       ==========
</TABLE>

8. OPERATING SEGMENTS

Sun designs, manufactures, markets, and services network computing systems and
software solutions that feature networked desktops and servers. The Company is
organized by various product groups. The following product groups are the only
reportable segments under the criteria of SFAS No. 131, "Disclosures About
Segments of an Enterprise and Related Information": (1) System Products and
Network Storage and (2) Enterprise Services. Products in the System Products and
Network Storage segment include a broad range of desktop systems, servers,
storage, and network switches, incorporating the UltraSPARC (TM) processors and
Solaris(TM) Operating Environment. In the Enterprise Services segment, the
Company provides a full range of services and support to existing and new
customers, including education, professional services, and systems integration.
Effective July 1, 2000, Sun consolidated its sales and manufacturing functions
into organizations known as the Global Sales Operations (GSO) and Worldwide
Operations (WWOPS), respectively. The GSO manages most of the Company's field
sales organizations and all field marketing organizations. Sales generated
through the sales and marketing efforts of the GSO are recorded as revenues by
the various product groups. Operating expenses (primarily sales and marketing)
related to the GSO are not allocated to the product groups and, accordingly, are
included under the Other segment. WWOPS manages all operations, supply chain and
purchasing functions. WWOPS manufacturing costs are allocated as cost of sales
to the various product groups.



                                       13
<PAGE>   14


The following table presents revenues, interdivision revenues, and operating
income (loss) for the Company's segments. The Other segment consists of certain
operating product groups, which did not meet the requirements for a reportable
segment as defined by SFAS 131, such as Sun's Software Systems Group, and other
miscellaneous functions, such as Corporate and the GSO.

<TABLE>
<CAPTION>
Three Months Ended:
                            System Products and   Enterprise
                              Network Storage     Services          Other             Total
                            -------------------  ----------       ----------        ----------
<S>                         <C>                  <C>              <C>               <C>
DECEMBER 31, 2000
  Revenues                          $3,834             $798            $ 483            $5,115
  Interdivision revenues                 -              118             (118)                -
  Operating income (loss)            1,465              170             (995)              640

DECEMBER 26, 1999
  Revenues                          $2,739             $557            $ 258            $3,554
  Interdivision  revenues                -               95              (95)                -
  Operating income (loss)            1,062              115             (681)              496
</TABLE>



<TABLE>
<CAPTION>
Six Months Ended:
                            System Products and   Enterprise
                              Network Storage     Services          Other             Total
                            -------------------  ----------       ----------        ----------
<S>                         <C>                  <C>              <C>               <C>
DECEMBER 31, 2000
  Revenues                          $7,779           $1,500          $   881           $10,160
  Interdivision revenues                 -              226             (226)                -
  Operating income (loss)            3,024              295           (1,981)            1,338

DECEMBER 26, 1999
  Revenues                          $5,266           $1,035          $   399           $ 6,700
  Interdivision  revenues                -              177             (177)                -
  Operating income (loss)            2,068              198           (1,392)              874
</TABLE>


9. SUBSEQUENT EVENTS

On December 3, 2000, the Company entered into an agreement to acquire HighGround
Systems, Inc. (HighGround) in a stock-for-stock merger. HighGround, a
privately-held company, is a leading developer of storage resource management
software for open systems. Under the terms of the merger agreement, the Company
will issue approximately 7.9 million shares of its common stock and assume
approximately 2.4 million stock options and warrants (after giving effect to the
two-for-one stock split effected December 5, 2000) in exchange for all of
HighGround's outstanding capital stock, options and warrants, resulting in an
aggregate purchase price of approximately $400 million. The closing of the
acquisition is subject to remaining regulatory approvals, HighGround stockholder
approval and other customary closing conditions. The transaction will be
accounted for as a purchase and the purchase price will be allocated to tangible
assets and identified intangible assets, with any excess being allocated to
goodwill.

On February 1, 2001, the Company entered into an agreement to acquire LSC,
Incorporated (LSC) in a stock-for-stock merger. LSC is a privately-held company
which designs, develops, and supports high performance file systems and data
storage software. Under the terms of the merger agreement, the Company will
issue up to approximately 1.7 million shares of its common stock and assume
approximately 0.7 million stock options and warrants in exchange for all of
LSC's outstanding capital stock, options and warrants, resulting in an

                                       14
<PAGE>   15

aggregate purchase price of approximately $74 million. The closing of the
acquisition is subject to regulatory approvals, LSC shareholder approval and
other customary closing conditions. The transaction will be accounted for as a
purchase and the purchase price will be allocated to tangible assets and
identified intangible assets, with any excess being allocated to goodwill.


                                       15
<PAGE>   16


ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
         OF OPERATIONS


This quarterly report, including the following sections, contains
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995. These statements include statements relating to
our expectations regarding product mix trends, our expectations to invest in our
services business, our expectations that products gross margins will be affected
by product mix, component costs, market conditions and new product
introductions, our products and services gross margins expectations for the
remainder of fiscal year 2001, our continuous evaluation of the competitiveness
of our product and service offerings and any possible repricing actions, our
plans to increase research and development spending on a dollar basis during the
remainder of fiscal 2001 and research and development expenses as a percentage
of net revenues, our expectations relating to selling, general and
administrative expenses on a dollar basis during the remainder of fiscal 2001
and as a percentage of net revenues and our continual investment in efforts to
achieve additional operating efficiencies and review and improvement of our
business processes and our focus on our cost structure, our expectations to
continue hiring personnel in certain areas and the rate of such hiring
activities, our expected effective income tax rate for the remainder of fiscal
2001, our expectations to continue leveraging our operating EBITDA on our cost
structure, our belief that we have sufficient capital to meet our requirements
for at least the next twelve months, and as set forth in the section entitled
"Purchased in-process research and development": statements regarding our
expectations that we will not achieve a material amount of expense reductions or
synergies from our acquisitions, our beliefs regarding realization of expected
economic return from acquired in-process technology and resulting or related
products, general availability of certain products and our ability to continue
making substantial progress in the development and commercialization of acquired
technologies.

These forward-looking statements involve risks and uncertainties, and the
cautionary statements set forth below and those contained in "Risk Factors,"
identify important factors that could cause actual results to differ materially
from those predicted in any such forward-looking statements. Such factors
include, but are not limited to, increased competition, adverse changes in
general economic conditions in the U.S. and internationally, including adverse
changes in the specific markets for our products, adverse business conditions,
adverse changes in customer order patterns, lack of acceptance of new products,
pricing pressures, lack of success in technological advancements, risks
associated with foreign operations, failure to reduce costs or improve operating
efficiencies, our ability to attract, hire and retain key and qualified
employees, and risks associated with acquiring companies.

With respect to risks related to purchased in-process research and development,
we cannot assure you that any new technologies will be developed into products,
that such products will achieve either technological or commercial success, or
that we will receive any economic benefit from such products as a result of
delays in the development of the technology or release of such products into the
market, the complexity of the technology, our ability to successfully manage
product introductions, lack of customer acceptance, competition and changes in
technological trends, and fluctuations in market or general economic conditions.


