<PAGE>   1

                       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 27, 1998 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)

<TABLE>
<S>                                         <C>
           DELAWARE                                      94-2805249
(State or other jurisdiction of             (I.R.S. Employer Identification No.)
 incorporation or organization)
</TABLE>

                    901 SAN ANTONIO ROAD PALO ALTO, CA 94303
             (Address of principal executive offices with zip code)

Registrant's telephone number, including area code:               (650) 960-1300

                                       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 ISSUERS INVOLVED IN
                          BANKRUPTCY PROCEEDINGS DURING
                            THE PRECEDING FIVE YEARS:

     Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court.

                               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.

<TABLE>
<S>                                             <C>
              CLASS                             OUTSTANDING AT DECEMBER 27, 1998
Common Stock - $0.00067 par value                          385,264,651
</TABLE>

<PAGE>   2

                                      INDEX

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

INDEX                                                                          2

PART I - FINANCIAL INFORMATION

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

     Item 2 - Management's Discussion and Analysis of
              Results of Operations and Financial Condition                   11

PART II - OTHER INFORMATION
     Item 1 -  Legal Proceedings                                              24
     Item 4 -  Submission of Matters to a Vote of Security Holders            24
     Item 5 -  Other Information                                              25
     Item 6 -  Exhibits and Reports on Form 8 - K                             25
     Item 7A - Quantitative and Qualitative Disclosures about
               Market Risk                                                    25

SIGNATURES                                                                    26
</TABLE>


                                       2

<PAGE>   3

                         PART I - FINANCIAL INFORMATION

ITEM 1 - FINANCIAL STATEMENTS

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

<TABLE>
<CAPTION>
                                                  December 27,       June 30,
                                                      1998             1998
                                                  -----------       -----------
                                                           (unaudited)
<S>                                               <C>               <C>        
ASSETS
Current assets:
      Cash and cash equivalents                   $   669,862       $   822,267
      Short-term investments                          902,929           476,185
      Accounts receivable, net                      2,108,237         1,845,765
      Inventories                                     363,664           346,446
      Deferred tax assets                             373,541           371,841
      Other current assets                            327,461           285,021
                                                  -----------       -----------
           Total current assets                     4,745,694         4,147,525
Property, plant and equipment, at cost              2,593,985         2,257,228
Accumulated depreciation and amortization          (1,141,377)         (956,616)
                                                  -----------       -----------
                                                    1,452,608         1,300,612
Other assets, net                                     363,218           262,925
                                                  -----------       -----------
                                                  $ 6,561,520       $ 5,711,062
                                                  ===========       ===========


LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
      Short-term borrowings                       $    12,351       $     7,169
      Accounts payable                                611,412           495,603
      Accrued liabilities                           1,230,718         1,166,491
      Income taxes payable                            205,340           188,641
      Other current liabilities                       288,169           264,967
                                                                    -----------
           Total current liabilities                2,347,990         2,122,871
Deferred income taxes and other obligations           112,527            74,563
Total stockholders' equity                          4,101,003         3,513,628
                                                                    -----------
                                                  $ 6,561,520       $ 5,711,062
                                                  ===========       ===========
</TABLE>

                             See accompanying notes


                                       3

<PAGE>   4

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


<TABLE>
<CAPTION>
                                                Three Months Ended             Six Months Ended
                                             ------------------------      ------------------------
                                             December 27,  December 28,    December 27,  December 28,
                                                 1998         1997             1998          1997
                                             ----------    ----------      ----------    ----------
<S>                                          <C>           <C>             <C>           <C>       
Net revenues:
   Products                                  $2,384,740    $2,161,992      $4,540,858    $4,009,880
   Services                                     399,700       288,251         734,766       538,967
                                             ----------    ----------      ----------    ----------
Total net revenues                            2,784,440     2,450,243       5,275,624     4,548,847
                                             ----------    ----------      ----------    ----------
Cost and expenses:
   Cost of sales-products                     1,121,500       997,301       2,109,737     1,858,628
   Cost of sales-services                       225,710       174,329         453,810       340,436
   Research and development                     303,482       259,228         586,762       481,846
   Selling, general and administrative          747,603       696,450       1,459,191     1,311,943
   Purchased in-process research and  
       development                               12,000       110,100          92,000       162,284
                                             ----------    ----------      ----------    ----------
          Total costs and expenses            2,410,295     2,237,408       4,701,500     4,155,137
Operating income                                374,145       212,835         574,124       393,710
Interest income, net                             20,306        10,197          35,661        20,768
                                             ----------    ----------      ----------    ----------
Income before income taxes                      394,451       223,032         609,785       414,478
Provision for income taxes                      133,364        73,600         234,824       156,613
                                             ----------    ----------      ----------    ----------
Net income                                   $  261,087    $  149,432      $  374,961    $  257,865
                                             ==========    ==========      ==========    ==========

Net income per common share - basic          $     0.68    $     0.40      $     0.99    $     0.69
                                             ==========    ==========      ==========    ==========
Net income per common share - diluted        $     0.64    $     0.38      $     0.93    $     0.65
                                             ==========    ==========      ==========    ==========

Shares used in the calculation of
   net income per share - basic                 382,547       373,875         379,883       372,968
                                             ==========    ==========      ==========    ==========
Shares used in the calculation of
   net income per share - diluted               405,288       393,231         401,445       394,165
                                             ==========    ==========      ==========    ==========
</TABLE>

                             See accompanying notes.


                                       4

<PAGE>   5

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

<TABLE>
<CAPTION>
                                                                      Six Months Ended
                                                                ---------------------------
                                                                December 27,    December 28,
                                                                    1998            1997
                                                                 ---------       ---------
<S>                                                              <C>             <C>      
Cash flows from operating activities:
   Net income                                                    $ 374,961       $ 257,865
   Adjustments to reconcile net income
         to operating cash flows:
         Depreciation and amortization                             313,370         183,472
         Tax benefit of options exercised                           96,740          74,466
         Purchased in-process research and development              92,000         162,284
         Net (increase) decrease in accounts receivable           (258,651)         16,004
         Net increase in inventories                               (17,218)        (15,765)
         Net increase in accounts payable                          114,749          14,414
         Net increase in other current
                 and non-current assets                            (87,687)        (97,594)
         Net increase in other current
                 and non-current liabilities                       143,529          19,301
                                                                 ---------       ---------
Net cash provided from operating activities                        771,793         614,447
                                                                 ---------       ---------
Cash flows from investing activities:
   Acquisition of property, plant and equipment                   (360,322)       (410,453)
   Acquisition of spare parts and other assets                     (68,481)        (49,080)
   Payments for acquisitions, net of cash acquired                 (31,269)       (227,655)
   Acquisition of short-term investments                          (935,266)       (305,738)
   Sale of short-term investments                                  235,617         224,309
   Maturities of short-term investments                            252,268         214,122
                                                                 ---------       ---------
Net cash used by investing activities                             (907,453)       (554,495)
                                                                 ---------       ---------
Cash flows from financing activities:
   Issuance of common stock, net                                    92,228          37,189
   Acquisition of treasury stock                                  (164,286)       (140,537)
   Proceeds from employee stock purchase plans                      58,529          50,649
   Net reduction of short-term borrowings and
    other obligations                                               (3,216)        (94,155)
                                                                 ---------       ---------
Net cash used by financing activities                              (16,745)       (146,854)
                                                                 ---------       ---------
Net decrease in cash and cash equivalents                         (152,405)        (86,902)
                                                                 ---------       ---------
Cash and cash equivalents, beginning of period                     822,267         660,170
                                                                 ---------       ---------
Cash and cash equivalents, end of period                         $ 669,862       $ 573,268
                                                                 =========       =========
</TABLE>


                                       5

<PAGE>   6

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

<TABLE>
<CAPTION>
                                                                      Six Months Ended
                                                                ---------------------------
                                                                December 27,    December 28,
                                                                    1998            1997
                                                                 ---------       ---------
<S>                                                              <C>             <C>      

Supplemental disclosures of cash flow information: 
   Cash paid during the period for:
   Interest                                                      $    745        $     388
   Income taxes                                                  $ 58,448        $  55,503
Supplemental schedule of non-cash investing activities:
   Stock issued in conjunction with an acquisition               $142,028               --
   Fair value of assets acquired                                 $198,629        $ 284,294
   Cash paid for assets                                          $ 35,684        $ 233,111
   Liabilities assumed                                           $ 20,737        $  51,183
                                                                 ---------       ---------
</TABLE>

                             See accompanying notes.


