**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-Q**

**(Mark One)**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe quarterly period ended October 1, 2006**

**or**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe transition period from***            *to*            *

**Commissionfile number: 0-15086**

**SUN MICROSYSTEMS, INC.**

(Exact name of registrantas specified in its charter)

| **Delaware**                     | ** ** | **94-2805249**       |
|----------------------------------|------------|----------------------|
| (State or other  jurisdiction of |       | (I.R.S. Employer     |
| incorporation or  organization)  |       | Identification  No.) |

 

**4150 Network Circle,Santa Clara, CA 95054**

(Address of principalexecutive offices with zip code)

**(650) 960-1300**

(Registrant’s telephonenumber, including area code)

**N/A**

(Former name, formeraddress and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90days.    YES  x    NO  o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer”  in Rule 12b-2of the Exchange Act) (Check one);

Large acceleratedfiler  x               Accelerated filer  o               Non-accelerated filer  o

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the ExchangeAct).    YES  o    No  x

APPLICABLE ONLY TOCORPORATE ISSUERS:

Indicate the number of shares outstanding of each ofthe issuer’s classes of common stock, as of the latest practicable date.

| **Class**                          | ** ** | **Outstanding  at November 1, 2006** |
|------------------------------------|------------|--------------------------------------|
| Common Stock -  $0.00067 par value |       | 3,519,558,876                        |

 

 

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** **

**INDEX**
| **PART I — FINANCIAL  INFORMATION** |   |                                                                                        |
|------------------------------------------|--------|---------------------------------------------------------------------------------------------|
|                                     |   |                                                                                        |   |   |
| Item 1.                             |   | Financial  Statements:                                                                      |   | 3 |
|                                     |   | Condensed Consolidated Statements of Operations                                             |   | 3 |
|                                     |   | Condensed Consolidated Balance Sheets                                                       |   | 4 |
|                                     |   | Condensed Consolidated Statements of Cash Flows                                             |   | 5 |
|                                     |   | Notes to Condensed Consolidated Financial Statements                                        |   | 6 |
|                                     |   | Report of Independent Registered Public Accounting  Firm                                    |   | 15 |
| Item 2.                             |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |   | 16 |
| Item 3.                             |   | Quantitative and Qualitative Disclosures About Market  Risk                                 |   | 26 |
| Item 4.                                  |   | Controls and Procedures                                                                     |   | 27 |
|                                     |   |                                                                                        |   |   |
| **PART  II — OTHER INFORMATION**    |   |                                                                                        |
|                                     |   |                                                                                        |   |   |
| Item 1.                             |   | Legal  Proceedings                                                                          |   | 28 |
| Item 1A.                                 |   | Risk Factors                                                                                |   | 28 |
| Item 2.                                  |   | Unregistered Sales of Equity Securities and Use of  Proceeds                                |   | 28 |
| Item 6.                             |   | Exhibits                                                                                    |   | 29 |
|                                     |   |                                                                                        |   |   |
| **SIGNATURES**                           |   | 30                                                                                          |

 

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**PART I — FINANCIALINFORMATION**

**ITEM 1. FINANCIALSTATEMENTS**

**SUN MICROSYSTEMS,INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(unaudited)(in millions, except per share amounts)**
| ** **                                                                                          | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                          | ** ** | **October 1,**              | ** ** | **September 25,** | ** ** |
| ** **                                                                                          | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| Net revenues:                                                                                       |       |                             |       |   |   |
| Products                                                                                            |       | $                                | 1,959      |   | $ | 1,704 |   |
| Services                                                                                            |       | 1,230                            |       | 1,022 |   |
| Total net  revenues                                                                                 |       | 3,189                            |       | 2,726 |   |
| Cost of sales:                                                                                      |       |                             |       |   |   |
| Cost of  sales-products (including stock-based compensation expense of $3 and $2(1))                |       | 1,123                            |       | 966 |   |
| Cost of  sales-services (including stock-based compensation expense of $8 and $7(1))                |       | 678                              |       | 558 |   |
| Total cost of  sales                                                                                |       | 1,801                            |       | 1,524 |   |
| Gross margin                                                                                        |       | 1,388                            |       | 1,202 |   |
|                                                                                                |       |                             |       |   |   |
| Operating expenses:                                                                                 |       |                             |       |   |   |
| Research and  development (including stock-based compensation expense of $18 and $17(1))            |       | 473                              |       | 439 |   |
| Selling, general  and administrative (including stock-based compensation expense of $29 and $24(1)) |       | 958                              |       | 828 |   |
| Restructuring  and related impairment of long-lived assets                                          |       | 21                               |       | 12 |   |
| Purchased  in-process research and development                                                      |       | —                           |       | 60 |   |
| Total operating expenses                                                                            |       | 1,452                            |       | 1,339 |   |
| Operating loss                                                                                      |       | (64                              | )          | (137 | ) |
| Gain on equity  investments, net                                                                    |       | —                           |       | 13 |   |
| Interest and other  income, net                                                                     |       | 42                               |       | 44 |   |
| Loss before  income taxes                                                                           |       | (22                              | )          | (80 | ) |
| Provision for income  taxes                                                                         |       | 34                               |       | 43 |   |
| Net loss                                                                                            |       | $                                | (56        | ) | $ | (123 | ) |
| Net loss per common  share-basic and diluted                                                        |       | $                                | (0.02      | ) | $ | (0.04 | ) |
| Shares used in the calculation of net loss per common share-basic and  diluted                      |       | 3,497                            |       | 3,407 |   |

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(1)                Forthe three months ended October 1, 2006 and September 25, 2005, respectively.

See accompanying notes.

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**SUN MICROSYSTEMS,INC.CONDENSED CONSOLIDATED BALANCE SHEETS(in millions)**
| ** **                                                   | ** ** | **October 1,** | ** ** | **June 30,** | ** ** |
|--------------------------------------------------------------|------------|---------------------|------------|-------------------|------------|
| ** **                                                   | ** ** | **2006**            | ** ** | **2006**          | ** ** |
| ** **                                                   | ** ** | **(Unaudited)**     | ** ** | ** **        | ** ** |
| **ASSETS**                                                   |       |                |       |              |       |
| Current assets:                                              |       |                |       |              |       |
| Cash and cash equivalents                                    |       | $                   | 3,362      |              | $          | 3,569 |   |
| Short-term marketable debt securities                        |       | 609                 |       | 496               |       |
| Accounts receivable, net                                     |       | 2,036               |       | 2,702             |       |
| Inventories                                                  |       | 584                 |       | 540               |       |
| Deferred and prepaid tax assets                              |       | 214                 |       | 209               |       |
| Prepaid expenses and other current assets                    |       | 747                 |       | 757               |       |
| Total current assets                                         |       | 7,552               |       | 8,273             |       |
| Property, plant  and equipment, net                          |       | 1,583               |       | 1,812             |       |
| Long-term  marketable debt securities                        |       | 700                 |       | 783               |       |
| Goodwill                                                     |       | 2,566               |       | 2.610             |       |
| Other  acquisition-related intangible assets, net            |       | 848                 |       | 929               |       |
| Other non-current assets, net                                |       | 645                 |       | 675               |       |
|                                                         |       | $                   | 13,894     |              | $          | 15,082 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                |       |                |       |              |       |
| Current liabilities:                                         |       |                |       |              |       |
| Current portion of long-term debt and short-term  borrowings |       | $                   | 2          |              | $          | 503 |   |
| Accounts payable                                             |       | 1,292               |       | 1,446             |       |
| Accrued payroll-related liabilities                          |       | 661                 |       | 777               |       |
| Accrued liabilities and other                                |       | 1,063               |       | 1,190             |       |
| Deferred revenues                                            |       | 1,695               |       | 1,988             |       |
| Warranty reserve                                             |       | 244                 |       | 261               |       |
| Total current liabilities                                    |       | 4,957               |       | 6,165             |       |
| Long-term debt                                               |       | 582                 |       | 575               |       |
| Long-term  deferred revenues                                 |       | 558                 |       | 506               |       |
| Other  non-current obligations                               |       | 1,388               |       | 1,492             |       |
| Stockholders’  equity                                   |       | 6,409               |       | 6,344             |       |
|                                                         |       | $                   | 13,894     |              | $          | 15,082 |   |

 

See accompanying notes.

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**SUN MICROSYSTEMS,INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited, in millions)**
| ** **                                                                                  | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                  | ** ** | **October 1,**              | ** ** | **September 25,** | ** ** |
| ** **                                                                                  | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| Cash flows from  operating activities:                                                      |       |                             |       |   |   |
| Net loss                                                                                    |       | $                                | (56        | ) | $ | (123 | ) |
| Adjustments to reconcile net loss to net cash  provided by operating activities:            |       |                             |       |   |   |
| Depreciation and amortization                                                               |       | 123                              |       | 143 |   |
| Amortization of other acquisition-related intangible  assets                                |       | 81                               |       | 46 |   |
| Stock-based compensation expense                                                            |       | 58                               |       | 50 |   |
| Purchased in-process research and development                                               |       | —                           |       | 60 |   |
| Gain on investments, net                                                                    |       | —                           |       | (13 | ) |
| Impairment of assets                                                                        |       | 8                                |       | — |   |
| Deferred taxes                                                                              |       | (3                               | )          | — |   |
| Changes in operating assets and liabilities:                                                |       |                             |       |   |   |
| Accounts receivable, net                                                                    |       | 672                              |       | 449 |   |
| Inventories                                                                                 |       | (71                              | )          | 67 |   |
| Prepaid and other assets                                                                    |       | 36                               |       | 203 |   |
| Accounts payable                                                                            |       | (151                             | )          | (174 | ) |
| Other liabilities                                                                           |       | (540                             | )          | (484 | ) |
| Net cash  provided by operating activities                                                  |       | 157                              |       | 224 |   |
| Cash flows from  investing activities:                                                      |       |                             |       |   |   |
| Purchases of marketable debt securities                                                     |       | (675                             | )          | (454 | ) |
| Proceeds from sales of marketable debt securities                                           |       | 515                              |       | 2,818 |   |
| Proceeds from maturities of marketable debt  securities                                     |       | 136                              |       | 75 |   |
| Proceeds from sales of equity investments, net                                              |       | 7                                |       | 9 |   |
| Proceeds from sales (purchases) of property, plant  and equipment, net                      |       | 160                              |       | (48 | ) |
| Purchases of spare parts and other assets                                                   |       | (34                              | )          | (20 | ) |
| Payments for acquisitions, net of cash acquired                                             |       | —                           |       | (3,150 | ) |
| Net cash  provided by (used in) investing activities                                        |       | 109                              |       | (770 | ) |
| Cash flows from  financing activities:                                                      |       |                             |       |   |   |
| Proceeds from issuance of common stock, net                                                 |       | 27                               |       | 3 |   |
| Principal payments on borrowings and other  obligations                                     |       | (500                             | )          | — |   |
| Net cash  provided by (used in) financing activities                                        |       | (473                             | )          | 3 |   |
| Net decrease in  cash and cash equivalents                                                  |       | (207                             | )          | (543 | ) |
| Cash and cash  equivalents, beginning of period                                             |       | 3,569                            |       | 2,051 |   |
| Cash and cash  equivalents, end of period                                                   |       | $                                | 3,362      |   | $ | 1,508 |   |
| Supplemental  disclosures of cash flow information:                                         |       |                             |       |   |   |
| Interest paid (net of interest received from swap  agreements of $10 and $20, respectively) |       | $                                | 30         |   | $ | 20 |   |
| Income taxes paid (received) (net of refunds of $14  and $137, respectively)                |       | $                                | 110        |   | $ | (76 | ) |
| Supplemental  schedule of noncash investing activities:                                     |       |                             |       |   |   |
| Stock and options issued in connection with  acquisitions                                   |       | —                           |       | $ | 89 |   |
| Net issuance of  nonvested stock awards (restricted stock)                                  |       | $                                | 5          |   | $ | 64 |   |

 

See accompanying notes.

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

**1. DESCRIPTION OFBUSINESS**

Sun Microsystems Inc.(Sun) provides network computing infrastructure solutions that include ComputerSystems (hardware and software), Data Management (hardware and software) andSupport Services and Client Solutions and Educational Services. Sun’s solutionsare based on Sun technology innovations such as the Java technology platform,the SolarisTM Operating System, Sun JavaTM products and the UltraSPARC® microprocessor technology, as well as otherwidely deployed technologies such as the Linux operating system and AMD OpteronTM microprocessor-based systems. Our networkcomputing infrastructure solutions are used in a wide range of technical/scientific,business and engineering applications in industries such as telecommunications,government, financial services, manufacturing, education, retail, lifesciences, media and entertainment, transportation, energy/utilities andhealthcare. We sell complete networking solutions, including products andservices, in most major markets worldwide through a combination of direct andindirect channels. In the first quarter of fiscal 2006, we completed theacquisition of Storage Technology Corporation (StorageTek) which allowed us tobroaden our offerings of storage products, services and solutions.

