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Executives

John Swenson - Vice President, Investor Relations and Treasurer

Jorge Titinger - Chief Executive Officer

Bob Nikl - Chief Financial Officer

Analysts

Brian Freed - Wunderlich Securities

Amelia Harris - Sterne Agee

Silicon Graphics International Corp. (SGI) F2Q 2013 Earnings Conference Call January 30, 2013 5:00 PM ET

Operator

Good day, ladies and gentlemen, and thank you for your patience. You have joined the Silicon Graphics International Corporation Second Quarter 2013 Financial Results Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be given at that time. (Operator Instructions) As a reminder, this conference may be recorded.

I would now like to turn the call over to your host, Mr. John Swenson. Sir, you may begin.

John Swenson

Thank you. Good afternoon everyone. I am John Swenson, Vice President of Investor Relations and Treasurer for SGI. Welcome to our second quarter fiscal 2013 conference call for the period ended December 28, 2012. Joining me on today’s call are Jorge Titinger, SGI’s CEO and Bob Nikl, CFO.

Today’s press release is available on the Investor Relations section of our website at investors.sgi.com. This call is being webcast and a replay of the webcast will be available on our website two hours after the conclusion of the call and will remain available until the next earnings call.

Please note the Safe Harbor disclosure in our earnings release regarding forward-looking information. Today’s conference call includes forward-looking statements, including financial projections for our next fiscal quarter as well as the second half of fiscal 2013, market growth projections, and product development plans. There can be no assurance that we will achieve our financial objectives and we ask that you refer to our most recent filings with the SEC for important risk factors that could cause actual results to differ materially from these forward-looking statements. All statements made in this conference call are made only as of today’s date. SGI undertakes no obligation to update the information in this conference call, whether as a result of new information, future events or otherwise. To obtain copies of our latest SEC filings, please visit sec.gov or our website. Also during today’s call, we will make reference to several non-GAAP financial measures. You can find a reconciliation of these non-GAAP financial measures to GAAP financial measures in our earnings press release, which again is posted on our website.

Now to our conference call. Jorge will provide some highlights of the company’s performance for the second quarter. Bob will then give you further detail on financial results and guidance for the third quarter of fiscal 2013. We’ll then take your questions. With that, I’d like to turn the call over to Jorge, SGI’s CEO. Jorge?

Jorge Titinger

Thank you, John and good afternoon to you all. I will start with a few comments on Q2 and then we’ll discuss our progress on our turnaround plan, as well as our market outlook. We had a solid second fiscal quarter. Compared with the same quarter last year, we achieved a 1.5 point improvement in gross margin and reduced operating expenses by more than $6 million. This resulted in non-GAAP EPS above our expectations at $0.10, an increase of 150% over the $0.04 reported one year ago. We also achieved our third consecutive quarter of improvement in working capital, growing net cash by $28 million quarter-over-quarter. This allowed us to fully pay down our line of credit and to exit the calendar year with a $128 million of cash and no debt.

As reported in our preliminary results on January 15th, revenue for the fiscal quarter was less than originally expected. As certain shipments for U.S. government customers pushed into our fiscal third quarter primarily due to uncertainly related to the fiscal cliff at year end. Specifically, in late December, system integrators and end customers in the federal space, accelerated contingency planning related to possible sequestration, which led to customer decisions to push out shipments. Ultimately, the sequestration was kicked down the road as a result of agreements that were signed into law on January 2nd, and we have since recognized more than $30 million of government-related revenue month-to-date including most of the deals that were pushed out of December.

To summarize our performance in Q2, the quarter reflected the significant progress we have made in deal quality, costs and expenses, and cash management. However, overall gross margin percentage in Q2 also benefited from favorable mix and lower manufacturing cost as a result of the lower volume. So, we believe that we still have more work to do before gross margins are consistently aligned with our target operating model. As you will remember, the mid-term target operating model is focused on achieving gross margins in the high-20s to low-30’s and operating margins in the range of 5% to 10%, by the end of calendar 2013. This timing aligns with the tactical execution phase of the turnaround, which is essentially at a halfway point as of today.