                                       16
<PAGE>   17
'

RESULTS OF OPERATIONS

NET REVENUES
(dollars in millions)
<TABLE>
<CAPTION>
                                   Three Months Ended                             Six Months Ended
                               December 31,    December 26,                 December 31,   December 26,
                                   2000           1999          Change         2000            1999         Change
                                 -------         -------        ------        -------         -------       -------
<S>                            <C>             <C>              <C>         <C>             <C>             <C>
Products net revenue             $ 4,317         $ 2,997         44.0%        $ 8,660         $ 5,665        52.9%
  Percentage of total net
  revenues                          84.4%           84.3%                        85.2%           84.6%
Services net revenue             $   798         $   557         43.3%        $ 1,500         $ 1,035        44.9%
  Percentage of total net
  revenues                          15.6%           15.7%                        14.8%           15.4%
Total net revenues               $ 5,115         $ 3,554         43.9%        $10,160         $ 6,700        51.6%
</TABLE>

Products net revenue

Products net revenue is comprised of revenue generated from the sales of our
scalable computer systems and storage, high-speed microprocessors, and our line
of high-performance software for operating network computing equipment. For the
second quarter of fiscal 2001, products net revenue increased by $1,320 million,
or 44.0% to $4,317 million, over the corresponding period of fiscal 2000. For
the first half of fiscal 2001, products net revenue increased by $2,995 million,
or 52.9% to $8,660 million, over the corresponding period of fiscal 2000. Growth
in enterprise and workgroup server product lines accounted for more than 60% of
the total increase in products net revenue in the second quarter and first half
of fiscal 2001. In addition, increased revenues generated by our storage
products, network service provider and iPlanet offerings also contributed to our
increase in products net revenue. As a result of the strong demand for our
servers, desktop system revenue as a percentage of products net revenue has
declined for the three and six months ended December 31, 2000, as compared to
the corresponding periods of fiscal 2000. We expect these product mix trends to
continue through the remainder of fiscal 2001.

Services net revenue

Services net revenue is comprised of revenue generated from the sales of a full
range of services, including support, education, and professional services. For
the second quarter of fiscal 2001, services net revenue increased by $241
million, or 43.3% to $798 million, over the corresponding period of fiscal 2000.
For the first half of fiscal 2001, services net revenue increased by $465
million, or 44.9% to $1,500 million, over the corresponding period of fiscal
2000. The increase in services net revenue is primarily the result of: (1) a
continuing shift towards premium service and support contracts generated from a
larger installed base of high-end server products and an overall shift in
customer expectations to higher levels of support; (2) a larger base of product
units related to the increase in product unit sales and installations; and (3)
an increase in revenues associated with our educational and professional
services.


                                       17
<PAGE>   18


Net revenues by geographic area
(dollars in millions)


<TABLE>
<CAPTION>
                              Three Months Ended                          Six Months Ended
                         December 31,     December 26,                December 31,   December 26,
                            2000             1999         Change         2000             1999        Change
                           -------         -------        ------        -------         -------       -------
<S>                      <C>              <C>             <C>         <C>            <C>              <C>
Domestic                   $ 2,438         $ 1,822         33.8%        $ 5,137         $ 3,506        46.5%
  Percentage of net
  revenues                    47.7%           51.3%                        50.6%           52.3%
International              $ 2,677         $ 1,732         54.6%        $ 5,023         $ 3,194        57.3%
  Percentage of net
  revenues                    52.3%           48.7%                        49.4%           47.7%
Total net revenues         $ 5,115         $ 3,554         43.9%        $10,160         $ 6,700        51.6%
</TABLE>

Domestic net revenues increased by 33.8% and 46.5% in the second quarter and
first half of fiscal 2001, respectively, over the corresponding periods of
fiscal 2000. In December 2000, we experienced an unexpected and significant
decline in U.S. demand primarily for our products. We cannot assure you that
this decline in U.S. demand will not continue to affect future operating
results. In U.S. dollars, international net revenues increased by 54.6% and
57.3% in the second quarter and first half of fiscal 2001, respectively, over
the corresponding periods of fiscal 2000. The revenue growth in international
net revenues is primarily due to continued strong demand for our network
computing products and services. To a lesser degree, the increase in
international revenues is due to our expanded presence in numerous emerging
countries. We experienced revenue growth in all European, Middle Eastern,
African (EMEA) and rest of world (ROW) regions during the second quarter and
first six months of fiscal 2001, as compared to the corresponding periods of
fiscal 2000. The United Kingdom, Germany, Northern Europe, and Japan regions
accounted for more than 50% of the total increase in international net revenues
for the second quarter and first half of fiscal 2001.

Fluctuations in exchange rates reduced total net revenues in the second quarter
of fiscal 2001 by approximately 8% due to the impact of exchange rate movements.
This reduction was principally driven by weakness in the Euro, the British pound
and to a lesser extent the Japanese yen. Although we have experienced U.S.
dollar revenue growth in the domestic and international marketplaces on a
year-over-year basis, we cannot assure you that such trends will continue. In
particular, if capital spending declines in certain countries or any such
countries experience changes in their economic environment, our results of
operations and cash flows could suffer.


                                       18
<PAGE>   19

GROSS MARGIN
(dollars in millions)
<TABLE>
<CAPTION>
                                   Three Months Ended                                Six Months Ended
                              December 31,     December 26,                      December 31,    December 26,
                                  2000             1999            Change            2000            1999          Change
                                --------         --------         --------         --------         ------        --------
<S>                           <C>              <C>                <C>            <C>              <C>             <C>
Products gross margin           $  2,164         $  1,627             33.0%        $  4,354         $3,087            41.0%
  Percentage of products
  net revenues                      50.1%            54.3%                             50.3%          54.5%
Services gross margin           $    280         $    208             34.6%        $    520         $  381            36.5%
  Percentage of services
  net revenues                      35.1%            37.3%                             34.7%          36.8%
Total gross margin              $  2,444         $  1,835             33.2%        $  4,874         $3,468            40.5%
  Percentage of net
  revenues                          47.8%            51.6%                             48.0%          51.8%
</TABLE>

Products gross margin

Products gross margin was 50.1% and 50.3% in the second quarter and first half
of fiscal 2001, respectively, as compared to 54.3% and 54.5% for the
corresponding periods in fiscal 2000. Most of the products gross margin decline
is due to the increased cost of various components. For the remainder of fiscal
2001, we expect products gross margin will continue to be affected by product
mix, component costs, market conditions and new product introductions. During
the second half of fiscal 2001, we expect products gross margin to be in a
similar range, or improve slightly to what we reported for the first half of
fiscal 2001.

Services gross margin

Services gross margin was 35.1% and 34.7% in the second quarter and first half
of fiscal 2001, respectively, as compared to 37.3% and 36.8% for the
corresponding periods in fiscal 2000. The decrease in services gross margin is
primarily due to the impact of: (1) increased expenditures for both fixed and
variable costs in supporting infrastructures; (2) capital and operating
expenditures related to acquisition and deployment of service delivery
technologies and processes; and (3) increasing field service delivery headcount
to support increased customer service expectations and expected future growth in
the services business. We expect to continue investing in our services business
by hiring field service delivery employees, increasing availability of spare
parts inventory to improve customer service response time, and evaluating other
infrastructure-related initiatives. We are currently expecting our services
gross margin to remain in the mid-30% range for the remainder of fiscal 2001.

We continuously evaluate the competitiveness of our product and service
offerings. These evaluations could result in repricing actions in the near term.
Our future operating results would be adversely affected if we reduced prices
and we were unable to mitigate the resulting margin pressure by maintaining a
favorable mix of systems, software, service, and other products, or if we were
unsuccessful in achieving component cost reductions, operating efficiencies, and
increasing volumes.