                                       6

<PAGE>   7


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


BASIS OF PRESENTATION

     The consolidated financial statements include the accounts of Sun
     Microsystems, Inc. ("Sun" or the "Company") and its wholly-owned
     subsidiaries. Intercompany accounts and transactions have been eliminated.
     Certain amounts from prior years have been reclassified to conform to
     current year presentation.

     While the interim financial information is unaudited, the financial
     statements included in this report reflect all adjustments (consisting of
     normal recurring accruals) 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 information included in
     this report should be read in conjunction with the 1998 Annual Report to
     Stockholders which is incorporated by reference in the Company's 1998 Form
     10-K .

INVENTORIES (IN THOUSANDS)

<TABLE>
<CAPTION>
                              December 27, 1998      June 30, 1998
                              -----------------      -------------
<S>                               <C>                  <C>     
        Raw materials             $127,115             $ 92,197

        Work in process             40,577               58,765

        Finished goods             195,972              195,484
                                  --------             --------
                                  $363,664             $346,446
                                  ========             ========
</TABLE>


INCOME TAXES

The Company accounts for income taxes under the liability method of Statement of
Financial Accounting Standards No. 109. The provision for income taxes during
the interim periods considers anticipated annual income before taxes, earnings
of foreign subsidiaries permanently invested in foreign operations, and other
differences.


RECENT PRONOUNCEMENTS

The Company adopted SOP 98-1 "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use" effective July 1, 1998. The adoption of
SOP 98-1 did not have a material effect on the Company's consolidated financial
position or operating results.

In June 1998, Financial Accounting Standard No. 133 ("FAS 133"), "Accounting for
Derivative Instruments and Hedging Activities" was issued and is effective for
all fiscal years beginning after June 15, 1999. FAS 133 requires the Company to
recognize all derivatives as either assets or liabilities and measure those
instruments at


                                       7

<PAGE>   8

fair value. It further provides criteria for derivative instruments to be
designated as fair value, cash flow and foreign currency hedges and establishes
respective accounting standards for reporting changes in the fair value of the
derivative instruments. Upon adoption, the Company will be required to adjust
hedging instruments to fair value in the balance sheet and recognize the
offsetting gains or losses as adjustments to be reported in net income or other
comprehensive income, as appropriate. The Company is evaluating its expected
adoption date and currently expects to comply with the requirements of FAS 133
in fiscal year 2000. The Company does not expect the adoption will be material
to the Company's financial position or results of operations.

COMPREHENSIVE NET INCOME

As of July 1, 1998, the Company adopted Financial Accounting Standards No. 130
("FAS 130") , "Reporting Comprehensive Income." FAS 130 establishes new rules
for the reporting and display of comprehensive net income and its components,
however, it has no impact on the Company's net income or stockholders' equity.
FAS 130 requires foreign currency translation adjustments and changes in fair
value for available for sale securities, which prior to adoption were reported
in stockholders' equity, to be included in comprehensive income.

The components of comprehensive net income, net of tax, are as follows:

<TABLE>
<CAPTION>
                                                Three Months Ended             Six Months Ended
                                             ------------------------      ------------------------
                                             December 27,  December 28,    December 27,  December 28,
                                                 1998         1997             1998          1997
                                             ----------    ----------      ----------    ----------
<S>                                          <C>           <C>             <C>           <C>
Net income                                   $ 261,087    $ 149,432        $ 374,961     $ 257,865
Unrealized gain (loss) on securities            (6,513)       9,406          (20,637)        9,592
Change in cumulative translation
        adjustment                                 242        7,515            2,201        (1,622)
                                             ---------    ---------        ---------     ---------
Comprehensive net income                     $ 254,816    $ 166,353        $ 356,525     $ 265,835
                                             =========    =========        =========     =========
</TABLE>


ACQUISITIONS

On August 28, 1998 the Company acquired all of the outstanding capital stock of
NetDynamics, Inc. ("NetDynamics") by means of a merger transaction pursuant to
which all the shares of NetDynamics capital stock were converted into the right
to receive Sun common stock based upon an agreed-upon exchange ratio which was
calculated using an agreed-upon average market price for Sun common stock. The
Company issued 2,746,785 shares of Sun common stock (with a fair market value of
$48.26875 per share) as the consideration for the acquisition. The transaction
was accounted for as a purchase and the excess purchase price over the estimated
fair value of net tangible assets has been allocated to various intangible
assets, primarily consisting of developed technology ($20 million) and goodwill
($36.2 million), customer base ($10 million) and assembled workforce ($2
million). In addition to the intangible assets acquired, the Company recorded an
$80 million charge, representing the write-off of in-process research and
development ("IPRD").

On September 28, 1998 the Company acquired all of the outstanding capital stock
of i-Planet, Inc. ("i-Planet") by means of a merger transaction pursuant to
which all the shares of i-Planet capital stock were converted into the right to
receive cash. The transaction was accounted for as a purchase and the excess
purchase price over the estimated fair value of net tangible assets has been
allocated to various intangible assets, primarily consisting of developed
technology ($3.3 million) and goodwill type assets ($18.3 million). In addition
to the intangible assets acquired, the Company recorded an $8.4 million charge,
representing the write-off of IPRD.


                                       8

<PAGE>   9

On October 16, 1998, the Company acquired all of the outstanding capital stock
of Beduin Communications Incorporated ("Beduin") by means of a share purchase
transaction pursuant to which all the shares of Beduin capital stock were
converted into the right to receive cash. The transaction was accounted for as a
purchase and the excess purchase price over the estimated fair value of net
tangible assets has been allocated to various intangible assets, primarily
consisting of developed technology ($3.1 million) and goodwill type assets ($1.4
million). In addition to the intangible assets acquired, the Company recorded an
$3.6 million charge, representing the write-off of IPRD.

For financial reporting purposes, the Company is required for each acquisition
to determine the fair value of all identified intangible assets acquired and
expense the fair value associated with IPRD for which there is no alternative
future use. The allocation of $80 million, $8.4 million, and $3.6 million of the
purchase price to IPRD in the case of the NetDynamics, i-Planet and Bediun
acquisitions, respectively, represents the estimated fair value based on risk
adjusted cash flows related to each incomplete project. The Company believes
that such fair values do not exceed the amount a third party would pay for each
such in-process technology. At the date of each of the acquisitions, the
projects associated with the IPRD efforts had not yet reached technological
feasibility and the in-progress technology had no alternative future use.
Accordingly, these costs were expensed.

In making its purchase price allocations for the NetDynamics, i-Planet, and
Bediun acquisitions, the Company considered present value calculations of
income, an analysis of project accomplishments and completion costs, an
assessment of overall contribution, as well as project risks. The values
assigned to IPRD related to each acquisition were determined by estimating the
costs to develop the purchased in-process technology into commercially viable
products, estimating the resulting net cash flows from each project, excluding
the cash flows related to the portion of each project that was incomplete at the
acquisition date, and discounting the resulting net cash flows to their present
value. Each of these forecasts were based upon future discounted cash flows,
taking into account the state of development of each in-process project, the
cost to complete that project, the expected income stream, the life cycle of the
product ultimately developed, and the associated risks. Projected future net
cash flows attributable to the in-process technology, assuming successful
development of such technologies, were discounted to their present value using a
discount rate which was derived based on the Company's estimated weighted
average cost of capital plus a risk premium to account for the inherent
uncertainty surrounding the successful completion of each project and the
associated estimated cash flows.

The values assigned to developed technologies related to each acquisition were
based upon future discounted cash flows related to each of the existing
products' projected income stream. The values of the customer bases were
determined based upon the value of existing relationships and the expected
revenue stream. The value of the assembled workforces were based upon the cost
to replace that workforce. Intangible assets, including goodwill, are being
amortized over their estimated useful lives, generally two to five years.


                                       9

<PAGE>   10
SUN MICROSYSTEMS, INC. AND AMERICA ONLINE, INC. STRATEGIC DEVELOPMENT AND
MARKETING AGREEMENT

On November 23, 1998, Sun and America Online, Inc. ("AOL") entered into a
Strategic Alliance consisting of several agreements between the parties,
including the Strategic Development and Marketing Agreement ("SDMA"). A copy of
the SDMA has been filed as exhibit 10.93 to this Form 10-Q and is incorporated
herein by reference. Under terms of the SDMA, AOL and Sun committed to
collaboratively develop, market and sell client and server software and
collaboratively develop an AOL specific Java environment that will enable AOL
services to be accessed through a variety of hardware devices. The SDMA provides
that over a three year period, AOL will develop and market, together with Sun,
client software and network application and server software based in part on the
Netscape Communications, Inc. ("Netscape") code base, on Sun code and
technology, and on certain AOL services features to business enterprises. In
addition, AOL and Sun have agreed to coordinate their sales efforts and share
revenues with respect to designated collaboratively developed client software
and network application and server software and associated services.

