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Silicon Graphics International Corp (NASDAQ:SGI)

F4Q2010 Earnings Call Transcript

August 31, 2010 5:00 pm ET

Executives

Erik Bylin – IR

Mark Barrenechea – President & CEO

Jim Wheat – SVP & CFO

Analysts

Brian Freed – Morgan Keegan

Operator

Good afternoon and thank you for standing by and welcome to today's conference call to discuss SGI's fourth quarter and fiscal 2010 earnings results. I would like to remind you that this call is being recorded and simultaneously webcast at investors.sgi.com.

At this time, I would like to turn the call over to Mr. Erik Bylin for opening remarks and introductions. Please go ahead.

Erik Bylin

Good afternoon. Thank you for joining us to discuss our fourth quarter fiscal year 2010 preliminary financial earnings press release of this afternoon, which is available on our website at www.sgi.com. I'm Erik Bylin, Investor Relations for SGI and I will be managing the call. Joining me today on the call are Mark Barrenechea, our President and Chief Executive Officer; and Jim Wheat, our Chief Financial Officer.

Before I turn the call over to Mark, I would like to bring the following to your attention. The date of this call is August 31st, 2010. This call is the property of SGI and any recording, reproduction or transmission of this conference call without the express prior written consent of SGI is strictly prohibited. This call is being webcast live and a web replay will be available on our website for approximately 90 days.

Our presentation today contains forward-looking statements reflecting management's expectations about our markets, business, products, 2010 outlook, long-term operating assumptions and plans and financial performance, as well as other events and circumstances that have not yet occurred. Statements containing the words such as will, expect, believe, project, and intend and other statements in the future tense are forward-looking statements.

Any statements made on this call that are not statements of historical facts may be deemed forward-looking statements. Actual outcomes and results may differ materially from the expectations expressed or implied in these statements due to a number of risks and uncertainties, including SGI operates in a very competitive market, which may cause pricing pressure and impair our market penetration; SGI has extensive international business activities which create risk from complex international operations, foreign currency exposure and changing legal, regulatory, political or economic conditions, and if SGI is unable to manage its more extensive international operations, its business will be harmed; uncertainty arising from SGI's increased dependence on business with the U.S. government entities; failure of our customers to accept new products and economic conditions impacting the purchasing decisions of SGI's customers.

Accordingly, we caution you not to place undue reliance on these forward-looking statements. These and other risks and uncertainties affecting SGI are set forth in our Annual Report on Form 10-K under the caption "Risk Factors," which was filed with the Securities and Exchange Commission on March 19th, 2009, as updated by SGI's subsequent filings with the SEC, all of which are available at www.sec.gov.

We expressly disclaim any obligation to update or alter our forward-looking statements whether as a result of new information, future events or otherwise, except as required by law. We will be disclosing non-GAAP financial measures in this presentation. For a reconciliation of these non-GAAP financial measures to the corresponding GAAP measures, please see our press release of today, which is posted on our website at www.sgi.com.

In addition, we will be comparing our results from the fourth quarter of fiscal 2010 to prior and year-ago quarters. Unless otherwise stated, we are using as a basis for these comparisons the results of our company, Silicon Graphics International Corp., which prior to our name change, was known as Rackable Systems Incorporated.

Today, we have posted a slide deck on our website that highlights the key details of today's conference call. Please go to investors.sgi.com if you would like to download it.

In addition, I am pleased to let you know that we will be presenting at ThinkEquity's Seventh Annual Growth Conference in New York on September 16th. Please join us via webcast if you are unable to attend the conference.

I will now turn the call over to SGI's CEO, Mark Barrenechea.

Mark Barrenechea

Thank you for joining us today to discuss our Q4 results, FY '10 results, FY '11 guidance, and select elements of our FY '12 and FY '13 internal plan.

Before we discuss results and highlights for the fourth quarter and year-end, I would like to address the reason for our reporting delay. We originally planned to report our results on August 17th. Because of our complex legacy systems, it took longer than expected to install and deploy our new accounting software. We took the view that it was in the best interest of our shareholders to take another two weeks in order to ensure accuracy and reliability of SGI's financial data.