                                       19
<PAGE>   20


OPERATING EXPENSES
(dollars in millions)
<TABLE>
<CAPTION>
                                     Three Months Ended                            Six Months Ended
                                 December 31,    December 26,                 December 31,  December 26,
                                     2000           1999          Change          2000          1999          Change
                                    ------         ------         ------         ------        ------         ------
<S>                              <C>             <C>              <C>         <C>           <C>               <C>
Research and development            $  497         $  398           24.9%        $  987        $  755          30.7%
  Percentage of net revenues           9.7%          11.2%                          9.7%         11.3%
Selling, general and
  administrative                    $1,236         $  941           31.3%        $2,478        $1,835          35.0%
  Percentage of net revenues          24.2%          26.5%                         24.4%         27.4%
Purchased in-process
  research and development          $   71              -            100%        $   71        $    4        1675.0%
  Percentage of net revenues           1.4%             -                           0.7%          0.1%
</TABLE>

Research and development expenses

Research and development (R&D) expenses, as a percentage of net revenues,
decreased to 9.7% in the second quarter and first half of fiscal 2001 from 11.2%
and 11.3% in the corresponding periods of fiscal 2000. The relative decline was
the result of the increase in net revenues. The dollar increase in R&D expenses
reflects our continued development of a broad line of scalable and reliable
systems, including servers, workstations, storage technologies, and SPARC(TM)
microprocessors, as well as software products which utilize the Java(TM)
platform, Solaris Operating Environment software, and Jini (TM) connection
technology. Furthermore, R&D expenses have increased due to additional
development of products acquired through acquisitions and increased compensation
and compensation-related costs related to higher levels of R&D staffing. The
increases in R&D spending reflect our belief 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.
All R&D is expensed as incurred. We are planning to continue to increase our R&D
spending on a dollar basis during the remainder of fiscal 2001, but expect R&D
expenses for fiscal 2001 to continue to be in the 9% to 10% range of annual net
revenues.

Selling, general and administrative expenses

Selling, general, and administrative (SG&A) expenses, as a percentage of net
revenues, decreased to 24.2% and 24.4% in the second quarter and first half of
fiscal 2001, respectively, from 26.5% and 27.4% in the corresponding periods of
fiscal 2000, as a result of higher revenues and operating efficiencies. The
dollar increase in SG&A expenses is primarily attributable to: (1) increased
headcount, principally in the global sales organization; (2) higher average
employee compensation; (3) increased commissions and bonuses; and (4) increased
marketing costs related to promotional programs. We also made additional
investments aimed at improving our internal business processes for the remainder
of fiscal 2001, and therefore, expect SG&A expense to increase in dollars as
compared to fiscal 2000. We plan on continuing to invest in efforts to achieve
additional future operating efficiencies through the continual review and
improvement of business processes. In addition, we expect to continue to hire
sales and marketing personnel as well as financial service and support
personnel. However, we anticipate hiring at a slower rate for the remainder of
fiscal 2001 and will continue to focus on our cost structure, gradually
decreasing our level of SG&A expenses, as a percentage of total net

                                       20
<PAGE>   21

revenues, on a year-over-year basis (excluding the impact of intangible asset
and deferred compensation amortization for mergers and acquisitions).

Purchased in-process research and development expenses

Overview

In the second quarter of fiscal 2001, we acquired (1) grapeVINE Technologies,
LLC (grapeVINE) and (2) Cobalt Networks, Inc. and its wholly-owned subsidiaries
(Cobalt). Purchased in-process research and development expenses (IPRD) of $71.3
million in the first half of fiscal 2001 represents the write-off of in-process
technologies associated with our acquisitions of grapeVINE ($0.5 million) and
Cobalt ($70.8 million). Purchased IPRD of $4.0 million in the first half of
fiscal 2000 represents the write-off of in-process technologies associated with
our acquisitions of Star Division Corporation (Star Division) and certain assets
and liabilities of Star Division Software-Entwicklung und Vertriebs GmbH (Star
Company), a related party of Star Division. All of these business combinations
are known collectively as "Acquired Companies." At the date of each acquisition
noted above, the projects associated with the IPRD efforts had not yet reached
technological feasibility and the IPRD had no alternative future uses.
Accordingly, these amounts were expensed on the respective acquisition dates of
each of the Acquired Companies. Also, see Note 3 of "Notes to Condensed
Consolidated Financial Statements (Unaudited) - Business Combinations".

See "Purchased In-Process Research and Development," in our Annual Report on
Form 10-K for fiscal 2000 for additional discussion on our valuation of IPRD,
overview of purchased IPRD and overall status of IPRD and intangible assets
acquired during fiscal 2000, 1999, and 1998.

Valuation of IPRD

We used independent third-party sources to calculate the amounts allocated to
IPRD. In calculating IPRD, the independent third party used established
valuation techniques accepted in the high-technology industry. These
calculations gave consideration to relevant market sizes and growth factors,
expected industry trends, the anticipated nature and timing of new product
introductions by us and our competitors, individual product sales cycles, and
the estimated lives of each of the products' underlying technology. The value of
the IPRD reflects the relative value and contribution of the acquired research
and development. We gave consideration to the R&D's stage of completion, the
complexity of the work completed to date, the difficulty of completing the
remaining development, costs already incurred, and the projected cost to
complete the project in determining the value assigned to IPRD.

The values assigned to developed technologies related to each acquisition were
based upon discounted cash flows related to the existing products' projected
income stream. Elements of the projected income stream included revenues, cost
of sales (COS), SG&A expenses, and R&D expenses. The discount rates used in the
present value calculations were generally derived from a weighted average cost
of capital, adjusted upward to reflect the additional risks inherent in the
development life cycle, including the useful life of the technology,
profitability levels of the technology, and the uncertainty of technology
advances that are known at the date of each acquisition. Since each acquired
entity's IPRD is unique, the discount rate, revenue, COS, R&D and SG&A
assumptions used varied on a case-by-case basis. We did not expect to achieve a
material amount of expense reductions or synergies, therefore the valuation
assumptions did not include significant anticipated cost savings.

                                       21
<PAGE>   22


Valuation Assumptions

The following table summarizes the significant assumptions underlying the
valuations related to the IPRD for the six months ended December 31, 2000
(dollars in millions, except percentages):

<TABLE>
<CAPTION>
                                                                                     --PERCENTAGE OF REVENUE--
                                      ESTIMATED
                                      COST TO
                                      COMPLETE       PERCENTAGE     AVERAGE
ACQUIRED                             TECHNOLOGY AT   COMPLETE AT    REVENUE
COMPANY/                               TIME OF        TIME OF       GROWTH        AVG.          AVG.           AVG.       DISCOUNT
BUSINESS                   IPRD      ACQUISITION    ACQUISITION     RATE          COS           SG&A           R&D        RATE USED
                          -------   -------------   -----------    -------       -------       -------       -------      --------
<S>                       <C>       <C>             <C>            <C>           <C>           <C>            <C>         <C>
Cobalt                    $  70.8      $   1.5            67%           50%           49%           28%            1%           22%
                          -------      -------       -------       -------       -------       -------       -------       -------

grapeVINE                 $   0.5      $   0.3            83%           10%           18%           48%            1%           23%
                          -------      -------       -------       -------       -------       -------       -------       -------
</TABLE>

Overview of Significant Purchased IPRD in the six months ended December 31, 2000

Included below are further details regarding the nature of the significant
amounts of purchased technology acquired during the six months ended December
31, 2000.