We expect to complete or initiate a number of additional actions over the course of this calendar year and primarily in enhancing responsiveness to customers, reducing costs and improving efficiency. First, we are accelerating discussions with potential supply chain partners and expect to have a contract manufacturing arrangement in place for at least one of our product lines by the end of June. Second, we are continuing an ongoing business simplification process, which is designed to significantly reduce the number of SKUs in our inventory, standardize certain product configurations and reduce cycle times. We expect this to result in faster RFP responses, better inventory turns and overall enhanced responsiveness to customers.

Third, we are streamlining our product life cycle process, which is designed to ensure the timely introduction of differentiated new products and features that can enjoy strong customer demand, and return on investment. And fourth, we are continuing the optimization of our global footprint, including the ongoing restructuring in EMEA. Many of these initiatives will be led by our new Chief Operating Officer, Cassio Conceicao who joined us last week after 13 years at Applied Materials. He is an electric engineer, and a seasoned business executive with over 20 years of experience, running operations in high-tech. At Applied, he ran a multi-billion dollar service, spares, logistics and supply chain organization that set industry standards for innovation, customer responsiveness, and profitability. He will add immediate leadership to our key operational functions. This will give me more bandwidth to concentrate on the other elements of our strategic plan, in particular the vertical market and horizontal solution strategies that are designed to drive our long-term growth and margin improvement.

Let me now give you an update on the progress we are making on vertical and horizontal strategies. We have added key marketing talent to our areas of focus, including hires in Big Data, media and entertainment and manufacturing. We also have established virtual sales teams for each of our key target verticals to leverage reference account relationships, and shared best practices. After a slow start, we are continuing to gain traction with our latest generation of UV products. The pipeline for the UV product line increased 29% in Q2 and we saw a nice improvement in UV sales quarter-over-quarter.

As examples of recent successes, we booked and shipped two large UV systems for a U.S. government customer, including one UV 2000 with 1,024 cores and four terabytes of memory. We also had significant wins for the UV 2000 in life sciences and earth sciences applications in Latin America and Asia. On ICE X product line, our ICE X product is also beginning to build momentum. We had a solid sales quarter for ICE X and have seen its pipeline increased by 16% quarter-over-quarter. In Q2, we began shipping a new double density configuration of the product line that is optimized for power and cooling performance, further extending the price performance characteristics of this HPC product.

In storage, our pipeline increased 10% over last quarter. We added to our partnerships in software-defined storage, building on our Nexenta’s relationship through a new agreement with Scality for object-based storage. We now provide in partnership with Scality a unified scale-out storage solution that offers both extreme scale, and high performance, allowing customers to manage massive unstructured data sprawl.

Bundled together with the extreme density of our SGI Modular InfiniteStorage, or MIS, Scality’s Organic Ring Storage software kit enables customers to take advantage of a converged multi-petabyte storage architecture that scales to billions of files. This is significant for SGI as we are now well positioned to capitalize on the industry trend towards software defined and scale out storage. We also had another solid quarter for our Rackable product line, selling into both traditional cloud infrastructure accounts and into large value added Hadoop deployments that continue to represent approximately half of our volume in this product line.

Overall, we are pleased with our strategic progress and are positioning for the large opportunity in Big Data. SGI has a heritage in Big Data having deployed the largest Hadoop installations and the largest single Hadoop cluster. We have long recognized that Big Data comes in many different shapes, sizes, and velocities and originates from a broad variety of sources. We provide an end-to-end Big Data architecture both scale up and scale out. We have UV 2000 Solutions that are capable of ingesting massive amounts of data at speeds of up to 4 terabytes per second. This would mean ingesting the entire library of Congress in three to four seconds.

Our ICE X and Rackable products along with UV provide a range of price performance and scale for data preprocessing and analysis. And when the data needs to be stored, we can handle petabytes of storage safely and cost effectively with DMF, our leading storage tier virtualization software and with MIS and our zero watch storage solutions.