Under the terms of the SDMA, Sun has committed that the total revenue earned by
AOL from certain existing Netscape contracts, the sale or license of certain AOL
and Netscape software and services, the sale or license of certain
collaboratively developed software products and services and the license to Sun
to distribute commercially existing Netscape software will not be less than $312
million, $330 million and $333 million in the first, second and third years of
the SDMA's three year term, respectively; for these purposes a portion of the
total revenue is determined as a percentage of the gross margin or net of sales
commissions earned by Sun. In addition, Sun will pay to AOL approximately $275
million in licensing and other fees in connection with licenses granted to Sun
by AOL. In a separate transaction, AOL signed a definitive agreement to acquire
Netscape (the "Merger"). The SDMA provides that in the event the Merger is not
consummated by June 30, 1999, AOL and Sun will negotiate in good faith for a
period of 30 days thereafter in an effort to agree to alternative terms, and
either party may terminate the SDMA if the parties fail to agree on alternative
terms during that period.

SUBSEQUENT EVENTS

On January 21, 1999 the Company announced a two-for-one stock split (to be
effected in the form of a stock dividend) to stockholders of record as of the
close of business on March 18, 1999. This dividend is subject to stockholder
approval of an increase in the number of authorized shares of the Company's
Common Stock to 1.8 billion shares which will be sought
at the Company's Special Meeting of Stockholders on March 17, 1999.

On January 22, 1999, the Company acquired all of the outstanding capital stock
of Maxstrat Corporation ("Maxstrat"), by means of a merger transaction pursuant
to which all of the shares of Maxstrat capital stock were converted into the
right to receive cash. The transaction will be accounted for as a purchase, and
the purchase price will be allocated to tangible and intangible assets and IPRD.


                                       10

<PAGE>   11

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

The following table sets forth items from the Condensed Consolidated Statements
of Income as a percentage of total net revenues:

<TABLE>
<CAPTION>
                                           Three Months Ended            Six Months Ended
                                       --------------------------   --------------------------
                                       December 27,  December 28,   December 27,  December 28,
                                           1998          1997           1998          1997
                                           -----         -----          -----         -----
<S>                                        <C>           <C>            <C>           <C>  
Net revenues:
        Products                            85.6%         86.5%          86.1%         88.2%
        Services                            14.4          13.5           13.9          11.8
                                           -----         -----          -----         -----
Total net revenues                         100.0         100.0          100.0         100.0
                                           -----         -----          -----         -----

Cost of sales:
        Products                            40.3          40.7           40.0          40.8
        Services                             8.1           7.1            8.6           7.5
                                           -----         -----          -----         -----
Total cost of sales                         48.4          47.8           48.6          48.3
                                           -----         -----          -----         -----

        Gross margin                        51.6          52.2           51.4          51.7

Research and development                    10.9          10.6           11.1          10.6

Selling, general and administrative         26.8          28.4           27.7          28.85
Purchased in-process research
        and development                      0.4           4.5            1.7           3.6
                                           -----         -----          -----         -----

Operating income                            13.4           8.7           10.9           8.7

Interest income, net                         0.8           0.4            0.7           0.4
                                           -----         -----          -----         -----

Income before income taxes                  14.2           9.1           11.6           9.1

Provision for income taxes                   4.8           3.0            4.5           3.4
                                           -----         -----          -----         -----

        Net income                           9.4%          6.1%           7.1%          5.7%
                                           =====         =====          =====         =====
</TABLE>


The following sections contain forward-looking statements within the meaning of
the Private Securities Litigation Reform Act of 1995. These forward-looking
statements involve risks and uncertainties, and the cautionary statements set
forth below, specifically those contained in "Future Operating Results" identify
important factors that could cause actual results over the next few quarters to
differ materially from those predicted in any such forward-looking statements.
Such factors include, but are not limited to, adverse changes in general
economic conditions, including adverse changes in the specific markets for the
Company's products, adverse business conditions, decreased or lack of growth in
the computing industry, adverse changes in customer order patterns, increased
competition, lack of acceptance of new products, pricing pressures, lack of
success in technological advancements, risks associated with foreign operations
(including the downturn of economic trends and unfavorable currency movements in
the Asia Pacific and Latin American marketplace), 


                                       11

<PAGE>   12

risks associated with the Company's efforts to comply with Year 2000
requirements, risks associated with the Company's new business practices,
processes and information systems, and other factors, including those listed
below. Other facts that may affect such results and financial condition are set
forth in the Company's 1998 Annual Report to Stockholders which is incorporated
by reference in the Company's Form 10-K.


RESULTS OF OPERATIONS

NET REVENUES

Net revenues were $2,784.4 million for the second quarter of fiscal 1999 and
$5,275.6 million for the first six months of fiscal 1999, representing increases
of 13.6% and 16.0%, respectively, over the corresponding periods of fiscal 1998.

Sun's products net revenues were $2,384.7 million for the second quarter of
fiscal 1999, an increase of $222.7 million or 10.3% over the second quarter of
fiscal 1998. Net product revenues were $4,540.9 million for the six months ended
December 27, 1998, an increase of $531.0 million or 13.2% over the corresponding
period of fiscal 1998. More than 50% of the growth in products revenues for
the quarter ended December 27, 1998 resulted from strong demand for low-end
desktop products and workgroup servers, and to a lesser extent from increased
revenues generated by richly configured enterprise servers. More than 50% of
the growth in products revenues for the six month period ended December 27, 1998
resulted from strong demand for low-end desktop products and workgroup servers
and to a lesser extent, the Company's storage products. The growth in product
revenues in both the quarter and year to date periods was partially offset by a
decline in high-end desktop product volumes as the result of a shift in customer
purchasing patterns towards low-end desktop products and workgroup servers.

Sun's services net revenues were $399.7 million for the second quarter of fiscal
1999, an increase of $111.4 million or 38.6% over the second quarter of fiscal
1998. Net revenues from services were $734.8 million for the six months ended
December 27, 1998, an increase of $195.8 million or 36.3% over the corresponding
period of fiscal 1998. The increases in services revenues are primarily the
result of a larger installed product base due to increased product unit sales,
as well as increased revenues associated with Sun's professional and educational
services.

Domestic net revenues increased by 10.1% and 14.9 % in the second quarter and
first six months of fiscal 1999, respectively. International net revenues
(including United States exports) grew 17.2% and 17.1% in the second quarter and
first six months of fiscal 1999, respectively, compared with the corresponding
periods of fiscal 1998. In US dollars, European net revenues increased 22.7% and
28.7%, Rest of World (ROW) net revenues increased 7.1% and 10.8%, and Japanese
net revenues increased 13.8% and decreased 3.3%, in the second quarter and first
six months of fiscal 1999, respectively, when compared with the corresponding
periods of fiscal 1998. The increases in Europe and the ROW are due to continued
market acceptance of Sun's network computing products and services primarily in
the United Kingdom and Germany. The Company attributes the increase in Japanese
revenues in the second quarter to increased demand within the region for Sun's
products, rather than a sign of strengthening in the Asian economies. Sun
remains cautious with regard to the Japanese market and does not expect the
current Japanese Macroeconomic trends to change significantly or materially in
the near term. The foregoing is a forward-looking statement that is subject to
risks and uncertainties, and actual results may differ materially from those set
forth in such statement as the result of a number of factors. In particular, if
the economic trends in Japan significantly worsen in a quarter or decline over
an extended period of time, the Company's results from operations and cash flows
would be adversely affected.

A portion of the Company's operations consists of manufacturing and sales
activities in foreign jurisdictions. As a result, the Company's results could be
significantly adversely affected by factors such as changes in foreign currency
exchange rates or economic conditions in the foreign markets in which the
Company distributes its 


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<PAGE>   13

products. The Company is primarily exposed to changes in exchange rates on the
Japanese yen, British pound sterling, French franc and German mark. When the
U.S. dollar strengthens against these currencies, the U.S. dollar value of
non-U.S. dollar-based sales decreases. When the U.S. dollar weakens against
these currencies, the U.S. dollar value of non-U.S. dollar-based sales
increases. Correspondingly, the U.S. dollar value of non-U.S. dollar-based costs
increases when the U.S. dollar weakens and decreases when the U.S. dollar
strengthens. Overall the Company is a net receiver of currencies other than the
U.S. dollar and, as such, benefits from a weaker dollar, and is adversely
affected by a stronger dollar relative to major currencies worldwide.
Accordingly, changes in exchange rates, and in particular a strengthening of the
U.S. dollar, may adversely affect the Company's consolidated sales and gross
margins as expressed in U.S. dollars.