The new software and processes have been extensively tested and our business is now operational on the new platform. With this behind us, we expect to file our 10-K in a timely manner. I want to emphasize we take these issues seriously, we are accountable for them, and we apologize for any inconvenience caused by the delay.

FY '10 was significantly transformative for SGI. We entered the year with a mission to establish SGI as a company that sustains its leadership, grows shares and earns profits. To accomplish these goals, we focused on completing the integration, delivering innovation, and making key investments. We believe market leadership, revenue growth, and profit are the path to creating value for our employees, customers, partners, and shareholders.

In a little over a year ago, we outlined a bold plan to combine Silicon Graphics with Rackable Systems in the midst of an economic global crisis. This combination has created a compelling opportunity for SGI within the technical computing market, a market roughly $9 billion in size according to IDC, and growing at 6% CAGR. This market is relevant and large and there is no clear leader today. SGI is well positioned to grow market and profit share within the technical computing market and take a leadership position.

Let us look back at the objectives we set our for FY '10; one, non-GAAP revenues of $500 million; two, non-GAAP gross margins in the mid-to-high 20s; and three, investing in sales, products, service, and company infrastructure in order to lead the market, grow share, and earn profits in future periods. The team completed the integration, exceeded the revenue objective, met the margin target, and established a solid foundation for the business. We did not provide EPS guidance for FY '10. While we lost money in FY '10, we did generate and grow our cash.

Our FY '10 non-GAAP revenues were $525 million, $25 million above our original guidance of $500 million. Our non-GAAP gross margin was 27.2%, instead of the last full reported year of Rackable Systems, whose revenues were $247 million and gross margin of 17.1%. We doubled our revenues and expanded margins by 1,000 basis points. This is a solid foundation to build on. We enter FY '11 with an experienced and established sales organization in 26 countries, primarily organized by geography, verticals, and channels.

In FY '10, we demonstrated clear strength within many industries. Our government business is comprehensive and well established across the intelligence communities, defense organizations, civilian agencies, national laboratories, and leading national universities. We won business at NASA, National Institute of Health, Defense Intelligence Agency, Los Alamos and leading U.S. intelligence agencies. We continue to build upon our strong relationships within the federal system integrators such as Raytheon, CFC, Northrop Grumman, Lockheed Martin and others.

Our cloud and internet business remains strong and we are participating in the current tech refresh cycle and cloud build-out trends. Larger deployments include Amazon, Microsoft, eBay, and Motorola.

We are winning within process and discrete manufacturers as they increase their spending to introduce new products or improve existing ones. Notable wins include Skoda, Audi, Sikorsky, and Boeing. Our business within higher education and research delivered incredible wins such as with Professor Steven Hawking at Cambridge University, the Institute of Cancer Research, A*STAR, the University of Minnesota, and the Pittsburgh Supercomputing Center.

We are also seeing growing customer adoption within financial services, telecommunication, media and entertainment, as well as earth and life sciences. I would highlight China Unicom, British Telecom, National Geographic, the NBA, Novo Nordisk, and Merck. We believe technical computing is relevant across leading industries. I am very pleased with our growing industry diversification, strength, and increasing maturity. I note we had only one greater than 10% customer in FY '10.

Expanding our routes to market is essential to scaling our business. In FY '10, we invested in people, processes, and tools to expand beyond our strategic direct sales organization. We ended FY '10 with over 180 trained partners. In fact, over 20% of our business was related to partners in FY '10. We will only build on this going forward.

We offer our customers a comprehensive service portfolio, backed by our robust global services infrastructure of approximately 400 service professionals in 26 countries. In FY '10, services contributed $160 million or 30% of our revenues. Overall, service margins are strong and there is opportunity to do even better.

Let me transition to products. Though we compete with multi-national companies 50 times our size, who spend billions a year in R&D, we continue to out-innovate and win. At the core is our focus on technical computing, best-of-breed integrated compute, storage and networking, and approach to open systems and software and agility. In FY '10, we stayed focused and delivered according to our compute and storage roadmap and strategy.