Given the uncertainties of the commercialization process, we cannot assure you
that deviations from our estimates will not occur. We believe there is a
reasonable chance of realizing the economic return expected from the acquired
in-process technology. However, there is risk associated with the realization of
benefits related to commercialization of an in-process project due to rapidly
changing customer needs, complexity of technology and growing competitive
pressures. Therefore, we cannot assure you that any project will meet with
commercial success. Failure to successfully commercialize an in-process project
would result in the loss of the expected economic return inherent in the fair
value allocation. Additionally, the value of our intangible assets acquired may
become impaired.

On December 7, 2000, we acquired all of the outstanding capital stock of Cobalt
in a stock-for-stock transaction valued at approximately $2,061.0 million. This
transaction was accounted for as a purchase, with the purchase price being
allocated to tangible assets, intangible assets, and IPRD.

At the acquisition date, Cobalt was engaged in development activity associated
with development of its Cobalt(TM) RaQ XTR, Qube ML and CacheRaQ server
appliance products as well as related software. As of the acquisition date,
Cobalt had made substantial progress in the areas of product definition,
architecture design and coding. Remaining efforts necessary to complete these
server appliance products relate primarily to additional coding, testing and
implementation. We released certain general availability versions of these
products in late January 2001 and will continue releasing general availability
versions of the remaining products through March 2001, at which time the Company
expects to begin to realize economic benefits associated with these server
appliance products.

Overall Status of Business Combinations Prior to Fiscal 2001

With respect to acquisitions completed prior to fiscal 2001, we believe that the
projections we used in performing our valuations for each acquisition are still
valid in all material respects; however, we cannot assure you that the projected
results will be achieved. We continue to make substantial progress related to
the development and commercialization of acquired technologies. Although we have
experienced delays in the completion of certain of our development efforts and
their related commercialization, the expected total costs to complete such
technologies have not materially increased, individually or in the aggregate. We
periodically evaluate our product development timeline and modify our overall
business plan in response to various factors.

                                       22
<PAGE>   23

Modifications to our business plan include the reallocation of resources among
various alternative development projects. The impact of delays in the
realization of economic benefits related to acquired technologies, individually
or in the aggregate, has not been material to our overall consolidated financial
position or results of operations as of and for the quarter ended December 31,
2000.

INTEREST INCOME, NET
(dollars in millions)
<TABLE>
<CAPTION>
                          Three Months Ended                     Six Months Ended
                       December 31,  December 26,             December 31,  December 26,
                           2000         1999         Change       2000         1999      Change
                          ------       ------        ------      ------       ------     ------
<S>                    <C>           <C>             <C>      <C>           <C>          <C>
Interest income, net      $   91       $   32        184.4%      $  166       $   61     172.1%
  Percentage of net
  revenues                   1.8%         0.9%                      1.6%         0.9%
</TABLE>

The increase in interest income (net of interest expense) of 184.4% and 172.1%
in the second quarter and first half of fiscal 2001, as compared to the
corresponding periods in fiscal 2000, is primarily due to higher average
balances of cash and marketable securities, partially offset by interest expense
related to our issuance of the $1.5 billion of unsecured debt securities in
August 1999.

Our interest income and expenses are sensitive to changes in the general level
of U.S. interest rates. In this regard, changes in U.S. interest rates affect
the interest earned on our cash equivalents and marketable securities. In
addition, to mitigate the impact of fluctuations in U.S. interest rates on our
fixed-rate unsecured debt securities, we have entered into interest rate swap
transactions so that the interest associated with these debt securities
effectively becomes variable.

INCOME TAXES
(dollars in millions)
<TABLE>
<CAPTION>
                          Three Months Ended                     Six Months Ended
                       December 31,  December 26,             December 31,  December 26,
                           2000         1999         Change       2000         1999      Change
                          ------       ------        ------      ------       ------     ------
<S>                    <C>           <C>             <C>      <C>           <C>          <C>
Provision for income
taxes                     $  309       $  174         77.6%      $  572       $  310      84.5%
  Percentage of income
  before income taxes       42.2%        33.0%                     38.0%        33.2%
</TABLE>


Our effective tax rate was 42.2% and 38.0% for the second quarter and first half
of fiscal 2001, as compared to 33.0% and 33.2% for the corresponding periods a
year ago. The change in our effective tax rate is primarily due to the
nondeductibility of certain accounting charges associated with our merger and
acquisition activities, such as IPRD and goodwill. Excluding these accounting
charges, our effective tax rate was 33.6% for the second quarter and first half
of fiscal 2001 as compared to 32.1% for the corresponding periods in fiscal
2000. The remaining increase in the effective tax rate is primarily due to
proportionately greater forecasted earnings in higher tax rate jurisdictions.

We currently expect our effective tax rate will be approximately 33.6% for the
remainder of fiscal 2001. This excludes the impact of accounting charges
associated with our merger and acquisition activities. Our expected rate is
based on current tax law and current estimates of earnings, and is subject to
change. While our effective tax rate under generally accepted accounting
principles for the remainder of fiscal 2001 is expected to be

                                       23
<PAGE>   24

approximately 36.3%, this rate may change upon the completion of new mergers and
acquisitions, such as the pending acquisitions of HighGround Systems, Inc.
(HighGround) and LSC, Incorporated (LSC), or changes in the amount of goodwill
amortization we recognize.

OPERATING EBITDA
(dollars in millions)

<TABLE>
<CAPTION>
                          Three Months Ended                     Six Months Ended
                       December 31,  December 26,             December 31,  December 26,
                           2000         1999         Change       2000         1999      Change
                          ------       ------        ------      ------       ------     ------
<S>                    <C>           <C>             <C>      <C>           <C>          <C>
Operating EBITDA          $  948       $  666         42.3%      $ 1,854      $ 1,235     50.1%
   Percentage of net
   revenues                 18.5%        18.7%                      18.2%        18.4%
</TABLE>

Operating EBITDA represents earnings before interest, income taxes,
depreciation, amortization (including amortization of stock-based compensation),
and other non-operating items, such as gain on sale of investments and IPRD. We
believe that operating EBITDA is a useful measure of operating performance which
provides focus on business fundamentals that track critical longer term trends.
Though operating EBITDA as a measure of performance is significantly more
cash-like, it is not intended to represent, nor does it represent, cash flows
for the period, or funds available for dividends, reinvestment or other
discretionary uses. Operating EBITDA has been presented as a useful supplement,
not as a substitute, for measures of performance prepared and presented in
accordance with generally accepted accounting principles.

During the second quarter and first half of fiscal 2001, operating EBITDA as a
percentage of net revenues has remained essentially flat as compared to the
corresponding periods in fiscal 2000. Despite the decline in total gross margin
as a percentage of net revenues in the second quarter and first half of fiscal
2001, our operating EBITDA has remained consistent due to our ability to grow
revenues without incurring proportionate increases in operating expenses. We are
continuing to focus on improving this leverage on our cost structure.