To mitigate the short-term effect of changes in currency exchange rates on the
Company's non-US dollar-based sales, product procurement, and operating
expenses, the Company regularly hedges its net non-U.S. dollar-based exposures
by entering into foreign exchange forward and option contracts to hedge
transactions. Currently, hedge contracts do not extend beyond three months.
Given the short-term nature of the Company's foreign exchange forward and
options contracts, the Company's exposure to risk associated with currency
market movement on these instruments is not material.


GROSS MARGIN

Total gross margin was 51.6% for the second quarter of fiscal 1999 and 51.4% for
the first six months of fiscal 1999, compared with 52.2% and 51.7%,
respectively, for the corresponding periods of fiscal 1998.

Products gross margin was 53.0% in the second quarter of fiscal 1999 and 53.5%
for the first six months of fiscal 1999, compared with 53.9% and 53.6%,
respectively, for the corresponding periods of fiscal 1998. The decrease in the
products gross margin for the second quarter of fiscal 1999 reflects the effects
of increased volumes of lower margin low-end desktop products, partially offset
by higher margin servers and reduced component costs across product lines. There
could be a further impact upon products gross profit margins as the result of
any continued shift in customer purchasing patterns towards low-end desktop
products and workgroup servers. The foregoing is a forward-looking statement
that is subject to risks and uncertainties, and actual results may differ
materially from those set forth in such statement as the result of a number of
factors. Services gross margin was 43.5% for the second quarter of fiscal 1999
and 38.2% for the first six months of fiscal 1999, compared with 39.5% and
36.8%, respectively, for the corresponding periods of fiscal 1998. The increases
in services gross margin reflect increased market penetration in Enterprise
datacenter accounts, increased enrollment in datacenter training courses and
other offerings, and continued growth in professional services offerings. These
increases have been partially offset by increased investment by the Company in
its services business.

The Company continuously evaluates the competitiveness of its product offerings.
These evaluations could result in repricing actions in the near term. Sun's
future operating results would be adversely affected if such repricing actions
were to occur and the Company were unable to mitigate the resulting margin
pressure by maintaining a favorable mix of systems, software, service, and other
products and by achieving component cost reductions, operating efficiencies and
increasing volumes.

RESEARCH AND DEVELOPMENT

Research and development (R&D) expenses increased to $303.5 million in the
second quarter of fiscal 1999, compared with $259.2 million for the second
quarter of fiscal 1998. R&D expenses were $586.8 million for the first six
months of fiscal 1999, compared with $481.8 million for the corresponding period
of fiscal 1998. As a percentage of total net revenues, R&D expenses increased to
10.9% and 11.1% for the second quarter and first six months of fiscal 1999,
respectively, compared with 10.6% in each of the corresponding periods of fiscal
1998. Both the dollar and percentage increase in R&D expenses in the second
quarter and first half of fiscal 1999 over the corresponding periods in fiscal
1998 primarily reflect increased expenditures focused on the development of
hardware and software products which utilize the Java (TM) platform and new
server and storage products. The remaining increase in R&D expenses is due to 


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<PAGE>   14
further development of products acquired through acquisitions and increased
compensation due primarily to higher levels of R&D staffing. The increase in R&D
expenses reflects the Company's belief that to maintain its competitive position
in a market characterized by rapid rates of technological advancement, the
Company must continue to invest significant resources in new systems, software
products and microprocessor development, as well as enhancements to existing
products. The Company continues to expect the level of R&D expenses to be in the
range of 10 to 11% of revenue for fiscal 1999.

SELLING, GENERAL AND ADMINISTRATIVE

Selling, general and administrative (SG&A) expenses increased to $747.6 million
in the second quarter of fiscal 1999, compared with $696.5 million for the
second quarter of fiscal 1998. SG&A expenses were $1,459.2 million for the first
six months of fiscal 1999, compared with $1,311.9 million for the corresponding
period of fiscal 1998. As a percentage of total net revenues, SG&A expenses
decreased to 26.8% and 27.7% in the second quarter and first six months of
fiscal 1999, respectively, from 28.4% and 28.8%, respectively, in the
corresponding periods of fiscal 1998. Overall SG&A spending increased by
approximately $51.1 million or 7.3% in the second quarter of fiscal 1999 in
comparison with the same period of fiscal 1998. For the six month period ended
December 27, 1998, overall SG&A spending increased by approximately $147.2
million or 11.2% in comparison to the corresponding period of fiscal 1998. The
dollar increases in fiscal 1999 are primarily attributable to increased
compensation resulting from higher levels of headcount, principally in the sales
organization, annual salary adjustments and to a lesser extent marketing costs
related to promotional programs. The dollar increase also reflects investments
aimed at improving Sun's own business processes. The Company expects to continue
to hire personnel, although at a lower rate than in fiscal 1998 and early 1999,
to further expand its demand creation programs and support organizations.

PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT

     NETDYNAMICS, INC.

On August 28, 1998, the Company acquired all of the outstanding capital stock of
NetDynamics by means of a merger transaction pursuant to which all the shares of
NetDynamics capital stock were converted into the right to receive shares of Sun
common stock based upon an agreed-upon exchange ratio which was calculated using
an agreed-upon average market price for Sun common stock. The Company issued
2,746,785 shares of Sun common stock (with a fair market value of $48.26875 per
share) as the consideration for the acquisition. The transaction was accounted
for as a purchase and the excess purchase price over the estimated fair value of
net tangible assets has been allocated to various intangible assets, primarily
consisting of developed technology ($20 million), goodwill ($36.2 million),
customer base ($10 million) and assembled workforce ($2 million). In addition to
the intangible assets acquired, the Company recorded an $80 million charge,
representing the write-off of IPRD.

At the acquisition date, NetDynamics was conducting development, engineering,
and testing activities associated with the completion of a new enterprise
application platform product scheduled to be released in mid calendar 1999. It
is anticipated that this new product offering ("NetDynamics New Product
Offering") will employ a new server-side component model, based on the
Enterprise JavaBeans (TM) ("EJB") architecture, which will allow business logic
to reside in the middle tier of the enterprise computing model independent of
the client presentation layer and independent of legacy and database systems.
This architecture is significantly different than the business logic
architecture in NetDynamics' existing product offering in which the server
components are tightly integrated with the presentation interface. The EJB
architecture will allow for the development of more robust applications with
improved reusability, better connectivity to a wide variety of data sources, and
a more-industry standard interface through the use of Java enterprise
application 


                                       14

<PAGE>   15

programming interfaces. Other new features include significant security
enhancements and performance and scalability improvements and the addition of
new platform adaptor components for legacy systems integration.

At the acquisition date, NetDynamics was in mid-stages of development and
substantial progress had been made in the areas of specifications, design, and
implementation. Remaining efforts necessary to complete the NetDynamics New
Product Offering relate primarily to coding, testing, and addressing additional
implementation issues. The Company anticipates that the NetDynamics New Product
Offering will be complete by the end of the Company's fiscal year ending June
30, 1999, after which the Company expects to begin generating economic benefits
from the value of the completed development associated with the IPRD. The
Company continues to expect expenditures to complete the NetDynamics New Product
Offering to total approximately $5.7 million in fiscal 1999 of which $2.4
million has been incurred. The preceding two sentences are forward-looking
statements that are subject to risks and uncertainties and actual results may
differ materially from those set forth in such sentences as a result of a number
of factors. In particular, there can be no assurance that the NetDynamics New
Product Offering will be completed by the end of the Company's fiscal year
ending June 30, 1999, that it will meet either technological or commercial
success or that the Company will receive any economic benefit from the
NetDynamics New Product Offering. In addition, the expenditures related to
completing the NetDynamics New Product Offering may exceed the Company's current
estimates as a result of delays in the development of the technology, the
complexity of the technology, changes in customer needs, or for other reasons.


     I-PLANET, INC.

On September 28, 1998 the Company acquired all of the outstanding capital stock
of i-Planet by means of a merger transaction pursuant to which all the shares of
i-Planet capital stock were converted into the right to receive cash. The
transaction was accounted for as a purchase and the excess purchase price over
the estimated fair value of net tangible assets has been allocated to various
intangible assets, primarily consisting of developed technology ($3.3 million)
and goodwill type assets ($18.3 million). In addition to the intangible assets
acquired, the Company recorded an $8.4 million charge, representing the
write-off of IPRD.

At the acquisition date, i-Planet was conducting development, engineering, and
testing activities associated with the completion of a new Java technology-based
remote Internet access product scheduled to be released in early calendar 1999.
It is anticipated that this new product offering ("i-Planet New Product
Offering") when combined with a new Sun software product will be designed to
allow cost-effective, secure, and ubiquitous internet access for applications
such as remote access to corporate intranets, supply chain management and
commerce applications.