**2. SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

*FiscalYear*

Sun’s first threequarters in fiscal year 2007 end on October 1, 2006, December 31,2006, and April 1, 2007. In fiscal year 2006, the quarters ended on September 25,2005, December 25, 2005, and March 26, 2006. The fourth quarter inall fiscal years ends on June 30.

*Basisof Presentation*

The accompanyingcondensed consolidated financial statements (Interim Financial Statements)include the accounts of Sun and its subsidiaries. Intercompany accounts andtransactions have been eliminated.

These Interim FinancialStatements have been prepared in accordance with generally accepted accountingprinciples in the United States (U.S. GAAP) for interim financial informationand the rules and regulations of the Securities and Exchange Commission (SEC)for interim financial statements and accounting policies, consistent, in allmaterial respects, with those applied in preparing our audited consolidatedfinancial statements included in our Annual Report on Form 10-K for the fiscalyear ended June 30, 2006, filed with the SEC on September 8, 2006(2006 Form 10-K). These Interim Financial Statements are unaudited but reflectall adjustments, including normal recurring adjustments management considersnecessary for a fair presentation of our financial position, operating resultsand cash flows for the interim periods presented. The results for the interimperiods are not necessarily indicative of the results for the entire year. Thecondensed consolidated balance sheet as of June 30, 2006 has been derivedfrom the audited consolidated balance sheet as of that date. The informationincluded in this report should be read in conjunction with our 2006 Form 10-K.

*Computationof Net Income (Loss) per Common Share*

Basic net income (loss)per common share is computed using the weighted-average number of common sharesoutstanding (adjusted for treasury stock and common stock subject to repurchaseactivity) during the period.

Diluted net income (loss)per common share is computed using the weighted-average number of common anddilutive common equivalent shares outstanding during the period. Dilutivecommon equivalent shares consist primarily of stock options and nonvested stockawards. Due to our net loss for all periods presented, all of our outstandingoptions and nonvested stock awards were excluded from the diluted loss pershare calculation because their inclusion would have been anti-dilutive.

If we had earned a profitduring the three months ended October 1, 2006 and September 25, 2005,we would have added 26 million and 4 million common equivalentshares, respectively, to our basic weighted-average shares outstanding tocompute the diluted weighted-average shares outstanding.

*RecentPronouncements*

In May 2005, the FASBissued SFAS 154, “Accounting Changes and Error Corrections” (SFAS 154),which replaces Accounting Principles Board Opinions (APB) 20 “AccountingChanges” and SFAS 3, “Reporting Accounting Changes in Interim FinancialStatements — An Amendment of APB Opinion No. 28.” SFAS 154 providesguidance on the accounting for and reporting of accounting changes and errorcorrections. It establishes retrospective application, or the earliestpracticable date, as the required method for reporting a change in accountingprinciple and restatement with respect to the

6

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reporting of a correctionof an error. Our adoption of SFAS 154 in the first quarter of fiscal 2007 didnot have a material impact on our results of operations and financial position.

In July 2006, the FASBissued FASB Interpretation No. 48, Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109 (FIN 48), which clarifies theaccounting for uncertainty in tax positions. This Interpretation requires thatwe recognize in our financial statements, the impact of a tax position, if thatposition is more likely than not to be sustained on audit, based on thetechnical merits of the position. The provisions of FIN 48 are effective in thefirst quarter of fiscal 2008, with the cumulative effect, if any, of the changein accounting principle recorded as an adjustment to opening retained earnings.We are currently evaluating the impact of adopting FIN 48 on our consolidatedfinancial statements.

In September 2006,the SEC released Staff Accounting Bulletin No. 108, “Considering theEffects of Prior Year Misstatements when Quantifying Misstatements in CurrentYear Financial Statements” (SAB 108). SAB 108 provides interpretiveguidance on the SEC’s views regarding the process of quantifying materiality offinancial statement misstatements. SAB 108 is effective for fiscal yearsending after November 15, 2006, and early application for the firstinterim period of the same fiscal year is encouraged. The application ofSAB 108 in the first quarter of fiscal 2007 would not have a materialeffect on our results of operations or financial position.

In September 2006, the FASB issued Statement No. 157, “FairValue Measurements” (SFAS 157). SFAS 157 defines fair value,establishes a framework and gives guidance regarding the methods used formeasuring fair value, and expands disclosures about fair value measurements. SFAS 157is effective for financial statements issued for fiscal years beginning afterNovember 15, 2007, and interim periods within those fiscal years. We arecurrently evaluating the impact of adopting SFAS 157 on our consolidatedfinancial statements.

In September 2006, the FASB issued Statement No. 158, “Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans, anamendment of FASB Statements No. 87, 88, 106, and 132(R)” (SFAS 158)*.*SFAS 158 requires companies to recognize theoverfunded or underfunded status of a defined benefit post-retirement plan asan asset or liability in their balance sheet and to recognize changes in thatfunded status in the year in which the changes occur through comprehensiveincome, effective for fiscal years ending after December 15, 2006. SFAS 158also requires companies to measure the funded status of the plan as of the dateof its fiscal year-end, with limited exceptions, effective for fiscal yearsending after December 15, 2008. We are currently evaluating the impact ofadopting SFAS 158 on our consolidated financial statements.

**3. BALANCE SHEETDETAILS**

*Inventories*

Inventories consisted ofthe following (in millions):

|                 | ** ** | **October 1,** | ** ** | **June 30,** | ** ** |
|-----------------|------------|---------------------|------------|-------------------|------------|
| ** **      | ** ** | **2006**            | ** ** | **2006**          | ** ** |
| Raw materials   |       | $                   | 119        |              | $          | 68 |   |
| Work in process |       | 92                  |       | 97                |       |
| Finished goods  |       | 373                 |       | 375               |       |
|            |       | $                   | 584        |              | $          | 540 |   |

 

*WarrantyReserve*

We accrue for our productwarranty costs at the time of shipment. These product warranty costs areestimated based upon our historical experience and specific identification ofproduct requirements and may fluctuate based on product mix.

The following table setsforth an analysis of warranty reserve activity (in millions):

| Balance at June 30,  2006   |   | $   | 261    |   |
|----------------------------------|--------|-----|--------|--------|
| Charged to costs and expenses    |   | 75  |   |
| Utilized                         |   | (92 | )      |
| Balance at October 1,  2006 |   | $   | 244    |   |

 

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**4. GOODWILL ANDOTHER ACQUISITION-RELATED INTANGIBLE ASSETS**

Information regarding ourgoodwill by reportable segment is as follows (in millions):

|                                                     | ** ** | **Product** | ** ** | **Services** | ** ** | ** ** | ** ** |
|-----------------------------------------------------|------------|-------------|------------|--------------|------------|------------|------------|
| ** **                                          | ** ** | **Group**   | ** ** | **Group**    | ** ** | **Total**  | ** ** |
| Balance as of June 30,  2006                   |       | $           | 1,321      |         | $          | 1,289      |       | $ | 2,610 |   |
| Adjustment to acquired companies’ tax reserves |       | (19         | )          | (25          | )          | (44        | )          |
| Balance as of October 1,  2006                 |       | $           | 1,302      |         | $          | 1,264      |       | $ | 2,566 |   |

 

Information regarding ourother acquisition-related intangible assets is as follows (in millions):
| ** **                    | ** ** | **Gross Carrying Amount** | ** ** | **Accumulated Amortization** | ** ** | **Net**             | ** ** |
|-------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|---------------------|------------|
| ** **                    | ** ** | **June 30,**                   | ** ** | ** **                        | ** ** | **October 1,** | ** ** | **June 30,** | ** ** | ** ** | ** ** | **October 1,** | ** ** | **October 1,** | ** ** |
| ** **                    | ** ** | **2006**                            | ** ** | **Additions**                     | ** ** | **2006**            | ** ** | **2006** | ** ** | **Additions** | ** ** | **2006** | ** ** | **2006** | ** ** |
| Developed  technology         |       | $                                   | 889        |                              | $          | —              |       | $ | 889 |   | $ | (471 | ) | $ | (38 | ) | $ | (509 | ) | $ | 380 |   |
| Customer base                 |       | 650                                 |       | —                            |       | 650                 |       | (204 | ) | (39 | ) | (243 | ) | 407 |   |
| Trademark                     |       | 63                                  |       | —                            |       | 63                  |       | (10 | ) | (1 | ) | (11 | ) | 52 |   |
| Acquired  workforce and other |       | 94                                  |       | —                            |       | 94                  |       | (82 | ) | (3 | ) | (85 | ) | 9 |   |
|                          |       | $                                   | 1,696      |                              | $          | —              |       | $ | 1,696 |   | $ | (767 | ) | $ | (81 | ) | $ | (848 | ) | $ | 848 |   |

 

Amortization expense ofother acquisition-related intangible assets was $81 million and $46 millionfor the three months ended October 1, 2006 and September 25, 2005,respectively. Our acquisition-related intangible assets are amortized primarilyover periods ranging between one and five years on a straight-line basis.

Estimated amortizationexpense for other acquisition-related intangible assets on our October 1,2006 balance sheet for the fiscal years ending June 30, is as follows (in millions):

| Remainder of 2007 |   | $   | 229    |   |
|-------------------|--------|-----|--------|--------|
| 2008              |   | 289 |   |
| 2009              |   | 240 |   |
| 2010              |   | 50  |   |
| 2011              |   | 4   |   |
| Thereafter        |   | 36  |   |
|              |   | $   | 848    |   |

 

**5. RESTRUCTURINGCHARGES AND RELATED IMPAIRMENT OF LONG-LIVED ASSETS**

In accordance with SFAS 112,“Employers’ Accounting for Post Employment Benefits” (SFAS 112) and SFAS 146,“Accounting for Costs Associated with Exit or Disposal Activities” (SFAS 146**)**, we recognized a total of $21 millionand $12 million in restructuring and related impairment of long-livedassets in the three months ended October 1, 2006 and September 25,2005, respectively. The determination of when we accrue for severance costs andwhich standard applies depends on whether the termination benefits are providedunder a one-time benefit arrangement as defined by FAS 146 or under anon-going benefit arrangement as described in FAS 112.

We estimated the cost ofexiting and terminating our facility leases or acquired leases by referring tothe contractual terms of the agreements and by evaluating the current realestate market conditions. In addition, we have estimated sublease income byevaluating the current real estate market conditions or, where applicable, byreferring to amounts being negotiated. As of October 1, 2006, ourestimated sublease income to be generated from sublease contracts not yetnegotiated approximated $24 million. Our ability to generate this amountof sublease income, as well as our ability to terminate lease obligations atthe amounts we have estimated, is highly dependent upon the commercial realestate market conditions in certain geographies at the time we perform ourevaluations or negotiate the lease termination and sublease arrangements withthird parties. The amounts we have accrued represent our best estimate of theobligations we expect to incur and could be subject to adjustment as marketconditions change.

Restructuring Plan VI

In May 2006, weimplemented a plan to better align our resources with our strategic businessobjectives (Restructuring Plan VI). As part of this plan, we expect to reduceour workforce by approximately 4,000 employees across certain businessfunctions, operating units and geographic regions as

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well as implementingother expense reduction measures. Through the first quarter of fiscal 2007, wereduced our workforce by approximately 1,700 and recognized cumulative expensesrelating to severance and benefit costs of $165 million, primarily inworkforce reduction charges associated with Restructuring Plan VI.

Restructuring Plan V

In June 2005, weimplemented a workforce reduction and in July 2005, we committed to a facilityexit plan (Restructuring Plan V). This plan included reducing our workforceacross all levels, business functions, operating units and geographic regions.Through the first quarter of fiscal 2007, we reduced our workforce byapproximately 1,400 employees, and recognized cumulative expenses relating toseverance and benefit costs of $94 million, associated with RestructuringPlan V. As of October 1, 2006, all employees to be terminated as a resultof Restructuring Plan V had been notified in accordance with local employmentlaws*.*All facilities relating to the amountsaccrued under this restructuring plan were exited by October 1, 2006 inaccordance with SFAS 146.

In the fourth quarter offiscal 2006, we committed to the closure of our Newark, California campus andas a result recognized an impairment loss of approximately $80 million inaccordance with FAS 144. We completed the sale of our Newark, Californiacampus in the first quarter of fiscal 2007 and received approximately $213 million,net of $1 million in closing costs, which is included in the “Proceedsfrom sales of property, plant and equipment, net” in our Condensed ConsolidatedStatements of Cash Flows.

Restructuring Plans Prior to Phase V

Prior to the initiationof Restructuring Plan V, we implemented certain workforce reduction andfacilities exit actions. As of June 30, 2006, all employees to beterminated under these plans had been notified and all facilities relating tothe amounts accrued under these restructuring plans were exited by June 30,2005.