Next, I’d like to provide an update on our IP valuation effort. Overall, our goal is to maintain a high-value IP portfolio that gives us freedom to operate and helps to protect our technology differentiation as part of our long-term strategic plan. As part of the evaluation, we are identifying the IP that is core to the business and merits additional investment and protection. We also are identifying opportunities to reduce costs through abandonment or sale of IP that does not merit further investment by us. Our evaluation to-date has confirmed our long-held belief that our patent assets are overall of better than average quality compared to our peers in the industry. We are filing many new patents on current innovation, especially before the March 17th change in U.S. law to our first to file system. So, we can take advantage of the benefits of that prior law and protect our new products.

We also have identified a number of existing patents that are no longer core to our current products and strategy and are evaluating opportunities to monetize these and remove them from our cost base. In most cases, the potential monetization or cost savings are modest, but nonetheless are meaningful in the context of an overall business simplification and cost reduction process. This evaluation process has also confirmed the strength of the NUMAlink IP, in particular. This is our core asset and a critical part of our strategic plan in terms of both growth and margin expansion. We therefore currently plan to retain and invest in the NUMAlink IP as we believe this is the path that best maximizes its value.

In summary, we continue to see great opportunity across our served markets. This is being driven by continuing growth of traditional HPC markets and the growing challenges associated with Big Data. Customer feedback, benchmarking and our win rate repeatedly confirm for us that we have the right products to capitalize on this market growth. Our opportunity pipeline is growing, particularly for UV, ICE X and storage. And although in the very near term, we are confronting challenging macro conditions in Europe and Japan, as well as budget uncertainty in the U.S., we believe we are making the right moves to expand the pipeline and to drive sustainable more profitable growth globally.

Our ultimate goal is to achieve strong doubt-digit earnings growth over a multi-year horizon. We believe achieving this goal requires both operational improvements and the execution of our strategic plan. We are pleased with our demonstrated progress to-date on the operational improvements. And as I said, there are more to come. We also have taken some of the initial actions necessary to realize our strategic vision, and we believe we will see results from these efforts in coming quarters.

With that, let me turn it over to Bob Nikl for a further review of the financial results and for our outlook. Bob?

Bob Nikl

Thanks, Jorge and good afternoon everyone. I will start by discussing our second quarter financial performance and then provide guidance for the third quarter of fiscal 2013. Please note that many of the figures I referenced will be non-GAAP measures, which typically exclude restructuring and severance charges, stock-based compensation, and amortization of intangibles. A full reconciliation to our GAAP financial results is provided in our press release.

Revenue was $171 million, down 11% from the prior quarter and down 12% from the year-ago period. As expected, we recognized none of the two remaining low margin deals in the second quarter. Product revenue represented 75% of total revenue for the quarter. Within products compute accounted for 88% and storage was 12%. And this compares with 90% compute and 10% storage in Q1.

In our market segments, the public sector was approximately 47% of total revenue, while the cloud segment accounted for 22%. This was relatively unchanged from last quarter. And as a reminder, our public sector includes direct U.S. federal business, which is roughly a quarter of total revenue, as well as indirect federal business that we serve through system integrators. The public sector also includes universities, research labs and foreign government agencies. Domestic revenue was 62% of total revenue, while international was 38%, the same as in the prior quarter. Approximately 84% of revenue came there direct and indirect sales, which includes our system integrated partners. The remaining 16% was from the channel. And during the quarter we had one customer representing greater than 10% of revenue.

Non-GAAP gross margin was 28.5%, up six points from 22.4% in the previous quarter. We believe that this is more indicative of our gross margin profile without the low margin deals. Although as Jorge mentioned, we had other favorable factors reflected in margin for the quarter. Of the six points of total improvement, approximately two points were attributable to the lack of M&Ds, two points were due to improved product mix, and two points were the result of favorable overhead absorption and other COGS. Although the reported gross margin percentage aligns with our mid-term targets, these factors contributed to an especially strong margin performance relative to our original expectations for the quarter and relative to where we are in our margin improvement program.