At the acquisition date, i-Planet was in mid-stages of development and
substantial progress had been made in the areas of specifications, design, and
implementation. Remaining efforts necessary to complete the i-Planet New Product
Offering relate primarily to coding, testing, and addressing additional
implementation issues. The Company anticipates that the i-Planet New Product
Offering will be complete by the end of the Company's third quarter of fiscal
1999, after which the Company expects to begin generating economic benefits from
the value of the completed development associated with the IPRD. Expenditures to
complete the i-Planet New Product Offering are expected to total approximately
$6 million in fiscal 1999. The preceding two sentences are forward-looking
statements that are subject to risks and uncertainties and actual results may
differ materially from those set forth in such sentences as a result of a number
of factors. In particular, there can be no assurance that the i-Planet New
Product Offering will be completed by the end of the Company's fiscal year
ending June 30, 1999, that it will meet either technological or commercial
success or that the Company will receive any economic benefit from the i-Planet
New Product Offering. In addition, the expenditures related to completing the
i-Planet New Product Offering may exceed the Company's current estimates as a
result of delays in the development of the technology, the complexity of the
technology, changes in customer needs, or for other reasons.

     BEDIUN COMMUNICATIONS INCORPORATED

On October 16, 1998, the Company acquired all of the outstanding capital stock
of Beduin by means of a share purchase transaction pursuant to which all the
shares of Beduin capital stock were converted into the right to receive cash.
The transaction was accounted for as a purchase and the excess purchase price
over the estimated fair value of net tangible assets has been allocated to
various intangible assets, primarily consisting of developed technology ($3.1
million) and goodwill type assets ($1.4 million). In addition to the intangible
assets acquired, the Company recorded an $3.6 million charge, representing the
write-off of IPRD.

At the acquisition date, Bediun was conducting development, engineering, and
testing activities associated with the completion of a suite of products
("Bediun New Product Offerings") which included: Lifestyle Manager Personal
Information Manager ("PIM") (a next generation PIM targeted at smart devices
incorporating Java technology), and email Client (a next generation email client
specialized to take advantage of the benefits of 


                                       15

<PAGE>   16

these smart devices). The Lifestyle PIM and the email client were scheduled to
be released in the second quarter of calendar year 1999. It is anticipated that
these Bediun New Product Offerings will provide the core functionality for smart
devices incorporating Java technology and enable more efficient communication,
regardless of time, location or type of device. These Bediun New Product
Offerings are designed to integrate and synchronize communications and data
processing systems to enable communications across time and space.

At the acquisition date, Bediun was in mid-stages of development and substantial
progress had been made in the areas of specifications, design, and
implementation. Remaining efforts necessary to complete the Bediun New Product
Offerings relate primarily to coding, testing, and addressing additional
implementation issues. The Company anticipates that the Bediun New Product
Offerings will be complete during the fourth quarter of the Company's fiscal
year ending June 30, 1999, after which the Company expects to begin generating
economic benefits from the value of the completed development associated with
the IPRD. Expenditures to complete the Bediun New Product Offerings are expected
to total approximately $1 million in fiscal 1999. The preceding two sentences
are forward-looking statements that are subject to risks and uncertainties and
actual results may differ materially from those set forth in such sentences as a
result of a number of factors. In particular, there can be no assurance that the
Bediun New Product Offerings will be completed by the end of the Company's
fiscal year ending June 30, 1999, that it will meet either technological or
commercial success or that the Company will receive any economic benefit from
the Bediun New Product Offerings. In addition, the expenditures related to
completing the Bediun New Product Offerings may exceed the Company's current
estimates as a result of delays in the development of the technology, the
complexity of the technology, changes in customer needs, or for other reasons.


     VALUATIONS OF IPRD

For financial reporting purposes, the Company is required to determine the fair
value of all identified intangible assets and expense the fair value associated
with IPRD for which there is no alternative future use for each of its
acquisitions. The allocation of $80 million, $8.4 million, and $3.6 million of
the purchase price to IPRD in the case of the NetDynamics, i-Planet and Bediun
acquisitions, respectively, represents the estimated fair values based on risk
adjusted cash flows related to each incomplete project. The Company believes
that such fair values do not exceed the amount a third party would pay for each
such in-process technology. At the date of each of the acquisitions, the
projects associated with the IPRD efforts had not yet reached technological
feasibility and the R&D in progress had no alternative future uses. Accordingly,
these costs were expensed.

Forecasts of future results that management believes are likely to occur were
the basis for assigning value to IPRD. For the NetDynamics, i-Planet, and Bediun
acquisitions, the values assigned to IPRD were determined by estimating the
costs to develop the purchased in-process technology into commercially viable
products, estimating the resulting net cash flows from each project, excluding
the cash flows related to the portion of each project that was incomplete at the
acquisition date, and discounting the resulting net cash flows to their present
value. Each of these forecasts were based upon future discounted cash flows,
taking into account the state of development of each in-process project, the
cost to complete that project, the expected income stream, the life cycle of the
product ultimately developed, and the risks associated with successful
development and commercialization of each project. Projected future net cash
flows attributable to the in-process technology, assuming successful development
of such technologies, were discounted to their present value using a discount
rate which was derived based on the Company's estimated weighted average cost of
capital ("WACC") plus a risk premium to account for the inherent uncertainty
surrounding the successful completion of each project and the associated
estimated cash flows. The discount rates used in valuing the net cash flows from
each purchased in-process technology were 20% for the NetDynamics acquisition,
25% for the i-Planet acquisition, and 40% for the Bediun acquisition. These
discount rates are higher than the WACC due to the inherent uncertainties in the
estimates described above, including the uncertainty surrounding the successful
development of the purchased in-process technologies, the useful life of such
technologies, the profitability levels of such technology and the uncertainty of
technological advances that are unknown at this time.

The estimates utilized in the valuation of the IPRD charges are subject to
change, given the uncertainties of the development process, and no assurance can
be given that deviations from these estimates will not occur. Management expects
to continue its development each project and believes that there is a reasonable
chance of successfully completing such development. However, there is risk
associated with the completion of the in-process projects and there can be no
assurance that any project will meet with either technological or commercial
success. Failure to successfully develop and commercialize these in-process
projects would result 


                                       16

<PAGE>   17

in the loss of the expected economic return inherent in the fair value
allocation. Additionally, the value of other intangible assets acquired may
become impaired. The foregoing statements in this paragraph are forward-looking
statements that are subject to risks and uncertainties, and actual results may
differ materially from those set forth in such statements as the result of a
number of factors, including those stated in this paragraph.

Purchased IPRD of $110.1 million and $162.3 million in the second quarter and
first six months of fiscal 1998, respectively, represent the write-off of
purchased IPRD associated with the Company's acquisitions of Chorus Systems
S.A., and the storage products business of Encore Computer Corporation in the
second quarter of fiscal 1998 and Diba, Inc. and Integrity Arts, Inc. in the
first quarter of fiscal 1998.

INTEREST INCOME, NET

Net interest income was $20.3 million for the second quarter and $35.7 million
for the first six months of fiscal 1999, compared with $10.2 million and $20.8
million, respectively for the corresponding periods in fiscal 1998. The
increases in 1999 are primarily the result of higher interest earnings due to a
larger average portfolio of cash and short-term investments.

INCOME TAXES

The Company's effective income tax rate was 33% for the second quarter and first
six months of fiscal 1999, before non-recurring tax charges of $3.2 million
resulting from a write-off of IPRD associated with the acquisition of i-Planet
in the second quarter of fiscal 1999 and $30.4 million resulting from a
write-off of IPRD associated with the acquisition of NetDynamics in the first
quarter of fiscal 1999. The effective tax rate including such charges for the
second quarter and six months ended December 27, 1998 was 33.8% and 38.5%,
respectively. The Company's effective income tax rate for the second quarter and
six months ended December 28, 1997 was 33% before a tax charge of $19.8 million
resulting from a write-off of IPRD associated with the acquisitions of Diba Inc.
and Integrity Arts, Inc. in the first quarter of fiscal 1998. The Company
currently expects its effective tax rate to remain at 33% for the balance of
fiscal 1999, exclusive of any acquisition- related charges.