The following table setsforth an analysis of our restructuring accrual activity for the three monthsended October 1, 2006 (in millions):
| ** **                          | ** ** | **Restructuring Plans** | ** ** | ** **         | ** ** |
|-------------------------------------|------------|------------------------------|------------|--------------------|------------|
| ** **                          | ** ** | **VI**                       | ** ** | **V**              | ** ** | **Prior to V** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **Severance**                | ** ** | **Facilities**     | ** ** | **Severance** | ** ** | **Facilities** | ** ** | **Severance** | ** ** | **Facilities** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **and**                      | ** ** | **Related**        | ** ** | **and** | ** ** | **Related** | ** ** | **and** | ** ** | **Related** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **Benefits**                 | ** ** | **and Other** | ** ** | **Benefits** | ** ** | **and Other** | ** ** | **Benefits** | ** ** | **and Other** | ** ** | **Total** | ** ** |
| Balance as of June 30,  2006   |       | $                            | 132        |               | $          | — |   | $ | 21 |   | $ | 1 |   | $ | 6 |   | $ | 300 |   | $ | 460 |   |
| Severance and benefits              |       | 23                           |       | —             |       | — |   | — |   | — |   | — |   | 23 |   |
| Accrued lease costs                 |       | —                       |       | —             |       | — |   | 1 |   | — |   | 5 |   | 6 |   |
| Property and equipment impairment   |       | —                       |       | 8                  |       | — |   | — |   | — |   | — |   | 8 |   |
| Provision adjustments               |       | (4                           | )          | —             |       | (8 | ) | — |   | (4 | ) | — |   | (16 | ) |
| Total restructuring charges         |       | 19                           |       | 8                  |       | (8 | ) | 1 |   | (4 | ) | 5 |   | 21 |   |
| Cash paid                           |       | (52                          | )          | —             |       | (13 | ) | — |   | (2 | ) | (20 | ) | (87 | ) |
| Non-cash                            |       | —                       |       | (8                 | )          | — |   | (1 | ) | — |   | — |   | (9 | ) |
| Balance as of October 1,  2006 |       | $                            | 99         |               | $          | — |   | $ | — |   | $ | 1 |   | $ | — |   | $ | 285 |   | $ | 385 |   |

 

The above restructuringcharges are based on estimates that are subject to change. Changes to theprevious estimates have been reflected as “Provision adjustments” on the abovetable in the period the changes in estimates were made. Accrued lease costsinclude accretion adjustments associated with the passage of time.

The remaining cashexpenditures relating to workforce reductions are expected to be paid over thenext few quarters. Our accrual as of October 1, 2006 for facility-relatedleases (net of anticipated sublease proceeds) will be paid over theirrespective lease terms through fiscal 2023. As of October 1, 2006, $156 millionof the total $385 million accrual for workforce reductions andfacility-related leases was classified as current accrued liabilities and otherand the remaining $229 million was classified as other non-current obligations.

9

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We anticipate recordingadditional charges related to our workforce and facilities reductions over thenext several quarters, the timing of which will depend upon the timing ofnotification of the employees leaving Sun as determined by local employment lawsand as we exit facilities. In addition, we anticipate incurring additionalcharges associated with productivity improvement initiatives and expensereduction measures. The total amount and timing of these charges will dependupon the nature, timing, and extent of these future actions.

*Acquisition-relatedRestructuring Costs*

As a result of our acquisition of StorageTek, we have recordedacquisition-related restructuring costs associated with the costs ofintegrating the operating locations and activities of StorageTek with those ofSun and eliminating duplicative activities. U.S. GAAP (EITF 95-3,“Recognition of Liabilities in Connection with Purchase Business Combinations”)requires that these acquisition-related restructuring costs, which are notassociated with the generation of future revenues and have no future economicbenefit, be recorded as assumed liabilities in the allocation of the purchaseprice. As a result, during the year ended June 30, 2006, we recordedapproximately $172 million of restructuring costs in connection with theStorageTek acquisition, which are based upon plans committed to by management.To estimate restructuring liabilities, management utilized assumptions of thenumber of employees that would be involuntarily terminated and of costsassociated with the disposition of duplicate or excess acquired facilities.Decreases to the estimates of executing the currently approved acquisitionrelated restructuring plans are recorded as an adjustment to goodwillindefinitely, whereas increases to the estimates are recorded as an adjustmentto goodwill during the purchase price allocation period and as operatingexpenses thereafter. The following table sets forth an analysis of theacquisition-related restructuring liabilities for StorageTek for the threemonths ended October 1, 2006 (in millions):

|                                    | ** ** | **Severance** | ** ** | ** **     | ** ** | ** **           | ** ** | ** ** | ** ** |
|------------------------------------|------------|---------------|------------|----------------|------------|----------------------|------------|------------|------------|
| ** **                         | ** ** | **and**       | ** ** | **Facilities** | ** ** | **Termination**      | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **Benefits**  | ** ** | **Related**    | ** ** | **of Contract** | ** ** | **Total**  | ** ** |
| Balance as of June 30,  2006       |       | $             | 73         |           | $          | 45                   |       | $          | 27         |   | $ | 145 |   |
| Cash paid                          |       | (19           | )          | (3             | )          | (2                   | )          | (24        | )          |
| Balance as of October 1, 2006 |       | $             | 54         |           | $          | 42                   |       | $          | 25         |   | $ | 121 |   |

 

As of October 1, 2006, our estimated sublease income to begenerated from sublease contracts not yet negotiated approximated $11 million.The balance of the StorageTek severance accrual at October 1, 2006 isexpected to be utilized during the remainder of fiscal 2007 and 2008 due tolegal restrictions imposed in certain European countries and is expected to befunded through cash flows from the combined operations.

**6. COMPREHENSIVELOSS**

The components ofcomprehensive loss were as follows (in millions):

|                                                                           | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                | ** ** | **October 1,**              | ** ** | **September 25,** | ** ** |
| ** **                                                                | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| Net loss                                                                  |       | $                                | (56        | ) | $ | (123 | ) |
| Change in unrealized  value of investments, net                           |       | (3                               | )          | (17 | ) |
| Change in unrealized  fair value of derivative instruments and other, net |       | 3                                |       | (1 | ) |
| Translation  adjustments, net                                             |       | 37                               |       | (19 | ) |
|                                                                      |       | $                                | (19        | ) | $ | (160 | ) |

 

The components ofaccumulated other comprehensive income were as follows (in millions):

|                                                             | ** ** | **October 1,** | ** ** | **June 30,** | ** ** |
|-------------------------------------------------------------|------------|---------------------|------------|-------------------|------------|
| ** **                                                  | ** ** | **2006**            | ** ** | **2006**          | ** ** |
| Unrealized gains on  investments, net                       |       | $                   | 6          |              | $          | 9 |   |
| Unrealized losses on  derivative instruments and other, net |       | (17                 | )          | (20               | )          |
| Cumulative translation  adjustments, net                    |       | 228                 |       | 191               |       |
|                                                        |       | $                   | 217        |              | $          | 180 |   |

 

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** **

**7. INCOME TAXES**

For the first quarter offiscal 2007, we recorded an income tax provision of $34 million, ascompared with $43 million for the first quarter of fiscal 2006. These taxprovisions are primarily based on income generated in certain state and foreigntax jurisdictions. The tax provision for the first quarter of fiscal 2007 alsoincludes a benefit of $14 million for the reduction in accrued withholdingtaxes on unremitted foreign earnings as a result of restructuring some of ourEuropean subsidiaries during the quarter.

We currently haveprovided a full valuation allowance on our U.S. deferred tax assets and a fullor partial valuation allowance on certain overseas deferred tax assets. Weintend to maintain these valuation allowances until sufficient positiveevidence exists to support reversal of the valuation allowance in a specifictaxing jurisdiction. Likewise, the occurrence of negative evidence with respectto certain of our foreign deferred tax assets could result in an increase tothe valuation allowance. Our income tax expense recorded in the future will bereduced or increased to the extent of offsetting decreases or increases to ourvaluation allowance.

During the third quarterof fiscal 2006, we received a revenue agent report from the Internal RevenueService relating to their examination of our tax returns filed for fiscal years2001 and 2002. Pursuant to the report, the Internal Revenue Service hasproposed various adjustments resulting in a tax assessment of approximately $27 million.On April 17, 2006, we filed a protest with the Internal Revenue Service tocontest several items. Although the ultimate outcome is unknown, we believethat we have adequately reserved for these potential adjustments and the finaloutcome will not have a material adverse affect on our results of operations.

We are currently underexamination by the IRS for tax returns filed in fiscal years 2001 through 2005.Although the ultimate outcome is unknown, we have reserved for potentialadjustments and we believe that the final outcome will not have a materialaffect on our results of operations.

We have also providedamounts for other anticipated tax audit adjustments in the U.S., state andforeign tax jurisdictions based on our estimate of whether, and the extent towhich, additional taxes and interest may be due. In addition, although specificforeign country transfer pricing exposures have not been identified, the riskof potential adjustment exists. If our estimate of the federal, state andforeign income tax liabilities proves to be less than the ultimate assessment,a further charge to expense would result. If events occur which indicatepayment of these amounts is unnecessary, the reversal of the liabilities wouldresult in tax benefits being recognized in the period when we determine theliabilities are no longer necessary.

**8. STOCK-BASEDCOMPENSATION**

We have a stock-basedcompensation program that provides our Board of Directors broad discretion increating employee equity incentives. This program includes incentive andnon-statutory stock options and nonvested stock awards (also known asrestricted stock and restricted stock units that are settled in stock). Theseawards to employees are granted under various plans, the majority of which arestockholder approved. Stock options are generally time-based, vesting 20% oneach annual anniversary of the grant date over five years and expire eightyears from the grant date. Nonvested stock awards are generally time-based andvest 50% in two tranches within a five year period from the grant date. We alsohave a Directors’ Stock Option Plan that provides for the automatic grant ofstock options to non-employee members of our Board of Directors on the datesuch person initially becomes a director, and on the date of each annualmeeting of stockholders. Additionally, we have an Employee Stock Purchase Plan(ESPP) that allows employees to purchase shares of common stock at 85% of thefair market value at the date of purchase. Shares issued as a result of stockoption exercises, nonvested stock awards and our ESPP are generally firstissued out of treasury stock. As of October 1, 2006, we had approximately382 million shares of common stock reserved for future issuance under ourstock option plans and ESPP.

On July 1, 2005, weadopted the provisions of SFAS 123R, requiring us to recognize expenserelated to the fair value of our stock-based compensation awards. We elected touse the modified prospective transition method as permitted by SFAS 123R.Under this transition method, stock-based compensation expense after adoptionincludes compensation expense for all stock-based compensation awards grantedprior to, but not yet vested as of July 1, 2005, based on the grant datefair value estimated in accordance with the original provisions of SFAS 123.Stock-based compensation expense for all stock-based compensation awardsgranted subsequent to July 1, 2005 was based on the grant-date fair valueestimated in accordance with the provisions of SFAS 123R. We recognizecompensation expense for stock option awards on a straight-line basis over therequisite service period of the award.

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The following table setsforth the total stock-based compensation expense resulting from stock options,nonvested stock awards, ESPP and options assumed as a result of our acquisitionsincluded in our Condensed Consolidated Statements of Operations (in millions):

|                                                           | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                | ** ** | **October 1,**              | ** ** | **September 25,** | ** ** |
| ** **                                                | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| Cost of sales —  products                            |       | $                                | 3          |   | $ | 2 |   |
| Cost of sales — services                             |       | 8                                |       | 7 |   |
| Research and  development                                 |       | 18                               |       | 17 |   |
| Selling, general and  administrative                      |       | 29                               |       | 24 |   |
| Stock-based  compensation expense before income taxes     |       | 58                               |       | 50 |   |
| Income tax benefit                                        |       | —                           |       | — |   |
| Total stock-based compensation expense after income taxes |       | $                                | 58         |   | $ | 50 |   |

 

Net cash proceeds fromthe exercise of stock options were $38 million and $3 million for thethree months ended October 1, 2006, and September 25, 2005,respectively. No income tax benefit was realized from stock option exercisesduring the three months ended October 1, 2006, and September 25,2005. In accordance with SFAS 123R, we present excess tax benefits fromthe exercise of stock options, if any, as financing cash flows rather thanoperating cash flows.

The fair value ofstock-based awards was estimated using the Black-Scholes model with thefollowing weighted-average assumptions for the three months ended October 1,2006 and September 25, 2005, respectively:

|                                           | ** ** | **Options**         | ** ** | **ESPP**               | ** ** |
|-------------------------------------------|------------|---------------------|------------|------------------------|------------|
| ** **                                | ** ** | **October 1,** | ** ** | **September 25,** | ** ** | **October 1,** | ** ** | **September 25,** | ** ** |
| ** **                                | ** ** | **2006**            | ** ** | **2005**               | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected life (in  years)                 |       | 4.6                 |       | 4.8                    |       | 0.5 |   | 0.5 |   |
| Interest rate                             |       | 4.99                | %          | 4.03                   | %          | 4.95 | % | 3.18 | % |
| Volatility                                |       | 48.14               | %          | 43.10                  | %          | 33.78 | % | 42.49 | % |
| Dividend yield                            |       | —              |       | —                 |       | — |   | — |   |
| Weighted-average fair value at grant date |       | $                   | 1.97       |                   | $          | 1.54 |   | $ | 0.74 |   | $ | 0.98 |   |
|                                           |            |                     |            |                        |            |  |  |  |  |  |  |  |  |

 

Our computation ofexpected volatility for the quarter ended October 1, 2006 is based on acombination of historical and market-based implied volatility. Our computationof expected life is based on historical exercise patterns. The interest ratefor periods within the contractual life of the award is based on the U.S.Treasury yield curve in effect at the time of grant.