Non-GAAP operating expenses in the quarter were $45 million, flat with the prior quarter. While R&D program spending was up as expected, other operating expenses were lower due to headcount related savings, as well as tighter expense management. Worldwide headcount declined by 42 to approximately 1450 full-time and temporary heads. This represents reduction of approximately 8%, since the start of the fiscal year. Net income for the quarter on a GAAP basis was $0.03 per share. This includes the impact of a non-cash $4 million tax related benefit. Non-GAAP net income was $0.10 per share and excludes the impact of stock-based comp, restructuring and severance charges, amortization of intangibles and other one time charges, as well as the tax benefit. Again, the non-GAAP net income performance excludes the tax benefit.

Now, some brief comments on the balance sheet. Cash as of the end of the quarter was $128 million, up from a $111 million last quarter. We also paid down the remaining $10 million principal balance, as well as accrued interest on our line of credit in the quarter, resulting in a $28 million improvement in our overall net cash position quarter-on-quarter. I would like to highlight that we received more than $70 million of milestone payments in the quarter, which reflects our continuing focus on managing both supplier and customer terms to improve our cash to cash cycle time. Our general experience has been that many customers are open to this advance and milestone payments, particularly when the discussion is part of the initial negotiation of a large deal.

Cash performance in the quarter was especially strong with approximately $30 million of milestones received in December that were originally expected in Q3. I would like to point out that these milestone receipts are recorded as deferred revenue, which accounts for the large increase in that balance sheet line item in Q2. Although we expect to collect more milestones in Q3, we anticipate that deferred revenue will come down substantially in the quarter as we recognize the revenue related to these Q2 milestone payments.

Ending accounts receivable were $89 million and essentially flat with last quarter. And our DSO was 47 days compared to 42 days in the prior quarter. Note that the DSO calculation does not include the impact of the milestone related billings and payments recorded in deferred revenue.

Total inventory of $147 million was also essentially unchanged from the prior quarter, while finished goods in our facility or already on site at customers awaiting acceptance increased sequentially by over $34 million. All other inventory categories decreased by approximately $33 million. We believe that the decline in raw material and work in process is a good indication of our continuing improvements in working capital management.

Trade accounts payable were $58 million, a decrease of $30 million from last quarter. And our days payable decreased to 43 days down from 53 days last quarter. The decline in AP reflects the flow through from our large material receipts and inventory build in prior quarters. Capital expenditures in the quarter were $1 million, while depreciation and amortization expense was $4 million. Both items were essentially unchanged from last quarter.

Finally, adjusted EBITDA was approximately $7 million significantly better than the essentially breakeven EBITDA reported in Q2. As we announced on January 15th, our Board authorized a $15 million stock repurchase plan which will expire in December 2014. We are considering two potential brokers for a proposed rotation and are in the process of establishing 10b-5 programs which we expect to have in place this quarter.

Before going on to our guidance, I want to take a few comments or make a few comments with regard to the extended build cycles and acceptance periods involved with large deals. Generally speaking, we recognized revenue on these deals only upon final acceptance of the system. In some cases, final acceptance can require performance and uptime tests that can span as long as 60 to 90 days. As a result, the timing of final acceptance on large deals is difficult to predict and can cause significant swings in quarterly revenue that are unrelated to the underlying demand for our solutions. The two large deals expected to be recognized in Q3 are what prompts us to provide a larger range of revenue guidance than we have in the past.

With that in mind, our guidance is as follows. Revenue for the third fiscal quarter is expected to be between $200 million and $230 million and is expected to include up to $50 million of the low margin deals. Over the second half of our fiscal year ending June, we continue to expect total revenues of $400 million to $420 million including the final $50 million of the low margin deals. GAAP net loss per share for the third fiscal quarter is expected to be a minus $0.12 to a minus $0.06 per share. And non-GAAP net income per share for the third fiscal quarter after excluding approximately $8 million of restructuring and severance charges, stock-based comp and intangibles amortization is expected to be between $0.12 and $0.18 per share.