                                       24
<PAGE>   25


LIQUIDITY AND CAPITAL RESOURCES
(dollars in millions)

<TABLE>
<CAPTION>
                                                   December 31, 2000          June 30, 2000         Change
                                                   -----------------          -------------         ------
<S>                                                <C>                        <C>                   <C>
Cash, cash equivalents, and investments                       $7,442                 $6,971           6.8%
Percentage of total assets                                     41.2%                  49.3%
Days sales outstanding (DSO)                                      57                     48
Inventory turns                                                 14.2                   17.5
</TABLE>

<TABLE>
<CAPTION>
                                                               Six Months Ended
                                                   December 31, 2000     December 26, 1999            Change
                                                   -----------------     -----------------            ------
<S>                                                <C>                   <C>                         <C>
Net cash provided by operating activities                     $1,256                $1,164              7.9%
Net cash used in investing activities                       ($1,620)              ($2,217)             26.9%
Net cash (used in) provided by financing
activities                                                     ($82)                $1,263          (106.5%)
</TABLE>


At December 31, 2000, cash, cash equivalents and investments increased $471
million from June 30, 2000. The increase in the six months ended December 31,
2000 is due to cash flows generated from operating activities of $1,256 million,
which represents our principal source of cash. Cash flows provided by operating
activities were generated primarily from net income as adjusted for income tax
benefits from employee stock plans and depreciation and amortization, which were
partially offset by decreases in working capital. The cash flows provided by
operating activities were offset by the following investing and financing
activities: (1) capital spending of $572 million for real estate development and
equipment additions to support increased headcount, primarily in our services,
engineering and marketing organizations and (2) acquisition of treasury stock
for $311 million.

The decrease in working capital was primarily generated by increases in accounts
receivable (net) and inventory. Accounts receivable (net) increased to $3,215
million at December 31, 2000 from $2,690 million at June 30, 2000. The increase
in accounts receivable (net) and DSO are primarily due to increased revenues and
the timing of payments by customers. Inventory increased to $792 million at
December 31, 2000 from $557 million at June 30, 2000. The increase in inventory
and decline in inventory turns is primarily due to Sun's decision to carry more
inventory to better meet customer demand and provide better customer service.

We have a $500 million revolving credit facility ("Facility") with a syndicate
of commercial banks. The Facility is available subject to compliance with
certain covenants, with which we are currently in compliance. No amounts were
outstanding under the Facility at December 31, 2000.

We currently have effective shelf registration statements on file with the
Securities and Exchange Commission that permit us to offer up to $4.0 billion of
debt securities and common and preferred stock in one or more separate series,
in amounts, at prices, and on terms to be set forth in the prospectus contained
in these registration statements and in one or more supplements to the
prospectus. On August 4, 1999, we issued $1.5 billion in unsecured debt
securities in four tranches (the "Senior Notes") under these registration
statements. The Senior Notes are due at various times between August 2002 and
August 2009.

We believe that the liquidity provided by existing cash, cash equivalents, and
investments, along with the borrowing arrangements described above and cash
generated from operations, will provide sufficient capital to meet our
requirements for at least the next twelve months. We believe the level of
financial resources is a significant competitive factor in our industry and we
may choose at any time to raise additional capital through debt or equity
financing to strengthen our financial position, facilitate growth, and provide
us with additional flexibility to take advantage of business opportunities that
may arise.


                                       25
<PAGE>   26

RISK FACTORS

IF WE ARE UNABLE TO COMPETE EFFECTIVELY WITH EXISTING OR NEW COMPETITORS, OUR
RESULTING LOSS OF COMPETITIVE POSITION COULD RESULT IN PRICE REDUCTIONS, FEWER
CUSTOMER ORDERS, REDUCED REVENUES, REDUCED MARGINS, REDUCED LEVELS OF
PROFITABILITY, AND LOSS OF MARKET SHARE.

We compete in the hardware and software products and services markets. These
markets are intensely competitive. If we fail to compete successfully in these
markets, the demand for our products would decrease. Any reduction in demand
could lead to a decrease in the prices of our products, fewer customer orders,
reduced revenues, reduced margins, reduced levels of profitability, and loss of
market share. These competitive pressures could adversely affect our business
and operating results.

Our competitors are some of the largest, most successful companies in the world.
They include Hewlett-Packard Company (HP), International Business Machines
Corporation (IBM), Compaq Computer Corporation (Compaq), and EMC Corporation
(EMC). Our future competitive performance depends on a number of factors,
including our ability to: continually develop and introduce new products and
services with better prices and performance than those offered by our
competitors; offer a wide range of products and solutions from small
single-processor systems to large complex enterprise-level systems; offer
solutions to customers that operate effectively within a computing environment
that includes hardware and software from multiple vendors; offer products that
are reliable and that ensure the security of data and information; create
products for which third party software vendors will develop a wide range of
applications; and offer high quality products and services.

We also compete with systems manufacturers and resellers of systems based on
microprocessors from Intel Corporation (Intel) and Windows operating system
software from Microsoft Corporation (Microsoft). These competitors include Dell
Computer Corporation (Dell), HP, and Compaq, in addition to Intel and Microsoft.
This competition creates increased pressure, including pricing pressure, on our
workstation and lower-end server product lines. We expect this competitive
pressure to intensify considerably during fiscal year 2001, with the anticipated
releases of new software products from Microsoft and new microprocessors from
Intel.

The computer systems that we sell are made up of many products and components,
including workstations, servers, storage products, microprocessors, the Solaris
Operating Environment and other software products. In addition, we sell some of
these components separately and as add-ons to installed systems. If we are
unable to offer products and services that compete successfully with the
products and services offered by our competitors or that meet the complex needs
of our customers, our business and operating results could be adversely
affected. In addition, if in responding to competitive pressures, we are forced
to lower the prices of our products and services and we are unable to reduce our
component costs or improve operating efficiencies, our business and operating
results would be adversely affected.

Over the last several years, we have invested significantly in our storage
products business with a view to increasing the sales of these products both on
a stand-alone basis to customers using the systems of our competitors, and as
part of the systems that we sell. The intelligent storage products business is
intensely competitive. EMC is currently the leader in this market. To the extent
we are unable to penetrate this market and compete effectively, our business and
operating results could be adversely affected. In addition, we will be making
significant investments to develop, market, and sell software products under our
alliance with America Online, Inc. (AOL) and have agreed to significant minimum
revenue commitments. These alliance products are targeted at the e-commerce
market and are strategic to our ability to successfully compete in this market.
If we are unable to successfully compete in this market, our business and
operating results could be adversely affected.

                                       26
<PAGE>   27

THE PRODUCTS WE MAKE ARE VERY COMPLEX AND IF WE ARE UNABLE TO RAPIDLY AND
SUCCESSFULLY DEVELOP AND INTRODUCE NEW PRODUCTS, WE WILL NOT BE ABLE TO SATISFY
CUSTOMER DEMAND.

We operate in a highly competitive, quickly changing environment, and our future
success depends on our ability to develop and introduce new products that our
customers choose to buy. If we are unable to develop new products, our business
and operating results could be adversely affected. We must quickly develop,
introduce, and deliver in quantity new, complex systems, software, and hardware
products and components. These include products we plan to introduce later in
fiscal 2001 which incorporate our new UltraSPARC(TM) III architecture, the
Solaris Operating Environment, our Sun StorEdge(TM) storage products, and other
software products, such as those products under development or to be developed
under our alliance with AOL. The development process for these complicated
products is very uncertain. It requires high levels of innovation from both our
product designers and our suppliers of the components used in our products. The
development process is also lengthy and costly. If we fail to accurately
anticipate our customers' needs and technological trends, or are otherwise
unable to complete the development of a product on a timely basis, we will be
unable to introduce new products into the market on a timely basis, if at all,
and our business and operating results would be adversely affected. In addition,
the successful development of software products under our alliance with AOL
depends on many factors, including our ability to work effectively within the
alliance on complex product development and any encumbrances on the licensed
technology that may arise from time to time may prevent us from developing,
marketing, or selling these alliance software products. If we are unable to
successfully develop, market, or sell the alliance software products or other
software products, our business and operating results could be adversely
affected.