Entering FY '11, our product portfolio is even stronger. As it relates to compute, Altix UV is now shipping and targeted for big data, scalable I/O and RISC processor migration. Altix ICE 8400 is now shipping and targeted for large-scale HPC. Our cloud inspired Rackable products, Foundation, CloudRack, XE, and ICE Cube have all been refreshed with the latest Intel and AMD technologies and optimized with the maximum performance per dollar, per watt, per square foot. Our scalable entry HPC systems of Octane III, UV 10, Origin 400, and CloudRack X2 are all new in FY '10 and primed for an easy first experience with SGI products.

And we recently introduced our new SGI Management Center software to simplify the operations and management of our computers. I note our software revenues in FY '10 were just about $10 million, a good start.

As it relates to storage, we are expecting a strong FY '11. Our well established InfiniteStorage 1000 is designed for high-capacity, price optimized EBOD. Our new InfiniteStorage 3500 is designed for integrated storage service. The 3500 series targets application-specific needs such as Hadoop and Memcached to the more popular cloud building blocks.

Our rebranded LSI and DDN systems are rate-based storage systems, balancing price, capacity, and performance. We expanded our LSI relationship recently to include a distribution agreement whereby we will resell the LSI product line through our channel. We introduced COPAN, targeted at the growing market for disk-based persistent data storage and management. We are pretty excited about the product line and its wide appeal across industries and workloads, such as virtual tape libraries, disk-to-disk backups and file systems. And our storage software, integrates the many storage tiers through file systems and our optical storage management software.

In FY '10, compute was 78% of our product revenue, storage was 22%. We are planning for a larger storage mix in FY '11.

With that, Jim will now get into the details of Q4 and the full fiscal year, after which I will review our FY '11 guidance and FY '12 and '13 internal plan. Jim?

Jim Wheat

Thank you, Mark. Before I begin, please let me add to what Erik said earlier about our use of non-GAAP financial measures. Our non-GAAP financial measures appear in our press release issued today, which is available on our website along with the required reconciliation tables. In this call, I will be discussing revenue, gross margin, operating expense, and net income from continuing operations on a non-GAAP basis, which are reconciled in those tables. If an item is not specified as non-GAAP, then I am referring to a GAAP number in my remarks.

We integrated Rackable and Silicon Graphics headquarters and manufacturing and had the company on one IT system within seven months. Our sales and service organizations have been extensively trained on all products, including our new storage offering. We have reengaged customers that were on the sidelines with powerful new compute and storage solutions. We made another acquisition, COPAN, and integrated them into SGI.

We have a year under our belt managing the business and the team is working tightly together to grow the business and improve profitability. We are excited about the coming year and our employees are passionate about winning and growing the business.

In FY '10, SGI performed well against each of our non-GAAP objectives. We handily beat our $500 million revenue objective with $525 million in revenues; and we originally stated gross margin would be in the mid-to-high 20s and we came in at 27.3% gross margin. Within our FY '10 non-GAAP revenues, services represented $160 million and of the $365 million in product revenue, 78% was compute and 22% was storage. 27% of our business went through our channel partners and 33% with international. Our federal business was 32% and our commercial business was 38% with some of that coming internationally.

We generated more than $8.2 million in cash flow from operations through fiscal '10. For the year, our non-GAAP OpEx came in at $165.6 million and our non-GAAP net loss was $24.7 million. I would like to point out approximately $21 million of non-GAAP costs that occurred within fiscal year '10, net foreign exchange losses related to the euro devaluation amounted to $7 million.

During the year, we spent $4 million integrating the facilities and IT systems of Rackable and SGI. There were more than $4 million in E&O charges that were related to the economic slowdown and product rationalization. $3 million went into integrating and running COPAN, which included rationalizing the workforce, moving manufacturing, and operating the business for more than four months. And we spent over $3 million extending Oracle applications for our new revenue system and our new SOX procedures with the new SGI.