Stock option activity forthe three months ended October 1, 2006, is as follows (in millions,except per share amounts):

|                                      | ** ** | ** ** | ** ** | ** **              | ** ** | **Weighted-Average**      | ** ** | ** **               | ** ** |
|--------------------------------------|------------|------------|------------|-------------------------|------------|---------------------------|------------|--------------------------|------------|
| ** **                           | ** ** | ** ** | ** ** | ** **              | ** ** | **Remaining**             | ** ** | ** **               | ** ** |
| ** **                           | ** ** | ** ** | ** ** | **Weighted-Average**    | ** ** | **Contractual Term** | ** ** | **Aggregate**            | ** ** |
| ** **                           | ** ** | **Shares** | ** ** | **Exercise Price** | ** ** | **(in years)**       | ** ** | **Intrinsic Value** | ** ** |
| Outstanding at June 30,  2006        |       | 523        |       | $                       | 11.28      |                      |       |                     |       |   |
| Grants                               |       | 7          |       | 4.26                    |       |                      |       |                     |       |
| Exercises                            |       | (11        | )          | 3.30                    |       |                      |       |                     |       |
| Forfeitures or  expirations          |       | (19        | )          | 9.44                    |       |                      |       |                     |       |
| Outstanding at  October 1, 2006 |       | 500        |       | $                       | 11.43      |                      | 4.1        |                     | $          | 330 |   |
| Exercisable at October 1, 2006  |       | 353        |       | $                       | 14.58      |                      | 3.2        |                     | $          | 171 |   |

 

The aggregate intrinsicvalue in the table above represents the total pretax intrinsic value (i.e., thedifference between Sun’s closing stock price on the last trading day of ourfirst quarter of fiscal 2007 and the exercise price, times the number ofshares) that would have been received by the option holders had all optionholders exercised their options on October 1, 2006. This amount changesbased on the fair market value of Sun’s stock. The total intrinsic value ofoptions exercised was $18 million and nil for the three months ended October 1,2006 and September 25, 2005. respectively. The total fair value of optionsvested was $53 million and $52 million for the three months ended October 1,2006 and September 25, 2005, respectively.

As of October 1,2006, $302 million of total unrecognized compensation cost related tostock options is expected to be recognized over a weighted-average period of 2years.

The following tablesummarizes our restricted stock and restricted stock unit activity for thethree months ended October 1, 2006 (in millions, except per shareamounts):

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|                                         | ** ** | ** **         | ** ** | **Weighted-Average** | ** ** |
|-----------------------------------------|------------|--------------------|------------|----------------------|------------|
| ** **                              | ** ** | ** **         | ** ** | **Grant Date**  | ** ** |
| ** **                              | ** ** | **Number**         | ** ** | **Fair Value**  | ** ** |
| ** **                              | ** ** | **of Shares** | ** ** | **(per share)** | ** ** |
| Nonvested stock at June  30, 2006       |       | 46                 |       | $                    | 4.16       |   |
| Granted                                 |       | 7                  |       | 4.52                 |       |
| Vested                                  |       | (11                | )          | 3.72                 |       |
| Forfeited                               |       | (3                 | )          | 4.30                 |       |
| Nonvested stock at October 1, 2006 |       | 39                 |       | $                    | 4.34       |   |

 

As of October 1,2006, we retained purchase rights to 8 million shares issued pursuant tostock purchase agreements and other stock plans at a weighted-average price ofapproximately $0.01.

As of October 1,2006, $112 million of total unrecognized compensation costs related tononvested stock is expected to be recognized over a weighted-average period of4 years.

**9. OPERATINGSEGMENTS**

We design, manufacture,market and service network computing infrastructure solutions that consist ofComputer Systems (hardware and software), Data Management (hardware andsoftware), Support Services and Client Solutions and Educational Services. Ourorganization is primarily structured in a functional manner. During the periodspresented, our current Chief Executive Officer was identified as our ChiefOperating Decision Maker (CODM) as defined by SFAS No. 131, “DisclosuresAbout Segments of an Enterprise and Related Information” (SFAS 131).

Our CODM manages ourcompany based primarily on broad functional categories of sales, services,manufacturing, product development and engineering and marketing and strategy.Our CODM reviews consolidated financial information on revenues and grossmargins for products and services and also reviews operating expenses, certainof which has been allocated to our two operating segments. Our Product Groupsegment comprises our end-to-end networking architecture of computing productsincluding our Computer Systems and Data Management systems product lines. OurServices Group segment comprises a full range of services to existing and newcustomers, including Support Services and Client Solutions and EducationalServices. StorageTek’s former storage and services segments have been includedin our Product Group and Sun Services segments, respectively.

We have a WorldwideOperations (WWOPS) organization and a Global Sales Organization (GSO) that,respectively, manufacture and sell all of our products. The CODM held the GSOaccountable for overall products and services revenue and margins on aconsolidated level. GSO and WWOPS managed the majority of our accountsreceivable and inventory, respectively. In addition, we have a WorldwideMarketing Organization (WMO) that is responsible for developing and executingSun’s overall corporate, strategic and product marketing and advertisingstrategies. The CODM looked to this functional organization for advertising,pricing and other marketing strategies for the products and services deliveredto market. Operating expenses (primarily sales, marketing and administrative)related to the GSO and the WMO are not allocated to the reportable segmentsand, accordingly, are included under the Other segment reported below.

**Segmentinformation**

The following tablepresents revenues, interdivision revenues and operating income (loss) for oursegments. The Other segment consists of certain functional groups that did notmeet the requirements for a reportable segment as defined by SFAS 131,such as GSO and WMO and other miscellaneous functions such as Finance, HumanResources, and Legal (in millions):

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|                              | ** ** | **Product** | ** ** | **Services** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------------------------|------------|-------------|------------|--------------|------------|------------|------------|------------|------------|
| ** **                   | ** ** | **Group**   | ** ** | **Group**    | ** ** | **Other**  | ** ** | **Total**  | ** ** |
| **Three  Months Ended:**     |       |        |       |         |       |       |       |       |       |
| ** **                   |       |        |       |         |       |       |       |       |       |
| **October 1,  2006**    |       |        |       |         |       |       |       |       |       |
| Revenues                     |       | $           | 1,959      |         | $          | 1,230      |       | $          | —     |   | $ | 3,189 |   |
| Interdivision  revenues      |       | 58          |       | 91           |       | (149       | )          | —     |       |
| Operating income  (loss)     |       | 363         |       | 523          |       | (950       | )(1)       | (64        | )          |
|                         |       |        |       |         |       |       |       |       |       |
| **September 25,  2005** |       |        |       |         |       |       |       |       |       |
| Revenues                     |       | $           | 1,704      |         | $          | 1,022      |       | $          | —     |   | $ | 2,726 |   |
| Interdivision  revenues      |       | 58          |       | 92           |       | (150       | )          | —     |       |
| Operating income (loss)      |       | 307         |       | 397          |       | (841       | )(1)       | (137       | )          |

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(1)                Includesrestructuring and related impairment of long-lived assets and purchased IPRD,if applicable.

**10. LEGALPROCEEDINGS AND CONTINGENCIES**

In fiscal 2005, theGeneral Services Administration (GSA) began auditing our records under theschedule contracts it had with us to verify our compliance with variouscontract provisions from October 1997 to February 2005. If the auditdetermines that we did not comply with such provisions, we may be required topay the GSA a potential settlement. We have made a assessment of our exposurefor such amounts potentially due and such assessment is reflected in our fiscal2006 and 2005 consolidated financial statements. We cannot predict withreasonable certainty when the audit and the subsequent negotiation process willbe concluded and it may take several quarters for all issues to be resolved.

In fiscal 2006 as part ofa service-based sales arrangement involving a governmental institution inMexico, we were required to deposit approximately $41 million with asurety company as collateral guaranteeing our performance under thearrangement. As of October 1, 2006 and June 30, 2006, this cash isclassified as Other non-current assets, net, in our Condensed ConsolidatedBalance Sheet.

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors andStockholders, Sun Microsystems, Inc.

We have reviewed thecondensed consolidated balance sheet of Sun Microsystems, Inc. as of October 1,2006, and the related condensed consolidated statements of operations for thethree-month period ended October 1, 2006 and September 25, 2005, andthe condensed consolidated statements of cash flows for the three-month periodended October 1, 2006 and September 25, 2005. These financialstatements are the responsibility of the Company’s management.

We conducted our reviewin accordance with the standards of the Public Company Accounting OversightBoard (United States). A review of interim financial information consistsprincipally of applying analytical procedures and making inquiries of personsresponsible for financial and accounting matters. It is substantially less inscope than an audit conducted in accordance with the standards of the PublicCompany Accounting Oversight Board, the objective of which is the expression ofan opinion regarding the financial statements taken as a whole. Accordingly, wedo not express such an opinion.

Based on our reviews, weare not aware of any material modifications that should be made to thecondensed consolidated financial statements referred to above for them to be inconformity with U.S. generally accepted accounting principles.

We have previouslyaudited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the consolidated balance sheet of SunMicrosystems, Inc. as of June 30, 2006, and the related consolidated statementsof operations, stockholders’ equity, and cash flows for the year then ended notpresented herein, and in our report dated September 1, 2006, we expressedan unqualified opinion on those consolidated financial statements. In ouropinion, the information set forth in the accompanying condensed consolidatedbalance sheet as of June 30, 2006, is fairly stated, in all material respects,in relation to the consolidated balance sheet from which it has been derived.

/s/ Ernst & Young LLP

San Jose, California

October 25, 2006

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**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

The following is intended to be an overview of theareas that management believes are important in understanding the results ofthe quarter. This overview is not intended as a substitute for the detailprovided in the following pages or for the condensed consolidated financialstatements and notes that appear elsewhere in this document.

**ExecutiveOverview**

Sun provides network computing infrastructuresolutions that include Computer Systems (hardware and software), DataManagement (hardware and software), Support Services and Client Solutions andEducational Services. Sun’s solutions are based on major Sun technologyinnovations such as the Java technology platform, the Solaris Operating System(Solaris OS), Sun Java products and the UltraSPARC microprocessor technology,as well as other widely deployed technologies such as the Linux operatingsystem and AMD Opteron microprocessor-based systems. Our network computinginfrastructure solutions are used in a wide range of technical/scientific,business and engineering applications in industries such as telecommunications,government, financial services, manufacturing, education, retail, lifesciences, media and entertainment, transportation, energy/utilities andhealthcare. We sell complete networking solutions, including products andservices, in most major markets worldwide through a combination of direct andindirect channels.

In the first quarter of fiscal 2006, we completed theacquisition of Storage Technology Corporation (StorageTek) which allowed us tobroaden our offerings of storage products, services and solutions. Our resultsof operations for the quarter ended September 25, 2005 included theresults for StorageTek from August 31, 2005, the date of acquisition andthe beginning of the last month of StorageTek’s fiscal quarter. StorageTek hashistorically experienced a disproportionately high product revenue volume inthe last month of each fiscal quarter. Therefore, the results of operationsincluded for the three months ended September 25, 2005 are not indicativeof the results for a full three months. StorageTek’s products revenues areincluded in Data Management and StorageTek’s services revenues are included inSupport Services. Due to certain integration activities, it is no longerpossible to accurately separately quantify the results of the former StorageTekbusiness.

During the first quarter of fiscal 2007, weexperienced a year over year increase in total net revenues of approximately17.0%. Our Products net revenue for the first quarter of fiscal 2007 wasfavorably impacted by storage revenue related to the inclusion of a fullquarter of the operations of StorageTek and increased sales of our entry-leveland mid-range enterprise servers as a result of our fiscal 2006 introduction ofcertain UltraSPARC IV+, UltraSPARC T1 and Opteron-based systems. Our Servicesnet revenue for the first quarter of fiscal 2007 was similarly favorablyimpacted by the inclusion of a full quarter of services revenue related to theoperations of StorageTek and SeeBeyond Technology Corporation (SeeBeyond). Weexperienced a sequential quarterly decrease in total net revenues of approximately16.7%, which reflects the normal seasonal decline we experience between thefourth quarter of the previous fiscal year and the first quarter of the nextfiscal year.