Software and hardware products such as ours may contain known as well as
undetected errors, and these defects may be found following introduction and
shipment of new products or enhancements to existing products. Although we
attempt to fix errors that we believe would be considered critical by our
customers prior to shipment, we may not be able to detect or fix all such
errors, and this could result in lost revenues and delays in customer
acceptance, and could be detrimental to our business and reputation.

The manufacture and introduction of our new hardware and software products is
also a complicated process. Once we have developed a new product we face several
challenges in the manufacturing process. We must be able to manufacture new
products in high enough volumes so that we can have an adequate supply of new
products to meet customer demand. We must be able to manufacture the new
products at acceptable costs. This requires us to be able to accurately forecast
customer demand so that we can procure the appropriate components at optimal
costs. Forecasting demand requires us to predict order volumes, the correct
mixes of our software and hardware products, and the correct configurations of
these products. We must manage new product introductions like the introduction
of our new UltraSPARC III architecture during fiscal 2001, so that we can
minimize the impact of customers delaying purchases of existing products in
anticipation of the new product release. We must also try to reduce the levels
of older product and component inventories to minimize inventory write-offs.
Additionally, we may decide to adjust prices of our existing products during
this process in order to try to increase customer demand for these products. If
we are introducing new products at the same time or shortly after the price
adjustment, this will complicate our ability to anticipate customer demand for
our new products.

If we are unable to timely develop, manufacture, and introduce new products in
sufficient quantity to meet customer demand at acceptable costs, or if we are
unable to correctly anticipate customer demand for our new and existing
products, our business and operating results could be materially adversely
affected.


                                       27
<PAGE>   28


OUR RELIANCE ON SINGLE SOURCE SUPPLIERS COULD DELAY PRODUCT SHIPMENTS AND
INCREASE OUR COSTS.

We depend on many suppliers for the necessary parts and components to
manufacture our products. There are a number of vendors producing the parts and
components that we need. However, there are some components that can only be
purchased from a single vendor due to price, quality, or technology reasons. For
example, we depend on Sony for various monitors, and on Texas Instruments for
our SPARC microprocessors. If we were unable to purchase the necessary parts and
components from a particular vendor and we had to find a new supplier for such
parts and components, our new and existing product shipments could be delayed,
severely affecting our business and operating results.

OUR FUTURE OPERATING RESULTS DEPEND ON OUR ABILITY TO PURCHASE A SUFFICIENT
AMOUNT OF COMPONENTS TO MEET THE DEMANDS OF OUR CUSTOMERS.

We depend heavily on our suppliers to timely design, manufacture, and deliver
the necessary components for our products. While many of the components we
purchase are standard, we do purchase some components, specifically color
monitors and custom memory integrated circuits such as static random access
memories (SRAMS) and video random access memories (VRAMS), that require long
lead times to manufacture and deliver. Long lead times make it difficult for us
to plan component inventory levels in order to meet the customer demand for our
products. In addition, in the past, we have experienced shortages in certain of
our components (specifically dynamic random access memories (DRAMS) and SRAMS).
If a component delivery from a supplier is delayed, if we experience a shortage
in one or more components, or if we are unable to provide for adequate levels of
component inventory, our new and existing product shipments could be delayed and
our business and operating results could be adversely affected.

SINCE WE ORDER OUR COMPONENTS (AND IN SOME CASES COMMIT TO PURCHASE) FROM
SUPPLIERS IN ADVANCE OF RECEIPT OF CUSTOMER ORDERS FOR OUR PRODUCTS WHICH
INCLUDE THESE COMPONENTS, WE FACE A SUBSTANTIAL INVENTORY RISK.

As part of our component inventory planning, we frequently pay certain suppliers
well in advance of receipt of customer orders. For example, we often enter into
noncancelable purchase commitments with vendors early in the manufacturing
process of our microprocessors to make sure we have enough of these components
for our new products to meet customer demand. Because the design and
manufacturing process for these components is very complicated it is possible
that we could experience a design or manufacturing flaw that could delay or even
prevent the production of the components for which we have previously committed
to pay. We also face the risk of ordering too many components, or conversely,
not enough components, since the orders are based on the forecasts of customer
orders rather than actual orders. If we cannot change or be released from the
noncancelable purchase commitments, we could incur significant costs from the
purchase of unusable components, due to a delay in the production of the
components or as a result of inaccurately predicting component orders in advance
of customer orders. Our business and operating results could be adversely
affected as a result of these increased costs.

DELAYS IN PRODUCT DEVELOPMENT OR CUSTOMER ACCEPTANCE AND IMPLEMENTATION OF NEW
PRODUCTS AND TECHNOLOGIES COULD SERIOUSLY HARM OUR BUSINESS.

Generally, the computer systems we sell to customers incorporate hardware and
software products that we sell, such as UltraSPARC microprocessors, the Solaris
Operating Environment and Sun StorEdge storage products. Any delay in the
development of the software and hardware included in our systems could delay our
shipment of these systems. Delays in the development and introduction of our
products may occur for various reasons. For example, delays in software
development could delay shipments of related new hardware products.

                                       28
<PAGE>   29

In addition, if customers decided to delay the adoption and implementation of
new releases of our Solaris Operating Environment this could also delay customer
acceptance of new hardware products tied to that release. Adopting a new release
of an operating environment requires a great deal of time and money for a
customer to convert its systems to the new release. The customer must also work
with software vendors who port their software applications to the new operating
system and make sure these applications will run on the new operating system. As
a result, customers may decide to delay their adoption of a new release of an
operating system because of the cost of a new system and the effort involved to
implement it. Such delays in product development and customer acceptance and
implementation of new products could adversely affect our business.

IF WE ARE UNABLE TO CONTINUE GENERATING SUBSTANTIAL REVENUES FROM INTERNATIONAL
SALES OUR BUSINESS COULD BE ADVERSELY AFFECTED.

Currently, approximately half of our revenues come from international sales. Our
ability to sell our products internationally is subject to the following risks:
general economic and political conditions in each country could adversely affect
demand for our products and services in these markets; currency exchange rate
fluctuations could result in lower demand for our products, as well as currency
translation losses; changes to and compliance with a variety of foreign laws and
regulations may increase our cost of doing business in these jurisdictions;
trade protection measures and import and export licensing requirements subject
us to additional regulation and may prevent us from shipping products to a
particular market, and increase our operating costs.

WE EXPECT OUR QUARTERLY REVENUES AND OPERATING RESULTS TO FLUCTUATE FOR A NUMBER
OF REASONS.

Future operating results will continue to be subject to quarterly fluctuations
based on a wide variety of factors, including:

SEASONALITY. Our sequential quarterly operating results usually fluctuate
downward in the first quarter of each fiscal year when compared to the
immediately preceding fourth quarter.

INCREASES IN OPERATING EXPENSES. Our operating expenses will continue to
increase as we continue to expand our operations. Our operating results could
suffer if our revenues do not increase at least as fast as our expenses.

ACQUISITIONS/ALLIANCES. If, in the future, we acquire technologies, products, or
businesses, or we form alliances with companies requiring technology investments
or revenue commitments (such as our alliance with AOL), we will face a number of
risks to our business. The risks we may encounter include those associated with
integrating or comanaging operations, personnel, and technologies acquired or
licensed, and the potential for unknown liabilities of the acquired or combined
business. Also, we will include amortization expense of acquired intangible
assets in our financial statements for several years following these
acquisitions. Our business and operating results on a quarterly basis could be
adversely affected if our acquisition or alliance activities are not successful.

