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Silicon Graphics International (NASDAQ:SGI)

Q3 2013 Earnings Call

April 30, 2013 5:00 pm ET

Executives

John Swenson

Jorge Luis Titinger - Chief Executive Officer, President and Director

Robert J. Nikl - Chief Financial Officer and Executive Vice President

Analysts

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Mark Kelleher - Dougherty & Company LLC, Research Division

Operator

Good day, ladies and gentlemen, and welcome to Silicon Graphics International Third Quarter 2013 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would like introduce your host for today's conference, Mr. John Swenson, SGI. Mr. Swenson, you may begin.

John Swenson

Thank you. And good afternoon, everyone. I'm John Swenson, Vice President of Investor Relations and Treasurer for SGI. Welcome to our Third Quarter Fiscal 2013 Conference Call for the period ended March 29, 2013.

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 2 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 fiscal 2014, growth expectations for certain products and various operational 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 to our website.

Now for our conference call. Jorge will provide some highlights of the company's performance for the third quarter and an update on the business outlook. Bob will give further detail on the Q3 results and financial guidance for the fourth quarter of fiscal 2013. We'll then take your questions.

With that, I'd like to turn the call over to Jorge Titinger, SGI's CEO. Jorge?

Jorge Luis Titinger

Thank you, John, and good afternoon to you all. I will comment on our solid Q3 results, and then we'll provide a progress report on our operational and strategic plan. In the third quarter, revenue of $233 million and non-GAAP EPS of $0.18 both came in at the high end of our guidance. We also ended the quarter with $153 million of cash and no debt, an increase of $25 million over the prior quarter and up $75 million from 1 year ago. We completed and recognized in revenue the final 2 low-margin deals, which were by far the largest of the LMDs and accounted for approximately $50 million of revenue in the quarter.

If we exclude the impact of the low-margin deals, revenue for the quarter was in the mid-180s and non-GAAP operating margin was more than 3%. This represents a substantial improvement of our Q2, which did not include any revenue from LMDs. On this basis, the biggest difference between the 2 quarters is that we recognized revenue on one other large deal in Q3, while we had no large deals in the second quarter. Although the timing of large deals will continue to introduce some lumpiness in revenues and profitability, Q2 and Q3 both serve as near-term proof points of our operational and strategic progress.

Our ultimate objective is to achieve sustainable growth in cash flow and earnings per share over a multi-year time horizon. Assuming the midpoint of our guidance for Q4 for the full 2013 fiscal year, we expect to deliver more than $0.30 per share non-GAAP on revenue of approximately $775 million. This would compare with $0.12 on revenues of $753 million in FY '12. With approximately $65 million of LMDs in the current fiscal year, our significant improvement in EPS was driven primarily by a focus on deal quality as well as cost and expense reductions. We are continuing to improve our productivity by driving initiatives such as supply chain optimization as well as cost reductions globally. We also expect to grow the business next year on the non-LMD base of approximately $700 million, leveraging new products as well as ongoing focus on our go-to-market strategy.

We therefore believe we are well positioned to achieve our midterm operating margin target of at least 5% exiting calendar 2013, as well as $1 per share of annualized non-GAAP earnings power when we reach the midterm target. Let me now provide an update on the progress we are making on our vertical and horizontal strategies.

We hired a new Chief Marketing Officer, Bob Braham. Bob comes to us from EMC, where he was Vice President of marketing for the company's Enterprise Storage Division. Bob also held senior marketing, product management and sales roles at Brocade, NetApp and Sun MicroSystems. He is leading all product management and marketing efforts globally, including defining and refining our value proposition across compute, storage, service and Big Data solutions. Bob led the introduction of our new InfiniteStorage Gateway, which already has generated significant customer interest.

With Bob's arrival, we believe we now have the right combination of great products and sales enablement to drive strong growth in our focus areas, and we expect the new InfiniteStorage Gateway will be a significant contributor to that growth. Bob has continued to consolidate and fill out his team around our other horizontal solutions and vertical markets, and we're extremely excited to attract a leader of Bob's caliber to guide our marketing effort.