During the first quarter of fiscal 2007, our year overyear total gross margin decreased by approximately 0.6 of a percentage point. Duringthe first quarter of fiscal 2007, our year over year Products gross margindecreased by approximately 0.6 of a percentage point due to the unfavorableimpact of discounting pricing actions and an unfavorable shift in volume andmix, partially offset by manufacturing and component cost reductions. Oursequential quarterly Products gross margin increased by approximately 1.6 percentagepoints primarily due to a reduction in discounting actions and a favorableshift in product and volume mix, partially offset by an increase in cost. Ourfirst quarter year over year Services gross margin decreased by 0.5 of apercentage point primarily due to the inclusion of a full quarter of theoperations of StorageTek, partially offset by a favorable shift in productvolume and mix.  Our sequential quarterlyServices gross margin decreased by 1.2 percentage points primarily due toan increase in service costs.

During the first quarter of fiscal 2007, as comparedwith the corresponding period of fiscal 2006, our research and developmentexpenses increased $34 million and our sales, general and administrativeexpenses increased $130 million. These increases were primarily due to theinclusion of a full fiscal quarter of StorageTek-related operating expenses andthe inclusion of a full fiscal quarter of amortization cost associated withacquisition-related intangible assets, partially offset by savings resultingfrom our restructuring activities.

In the first quarter of fiscal 2007, we continued toexecute on our global workforce and other costs reduction plan announced infiscal 2006. As a result, we have recorded an incremental $7 million ofworkforce reduction charges and $14 million of facilities and relatedasset impairment charges in the quarter.

During the first quarter of fiscal 2007, our operatingactivities generated cash in-flows of $157 million. Cash managementremains a priority and we plan to remain focused on our cash conversion cycle.At October 1, 2006, we had total cash, cash equivalents and marketabledebt securities of approximately $4.7 billion. Our cash flows during the firstquarter of fiscal 2007 included a $500 million payment to settle a portionof our Senior Notes, partially offset by $213 million in cash proceedsreceived from the sale of our Newark, California facility.

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**CriticalAccounting Policies and Estimates**

The accompanyingdiscussion and analysis of our financial condition and results of operationsare based upon our consolidated financial statements, which have been preparedin accordance with generally accepted accounting principles in the UnitedStates (U.S. GAAP). Some of our accounting policies require us to makedifficult and subjective judgments, often as a result of the need to makeestimates of matters that are inherently uncertain. We base our estimates andjudgments on historical experience and on various other assumptions that webelieve are reasonable under the circumstances, however, to the extent thereare material differences between these estimates, judgments or assumptions and ouractual results, our financial statements will be affected. We believe theaccounting policies disclosed reflect our more significant assumptions,estimates and judgments and are the most critical to aid in fully understandingand evaluating our reported financial results. Our senior management hasdiscussed the development, selection and disclosure of these criticalaccounting policies and related disclosures with the Audit Committee of ourBoard of Directors.

During the three monthsended October 1, 2006, we believe there have been no significant changes tothe items that we disclosed as our critical accounting policies and estimatesin our discussion and analysis of financial condition and results of operationsin our 2006 Form 10-K.

**RESULTSOF OPERATIONS**

**NetRevenues**

(dollars in millions,except revenue per employee dollars in thousands)

|                                            | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|------------------------|------------|
| ** **                                 | ** ** | **October 1,**              | ** ** | **September 25,** | ** ** | ** ** | ** ** |
| ** **                                 | ** ** | **2006**                         | ** ** | **2005**               | ** ** | **Change** | ** ** |
| Computer Systems  products                 |       | $                                | 1,468      |                   | $          | 1,274 |   | 15.2 | % |
| Data Management  products                  |       | 491                              |       | 430                    |       | 14.2 | % |
| Products net revenue                       |       | $                                | 1,959      |                   | $          | 1,704 |   | 15.0 | % |
| Percentage of total net revenues           |       | 61.4                             | %          | 62.5                   | %          | (1.1 | ) pts |
| Support services                           |       | $                                | 987        |                   | $          | 835 |   | 18.2 | % |
| Client Solutions  and Educational services |       | 243                              |       | 187                    |       | 29.9 | % |
| Services net revenue                       |       | $                                | 1,230      |                   | $          | 1,022 |   | 20.4 | % |
| Percentage of total net revenues           |       | 38.6                             | %          | 37.5                   | %          | 1.1 |  pts |
| Total net  revenues                        |       | $                                | 3,189      |                   | $          | 2,726 |   | 17.0 | % |
| Revenue per employee(1)                    |       | $                                | 86         |                   | $          | 78 |   | 10.3 | % |

----

(1)             Revenueper employee is calculated by dividing the revenue during the period by theaverage number of employees during the period, including contractors. We usethis as a measure of our productivity.

Due to the generallyweakened U.S. dollar during the first quarter of fiscal 2007, as compared withthe corresponding period of fiscal 2006, our total net revenues were favorablyimpacted by foreign currency exchange rates. The net foreign currency impact toour total net revenues is difficult to precisely measure. However, our bestestimate of the foreign exchange rate impact during the first quarter of fiscal2007 as compared with the corresponding period of fiscal 2006, was nil onProducts net revenue and approximated a benefit of 2% of Services net revenue.

*ProductsNet Revenue*

Products net revenueconsists of revenue generated from the sale of Computer Systems and DataManagement products.

During the first quarterof fiscal 2007, as compared with the corresponding period in fiscal 2006,Computer Systems revenue increased primarily due to increased sales of ourentry-level and mid-range enterprise servers based on increased demandresulting from our fiscal 2006 introduction of certain UltraSPARC IV+,UltraSPARC T1 and Opteron-based systems. During the first quarter of fiscal2007, as compared with the corresponding period in fiscal 2006, Data Managementrevenue increased primarily due to the inclusion of StorageTek’s high andlow-end tape storage product revenue for a full fiscal quarter.

17

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*ServicesNet Revenue*

Services net revenueconsists of revenue generated from Support services, Client Solutions andEducational Services.

Support services revenueconsists primarily of maintenance contract revenue, which is recognized ratablyover the contractual period. During the first quarter of fiscal 2007, ascompared with the corresponding period in fiscal 2006, Support services netrevenue increased due to the inclusion of a full fiscal quarter of theoperations of StorageTek and SeeBeyond.

Client Solutions andEducational services revenue consists primarily of revenue generated fromprofessional services, such as technical consulting that helps our customersplan, implement, and manage distributed network computing environments. Theoverall increase in Client Solutions and Educational Services revenues duringthe first quarter of fiscal 2007, as compared with the corresponding period infiscal 2006, was primarily due to inclusion of the operations of StorageTek andSeeBeyond for a full fiscal quarter, as well as an increase in technicalconsulting revenue.

**NetRevenues by Geographic Area**

(dollars in millions)

|                                                    | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|------------------------|------------|
| ** **                                         | ** ** | **October 1,**              | ** ** | **September 25,** | ** ** | ** ** | ** ** |
| ** **                                         | ** ** | **2006**                         | ** ** | **2005**               | ** ** | **Change** | ** ** |
| United States                                      |       | $                                | 1,296      |                   | $          | 1,159 |   | 11.8 | % |
| Percentage of  total net revenues                  |       | 40.6                             | %          | 42.5                   | %          | (1.9 | ) pts |
|                                               |       |                             |       |                   |       |   |   |
| International Americas  (Canada and Latin America) |       | $                                | 217        |                   | $          | 141 |   | 53.9 | % |
| Percentage of  total net revenues                  |       | 6.8                              | %          | 5.2                    | %          | 1.6 |  pts |
| EMEA (Europe, Middle  East and Africa)             |       | $                                | 1,131      |                   | $          | 970 |   | 16.6 | % |
| Percentage of  total net revenues                  |       | 35.5                             | %          | 35.6                   | %          | (0.1 | ) pts |
| APAC (Asia, Australia  and New Zealand)            |       | $                                | 545        |                   | $          | 456 |   | 19.5 | % |
| Percentage of  total net revenues                  |       | 17.1                             | %          | 16.7                   | %          | 0.4 |  pts |
| Total International  revenues                      |       | $                                | 1,893      |                   | $          | 1,567 |   | 20.8 | % |
| Percentage of  total net revenues                  |       | 59.4                             | %          | 57.5                   | %          | 1.9 |  pts |
|                                               |       |                             |       |                   |       |   |   |
| Total net revenues                                 |       | $                                | 3,189      |                   | $          | 2,726 |   | 17.0 | % |

 

*UnitedStates (U.S.)*

During the first quarterof fiscal 2007, as compared with the corresponding period of fiscal 2006, netrevenues in the U.S. increased by $137 million due to the inclusion of theoperations of StorageTek for a full fiscal quarter and increased sales of ourentry level servers due to increased customer acceptance of certain UltraSPARCT1 based systems introduced in fiscal 2006. During the first quarter of fiscal2007, we experienced increased demand in certain segments of the educationaland state and local government sectors, partially offset by a decline in netrevenues in other government and financial services sectors.

The following table setsforth net revenues in those geographic markets that contributed significantlyto international net revenues during the first quarter of fiscal 2007 (dollarsin millions):

|                              | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** |
|------------------------------|------------|----------------------------------|------------|------------------------|------------|
| ** **                   | ** ** | **October 1,**              | ** ** | **September 25,** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | **2006**                         | ** ** | **2005**               | ** ** | **Change** | ** ** |
| United Kingdom               |       | $                                | 284        |                   | $          | 234 |   | 21.4 | % |
| Central and Northern  Europe |       | $                                | 240        |                   | $          | 156 |   | 53.8 | % |
| Japan                        |       | $                                | 200        |                   | $          | 166 |   | 20.5 | % |
| Germany                      |       | $                                | 204        |                   | $          | 216 |   | (5.6 | )% |

 

18

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*UnitedKingdom (UK)*

During the first quarterof fiscal 2007, as compared with the corresponding period of fiscal 2006, netrevenues in the UK increased by $50 million primarily due to the inclusionof StorageTek products and services revenue for a full fiscal quarter, thefavorable impact of foreign currency exchange rates and our fiscal 2006introduction of certain UltraSPARC IV+, UltraSPARC T1, and Opteron-basedsystems. This increase in demand is partially attributable to improvedmacroeconomic conditions, particularly in the energy, manufacturing andfinancial services sectors.

*Centraland Northern Europe (CNE)*

During the first quarterof fiscal 2007, as compared with the corresponding period of fiscal 2006, netrevenues in CNE increased by $84 million primarily due to the inclusion ofStorageTek products and services revenue for a full fiscal quarter andincreased demand for certain entry-level servers including our UltraSPARCT1-based servers.

*Japan*

During the first quarterof fiscal 2007, as compared with the corresponding period of fiscal 2006, netrevenues in Japan increased by $34 million primarily due to the inclusionof StorageTek products and services revenue for a full fiscal quarter and asignificant Computer Systems sale. These increases were partially offset by theunfavorable impact of foreign exchange rates and decreases in Data Managementand Services revenue. Increased demand in the education and financial servicessectors was partially offset by continued competitive pressure in thetelecommunications sector.

*Germany*

During the first quarterof fiscal 2007, as compared with the corresponding period of fiscal 2006, netrevenues in Germany decreased by $12 million primarily due a shift inproduct mix from sales of high-end datacenters to entry-level and mid-rangeenterprise servers. This decrease was partially offset by the inclusion of StorageTekproducts and services revenue for a full fiscal quarter and the favorableimpact of foreign currency exchange rates.

**GrossMargin**

(dollars in millions)

|                                     | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** |
|-------------------------------------|------------|----------------------------------|------------|------------------------|------------|
| ** **                          | ** ** | **October 1,**              | ** ** | **September 25,** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **2006**                         | ** ** | **2005**               | ** ** | **Change** | ** ** |
| Products gross margin               |       | $                                | 836        |                   | $          | 738 |   | 13.3 | % |
| Percentage of  products net revenue |       | 42.7                             | %          | 43.3                   | %          | (0.6 | ) pts |
| Services gross margin               |       | $                                | 552        |                   | $          | 464 |   | 19.0 | % |
| Percentage of  services net revenue |       | 44.9                             | %          | 45.4                   | %          | (0.5 | ) pts |
| Total gross margin                  |       | $                                | 1,388      |                   | $          | 1,202 |   | 15.5 | % |
| Percentage of total net  revenues   |       | 43.5                             | %          | 44.1                   | %          | (0.6 | ) pts |

 

*ProductsGross Margin*

Products gross marginpercentage is influenced by numerous factors including product volume and mix,pricing, geographic mix, foreign currency exchange rates, the mix between salesto resellers and end-users, third-party costs (including both raw material andmanufacturing costs), warranty costs and charges related to excess and obsoleteinventory. Many of these factors influence, or are interrelated with, otherfactors. As a result, it is difficult to precisely quantify the impact of eachitem individually. Accordingly, the following quantification of the reasons forthe change in the products gross margin percentage is an estimate.

During the first quarterof fiscal 2007, as compared with the corresponding period of fiscal 2006, ourproducts gross margin percentage decreased by 0.6 of a percentage point due toprice reductions and sales discounting actions of approximately 4 percentagepoints and an unfavorable shift in volume and mix of approximately 1 percentagepoint, partially offset by manufacturing and component cost savings ofapproximately 4 percentage points.