SIGNIFICANT CUSTOMERS. Sales to a single customer accounted for approximately
19% and 15% of our fiscal 2000 and 1999 net revenues, respectively. The major
customer revenues in fiscal 2000 and 1999 were primarily generated by two
subsidiaries of an international organization: (1) a reseller (16% and 14% of
net revenues in 2000 and 1999, respectively), acquired by the international
organization in fiscal 1999; and (2) a finance/leasing company (3% and 1% of net
revenues in fiscal 2000 and 1999, respectively). Revenue is generated with the
finance/leasing company whenever a Sun customer elects to lease equipment; in
such cases, Sun sells the equipment to the leasing company. Our business could
suffer if these customers or any other

                                       29
<PAGE>   30

significant customer terminated its business relationship with us or
significantly reduced the amount of business it did with us.

OUR ACQUISITION AND ALLIANCE ACTIVITIES COULD DISRUPT OUR ONGOING BUSINESS.

We intend to continue to make investments in companies, products, and
technologies, either through acquisitions or investment alliances. For example,
we have purchased several companies in the past and have also formed alliances,
including our alliance with AOL. Acquisitions and alliance activities often
involve risks, including: difficulty in assimilating the acquired operations and
employees; difficulty in managing product codevelopment activities with our
alliance partners; retaining the key employees of the acquired operation;
disruption of our ongoing business; inability to successfully integrate the
acquired technology and operations into our business and maintain uniform
standards, controls, policies, and procedures; and lacking the experience to
enter into new markets, products, or technologies.

Failure to manage these alliance activities effectively and to integrate
entities or assets that we acquire could affect our operating results or
financial condition.

WE DEPEND ON KEY EMPLOYEES AND FACE COMPETITION IN HIRING AND RETAINING
QUALIFIED EMPLOYEES.

Our employees are vital to our success, and our key management, engineering, and
other employees are difficult to replace. We generally do not have employment
contracts with our key employees. Further, we do not maintain key person life
insurance on any of our employees. The expansion of high technology companies in
Silicon Valley and Colorado, as well as many other cities, has increased demand
and competition for qualified personnel. We may not be able to attract,
assimilate, or retain highly qualified employees in the future. These factors
could adversely affect our business.

BUSINESS INTERRUPTIONS COULD ADVERSELY AFFECT OUR BUSINESS.

Our operations are vulnerable to interruption by fire, earthquake, power loss,
telecommunications failure and other events beyond our control. A substantial
portion of our facilities, including our corporate headquarters and other
critical business operations, are located near major earthquake faults. In
addition, many of our facilities are located on filled land and, therefore, may
be more susceptible to damage if an earthquake occurs. We do not carry
earthquake insurance and do not self insure for earthquake-related losses. Our
facilities in the State of California, including our corporate headquarters and
other critical business operations, are currently subject to electrical
blackouts as a consequence of a shortage of available electrical power. In the
event these blackouts continue or increase in severity, they could disrupt the
operations of our affected facilities. In addition, we do not carry business
interruption insurance or carry financial reserves against business
interruptions arising from earthquakes or intentional electrical blackouts. If a
business interruption occurs, our business could be seriously harmed.

OUR MARKETABLE STRATEGIC EQUITY SECURITIES ARE SUBJECT TO EQUITY PRICE RISK AND
THEIR VALUE MAY FLUCTUATE.

From time to time, we make equity investments for the promotion of business and
strategic objectives with publicly traded and non-publicly traded companies. The
market price and valuation of the securities that we hold in these companies may
fluctuate due to market conditions and other circumstances over which we have
little or no control. Many of the companies in which we have invested have
experienced significant volatility in their stock prices. We typically do not
attempt to reduce or eliminate this equity price risk, through hedging or
similar techniques, and market price and valuation fluctuations could impact our
financial results. To the extent

                                       30
<PAGE>   31

that the fair value of these securities was less than our cost over an extended
period of time, our net income would be reduced. Also, refer to Item 3 -
Quantitative and Qualitative Disclosures about Market Risk.

ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk related to changes in interest rates, foreign
currency exchange rates, and equity security prices. To mitigate some of these
risks, we utilize derivative financial instruments. We do not use derivative
financial instruments for speculative or trading purposes. All of the potential
changes noted below are based on sensitivity analyses performed on our financial
position at December 31, 2000. Actual results may differ materially.

Interest Rate sensitivity

Our investment portfolio consists primarily of fixed income instruments with an
average duration of less than 1.50 years. The primary objective of our
investments in debt securities is to preserve principal while maximizing yields,
without significantly increasing risk. These available-for-sale securities are
subject to interest rate risk and will decrease in value if market interest
rates increase. The sensitivity analysis applied to this investment portfolio
was based on a modeling technique that measures the hypothetical market value
changes that would result from a parallel shift in the yield curve of plus 150
basis points (BPS). The hypothetical 150 BPS increase in interest rates would
result in an approximate $104 million decrease in the fair value of our
investments in debt securities as of December 31, 2000.

We also entered into various interest-rate swap agreements to modify the
interest characteristics of the Senior Notes so that the interest associated
with the Senior Notes effectively becomes variable and thus matches the variable
interest rate associated with our cash and marketable securities.

Foreign Currency Exchange Risk

The majority of our revenue, expense, and capital purchasing activities are
transacted in U.S. dollars. However, since a portion of our operations consists
of manufacturing and sales activities outside of the U.S., we enter into
transactions in other currencies, primarily the Japanese yen, the British pound
and the Euro. We enter into foreign exchange forward and option contracts to
hedge certain balance sheet exposures and intercompany balances against future
movements in foreign exchange rates. The gains or losses on the forward and
option contracts are largely offset by gains or losses on the underlying
transactions and, consequently, a sudden or significant change in foreign
exchange rates is not expected to have a material impact on future net income or
cash flows. Based on our foreign currency exchange instruments outstanding at
December 31, 2000, we estimate a maximum potential one-day loss in fair value of
approximately $26 million, using a Value-at-Risk (VAR) model. The VAR model
estimates were made assuming normal market conditions and a 95% confidence
level. We used a Monte Carlo simulation type model that valued foreign currency
instruments against a thousand randomly generated market price paths.
Anticipated transactions, firm commitments, receivables, and accounts payable
denominated in foreign currencies were excluded from the model. The VAR model is
a risk estimation tool, and as such is not intended to represent actual losses
in fair value that will be incurred by us. Additionally, as we utilize foreign
currency instruments for hedging anticipated and firmly committed transactions,
a loss in fair value for those instruments is generally offset by increases in
the value of the underlying exposure. Foreign currency fluctuations did not have
a material impact on our results of operations and financial position for the
first six months of fiscal 2001. Also, refer to Note 5 of "Notes to Condensed
Consolidated Financial Statements (Unaudited) Derivative Financial Instruments"
for additional discussion.


                                       31
<PAGE>   32


Euro Conversion

On January 1, 1999, certain member countries of the European Union established
fixed conversion rates between their existing currencies and the Euro. The
transition period for the introduction of the Euro ends June 30, 2002. Issues
facing us as a result of the introduction of the Euro include converting
information technology systems, reassessing currency risk, negotiating and
amending licensing agreements and contracts, and processing tax and accounting
records. We continue to address these issues and do not currently expect the
Euro conversion to have a material effect on our financial conditions or results
of operations.