So, with that, I will turn the call over to the operator to open the line for your questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Brian Freed of Wunderlich Securities. Your line is open.

Jorge Titinger

Hi, Brian.

Brian Freed - Wunderlich Securities

On a better quarter than I already expected, looking to next quarter and particularly the March quarter as well, your EPS is materially higher than I would have expected given the expected contribution of the low margin deal. Does that EPS range reflect an expectation that all $50 million hit in the March quarter or is it reflective of some split of those low margin deals between two quarters?

Bob Nikl

Brian, the range currently assumes that both deals would recognize in Q3.

Brian Freed - Wunderlich Securities

Okay. And are those deals profitable from an EPS standpoint or would the movement of one of those deals into the June quarter potentially improve your earnings per share?

Bob Nikl

It would be the latter. These two deals are really at the margins barely breakeven to slightly unprofitable.

Brian Freed - Wunderlich Securities

Great. And then secondly, as you think about the increasing focus on big data, obviously you guys play in a couple of elements of that space. Can you talk a little bit about what you guys are doing with respect to the DataRaptor product line, what you see as opportunities to either drive incremental customer demand in new verticals or potentially additional working relationships and what you did with MarkLogic? Thanks.

Jorge Titinger

Sure. So, right now the one announced partnership is with MarkLogic. There are a number of joints, for lack of better word, joint marketing efforts with them to continue to build the pipeline for that product. We both believe it is a very attractive product. And that it will do well in the big data market. But as you said, there are – big data has many elements and multiple flavors and so we continue to work with other potential partners on the compute side. For other appliances that would go under the DataRaptor umbrella. And for example, the announced partnership with Scality is also targeted at big data, but from a storage perspective. So, we’re continuing to build the solutions portfolio for big data solutions.

Brian Freed - Wunderlich Securities

Great. Thank you.

Jorge Titinger

Thank you.

Operator

(Operator Instructions) Our next question comes from Alex Kurtz of Sterne Agee. Your line is open.

Amelia Harris - Sterne Agee

This is Amelia in for Alex today. Thanks for taking the questions. Just a moment on your OpEx run rate for 4Q ’13, are you still expecting to hit that $43 million to $45 million range and any color on Altix UV pipe on the fourth quarter would be great? Thanks.

Bob Nikl

Sure, Amelia. Yeah, it’s funny; we were contemplating the same question here in as much as the first half of the year OpEx at $90 million from where we said came in below expectations by more than about $1 million or $2 million. So, for me depending upon the level of investment that we continue to make that represents execution of our strategic plan and the vertical markets I could see go out Q4 being a little bit higher than that range say $44 million to $46 million, but we’ll still be significantly down from last year’s nearly $200 million of OpEx.

On the UV pipeline, as I have mentioned during the prepared remarks that we started slow on the UV 2000 and this was after a very successful introduction of the prior product that sold really nicely. And we have had since then in both at last quarter and this quarter a nice increase in the pipeline I think we said about 50% last quarter and another 26% this quarter. And so we are – we feel like we are building the right momentum on the UV 2000 and actually it’s the UV 2 product line, so there are multiple sizes if you will of the product that can be purchased by customers. And we are seeing this not only in our traditional accounts, but also the internationally and in commercial accounts as well. So, we are finally starting to see the momentum picking up on UV as may be a little later that we would have hope, but it’s finally getting some nice legs.

Amelia Harris - Sterne Agee

Thank you.

Jorge Titinger

Thank you.

Operator

As there appear to be no further questions in queue at this time, I would like to turn the call over to management for any closing remarks.

John Swenson

Thanks very much everyone for joining us. Note, we will be presenting two conferences in February, the Stifel Nicolaus conference, February 5 in San Francisco, as well as Morgan Stanley, also in San Francisco on February 25. This ends our call for today. Thank you.

Jorge Titinger

Thank you everybody.

Operator

Thank you, gentlemen and thank you everyone for your participation. That does conclude your program. You may disconnect your lines at this time. Have a great day.

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