In Q3, we had another good revenue quarter for the UV 2 and continued to build a pipeline of addressable deals. The pipeline for the UV 2 increased by 9% quarter-on-quarter and now is more than double what it was 1 year ago. Our objective is to build the UV 2 to be between 15% and 20% of our product revenue, which will be more than double our current run rate with that product.

The pipeline for ICE X expanded 30% in Q3, following a 16% gain in Q2. The total pipeline for ICE X is now more than $400 million and includes a number of large deal opportunities that we expect will be decided over the next 3 to 6 months. We were very pleased to see the broad media coverage of our new ICE X installation at Total, the French oil and gas company. Their system, which they call Pangea, runs at 2.3 petaflops and contains more than 110,000 cores and 442 terabytes of memory. It is the most powerful commercial HPC system on the planet and includes 7 terabytes of our MIS storage virtualized with our DMF hierarchical storage management software. Total held a large media event and produced a video that highlighted both the compute and storage solutions.

We also completed our large federal implementation of ICE X during the quarter. Since introduction, we have improved many aspects of this product line, and it is now ready for broader deployment. We believe ICE X is very competitive and highly differentiated in terms of power, cooling and density, and we are now accelerating our efforts to pursue ICE X deals. We currently are shipping approximately 600 petabytes of storage annually, which is an order of magnitude greater than our slower competitors in HPC.

Our storage pipeline increased 6% quarter-on-quarter after a 10% increase in Q2. However, this does not include any incremental opportunities for our new InfiniteStorage Gateway, which provides virtualized data management to deliver high-volume storage for as little as 1/10 the cost of what customers are paying today for primary storage. We are extremely excited about this product. It leverages our more than 20 years of experience in supporting large volumes of data with our highly differentiated DMS software to provide what we believe is a material competitive advantage in price performance for our Tier 2 storage solution. This product is not designed to compete head-to-head with primary storage offered by other leading storage providers. Instead, it is designed to be a highly cost-effective virtualized storage fabric for less active data across media that can include SSDs, disk, tape, object and cloud storage

With the exponential growth of big, unstructured data across both enterprise and government, customers are being challenged by the high cost of primary storage as well as costs related to power and cooling, backup and personnel to manage this data sprawl. What customers are finding is that on average, 85% of their data in high-cost storage is not regularly accessed. SGI's InfiniteStorage Gateway provides transparent movement and retrieval of data regardless of where it resides in customers' overall tiered storage architecture. Some of our best storage people, many of whom came from big names in the storage industry, believe that this is a game-changing product for the use case we are targeting. Early customer response has been excellent, and we expect to be shipping the product to some of these early customers in the current quarter, with volume available by the September quarter.

Finally, we had another solid quarter for our Rackable product line, selling into both traditional cloud infrastructure accounts and into large value-added Hadoop deployments. Based on public data in 2012, we shipped 8% of all Hadoop cluster nodes globally, which we believe quantifies SGI as an industry leader in Big Data. We continue to see strong demand for Hadoop clusters as well as increasing demand for expertise in deployment and application of Hadoop for Big Data Analytics. There is a large market for low-cost, high-efficiency clusters, and this business continues to deliver a positive operating margin contribution. Within this product line, we are working on optimizing the supply chain model to enhance our responsiveness to customers, increase flexibility and reduce cycle times, which we believe can facilitate more turns business and higher volumes over time.

In summary, we have dramatically improved the profitability of the base business and enhanced our ability to pursue big deals profitably. We have doubled the net cash position in the past 12 months, we are debt-free, and have made our balance sheet a competitive advantage. We are on schedule to announce a contract manufacturer partner for at least one of our product lines by the end of June. Our opportunity pipeline is growing, particularly for the UV, ICE X and storage. Our meaningful share in Big Data is impressive, and we will continue to leverage our strong position into this fast-growing market.