FUTURE OPERATING RESULTS

COMPETITION

The markets for Sun's hardware and software products and services are intensely
competitive and subject to continuous, rapid technological change, short product
life cycles and frequent product performance improvements and price reductions.
Due to the breadth of the Company's product lines and the scalability of its
products and network computing model, Sun competes principally with
Hewlett-Packard Company, International Business Machines Corporation, Compaq
Computer Corporation, Silicon Graphics, Inc. and EMC Corporation, in many
segments of the network computing market across a broad spectrum of customers.
The Company expects the markets for its products, technologies, and services, as
well as its competitors within such markets, will continue to change as the
rightsizing trend shifts customer buying patterns to network-based systems which
often employ solutions from multiple vendors. Competition in these markets will
also continue to intensify as Sun and many of its competitors, aggressively
position themselves to benefit from this shifting of customer buying patterns
and demand. The Company is also facing competition from certain systems
manufacturers, including Dell Computer Corporation and certain of its
competitors listed above, whose products are based on microprocessors from Intel
Corporation coupled with Windows NT operating system software from Microsoft
Corporation. These products demonstrate the viability of certain networked
personal computer solutions and have increased the competitive pressure,
particularly in the Company's workstation and 


                                       17

<PAGE>   18

lower-end server product lines. Finally, the timing of introductions of new
products and services by Sun's competitors may negatively impact the future
operating results of the Company, particularly when such introductions occur in
periods leading up to the Company's introduction of its own new enhanced
products. The Company expects this pressure to continue and intensify throughout
fiscal 1999. While many other technical, service and support capabilities affect
a customer's buying decision, the Company's future operating results will
depend, in part, on its ability to compete with these technologies.

PRODUCT DEVELOPMENT

The Company's future operating results will depend to a considerable extent on
its ability to rapidly and continuously develop, introduce, and deliver in
quantity new systems, software, and service products, as well as new
microprocessor technologies, that offer its customers enhanced performance at
competitive prices. The development of new high-performance computer products,
such as the Company's recent development of the UltraSPARC microprocessor is a
complex and uncertain process requiring high levels of innovation from the
Company's designers and suppliers, as well as accurate anticipation of customer
requirements and technological trends. Once a hardware product is developed, the
Company must rapidly bring such products to volume manufacturing, a process that
requires accurate forecasting of volumes, mix of products and configurations,
among other things, in order to achieve acceptable yields and costs. Future
operating results will depend to a considerable extent on the Company's ability
to closely manage product introductions in order to minimize unfavorable
patterns of customer orders, to reduce levels of older inventory and to ensure
that adequate supplies of new products can be delivered to meet customer demand.
The ability of the Company to match supply and demand is further complicated by
the Company's need to adjust prices to reflect changing competitive market
conditions as well as the variability and timing of customer orders with respect
to the Company's older products. As a result, the Company's operating results
could be materially adversely affected if the Company is not able to correctly
anticipate the level of demand for the mix of products. Because the Company is
continuously engaged in this product development, introduction, and transition
process, its operating results may be subject to considerable fluctuation,
particularly when measured on a quarterly basis.

MANUFACTURING AND SUPPLY

Sun uses many standard parts and components in its products and believes there
are a number of competent vendors for most parts and components. However, a
number of important components are developed by and purchased from single
sources due to price, quality, technology or other considerations. In some
cases, those components are available only from single sources. In particular,
Sun is dependent on Sony Corporation for various monitors and on Texas
Instruments Incorporated for different implementations of SPARC(TM)
microprocessors. Certain custom silicon parts are designed by and produced on a
contractual basis for Sun. The process of substituting a new producer of such
parts could materially adversely affect Sun's operating results. Some suppliers
of certain components, including color monitors and custom silicon parts,
require long lead times such that it can be difficult for the Company to plan
inventory levels of components to consistently meet demand for Sun's products.
Certain other components, especially memory integrated circuits such as DRAMs,
SRAMs, and VRAMs, have from time to time been subject to industry wide
shortages. Future shortages of components could negatively affect the Company's
ability to match supply and demand, and therefore could materially adversely
impact the Company's future operating results.

The Company is increasingly dependent on the ability of its suppliers to design,
manufacture, and deliver advanced components required for the timely
introduction of new products. The failure of any of these suppliers to deliver
components on time or in sufficient quantities, or the failure of any of the
Company's own designers to develop advanced innovative products on a timely
basis, could result in a material adverse impact on the Company's operating
results. The inability to secure enough components to build products, including
new products, in the quantities and configurations required, or to produce, test
and deliver sufficient products to meet demand in a timely manner, would
materially adversely affect the Company's net revenues and operating 


                                       18

<PAGE>   19

results. To secure components for development, production, and introduction of
new products, the Company frequently makes advanced payments to certain
suppliers and often enters into noncancelable purchase commitments with vendors
early in the design process. Due to the variability of material requirement
specifications during the design process, the Company must closely manage
material purchase commitments and respective delivery schedules. In the event of
a delay or flaw in the design process, the Company's operating results could be
materially adversely affected due to the Company's obligations to fulfill such
noncancelable purchase commitments.

SALES, DISTRIBUTION AND MARKETING

Generally, the computer systems sold by Sun, such as products based on
UltraSPARC (TM) processors, are the result of hardware and software development,
such that delays in the software development can delay the ability of the
Company to ship new hardware products. In addition, adoption of a new release of
an operating system may require effort on the part of the customer and porting
by software vendors providing applications. As a result, the timing of
conversion to a new release is inherently unpredictable. Moreover, delays by
customers in adopting a new release of an operating system can limit the
acceptability of hardware products tied to that release. Such delays could
materially adversely affect the future operating results of the Company.

A significant portion of the Company's revenues is derived from international
sales and is therefore subject to inherent risks related thereto, including the
general economic and political conditions in each country, currency exchange
rate fluctuations, the effect of the tax structures of various jurisdictions,
changes to and compliance with a variety of foreign laws and regulations, trade
protection measures and import and export licensing requirements. There can be
no assurance that the economic crisis and currency issues currently being
experienced in certain parts of Asia will not have an adverse effect on the
Company's revenue or revenue growth rates in the future. The impact of any of
the foregoing factors could have a material adverse effect on the Company's
future financial condition and operating results.

Seasonality also affects the Company's operating results, particularly in the
first and third quarter of each fiscal year. In addition, the Company's
operating expenses are increasing as the Company continues to expand its
operations, and future operating results will be adversely affected if revenues
do not increase accordingly. Additionally, the Company plans to continue to
evaluate and, when appropriate, make acquisitions of complementary technologies,
products or businesses. As part of this process, the Company will continue to
evaluate the changing value of its assets, and when necessary, make adjustments
thereto. Acquisitions may involve amortization of acquired intangible assets in
periods following such acquisitions. In addition, acquisition transactions are
accompanied by a number of risks, including, among other things, those
associated with integrating operations, personnel, and technologies acquired,
and the potential for unknown liabilities of the acquired business.

One customer accounted for more than 10% of revenues in fiscal 1998. Any
termination by a significant customer of its relationship with the Company or
material reduction in the amount of business such a customer does with the
Company could materially adversely effect the Company's business, financial
condition or operating results.

BUSINESS PRACTICES, PROCESSES AND INFORMATION SYSTEMS

In order to remain competitive in a rapidly changing industry, the Company is
continually improving and changing its business practices, processes, and
information systems. In this regard, during fiscal 1999 the Company implemented
a number of new business practices and a series of related information systems
across the enterprise that affect numerous operational and financial systems and
processes. Although the systems were fully operational by the end of the second
quarter of fiscal 1999, these systems will be further tested in the second half
of the Company's fiscal year, and in particular, the fourth quarter to the
extent that the Company 


                                       19

<PAGE>   20

experiences higher volumes of orders and shipments as it has typically
experienced during these periods. In addition, during the balance of fiscal
1999, the Company expects to continue its efforts to optimize usage of systems
capabilities, enhance user skills surrounding system features, and reduce
runtime errors. However, there can be no assurance that the system will be able
to support the increased volume of activities expected at the Company's fiscal
year end.

The time period in which the new business practices and related information
systems will be fully tested and leveraged are forward-looking statements
subject to risks and uncertainties, and actual results may differ materially
from those set forth above as a result of a number of risk factors. In
particular, the ability to fully leverage systems capabilities are subject to a
number of risks, including the complexity of the new systems themselves and the
need for substantial and comprehensive employee training in connection with the
adoption of such new business practices and information systems. While the
Company has tested these new systems and processes in advance of their
implementation and continues to monitor the systems and processes ability to
support increased volumes of transactions, there are inherent limitations in the
Company's ability to simulate a full-scale operating environment in advance of
actual transaction volumes. Any increase in the volume of orders and shipments
of products during the last half of the fiscal year may have a material adverse
effect on the Company's business and operating results, if the systems and
processes are unable to support the increased volume of activity. In addition,
to the extent that the Company encounters problems with these new systems and
practices that prevent or limit their full utilization, there could be a
material adverse impact on the Company's operating results.