*ServicesGross Margin*

Services gross marginpercentage is influenced by numerous factors including services mix, pricing,geographic mix, foreign currency exchange rates and third-party costs. Many ofthese factors influence, or are interrelated with, other factors. As a

19

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result, it is difficultto precisely quantify the impact of each item individually. Accordingly, thefollowing quantification of the reasons for the change in the services grossmargin percentage is an estimate.

During the first quarterof fiscal 2007, as compared with the corresponding period of fiscal 2006, ourservices gross margin decreased by 0.5 of a percentage point due to an increasein services costs partly as a result of the inclusion of the operations ofStorageTek for a full fiscal quarter of approximately 2 percentage points,partially offset by a favorable shift in product volume and mix of nearly 2percentage points.

**OperatingExpenses**

(dollars in millions)

|                                                            | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|------------------------|------------|
| ** **                                                 | ** ** | **October 1,**              | ** ** | **September 25,** | ** ** | ** ** | ** ** |
| ** **                                                 | ** ** | **2006**                         | ** ** | **2005**               | ** ** | **Change** | ** ** |
| Research and  development                                  |       | $                                | 473        |                   | $          | 439 |   | 7.7 | % |
| Percentage of  total net revenues                          |       | 14.8                             | %          | 16.1                   | %          | (1.3 | ) pts |
| Selling, general and  administrative                       |       | $                                | 958        |                   | $          | 828 |   | 15.7 | % |
| Percentage of  total net revenues                          |       | 30.0                             | %          | 30.4                   | %          | (0.4 | ) pts |
| Restructuring and  related impairment of long-lived assets |       | $                                | 21         |                   | $          | 12 |   | 75 | % |
| Percentage of  total net revenues                          |       | 0.7                              | %          | 0.4                    | %          | 0.3 |  pts |
| Purchased in-process  research and development             |       | $                                | —     |                   | $          | 60 |   | (100 | %) |
| Percentage of  total net revenues                          |       | —                           | %          | 2.2                    | %          | (2.2 | ) pts |
| Total operating expenses                                   |       | $                                | 1,452      |                   | $          | 1,339 |   | 8.4 | % |

 

*Researchand Development (R&D) Expenses*

R&D expensesincreased by $34 million during the first quarter of fiscal 2007, ascompared with the corresponding period of fiscal 2006, primarily due to theinclusion of the expenses associated with the operations of StorageTek andSeeBeyond for a full fiscal quarter, partially offset by savings resulting fromour restructuring activities. Included in the $34 million increase was a$36 million increase in compensation costs associated with salaries andbonuses, partially offset by a $6 million decrease in prototype expenses,depreciation expense and outside service costs.

We believe that to maintainour competitive position in a market characterized by rapid rates oftechnological advancement, we must continue to invest significant resources innew systems, software, and microprocessor development, as well as continue toenhance existing products.

*Selling,General and Administrative (SG&A) Expenses*

SG&A expensesincreased by $130 million during the first quarter of fiscal 2007, ascompared with the corresponding period of fiscal 2006, primarily due to theinclusion of the expenses associated with the operations of StorageTek andSeeBeyond for a full fiscal quarter, partially offset by savings resulting fromour restructuring activities. Included in the $130 million increase was a$77 million increase in compensation and salaries and bonuses, a $25 millionincrease in amortization expense, a $23 million increase infacility-related expenses and a $12 million increase in outside servicescosts.

We are continuing tofocus our efforts on achieving additional operating efficiencies by reviewingand improving upon our existing business processes and cost structure.

*Restructuringand Related Impairment of Long-lived Assets*

Restructuring and relatedimpairment of long-lived assets charges for the three months ended October 1,2006 were $21 million. These charges included $7 million in netseverance and benefit costs, $6 million in accrued lease costs associatedwith excess facilities and $8 million associated with the impairment ofcertain long-lived assets.

Restructuring and related impairment of long-livedassets charges for the three months ended September 25, 2005 were $12 million,primarily due to $9 million in severance and benefit costs and $2 millionin accrued lease costs associated with excess facilities.

For further detail, refer to Note 5 of ourConsolidated Condensed Financial Statements.

20

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*Purchased In-Process Research and Development(IPRD)*

Overview

In the first quarter of fiscal2007, we recorded no IPRD expense, however, in the first quarter of fiscal 2006we recorded total IPRD expense of $60 million related to our acquisitions ofStorageTek and SeeBeyond. At the date of each acquisition, the projects associatedwith the IPRD efforts had not yet reached technological feasibility and the IPRDhad no alternative future uses. Accordingly, these amounts were expensed on therespective acquisition dates of each of the acquired companies.

Valuation

Through the engagement ofan independent third party, we estimated the fair value of IPRD using the incomeapproach. These calculations gave consideration to relevant market sizes and growthfactors, expected industry trends, the anticipated nature and timing of new productintroductions by us and our competitors, individual product sales cycles, and theestimated lives of each of the product’s underlying technology. The value of theIPRD reflects the relative value and contribution of the acquired research and development.In determining the value assigned to IPRD, we considered the R&D’s stage ofcompletion, the complexity of the work completed to date, the difficulty of completingthe remaining development, costs already incurred, and the projected cost to completethe project.

The values assigned to developedtechnologies related to each acquisition were based upon discounted cash flows relatedto the existing products’ projected income stream. Elements of the projected incomestream included revenues, cost of sales (COS), R&D expenses and SG&A expenses.The discount rates used in the present value calculations were generally derivedfrom a weighted average cost of capital, adjusted upward to reflect the additionalrisks inherent in the development life cycle, including the useful life of the technology,profitability levels of the technology, and the uncertainty of technology advancesthat are known at the date of each acquisition. Because each acquired entity’s IPRDis unique, the discount rate, revenue, COS, R&D and SG&A assumptions usedvaried on a case-by-case basis.

Valuation assumptions

The following bullets summarizethe significant assumptions underlying the valuation related to IPRD as of the relevantacquisition dates:

·                  Acquisition of StorageTek— We acquired $49 million in IPRD related to nine projects within StorageTek’stape, disk and network product lines. At the date of acquisition, we estimated thatdevelopment efforts were generally 50% - 60% complete and that approximately $56 millionin additional costs were required to complete development. During the fourth quarterof fiscal 2006, as a result of our Phase VI restructuring activities, we exitedcertain StorageTek product lines comprising $9 million of the total $49 millionassigned to IPRD as of the acquisition date. All other key product releases andmajor enhancements were completed during fiscal 2006, with the exception of VSMOpen, which is scheduled for release during Q3FY2008. Ongoing feature and functionenhancements on all of our acquired IPRD projects are expected to continue for severalmore years.

·                  Acquisition of SeeBeyond— We acquired $11 million in IPRD related to the development of ICAN version5.1. At the date of acquisition, we estimated that development efforts were 75%complete and that approximately $3 million in additional costs were requiredto complete development. ICAN 5.1 was completed and released during the third quarterof fiscal 2006.

Given the uncertainties ofthe commercialization process, no assurances can be given that deviations from ourestimates will not occur. At the time of the acquisitions, we believed there wasa reasonable chance of realizing the economic return expected from the acquiredin-process technology. However, as there is risk associated with the realizationof benefits related to commercialization of an in-process project due to rapidlychanging customer needs, the complexity of technology, and growing competitive pressures,there can be no assurance that any project will meet commercial success. Failureto successfully commercialize an in-process project would result in the loss ofthe expected economic return inherent in the fair value allocation. Additionally,the value of our intangible assets may become impaired.

21

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** **

**Gain (Loss)on Equity Investments**

(dollars in millions)

|                                  | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** |
|----------------------------------|------------|----------------------------------|------------|------------------------|------------|
| ** **                       | ** ** | **October 1,**              | ** ** | **September 25,** | ** ** | ** ** | ** ** |
| ** **                       | ** ** | **2006**                         | ** ** | **2005**               | ** ** | **Change** | ** ** |
| Gain on equity  investments, net |       | $                                | —     |                   | $          | 13 |   | (100 | %) |
|                                  |            |                                  |            |                        |            |  |  |  |  |

 

As of October 1, 2006,our equity investment portfolio of $61 million consisted of $22 millionin marketable equity securities, $19 million in equity investments in privatelyheld companies and $20 million in investments in venture capital funds andjoint ventures. The ongoing valuation of our investment portfolio remains uncertainand may be subject to fluctuations based on whether we participate in additionalinvestment activity or as a result of the occurrence of events outside of our control.

**Interestand Other Income, net**

(dollars in millions)

|                                   | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** |
|-----------------------------------|------------|----------------------------------|------------|------------------------|------------|
| ** **                        | ** ** | **October 1,**              | ** ** | **September 25,** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **2006**                         | ** ** | **2005**               | ** ** | **Change** | ** ** |
| Interest and  other income, net   |       | $                                | 42         |                   | $          | 44 |   | (4.5 | )% |
| Percentage of  total net revenues |       | 1.3                              | %          | 1.6                    | %          |   |   |
|                                   |            |                                  |            |                        |            |  |  |  |  |

 

In the first quarter of fiscal2007, as compared with the corresponding period of fiscal 2006, interest and otherincome, net, remained relatively flat. Interest and other income, net was unfavorablyimpacted by a decrease in interest income due to lower cash and marketable debtsecurities balances in the first quarter of fiscal 2007 as compared with the correspondingperiod of fiscal 2006. This decrease was partially offset by an increase in interestrates.

As of October 1, 2006,the average duration of our portfolio of marketable debt securities decreased to0.18 years from 0.85 years at September 25, 2005. In general, we wouldexpect the volatility of this portfolio to decrease as its duration decreases. Thesignificant decrease in the average duration of our portfolio at October 1,2006, was due to a strategic repositioning of our portfolio and the liquidationof securities in order to repatriate $2 billion of foreign earnings in thefourth quarter of fiscal 2006.

Our interest income and expenseare sensitive primarily to changes in the general level of U.S. interest rates.In this regard, changes in U.S. interest rates affect the interest earned on ourcash equivalents and marketable debt securities, which are predominantly short-termfixed income instruments. To better match the interest rate characteristics of ourinvestment portfolio and our issued fixed-rate unsecured senior debt securities,we have entered into interest rate swap transactions so that the interest associatedwith these debt securities effectively becomes variable.

**Income Taxes**

(dollars in millions)

|                             | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** |
|-----------------------------|------------|----------------------------------|------------|------------------------|------------|
| ** **                  | ** ** | **October 1,**              | ** ** | **September 25,** | ** ** | ** ** | ** ** |
| ** **                  | ** ** | **2006**                         | ** ** | **2005**               | ** ** | **Change** | ** ** |
| Provision for  income taxes |       | $                                | 34         |                   | $          | 43 |   | (20.9 | )% |
|                             |            |                                  |            |                        |            |  |  |  |  |

 

For the first quarter of fiscal2007, we recorded an income tax provision of $34 million, as compared with$43 million for the first quarter of fiscal 2006. These tax provisions areprimarily based on income generated in certain state and foreign tax jurisdictions.The tax provision for the first quarter of fiscal 2007 also includes a benefit of$14 million for the reduction in accrued withholding taxes on unremitted foreignearnings as a result of restructuring some of our European subsidiaries during thequarter.

We currently have provideda full valuation allowance on our U.S. deferred tax assets and a full or partialvaluation allowance on certain overseas deferred tax assets. We intend to maintainthese valuation allowances until sufficient positive evidence exists to supportreversal of the valuation allowance in a specific taxing jurisdiction. Likewise,the occurrence of negative evidence with respect to certain of our foreign deferredtax assets could result in an increase to the valuation allowance. Our income taxexpense recorded in the future will be reduced or increased to the extent of offsettingdecreases or increases to our valuation allowance.

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We are currently under examinationby the IRS for tax returns filed in fiscal years 2001 through 2005. Although theultimate outcome is unknown, we have reserved for potential adjustments and we believethat the final outcome will not have a material affect on our results of operations.

We have also provided amountsfor other anticipated tax audit adjustments in the U.S., state and foreign tax jurisdictionsbased on our estimate of whether, and the extent to which, additional taxes andinterest may be due. In addition, although specific foreign country transfer pricingexposures have not been identified, the risk of potential adjustment exists. Ifour estimate of the federal, state and foreign income tax liabilities proves tobe less than the ultimate assessment, a further charge to expense would result.If events occur which indicate payment of these amounts is unnecessary, the reversalof the liabilities would result in tax benefits being recognized in the period whenwe determine the liabilities are no longer necessary.