We have an exciting new gateway storage product which we believe will lengthen [ph] our lead in pure play HPC storage and broaden our opportunities across Big Data. Although, in the near term, we are confronting challenging macro conditions in Europe and Japan as well as federal budget uncertainty in the U.S., we now have the team and the tools in place to execute in the market, which we believe will enable the FY '14 revenue growth as I've described.

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

Robert J. Nikl

Thanks, Jorge. I'll start by discussing our third quarter financial performance and then provide the company's guidance for the fourth quarter of fiscal 2013. Please note that many of the figures I reference will be non-GAAP measures, which typically exclude restructuring and severance charges, stock-based compensation, amortization of intangibles and other nonrecurring items. A full reconciliation to our GAAP financial results is provided in our press release.

Revenue of $233 million was up 36% from the prior quarter and up 17% from the year-ago period. As expected, we recognized the 2 remaining low-margin deals totaling approximately $50 million in the third quarter. Products represented 80% of total revenue for the quarter, with compute accounting for 89% while storage was 11%, essentially unchanged from the prior quarter. On an absolute basis, storage grew significantly to a record $20 million compared with $15 million in Q2. Although some of this growth is associated with completion of the LMDs, it is still notable as it reflects a strong contribution from our new MIS platform and is a precursor of what we expect will be a fast-growing storage product line in FY '14. In our market segments, Public Sector was approximately 55% of total revenue, while the Cloud segment accounted for 14%. All other commercial was 31%.

Domestic revenue was 59% of total revenue, while international revenue was 41%. And this compares with 62% domestic in Q2. Approximately 85% of revenue came from direct sales, while 15% was from systems integrators and other channel partners. During the quarter, we had 3 customers representing greater than 10% of revenue.

Non-GAAP gross margin was 22.9%, down 6 points from 28.5% in the previous quarter. Of the overall 6 points of decline in gross margin, approximately 7 points were attributable to the LMDs, offset by 1 point of net improvement due primarily to favorable product mix.

Non-GAAP operating expenses in the quarter were $46 million, an increase of $1 million from the prior quarter. This was consistent with our expectations, as we have brought onboard a number of key new hires over the past several months, which is offsetting some of the restructuring related savings we had achieved earlier in the year. Year-to-date, we have reduced non-GAAP operating expenses by approximately $15 million or 10%. Worldwide headcount declined by 16 from Q2 levels to 1,437 full time and temporary heads. This represents a reduction of approximately 9% since the start of the fiscal year.

We are continuing to address operating expenses in the context of funding our long-term growth while meeting our midterm operating margin targets. Over the next 6 to 9 months, we expect to be largely complete with our global restructuring activities, which we anticipate will result to non-GAAP operating expenses in the range of $42 million to $44 million per quarter.

Net income for the quarter on a GAAP basis was $0.27 per share and includes the favorable impact of an $8 million tax-related benefit, most of which is noncash. Non-GAAP net income was $0.18 per share and excludes the impact of the tax benefit, as well as stock-based compensation expense, restructuring and severance charges and amortization of intangibles. Again, our 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 $153 million, up from $120 million last quarter. The improvement in cash was driven primarily by positive adjusted EBITDA of $9 million, $12 million of net proceeds from the exercise of stock options and $4 million related to changes in working capital. We again received milestone payments in Q3. Milestones have become part of our standard terms and conditions for large projects, and going forward, we expect them to represent in the range of 15% to 30% of total collections in a quarter depending on the timing of large deals and agreed-upon payment terms. As expected, the deferred revenue balance declined substantially in the quarter as we recognized revenue related to significant Q2 milestone payments.