YEAR 2000 COMPLIANCE

Many currently installed computer systems and software products are coded to
accept only two digit entries in the date code field. As the Year 2000
approaches, these code fields will need to be able to distinguish years
beginning with "19" from those beginning with "20." As a result, in less than a
year, computer systems and/or software products used by many companies may need
to be upgraded to comply with such Year 2000 requirements. The Company is
currently expending resources to review its products and services, as well as
its internal use software in order to identify and modify those products,
services and systems that are not Year 2000 compliant. The Company believes that
the vast majority of these costs are not incremental to the Company but
represent a reallocation of existing resources and include regularly scheduled
system upgrades and maintenance. In addition, the Company is working to make
custom coding enhancements to its internal systems (described in the above
paragraphs) so that such systems will be Year 2000 compliant by the end of
fiscal year 1999.

Although the Company believes that the costs associated with the aforementioned
Year 2000 efforts are not material, the Company currently estimates that such
costs will be approximately $35 million, of which approximately $5 million has
been spent to date. The aforementioned costs are estimates due in large part to
the fact that the Company does not separately track the internal labor costs
associated with Year 2000 compliance, unless such costs are incurred by
individuals devoted primarily to Year 2000 compliance efforts. These cost
estimates do not include any potential costs related to any customer or other
claim. In addition, these cost estimates are based on the current assessment of
the ongoing activities described above, and are subject to change as the Company
continuously monitors these activities. The Company believes any modifications
deemed necessary will be made on a timely basis and does not believe that the
cost of such modifications will have a material adverse effect on the Company's
operating results. The Company currently expects the aforementioned evaluation
of its products, services, and systems and any remediation necessary will be
completed by the end of fiscal year 1999. The Company's expectations as to the
extent and timeliness of any modifications required in order to achieve Year
2000 compliance and the costs related thereto are forward-looking statements
subject to risks and uncertainties. Actual results may vary materially as a
result of a number of factors, including, among others, those described in this
section. There can be no assurance however, that the Company will be able to
successfully 


                                       20

<PAGE>   21

modify on a timely basis such products, services and systems to comply with Year
2000 requirements, which failure could have a material adverse effect on the
Company's operating results.

The Company has established a program to assess whether certain of its products
are Year 2000 compliant. Under the program, the Company is in the process of
performing tests on its products listed on the Company's price lists. To monitor
this program and to help customers evaluate their Year 2000 issues the Company
has created a web site at http://sun.com/y2000/cpl.html which identifies the
following categories: products that were released Year 2000 compliant; products
that require modifications to be Year 2000 compliant; products under review;
products that are not Year 2000 compliant and need to be replaced with a Year
2000 compliant product; source code products that could be modified and
implemented without Sun's review; and products that do not process or manipulate
date data or have no date-related technology. This list is periodically updated
as analysis of additional products is completed.

Based on the Company's assessment to date, most newly introduced products and
services of the Company are Year 2000 compliant, however, there can be no
assurance that the Company's current products do not contain undetected errors
or defects associated with Year 2000 functions that may result in material costs
to the Company. In addition, some of the Company's customers are running
products that are not Year 2000 compliant and will require an upgrade or other
remediation to become Year 2000 compliant. The Company provides limited
warranties as to Year 2000 compliance on certain of its products and services.
Except as specifically provided for in the limited warranties, the Company does
not believe it is legally responsible for costs incurred by customers to achieve
Year 2000 compliance. The Company has been taking steps to identify affected
customers, raise customer awareness related to noncompliance of the Company's
older products and encourage such customers to migrate to current products or
product versions. It is possible that the Company may experience increased
expenses in addressing migration issues for such customers or customer
dissatisfaction as a result of Year 2000 issues, which may have a material
adverse effect on the Company's operating results.

The Company also faces risks to the extent that suppliers of products, services
and systems purchased by the Company and others with whom the Company transacts
business on a worldwide basis do not have business systems or products that
comply with Year 2000 requirements. To the extent that Sun is not able to test
technology provided by third party hardware or software vendors, Sun is in the
process of obtaining Year 2000 compliance certifications from each of its major
vendors that their products and internal systems, as applicable, are Year 2000
compliant. In the event any such third parties cannot timely provide the Company
with products, services or systems that meet the Year 2000 requirements, the
Company's operating results could be materially adversely affected. Furthermore,
a reasonably likely worst case scenario would be if one of the Company's major
vendors experienced a material disruption in business, which caused the Company
to experience a material disruption in business, such a disruption would have a
material adverse effect on the Company's business, financial condition and
operating results. Should either the Company's internal systems or the internal
systems, products or services of one or more of the Company's major vendors fail
to achieve Year 2000 compliance, the Company's business, financial position or
results of operations could be materially adversely affected. The Company is
currently developing contingency plans to deal with potential Year 2000 problems
related to its internal systems and products and services provided by outside
vendors and expects these plans to be complete by the end of fiscal year 1999.

Although the Company believes that the cost of Year 2000 modifications for both
internal use software and systems, as well as the Company's products are not
material, there can be no assurance that various factors relating to the Year
2000 compliance issues will not have a material adverse effect on the Company's
business, operating results or financial position. For example, a significant
amount of litigation may arise out of Year 2000 compliance issues and there can
be no assurance as to the extent the Company may be affected by any such
litigation. Even though the Company does not believe that it is legally
responsible for its customer's Year 2000 compliance obligations, it is unclear
whether different governments or governmental agencies may decide 


                                       21

<PAGE>   22

to allocate liability relating to Year 2000 compliance to the Company without
regard to specific warranties or warranty disclaimers. Such allocation of
liability could have a materially adverse effect on the Company's financial
condition and results of operations in any given quarter. Furthermore, it is
unknown how customer spending patterns may be impacted by Year 2000 issues. As
customers focus on preparing their businesses for the Year 2000, capital budgets
may be spent on remediation efforts, potentially delaying the purchase and
implementation of new systems, thereby creating less demand for the Company's
products and services. These as well as other factors could have a material
adverse effect on the Company's revenues or operating results.

EURO COMPLIANCE

Eleven of the fifteen member countries of the European Union established fixed
conversion rates between their existing sovereign currencies and the Euro and
adopted the Euro as their common legal currency effective for the initial
implementation date of January 1, 1999. The Euro trades on currency exchanges
and is available for non-cash transactions, while the legacy currencies will
remain legal tender in the participating countries for a transition period
between January 1, 1999 and January 1, 2002. During the transition period,
cash-less payments can be made in the Euro and parties can elect to pay for
goods and services and transact business using either the Euro or the legacy
currency. Between January 1, 2002 and July 1, 2002, the participating countries
will introduce Euro notes and coins and withdraw all legacy currencies.

The Company has expended and continues to expend resources to review and modify
its products to support the Euro's requirements, determine pricing strategies in
the new economic environment, analyze the legal and contractual implications for
contracts, evaluate system capabilities, and ensure banking vendors can support
the Company's operations with respect to Euro transactions for the initial
implementation as of January 1, 1999 and during the transition period through to
January 1, 2002 and thereafter. The Company does not expect that the
introduction and use of the Euro will materially affect the Company's foreign
exchange and hedging activities, expects that modifications will be made to its
business operations and systems, as necessary, on a timely basis and does not
believe that the cost of such modifications will have a material adverse impact
on the Company's operating results. The Company's expectations as to the extent
and timeliness of modifications required to accommodate the conversion to Euro
transactions is a forward-looking statement subject to risks and uncertainties.
Actual results may vary materially, as a result of a number of factors,
including among others, those described in this paragraph. There can be no
assurance that the Company will be able to complete such modifications to comply
with Euro requirements, which could have a material adverse effect on the
Company's operating results. In addition, the Company faces risks to the extent
that vendors upon whom the Company relies and their suppliers are unable to make
appropriate modifications to support Euro transactions. The Company has not yet
completed its evaluation of the impact of the Euro upon its functional currency
designations.

While the Company cannot predict what effect these various factors may have on
its financial results, the aggregate effect of these and other factors could
result in significant volatility in the Company's future performance and stock
price.