**LIQUIDITY,CAPITAL RESOURCES AND FINANCIAL CONDITION**

(dollars in millions)

|                                                              | ** ** | **October 1,** | ** ** | **June 30,** | ** ** | ** ** | ** ** |
|--------------------------------------------------------------|------------|---------------------|------------|-------------------|------------|------------|------------|
| ** **                                                   | ** ** | **2006**            | ** ** | **2006**          | ** ** | **Change** | ** ** |
| Cash and cash  equivalents                                   |       | $                   | 3,362      |              | $          | 3,569      |       | $ | (207 | ) |
| Marketable debt  securities                                  |       | 1,309               |       | 1,279             |       | 30         |       |
| Total cash, cash  equivalents and marketable debt securities |       | $                   | 4,671      |              | $          | 4,848      |       | $ | (177 | ) |
| Percentage of  total assets                                  |       | 33.6                | %          | 32.1              | %          | 1.5        |  pts  |

 

|                                                  | ** ** | **Three Months Ended** | ** ** | ** **             | ** ** |
|--------------------------------------------------|------------|----------------------------------|------------|------------------------|------------|
| ** **                                       | ** ** | **October 1,**              | ** ** | **September 25,** | ** ** | ** ** | ** ** |
| ** **                                       | ** ** | **2006**                         | ** ** | **2005**               | ** ** | **Change** | ** ** |
| Cash provided by  operating activities           |       | $                                | 157        |                   | $          | 224 |   | $ | (67 | ) |
| Cash provided by  (used in) investing activities |       | 109                              |       | (770                   | )          | 879 |   |
| Cash provided by  (used in) financing activities |       | (473                             | )          | 3                      |       | (476 | ) |
| Net decrease in cash  and cash equivalents       |       | $                                | (207       | )                      | $          | (543 | ) | $ | 336 |   |

 

*Changesin Cash Flow*

During the first quarter offiscal 2007, our operating activities generated cash flows of $157 million.The following items significantly impacted our cash provided by operating activities:

·                  Net loss of $56 millionincluded non-cash charges of approximately $267 million, which included depreciationand amortization of $123 million, amortization of acquisition-related intangibleassets of $81 million and stock-based compensation of $58 million;

·                  Payment of $110 millionin income tax; and

·                  Payments associatedwith severance and facilities restructuring liabilities totaling $87 million.

The reasons for certain changesin our working capital are discussed further in the cash conversion cycle sectionbelow.

During the first quarter offiscal 2007, our cash provided by investing activities of $109 million wasprimarily attributable to proceeds from sale of property, plant and equipment, net,of $160 million, which included $213 million in cash received from thesale of our Newark, California facility. The increase in cash provided by investingactivities is partially offset by the acquisition of spare parts and other assetsof $34 million and purchases, net of proceeds from sales and maturities ofmarketable debt securities of $24 million. Our cash used in financing activitiesof $473 million was primarily attributable to $500 million paid to settlethe current portion of our Senior Notes, partially offset by $27 million receivedfrom issuance of common stock, net.

23

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*Cash ConversionCycle*

|                                       | ** ** | **October 1,** | ** ** | **June 30,** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|---------------------|------------|-------------------|------------|------------|------------|
| ** **                            | ** ** | **2006**            | ** ** | **2006**          | ** ** | **Change** | ** ** |
| Days sales  outstanding (DSO)(1)      |       | 57                  |       | 64                |       | 7          |       |
| Days of supply  in inventory (DOS)(2) |       | 29                  |       | 22                |       | (7         | )          |
| Days payable  outstanding (DPO)(3)    |       | (65                 | )          | (59               | )          | 6          |       |
| Cash conversion  cycle                |       | 21                  |       | 27                |       | 6          |       |
| Inventory turns —  products only |       | 8.8                 |       | 9.9               |       | (1.1       | )          |

----

(1)             DSO measures the numberof days it takes, based on a 90 day average, to turn our receivables into cash.

(2)             DOS measures the numberof days it takes, based on a 90 day average, to sell our inventory.

(3)             DPOmeasures the number of days it takes, based on a 90 day average, to pay the balancesof our accounts payable.

We ended the first quarterof fiscal 2007 with a cash conversion cycle of 21 days, an improvement of 6 daysfrom June 30, 2006. The cash conversion cycle is the duration between the purchaseof inventories and services and the collection of the cash for the sale of our productsand services and is a metric on which we have focused as we continue to try to efficientlymanage our assets. The cash conversion cycle results from the calculation of dayssales outstanding (DSO) added to days of supply in inventories (DOS), reduced bydays payable outstanding (DPO). DSO improved by 7 days due to seasonality andimproved billings and collections throughout the quarter. DOS negatively impactedour cash conversion cycle by 7 days primarily due to seasonality and an increasein inventories from June 30, 2006. Our products inventory turn rate is at 8.8 turnsat October 1, 2006 as compared to 9.9 turns at June 30, 2006. Inventoryturns is annualized and represents the number of times product inventory is replenishedduring the year. Inventory management will continue to be an area of focus as webalance the need to maintain sufficient inventory levels to help ensure competitivelead times with the risk of inventory obsolescence due to rapidly changing technologyand customer requirements. DPO improved 6 days due to seasonality despite the $154 milliondecrease in accounts payable from June 30, 2006.

*Stock Repurchases*

From time to time, our Boardof Directors approves common stock repurchase programs allowing management to repurchaseshares of our common stock in the open market pursuant to price-based formulas.In February 2001, we announced our intention to acquire up to $1.5 billionof our outstanding common stock under a stock repurchase program authorized by ourBoard of Directors. Under the February 2001 program, the timing and actual numberof shares subject to repurchase are at the discretion of management and are contingenton a number of factors, including our projected cash flow requirements, our returnto sustained profitability and our share price. During the the first three monthsof fiscal 2007 and fiscal year ended June 30, 2006, we did not repurchase commonstock under our repurchase program. All prior repurchases were made in compliancewith Rule 10b-18 under the Securities Exchange Act of 1934, as amended. As of October 1,2006, approximately $230 million of the $1.5 billion authorized remainsunused and available for stock repurchase.

*Borrowings*

Our $550 million of unsecuredsenior debt securities (Senior Notes) outstanding are due in August 2009. The SeniorNotes are subject to compliance with certain covenants that do not contain financialratios. We are currently in compliance with these covenants. If we failed to bein compliance with these covenants, the trustee of the Senior Notes or holders ofnot less than 25% in principal amount of the Senior Notes would have the abilityto demand immediate payment of all amounts outstanding.

In January 2005, our Boardof Directors authorized our management to repurchase debt from time to time in partialor full tranches based on available cash and market conditions. As of October 1,2006, we have not repurchased any debt.

In addition, we have uncommittedlines of credit aggregating approximately $451 million and no amounts weredrawn from these lines of credit as of October 1, 2006. Interest rates andother terms of borrowing under these lines of credit vary from country to countrydepending on local market conditions at the time of borrowing. There is no guaranteethat the banks would approve our request for funds under these uncommitted linesof credit.

*ContractualObligations*

Through the normal courseof our business, we purchase or place orders for the necessary components of ourproducts from various suppliers and have also committed to purchase certain outsourcedservices where we would incur a penalty if the agreement was canceled prior to acontractual minimum term. We estimate that our contractual obligations at October 1,2006 were no more than $1,007 million and were primarily due in less than 1year from October 1, 2006. This amount does not include contractual obligationsrecorded on the balance sheet as current liabilities. Contractual obligations forthe purchase of

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goods or services are comprisedof agreements that are enforceable and legally binding on Sun and that specify allsignificant terms, including fixed or minimum quantities to be purchased, fixed,minimum or variable price provisions, and the appropriate timing of the transactions.Our purchase orders are based on our current manufacturing needs and are fulfilledby our vendors within a short time. In addition, we have a contractual obligationunder the terms of our strategic alliance with Fujitsu, whereby we have committedto buy, provided certain conditions are met, Fujitsu products with a list priceof $230 million within the first twelve months following full implementationof Sun’s distribution of Fujitsu products and approximately $265 million duringthe second twelve months following full implementation of Sun’s distribution ofFujitsu products, at a predetermined discount from list price, depending upon thetype of product purchased.

Sun is insured by third-partyinsurers for certain potential liabilities, including worker’s compensation, generalliability, automobile liability, employer’s liability, errors and omissions liability,employment practices liability, property, cargo and crime and directors and officersliability. We have self insured with regard to certain risks such as Californiaearthquakes and as supplemental coverage for certain potential liabilities including,but not limited to general liability, automobile liability, employer’s liability,employment practices liability, directors and officers liability, workers compensation,errors and omissions liability, property, cargo, crime and employee life insurance.Effective July 1, 2006, we self-insure for all indemnification or defense paymentswe, as a company, may make to or on behalf of our directors and officers as a resultof obligations under applicable agreements, Sun’s by laws and applicable law. Wehave self-insured between $2 million and $25 million per occurrence onthese lines of coverage. Sun performs an annual actuarial analysis to develop anestimate of amounts to be paid for both claims reported and potential losses onactivities that have occurred but have not yet been reported. Loss accruals were$36 million and $35 million as of October 1, 2006 and June 30,2006, respectively.

In the normal course of business,we may enter into contractual arrangements under which we may agree to indemnifythe third party to such arrangement from any losses incurred relating to the servicesthey perform on behalf of Sun or for losses arising from certain events as definedwithin the particular contract, which may include, for example, litigation or claimsrelating to past performance. Such indemnification obligations may not be subjectto maximum loss clauses. Historically, payments made related to these indemnificationshave not been material.

During the third quarter offiscal 2006, we received a revenue agent report from the Internal Revenue Servicerelating to their examination of our tax returns filed for fiscal years 2001 and2002. Pursuant to the report, the Internal Revenue Service has proposed variousadjustments resulting in a tax assessment of approximately $27 million. OnApril 17, 2006, we filed a protest with the Internal Revenue Service to contestseveral items. Although the ultimate outcome is unknown, we believe that we haveadequately reserved for these potential adjustments and the final outcome will nothave a material adverse affect on our results of operations.

In fiscal 2005, the GeneralServices Administration (GSA) began auditing our records under the schedule contractsit had with us to verify our compliance with various contract provisions from October 1997to February 2005. If the audit determines that we did not comply with such provisions,we may be required to pay the GSA a potential settlement. We have made a preliminaryassessment of our exposure for such amounts potentially due and such assessmentis reflected in our fiscal 2006 and 2005 consolidated financial statements. We cannotpredict with reasonable certainty when the audit and the subsequent negotiationprocess will be concluded and it may take several quarters for all issues to beresolved.

In fiscal 2006 as part ofa service-based sales arrangement involving a governmental institution in Mexico,we were required to deposit approximately $41 million with a surety companyas collateral guaranteeing our performance under the arrangement. This cash is classifiedas other non-current assets, net, in our Condensed Consolidated Balance Sheet.

*CapitalResources and Financial Condition*

Our long-term strategy isto maintain a minimum amount of cash and cash equivalents in subsidiaries for operationalpurposes and to invest the remaining amount of our cash in interest bearing andhighly liquid cash equivalents and marketable debt securities. At October 1,2006, in addition to the $3,362 million in cash and cash equivalents, we hadapproximately $1,309 million in marketable debt securities that were availablefor shorter-term requirements, such as future operating, financing and investmentactivities, for a total cash and marketable debt securities position of approximately$4,671 million.

We believe that the liquidityprovided by existing cash, cash equivalents, marketable debt securities and cashgenerated from operations will provide sufficient capital to meet our requirementsfor at least the next 12 months. We believe our level of financial resources isa significant competitive factor in our industry and we may choose at any time toraise additional capital to strengthen our financial position, facilitate growth,and provide us with additional flexibility to take advantage of business opportunitiesthat arise.

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**NON-AUDIT SERVICESOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

Our Audit Committee haspre-approved tax compliance services, including those resulting from ouracquisitions of StorageTek and SeeBeyond, which are being transitioned to otherservice providers.

**FORWARD-LOOKINGSTATEMENTS**

This Quarterly Report,including the foregoing sections, contains forward-looking statements,particularly statements regarding: the estimated sublease income to begenerated from sublease contracts not yet negotiated; estimated futurerestructuring liabilities; our expectations with respect to workforce andfacility-related expenses; our expectations with respect to productivityimprovement initiatives and expense reduction measures; our plans to continueto invest significant resources in new technologies and to enhance existingproducts; our plans to continue to focus our efforts on achieving additionalcost efficiencies; our belief that the final outcome of an Internal RevenueService examination of our tax returns filed for fiscal years 2001 through2005 will not have a material affect on our results of operations; ourestimated contractual obligations at October 1, 2006; our estimates ofamounts to be paid for insurance claims; our belief that we have adequatelyreserved for potential adjustments resulting from an Internal Revenue Serviceexamination of our tax returns for fiscal 2001 and 2002; our belief that theliquidity provided by existing cash, cash equivalents, marketable debtsecurities and cash generated from operations will provide sufficient capitalto meet our requirements for at least the next twelve months; and our beliefthat the resolution of pending claims and legal proceedings will not have amaterial adverse affect on us.