Equity Security Price Risk

We are exposed to price fluctuations on the marketable portion of equity
securities included in our portfolio of strategic investments. These investments
are generally in companies in the high-technology industry sector, many of which
are small capitalization stocks. We typically do not attempt to reduce or
eliminate the market exposure on these securities. A 20% adverse change in
equity prices would result in an approximate $32 million decrease in the fair
value of our available-for-sale marketable strategic equity securities as of
December 31, 2000. At December 31, 2000, three equity securities represented
approximately $89 million of the total reported fair value of the marketable
strategic equity securities of $158 million. Also, refer to Note 4 of "Notes to
Condensed Consolidated Financial Statements (Unaudited) Balance Sheet Details"
for additional discussion on Sun's marketable strategic equity securities.




                                       32
<PAGE>   33

                           PART II - OTHER INFORMATION

ITEM 1 - LEGAL PROCEEDINGS

On January 23, 2001, Sun and Microsoft Corporation agreed to settle the
litigation initiated by Sun on October 7, 1997 regarding Sun's Java technology.
Under the terms of the settlement agreement, Microsoft agreed to pay Sun $20
million and to terminate its license of the Java technology. In addition,
Microsoft was permanently enjoined from using Sun's JAVA COMPATIBLE(TM)
trademark and Sun agreed to grant Microsoft a new limited and conditional
license to continue shipping, essentially as is, its currently shipping
implementations of the 1.1.4 version of the Java technology. This new license
covers only the products that already contain the 1.1.4 version of the Java
technology and successor versions of those products, and lasts for seven years.


ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

On November 8, 2000, the Annual Meeting of Stockholders of the Company was held
in Santa Clara, California. The share numbers contained in this Item 4 do not
reflect the Company's two-for-one stock dividend paid on December 5, 2000. The
results of voting of the 1,385,693,540 shares of common stock represented at the
meeting or by proxy are described below.

An election of directors was held with the following individuals being elected
to the Board of Directors of the Company:

<TABLE>
<CAPTION>
Name                       Shares Voted For             Votes Withheld
----                       ----------------             --------------
<S>                        <C>                          <C>
Scott G. McNealy             1,376,034,949                 9,658,591
James L. Barksdale           1,375,702,034                 9,991,506
L. John Doerr                1,176,883,446               208,810,094
Judith L. Estrin             1,376,015,015                 9,678,525
Robert J. Fisher             1,375,977,343                 9,716,197
Robert L. Long               1,375,976,455                 9,717,085
M. Kenneth Oshman            1,375,992,992                 9,700,548
Naomi O. Seligman            1,374,184,942                11,508,598
</TABLE>

The eight nominees who received the highest number of votes (all of the above
individuals) were elected to the Board of Directors.

The stockholders approved an amendment to the Company's Restated Certificate of
Incorporation to increase the number of authorized shares of common stock from
3,600,000,000 to 7,200,000,000 shares. There were 1,371,316,107 votes cast for
the amendment, 9,531,256 votes cast against the amendment, 4,846,177 abstentions
and no broker non-votes.

The stockholders approved an amendment to the Company's 1990 Long-Term Equity
Incentive Plan in order to increase the number of shares of common stock
authorized for issuance thereunder by 7,000,000 shares of common stock to an
aggregate of 558,600,000 shares. There were 837,990,961 votes cast for the
amendment, 541,210,871 votes cast against the amendment, 6,491,708 abstentions
and no broker non-votes.

The stockholders approved an amendment to the Company's Bylaws in order to
increase the number of directors to serve on the Company's Board of Directors to
no less than six (6) nor more than eleven (11), with the exact number to be set
by the Board within such range from time to time. There were 938,006,556 votes
cast for the

                                       33
<PAGE>   34

amendment, 6,327,436 votes cast against the amendment, 4,987,985 abstentions and
436,371,563 broker non-votes.


ITEM 5 - OTHER INFORMATION

SCHEDULE OF SALES BY EXECUTIVE OFFICERS DURING THE QUARTER

The following is a summary of all sales of our common stock by our executive
officers and directors who are subject to Section 16 of the Securities Exchange
Act of 1934, as amended, during the fiscal quarter ended December 31, 2000 (the
numbers below do not reflect Sun's two-for-one stock dividend paid on December
5, 2000):

<TABLE>
<CAPTION>
OFFICERS AND                 DATE OF                                     NUMBER OF
DIRECTORS                    TRANSACTION             PRICE               SHARES SOLD
------------                 -----------           ---------        ---------------------
<S>                          <C>                   <C>              <C>
Judith L. Estrin             10/24/00              $118.3048        298,000 sale

H. William Howard            10/24/00              $119.1875         40,000 same-day-sale

William N. Joy               11/27/00              $87.1625         150,000 same-day-sale
                             11/28/00              $84.7531          60,800 same-day-sale
                             11/28/00              $85.4750         100,000 same-day-sale
                             11/28/00              $84.7531          39,200 same-day-sale
                             11/28/00              $83.8417         150,000 same-day-sale
                             11/30/00              $73.9375         100,000 same-day-sale
                             11/30/00              $76.0141         200,000 same-day-sale

Michael E. Lehman            10/31/00              $105.0000        128,000 same-day-sale

M. Kenneth Oshman            10/24/00              $121.0141        300,000 same-day-sale

Gregory M. Papadopoulos      11/1/00               $108.9375         40,000 same-day-sale
                             11/2/00               $108.0000         20,000 same-day-sale

Michael L. Popov             11/1/00               $107.0000         48,000 same-day-sale

Janpieter T. Scheerder       11/7/00               $111.2798         42,000 same-day-sale

John C. Shoemaker            10/24/00              $120.0000         24,000 same-day-sale
                             11/7/00               $110.4793         48,000 same-day-sale

Patricia C. Sueltz           11/2/00               $109.0000         20,000 same-day-sale
</TABLE>

                                       34
<PAGE>   35



ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K

  (a) Exhibits

        3.2         Registrant's Bylaws, as amended November 8, 2000.

        3.5         Certificate of Amendment of Registrant's Restated
                    Certificate of Incorporation filed November 8, 2000.

        3.6(1)      Amended Certificate of Designations filed December 20, 2000.

        10.66       Registrant's 1990 Long-Term Equity Incentive Plan, as
                    amended on August 16, 2000.

        (1)         Incorporated by reference to Exhibit 2.2 to Amendment No. 9
                    to Registrant's Registration Statement on Form 8-A, filed
                    with the Securities and Exchange Commission on December 20,
                    2000.

(b) Reports on Form 8-K

        The Company filed a report on Form 8-K with the Securities and Exchange
        Commission on December 8, 2000, announcing its completion of the
        acquisition of Cobalt Networks, Inc.


                                       35
<PAGE>   36



                                   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
                                   Executive Vice President, Corporate Resources
                                   and Chief Financial Officer
                                   (Principal Financial Officer)


                                   /s/ Michael L. Popov
                                   ---------------------------------------------
                                   Michael L. Popov
                                   Vice President and Corporate Controller
                                   (Chief Accounting Officer)



Dated: February 14, 2001


                                       36
<PAGE>   37


                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
     EXHIBIT
      NUMBER                      DESCRIPTION
      ------                      -----------
<S>                 <C>
        3.2         Registrant's Bylaws, as amended November 8, 2000.

        3.5         Certificate of Amendment of Registrant's Restated
                    Certificate of Incorporation filed November 8, 2000.

        3.6(1)      Amended Certificate of Designations filed December 20, 2000.

        10.66       Registrant's 1990 Long-Term Equity Incentive Plan, as
                    amended on August 16, 2000.

        (1)         Incorporated by reference to Exhibit 2.2 to Amendment No. 9
                    to Registrant's Registration Statement on Form 8-A, filed
                    with the Securities and Exchange Commission on December 20,
                    2000.
</TABLE>


                                       37