Ending accounts receivable were $99 million, an increase of $10 million from last quarter, while our DSO was 38 days compared to 47 days in the prior quarter. Total inventory decreased $71 million from last quarter to $76 million. The reduction was largely due to the high balance of shipped, but not invoiced, finished goods at the end of Q2 that were accepted by customers and recognized as revenue in Q3. Trade accounts payable were $55 million, a decrease of $3 million from last quarter, and our days payable decreased 28 days, down from 43 days last quarter. The decline in AP and base payable primarily reflects the timing of material receipts, as our ongoing objective is to balance days sales and days payable outstanding. Capital expenditures in Q3 were $1 million, while depreciation and amortization expense was $4 million. Both items were essentially unchanged from last quarter.

During the third quarter, we implemented a 10b5 plan related to our stock repurchase authorization which was announced on January 15. The plan became effective in late February, and to date, we have repurchased approximately 70,000 shares for an aggregated purchase price of just under $1 million. The buyback is part of a larger capital allocation strategy that is being refined as we drive both working capital management and sustained profitability. We will be thoughtful and disciplined about capital allocation in terms of shareholder returns. We are in a growth mode in the business, and we intend to invest cash flow first in those things that support growth or improved productivity. This could be a new ERP system, for example, or expanding our benchmarking capability, or small technology acquisitions that make sense in the context of filling out our offering. Based on our expected future cash flows, we anticipate that there also will be opportunities to return capital to shareholders, such as our buyback program, but these opportunities will be funded after we have invested sufficiently back into the business.

Before moving on to our guidance, I want to remind you of the extended build cycles and acceptance periods involved with our larger deals. Generally speaking, we recognize revenue on these deals only upon final acceptance of the system. In some cases, final acceptance can require performance and uptime tests that can spend 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.

With that in mind, our guidance is as follows: revenue for the fourth fiscal quarter is expected to be between $170 million and $185 million; GAAP net loss per share for the quarter is expected to be $0.34 to $0.29 per share and is expected to include approximately $16 million of total adjustments consisting of $12 million of restructuring and severance costs related to previously announced or discussed restructuring activities and $4 million of stock-based compensation expense and intangibles amortization. As a result, non-GAAP net income per diluted share for the fourth fiscal quarter is expected to be $0.12 to $0.17.

In summary, we had another profitable cash-generating quarter in Q3, and we are on track with our internal expectations for fiscal 2013. We are extremely pleased to have completed the last of the low-margin deals, which we believe brings greater clarity to the underlying profitability of the business as we move forward. Our preliminary view of fiscal 2014 is that the timing of customer budget decisions and our revenue recognition will continue to be difficult to predict, but we approach the year with confidence that we will deliver better operating margins and stronger per-share earnings year-on-year.

With that, I'll turn the call over to the operator to open the line for your questions. Chuck?

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Alex Kurtz with Sterne Agee.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Bob, back on the cash for distribution to shareholders, as you move to a CEM strategy over the next couple of quarters, obviously that's going to likely lessen your need for cash. I understand there's acquisition, small tuck-in acquisitions that may occur from time to time. But why not outline a more aggressive buyback plan at this point, given that you're moving to a CEM?

Robert J. Nikl

It's a fair question, Alex. From our perspective, though, while we would expect obviously to realize some cash flow from an outsourcing agreement, it's still somewhat early days to assess how much that might well be inasmuch as we're planning on initiating a transfer with just a product line. The other thing that's worth keeping in mind is that's, in many respects, simply timing. The CEM will give me cash for the inventory but, ultimately, is going to consume it, and I'll have to pay for it. So I don't see that as freeing up an enormous amount of extra cash that we would want to initially redeploy as part of the share repurchase. Having said that, we do plan to regularly review with our board capital allocation, and that opportunity to revisit the share repurchases is certainly on our agenda.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Okay. And then moving on to the normalized gross margin. Jorge was talking about an operating margin that would -- it would seem to imply the gross margin x the LMD in march was sort of the gross margin, Bob, that you had in December. Is that 28% and change number, is that what we should be about for gross margin in June?