LIQUIDITY AND CAPITAL RESOURCES

The Company's financial condition strengthened as of December 27, 1998 when
compared with June 30, 1998. During the first six months of fiscal 1999, cash
flows from operating activities generated $771.8 million in cash and cash
equivalents. Non-cash expenses affecting cash provided by operating activities
in the first six months of fiscal 1999 included depreciation and amortization
expense of $313.4 million, tax benefits of options exercised of $96.8 million
and charges for IPRD of $92 million in connection with the acquisitions of


                                       22

<PAGE>   23

NetDynamics, i-Planet and Bediun. Favorably impacting cash provided by
operations were increases in accounts payable and other liabilities of $114.7
million and $144.5 million, respectively, which reflect the timing of payments
for inventory and other items. Offsetting these items, accounts receivable
increased $258.7 million which reflects an increase in days sales outstanding.
Additionally, other current assets increased due to the timing of payments for
insurance and other taxes. Other long-term assets increased primarily due to an
increase in intangible assets in connection with the acquisition of NetDynamics.

The Company's investing activities used $907.5 million of cash in the first six
months of fiscal 1999, an increase of $353 million from the prior year's
comparable period. The increase resulted primary from increased acquisitions of
short-term investments during the first six months of fiscal 1999, as compared
with the prior year's comparable period. Also included in investing activities
is capital spending for real estate development, as well as capital additions to
support increased headcount, primarily in the Company's engineering, services
and marketing organizations.

At December 27, 1998, the Company's primary sources of liquidity consisted of
cash, cash equivalents and short-term investments of $1,572.8 million and a
revolving credit facility with banks aggregating $500 million, which was
available subject to compliance with certain covenants. Additionally, on October
16, 1997, the Company filed a Registration Statement with the Securities and
Exchange Commission relating to the registration for public offering of senior
and subordinated debt securities and common stock with an aggregate initial
public offering price of up to $1 billion. On October 24, 1997, the Registration
Statement became effective, so that the Company may now choose to offer, from
time to time, the securities pursuant to Rule 415 in one or more separate
series, in amounts, at prices and on terms to be set forth in the prospectus
contained in the Registration Statement and in one or more supplements to the
prospectus. The Company believes that the liquidity provided by existing cash
and short-term investment balances and the borrowing arrangements described
above will be sufficient to meet the Company's capital requirements through
fiscal 1999. However, the Company believes the level of financial resources is a
significant competitive factor in its industry and may choose at any time to
raise additional capital through debt or equity financing to strengthen its
financial position, facilitate growth and provide the Company with additional
flexibility to take advantage of business opportunities that may arise.


                                       23

<PAGE>   24

                           PART II - OTHER INFORMATION

ITEM 1 - LEGAL PROCEEDINGS

On October 7, 1997, the Company filed suit against Microsoft Corporation in the
United States District Court for the Northern District of California alleging
breach of contract, trademark infringement, false advertising, unfair
competition, interference with prospective economic advantage and inducing
breach of contract. The Company filed an amended complaint on October 14, 1997.
Microsoft Corporation filed its answer, affirmative defenses and counterclaims
to the amended complaint. The counterclaims include breach of contract, breach
of the covenant of good faith and fair dealing, violation of the California
Business & Professions Code and declaratory judgment. The Company believes that
the counterclaims are without merit and/or that the Company has affirmative
defenses and intends vigorously to defend itself with respect thereto. On March
24, 1998 the United States District Court judge ruled in favor of the Company
granting a preliminary injunction directing Microsoft Corporation to cease using
the Company's Java Compatible Logo(TM) on Microsoft products that failed to pass
the applicable test suites from Sun. In addition, on May 12, 1998, the Company
filed a second amended complaint alleging copyright infringement by Microsoft
and motions requesting further preliminary injunctive relief directed against
the planned release by Microsoft of additional products that failed to pass the
applicable test suites from Sun. The Court held hearings and arguments on such
motions on September 8, 9, and 10, 1998. On November 17, 1998, the District
Court issued an Order granting, in substantial part, Sun's request for
preliminary injunctions. On December 15, 1998 Microsoft filed notice of its
intent to appeal the District Court's Order and on December 18, 1998 Microsoft
filed Motions with the District Court to extend the time for compliance with the
Order and to clarify or modify the Order. On December 29, 1998 the District
Court issued a further Order directing the parties to schedule a settlement
conference with respect to certain issues before a designated Magistrate or
mutually selected individual. On January 13, 1999, Microsoft filed an appeal to
the District Court's Order issued on November 17, 1998. The Company believes
that the outcome of this matter will not have a material adverse impact on Sun's
financial condition, results of operations or cash flows in any given fiscal
year.

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

     On November 11, 1998 the Annual Meeting of Stockholders of the Company was 
held in Menlo Park, California. The results of voting of the 313,381,495 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                   314,513,658              1,581,681
L. John Doerr                      305,306,845              10,788,494
Judith L. Estrin                   314,554,906              1,540,433
Robert J. Fisher                   314,551,674              1,543,665
Robert L. Long                     314,544,221              1,551,118
M. Kenneth Oshman                  314,556,052              1,539,287
A. Michael Spence                  314,511,203              1,584,136
</TABLE>


                                       24

<PAGE>   25

     The seven 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 1990 Long-Term
Equity Incentive Plan in order to increase the number of shares of Common Stock
authorized for issuance thereunder by 18,000,000 shares of Common Stock to an
aggregate of 119,400,000 shares. There were 193,531,834 votes cast for the
amendment, 121,004,835 votes cast against the amendment and 1,558,670
abstentions.

     The stockholders approved an amendment to the Company's 1988 Directors'
Stock Option Plan in order to decrease the number of shares of Common Stock
subject to the one-time automatic nonemployee director grant (granted on the
date of the initial appointment of a director who is not affiliated with an
entity having an equity investment in the Company) from 80,000 shares to 30,000
shares. There were 259,580,690 votes cast for the amendment, 54,345,777 votes
cast against the amendment and 2,168,872 abstentions.

ITEM 5 - OTHER INFORMATION

a) SCHEDULE OF SALES BY EXECUTIVE OFFICERS DURING THE QUARTER

     None

b) NON-RULE 14a-8 STOCKHOLDER PROPOSALS

Proposals of the Company's stockholders that such stockholders intend to present
at the Company's 1999 Annual Meeting of Stockholders (the "Annual Meeting"), but
not included in the Company's Proxy Statement and form of Proxy related to the
Annual Meeting (a "Non-Rule 14a-8 Proposal"), must be received by the Company's
Secretary at the Company's offices at 901 San Antonio Road, Palo Alto,
California 94303 no later than September 13, 1999 and no earlier than August 12,
1999. In the event that the Company does not receive timely notice with respect
to a Non-Rule 14a-8 Proposal, management of the Company would use its
discretionary authority to vote the shares it represents as the Board of
Directors may recommend.

ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K

     a)   EXHIBITS

<TABLE>
<S>                   <C>
          10.64       Registrant's 1998 Directors' Stock Option Plan as amended on
                      August 12, 1998.

          10.66(1)    Registrant's 1990 Long-Term Equity Incentive Plan, as amended
                      on August 12, 1998.

          10.93+      Strategic Development and Marketing Agreement dated November 23,
                      1998 by and between America Online, Inc. and the Registrant.

          27.0        Financial Data Schedule for the period ended December 27, 1998.
</TABLE>

     + Confidentiality Treatment Requested.

     (1)  Incorporated by reference to Exhibit 4.2 filed as an exhibit to
          Registrant's Amendment No. 1 to Registration Statement Form S-8/A file
          number 333-67183 filed with the Securities and Exchange Commission on
          January 26, 1999.

     b)   REPORTS ON FORM 8-K

     No reports on Form 8-K were filed during the quarter ended December 27, 
1998.


ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company's market risk disclosures set forth in the 1998 Form 10-K have not
changed significantly through the quarter ended December 27, 1998.


                                       25

<PAGE>   26

                                   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
                                        Vice President, Corporate Resources
                                        and Chief Financial Officer



                                        /s/ George Reyes
                                        ----------------------------------------
                                        George Reyes
                                        Vice President and Corporate Controller,
                                        Chief Accounting Officer



Dated: February 8, 1999


                                       26

<PAGE>   27

                               INDEX TO EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT
NUMBER                                                                        PAGE
-------                                                                       ----
<S>         <C>                                                               <C>
10.64       Registrant's 1998 Directors' Stock Option Plan as amended on
            August 12, 1998.

10.66(1)    Registrant's 1990 Long-Term Equity Incentive Plan, as amended
            on August 12, 1998.

10.93+      Strategic Development and Marketing Agreement dated November 23,
            1998 by and between America Online, Inc. and the Registrant.

27.0        Financial Data Schedule for the period ended December 27, 1998.
</TABLE>

        + Confidentiality Treatment Requested.

        (1) Incorporated by reference to Exhibit 4.2 filed as an exhibit to
Registrant's Amendment No. 1 to Registration Statement Form S-8/A file number
333-67183 filed with the Securities and Exchange Commission on January 26, 1999.



                                       27