These forward-lookingstatements involve risks and uncertainties, and the cautionary statements setforth above and those contained in the section of this report and our AnnualReport on Form 10-K for the fiscal year ended June 30, 2006 entitled “RiskFactors” identify important factors that could cause actual results to differmaterially from those predicted in any such forward-looking statements. Suchfactors include, but are not limited to, increased competition; increasedpricing pressures; the complexity of our products and the importance of rapidlyand successfully developing and introducing new products; lack of acceptance ofnew products and services; unexpected changes in the demand for our productsand services; delays in product introductions and projects; failure to further reducecosts or improve operating efficiencies; adverse business conditions; qualityissues associated with our hardware or software products; our failure to complywith income tax laws or regulations; our dependence upon key employees; andthat commercial real estate market conditions could affect our ability tosublease properties in our portfolio. Sun assumes no obligation to, and doesnot currently intend to, update these forward-looking statements.

**ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

We are exposed to marketrisk related to changes in interest rates, foreign currency exchange rates, andequity security prices. To mitigate some of these risks, we utilize derivativefinancial instruments to hedge these exposures. We do not use derivativefinancial instruments for speculative or trading purposes. All of the potentialchanges noted below are based on sensitivity analyses performed on ourfinancial position at October 1, 2006. Actual results may differmaterially.

*InterestRate Sensitivity*

Our investment portfolioconsists primarily of fixed income instruments with an average duration of 0.18 yearsas of October 1, 2006 as compared with 0.85 years as of September 25,2005. The primary objective of our investments in debt securities is topreserve principal while maximizing yields, without significantly increasingrisk. These available-for-sale securities are subject to interest rate risk.The fair market value of these securities may fluctuate with changes ininterest rates. A sensitivity analysis was performed on this investmentportfolio based on a modeling technique that measures the hypothetical fairmarket value changes (using a three-month horizon) that would result from aparallel shift in the yield curve of plus 150 basis points (BPS). Based on thisanalysis, for example, a hypothetical 150 BPS increase in interest rates wouldresult in an approximate $11 million decrease in the fair value of ourinvestments in debt securities as of October 1, 2006.

We have also entered intovarious interest-rate swap agreements to modify the interest characteristics ofthe Senior Notes so that the interest payable on the Senior Notes effectivelybecomes variable and thus matches the variable interest rate received from ourcash and marketable debt securities. Accordingly, interest rate fluctuationsimpact the fair value of our Senior Notes outstanding, which will be offset bycorresponding changes in the fair value of the swap agreements. However, byentering into these swap agreements, we have a cash flow exposure related tothe risk that interest rates may increase. For example, at October 1,2006, a hypothetical 150 BPS increase in interest rates would result in anapproximate $8 million increase in interest expense over a one-yearperiod.

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*ForeignCurrency Exchange Risk*

As a large portion of ourbusiness takes place outside of the U.S., we enter into transactions in othercurrencies. We are primarily exposed to changes in exchange rates for the Euro,Japanese yen, and British pound. We are a net receiver of currencies other thanthe U.S. dollar and, as such, can benefit from a weaker dollar, and can beadversely affected by a stronger dollar relative to major currencies worldwide.Accordingly, changes in exchange rates, and in particular a strengthening ofthe U.S. dollar, may adversely affect our consolidated revenue and operatingmargins as expressed in U.S. dollars. To minimize currency exposure gains andlosses, we may borrow funds in local currencies, and we often enter intoforward exchange contracts, purchase foreign currency options and promotenatural hedges by purchasing components and incurring expenses in localcurrencies. Currently, we have no plans to discontinue our hedging programs;however, we may evaluate the benefits of our hedging strategies and may chooseto discontinue them in the future.

Based on our foreigncurrency exchange instruments outstanding at October 1, 2006, we estimatea maximum potential one-day loss in fair value of approximately $2 million,as compared with $3 million as of June 30, 2006, using aValue-at-Risk (VAR) model. The VAR model estimates were made assuming normalmarket conditions and a 95% confidence level. We used a Monte Carlo simulationtype model that valued foreign currency instruments against three thousandrandomly generated market price paths. Anticipated transactions, firmcommitments, receivables, and accounts payable denominated in foreigncurrencies were excluded from the model. The VAR model is a risk estimationtool, and as such is not intended to represent actual losses in fair value thatwill be incurred by us. Additionally, as we utilize foreign currencyinstruments for hedging anticipated and firmly committed transactions, a lossin fair value for those instruments is generally offset by increases in thevalue of the underlying exposure.

*EquitySecurity Price Risk*

We are exposed to pricefluctuations on the marketable portion of equity securities included in ourportfolio of equity investments. These investments are generally in companiesin the high-technology sector, many of which are small capitalization stocks.We typically do not attempt to reduce or eliminate the market exposure on thesesecurities. A 20% adverse change in equity prices would result in anapproximate $4 million decrease in the fair value of ouravailable-for-sale equity investments as of October 1, 2006, as comparedwith $5 million as of September 25, 2005. At October 1, 2006,one equity security represented substantially all of the $22 million totalfair value of the marketable equity securities.

**ITEM 4. CONTROLSAND PROCEDURES**

*Evaluationof disclosure controls and procedures*. Our managementevaluated, with the participation of our Chief Executive Officer and our ChiefFinancial Officer, the effectiveness of our disclosure controls and proceduresas of the end of the period covered by this Quarterly Report on Form 10-Q. Basedon this evaluation, our Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures were effective such thatthe information required to be disclosed in our Securities and ExchangeCommission reports (i) is recorded, processed, summarized and reportedwithin the time periods specified in Securities and Exchange Commission rulesand forms, and (ii) is accumulated and communicated to Sun’s management,including our Chief Executive Officer and Chief Financial Officer, asappropriate to allow timely decisions regarding required disclosure.

*Changesin internal control over financial reporting.* There was nochange in our internal control over financial reporting that occurred duringthe fiscal quarter covered by this Quarterly Report on Form 10-Q that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

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**PART II — OTHERINFORMATION**

**ITEM 1. LEGALPROCEEDINGS**

From time to time, Sunbecomes involved in claims and legal proceedings that arise in the ordinarycourse of its business. We are currently subject to several such claims andlegal proceedings. We presently do not believe that the resolution of theselegal proceedings will have a material adverse affect on us.

**ITEM 1A. RISKFACTORS**

In addition to the other information set forth in this report, youshould carefully consider the factors discussed in Part I, “Item 1A.Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended June30, 2006, which have not materially changed other than as set forth below. Thoserisks, which could materially affect our business, financial condition orfuture results, are not the only risks we face. Additional risks anduncertainties not currently known to us or that we currently deem to beimmaterial also may materially adversely affect our business, financialcondition and/or operating results.

*Our reliance on single source suppliers could delayproduct shipments and increase our costs.*

We depend on many suppliers for the necessary parts and components tomanufacture our products. There are a number of vendors producing the parts andcomponents that we need. However, there are some components that can only bepurchased from a single vendor due to price, quality, technology or otherbusiness constraints. For example, we currently depend on Texas Instruments forthe manufacture of our UltraSPARC microprocessors, AMD for the Opteronprocessors used in our Sun Fire x64 servers, Imation for tape media used incertain tape storage products and several other companies for custom integratedcircuits. In addition, we recently outsourced the manufacture of all of ourlegacy StorageTek tape drives and libraries to Solectron Corporation. If wewere unable to purchase on acceptable terms or experienced significant delaysor quality issues in the delivery of necessary parts, components or productsfrom a particular vendor and we had to find a new supplier for these parts,components or products, our new and existing product shipments could bedelayed, which could have a material adverse effect on our business, results ofoperations and financial condition.

*Our sales to U.S. governmental agencies may sufferif our primary GSA schedule contract expires.*

We no longer face risks associated with the expiration of our primaryGSA schedule contract because the contract was renewed in September 2006.

**ITEM 2.UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

(c) Issuer Purchases of Equity Securities.

The table below sets forth informationregarding the Company’s purchases of its equity securities during the sixmonths ended October 1, 2006.

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| ** **                                           | ** ** | ** **                    | ** ** | ** **                   | ** ** | ** **                                | ** ** | **Approximate Dollar**             | ** ** |
|------------------------------------------------------|------------|-------------------------------|------------|------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                           | ** ** | ** **                    | ** ** | ** **                   | ** ** | **Total Number of Shares** | ** ** | **Value of Shares That** | ** ** |
| ** **                                           | ** ** | ** **                    | ** ** | ** **                   | ** ** | **Purchased As Part of**   | ** ** | **May Yet Be Purchased** | ** ** |
| ** **                                           | ** ** | **Total Number of** | ** ** | **Average Price**       | ** ** | **Publicly Announced**               | ** ** | **Under the Plans**           | ** ** |
| **Period**                                           | ** ** | **Shares Purchased(1)**  | ** ** | **Paid Per Share** | ** ** | **Plans or Programs(2)**        | ** ** | **or Programs(2)**                 | ** ** |
| March 27,  2006 through April 28, 2006     |       | 188,675                       |       | $                            | 0.09       |                                      | —     |                                    | $          | 230,000,000 |   |
| April 29,  2006 through May 26, 2006       |       | 8,141                         |       | $                            | 1.34       |                                      | —     |                                    | $          | 230,000,000 |   |
| May 27,  2006 through June 30, 2006        |       | 152,338                       |       | $                            | 2.22       |                                      | —     |                                    | $          | 230,000,000 |   |
| July 1,  2006 through August 4, 2006       |       | 2,413,430                     |       | $                            | 4.22       |                                      | —     |                                    | $          | 230,000,000 |   |
| August 5,  2006 through September 1, 2006  |       | 145,264                       |       | $                            | 1.59       |                                      | —     |                                    | $          | 230,000,000 |   |
| September 2,  2006 through October 1, 2006 |       | 512,102                       |       | $                            | 4.69       |                                      | —     |                                    | $          | 230,000,000 |   |
| Total                                                |       | 3,419,950                     |       | $                            | 3.85       |                                      | —     |                                    | $          | 230,000,000 |   |

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(1)    The total number of shares repurchased includes shares of restrictedstock withheld for the payment of withholding taxes upon vesting of restrictedstock and shares of unvested restricted stock repurchased by the Company fromemployees whose employment terminated before such shares vested.

(2)    From time to time, our Board of Directorsapproves common stock repurchase programs allowing management to repurchaseshares of our common stock in the open market pursuant to price-based formulas.In February 2001, we announced our intention to acquire up to $1.5 billion ofour outstanding common stock under a stock repurchase program authorized by ourBoard of Directors. Under the repurchase program, the timing and actual numberof shares subject to repurchase are at the discretion of management and arecontingent on a number of factors, including our projected cash flowrequirements, our return to sustained profitability and our share price. Duringthe six months ended October 1, 2006, we did not repurchase common stock underour repurchase program. As of October 1, 2006, approximately $230 million ofthe $1.5 billion authorized remained unused and available for repurchase underour repurchase program.

**ITEM 6. EXHIBITS**

See Index toExhibits on Page 31 hereof.

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                         | SUN MICROSYSTEMS, INC. |
|-------------------------|------------------------|
|                    |                   |   |
|                    |                   |   |
|                    | BY:                    | /s/ Michael E. Lehman |   |
|                    |                   | Michael E. Lehman |
| * *                | * *               | *Chief Financial Officer and Executive Vice  President, Corporate Resources  (Principal Financial Officer)* |
|                    |                   |   |
|                    | BY:                    | /s/ V. Kalyani Chatterjee |   |
|                    |                   | V. Kalyani Chatterjee |
| * *                | * *               | *Chief Accounting Officer  (Principal Accounting Officer)* |
|                    |                   |   |
| Dated: November 9, 2006 |                   |   |

 

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**INDEX TO EXHIBITS**
| Exhibit  Number | ** ** | **Description**                                                                                                        |
|-----------------|------------|------------------------------------------------------------------------------------------------------------------------|
| 3.2(1)          |       | Bylaws of the Registrant, as amended November 2,  2006.                                                                |
|            |       |                                                                                                                   |
| 10.1*           |       | Chief Executive Officer Bonus Terms for FY07 under  the Section 162(m) Executive Officer Performance-Based Bonus Plan. |
|            |       |                                                                                                                   |
| 10.2*           |       | Executive Officer Bonus Terms for FY07 under the  Section 162(m) Executive Officer Performance-Based Bonus Plan.       |
|            |       |                                                                                                                   |
| 15.1            |       | Letter re Unaudited Interim Financial Information                                                                      |
|            |       |                                                                                                                   |
| 31.1            |       | Rule 13a-14(a) Certification of Chief Executive  Officer                                                               |
|            |       |                                                                                                                   |
| 31.2            |       | Rule 13a-14(a) Certification of Chief Financial  Officer                                                               |
|            |       |                                                                                                                   |
| 32.1            |       | Section 1350 Certificate of Chief Executive Officer                                                                    |
|            |       |                                                                                                                   |
| 32.2            |       | Section 1350 Certificate of Chief Financial Officer                                                                    |

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*                    Indicatesa management contract or compensatory plan or arrangement.

(1)             Incorporatedby reference to Registrant’s Current Report on Form 8-K filed November 8, 2006.

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