Robert J. Nikl

I wouldn't stretch that far. So if we did it on an adjusted x LMD basis for the quarter, gross margin was roughly 30%. And we did benefit some very -- from some very favorable product mix in Q3, which I'm not yet persuaded will necessarily repeat next quarter. Having said that, we're still, I think, well within our target range of 28% to 29% in the near term for total gross margin x the LMDs.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

So as we look into fiscal '14, I think you talked about 30%, I think, what, 30% to 32% is what the longer-term target is. Nothing's changed from your perspective on your ability to get there, especially considering what you did here in March?

Robert J. Nikl

That's actually correct, Alex. I think one of the biggest factors will be at what point do we continue to get richer business, because that is in fact the focus right now, as well as when do we start to realize the benefits of the supply chain decision.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Okay. Just a couple of more quick question, and then I'll cede the floor here. It looked like the public sector grew substantially on a quarter-to-quarter basis. Given what's going on with sequester in the media, that sort of flies in the face of that. So was a portion of that LMD because there's some university revenue in that LMD?

Jorge Luis Titinger

No -- this is Jorge, Alex. What we've seen so far from the whole sequester is that, if you look at the key dates that were set out to trigger changes, right, first was March 1, and essentially at March 1, what happened was there was a continued resolution that carried the budgets through March 27. And in March 27, that continued resolution was extended through the fiscal year, which ends in September. So we haven't seen really any impact of sequester in the Q3 numbers so far. We think there are some impacts. We're seeing slight either reductions in project budgets or slight push-outs in project budgets. But I don't think there'll be a lot of clarity until whatever happens in September is more evident to everybody. In the quarter that we just reported was no impact from sequester.

Robert J. Nikl

Yes, Alex, I'd also mention that quarter-on-quarter, the compares benefit from the fact that we did have, you may recall, in Q2, some federal-related business that slipped out because of the end of December nervousness. So as I say, the compares benefited from that, but it didn't represent anything fundamentally different in our Fed business.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Okay, just 2 last questions. Do we have to wait for the Q, or can you tell us what the Amazon Web Services number was? And then, Bob, how should we think about tax rate for non-GAAP for fiscal '14?

Robert J. Nikl

I would defer to not mention anything specifically about the first question. As far as fiscal '14 is concerned, rate perspective is somewhat challenging here because of the NOL utilization. If I were looking at it from the standpoint of what I would start to assume, I would be looking at a tax provision on a quarterly basis of something like $500,000 to $750,000.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

So exiting at maybe $1 million?

Robert J. Nikl

No. Right now in terms of our work-up for guidance this quarter, I'd say our income tax provision will be somewhere between $0 and $300,000.

Alex Kurtz - Sterne Agee & Leach Inc., Research Division

Okay. And that'll scale into fiscal '14?

Robert J. Nikl

Yes, I think so. I don't think '14 should represent a significant departure from the standpoint of non-GAAP tax provisioning based upon the NOL profile.

Operator

Our next question comes from Mark Kelleher with Dougherty & Company.

Mark Kelleher - Dougherty & Company LLC, Research Division

I just want to go back to talk a little bit about the revenue upside. You had a very strong top line there. I know there were $50 million of deals coming in, but you mentioned that there was a little bit of push from the December quarter into the March quarter. Was -- how did the linearity play out in the quarter, and was there any pull from the June quarter into the March quarter?

Robert J. Nikl

No, I would say whatever was -- what was pulled was not by design. It would be based upon customer need. So nothing significant there. We had always, from the standpoint of crafting guidance last quarter, assumed a rather wide corridor, simply because of the 2 large deals. That's not to say the entire corridor was represented by what now has turned out to be nearly $50 million of LMD. But as we continue to emphasize, this business is fairly lumpy. That makes 90-day predictability a bit more challenging than for some companies, I think.

Mark Kelleher - Dougherty & Company LLC, Research Division

So were there any deals that you were expecting in the June quarter that recognized in the March quarter?

Robert J. Nikl

Not significant or material, no.

Mark Kelleher - Dougherty & Company LLC, Research Division

All right. And how about an update on competition? How's the competitive landscape look? Is it similar to what it usually is?

Jorge Luis Titinger

Yes, I'd say we continue to see similar competitors and, by market, if you would, by size of deal. So in some of the very large deals for us, we don't run into some of the smaller competitors, and the landscape in which we're playing is fairly broad. So we tend to see all of the players that are competing with us. But I don't -- we've not detected any, necessarily, changes in the competitive landscape.

Operator

[Operator Instructions] And our next question comes from Roxanne Gaugin [ph] with Surge Global Investment [ph].

Unknown Analyst

Sorry, I got on the phone -- I mean, I called a little bit late, and so I missed Jorge's initial comment. But could you make a few comments about growth, not in your competition, but in the workload demand and symmetric multiprocessing relative to more clustered workloads? And specifically, if you can, if you're seeing any activity with the Microsoft SQL Server?

Jorge Luis Titinger

This is Jorge. Yes, one of my early comments was on the growth of the UV pipeline, our shared memory product. And the pipeline for that product actually doubled in the next year and -- albeit from a slow -- from a small number. But we have seen healthy growth in the pipeline quarter after quarter and -- to where now it is twice as big as it was a year ago. And our goal is to get that product line to be 15% to 20% of our total product revenues in the time frame that we have specified in our strategic plan. So we're on track to achieve that. And a lot of it is, again, specific use cases with customers that really, truly benefit from having to not split their problem set into a cluster. So we have some types of problems that -- we're calling it the relationships between the different elements of the problem set rather than a needle-in-the-haystack type of problem, which a cluster serves very, very well. So we still a lot of work to do on the application, development, if you will, for SMP type of computers versus the more standard programming that's going on for clusters today. But we're very pleased with the progress of the UV 2 growth pipeline.

Unknown Analyst

Okay. And so, the gating factor, sounds like some more software work has to be done?

Jorge Luis Titinger

Yes. There's many more readily available applications, if you will, that sit on top of Linux that run on clusters. Although of those will run on the UV, but they don't take advantage of the coherent shared memory capability. So the differentiation and performance is not evident unless you actually have that application running native.

Unknown Analyst

Okay. And are these -- I'm sorry. Are these more in data searching or more in modeling, like in the physical plane? Just curious. More data-oriented?

Jorge Luis Titinger

Yes. So in the traditional technical computing world, a lot of modeling, a lot of research-oriented applications are written. A lot of those do run in the UV. But remember, what we want to do is make the UV more commercially appealing. And so for that is analytics, data search, data visualization types of applications that we want to get -- have running native on the UV.

Unknown Analyst

Okay. Super. I'm sorry, I didn't mean to interrupt. And then in the cloud space, we have the emergence of the Open Compute Project from Facebook on one hand, and then you have the growth of the cost-optimized computer on the other hand, where I would kind of put you. Could you talk about how though market's moving? You have Rackspace going into the OCP side, and then it seems like a lot of the SaaS vendors who are growing pretty fast are not. Do you have any comments on how those 2 markets are growing?

Jorge Luis Titinger

Not really. Actually, I will take your question and do some research, because we are looking at the cloud space in a probably more simplistic way, which is public cloud and growth of private cloud rather than [indiscernible] applications are run, different segments that you're mentioning.

Operator

[Operator Instructions] And at this time, I'm showing no further questions. I would like to turn the call back over to management for closing remarks.

John Swenson

Okay. Thanks very much, everyone. Note, we'll be presenting at 3 conferences as in May. The Robert Baird Conference on May 9 in Chicago; the JV Securities Conference, May 13 in San Francisco; and the Craig-Hallum Conference in Minneapolis in May 29. Look forward to seeing some of you there. This ends our call for today.

Jorge Luis Titinger

Thank you.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Have a great day.

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