I note that of this $21 million, more than half occurred in Q4. In addition, in Q4, the unfavorable exchange rate of the euro against the dollar unfavorably impacted our gross margin and therefore bottom lined by approximately $1 million. Excluding these events, our fiscal non-GAAP loss would have been greatly reduced.

Moving to an overview of our quarterly results, our revenue for the fourth fiscal quarter was $101.6 million and our non-GAAP revenue was $122.2 million. We had two greater than 10% customers, Amazon and the University of Tokyo.

In our non-GAAP revenues, our government and defense business contributed 31% of revenue; the internet vertical was 20% of revenue; higher education was 25%; and manufacturing was 7%. Our service business contributed 32% of revenue and within our products, storage was 15% and compute was 85%. International was strong at 38% of revenue and our channel delivered 33% of our business. We are pleased to report we shipped UV product to 14 customers during the quarter. In addition, we shipped and recognized revenue for COPAN product for the first time.

In FY '11, we are adopting the new accounting standards for revenue recognition. Under these new rules, we will be recognizing and not deferring more product revenue in the fiscal year. As a result, we expect to report fiscal year '11 GAAP revenue that is more in line with our non-GAAP revenue for that reporting period. Adopting these new accounting standards should not affect our non-GAAP revenue.

Gross margin for the fourth quarter was 19.3% and non-GAAP gross margin was 24%. The devalued euro effectively led to decreased pricing power and our EMEA business brought down our overall gross margin in the quarter. We do not expect this to have a long-term effect. Our non-GAAP gross margin for the fiscal year was 27.3% and our GAAP result was 22.2%.

Operating expenses for the fourth quarter were $44.3 million and our non-GAAP OpEx was $43 million. As I mentioned last quarter, the acquisition of COPAN adds about $2 million in increased operating expenses per quarter. Our operating expenses this quarter were slightly down from last quarter. Our non-GAAP OpEx total for the year was $165.6 million and our GAAP result was $176.2 million.

SGI's loss for the fourth fiscal quarter was $27.7 million and our non-GAAP loss was $16.7 million. As I mentioned earlier, of this total, our Q4 bottom line was affected by approximately $13 million due to the effects of foreign exchange, integrating and running COPAN, E&O charges, and extending our Oracle systems application.

We ended the quarter with cash, cash equivalents, restricted cash, and long and short-term investments of $140.8 million, up $1.3 million for the fiscal year. From the prior quarter, our accounts receivable decreased by $2.4 million to $79.5 million and our accounts payable were up $9.3 million to $49.2 million from the prior quarter. AP was driven by higher end-of-quarter inventory purchases and a transition to 45-day turn.

Continuing on the balance sheet, our inventory increased $13.7 million to $89.9 million, principally due to the increase in materials related to firm orders for UV and Rackable products. There was a decrease in our shipped-but-not-invoiced balance of $1.8 million to $28.5 million. For the year, inventory is down by $27.9 million.

At the end of the fourth quarter, total employee headcount including all temporary labor was 1,325. As you heard earlier from Mark, we are extremely pleased about our progress over the past fiscal year and about continuing to execute on our goals in fiscal year '11 and beyond. Over the next three years, SGI will continue to drive revenue growth and gross margin improvement, while controlling operating expenses.

For these reasons, we feel that as we enter fiscal '11, SGI is poised to increase shareholder value. We have almost $0.5 billion in assets on our balance sheet and no debt. At the end of June, we had over $4.67 per share in cash and cash equivalents. Our enterprise value of less than $50 million does not reflect what we believe to be our strong position with innovative, differentiated products focused on a large and growing market with established sales and service organizations.

The team has had a year of experience running the business and is dedicated to getting to break-even this fiscal year. We hope continued solid execution and greater forward-looking clarity will help unlock our value in the market. To that end, we have resumed our $40 million share repurchase as an indication of our confidence in the business and that our stock represents an attractive investment for the company.

With that, I would like to hand the call back to Mark for concluding remarks.

Mark Barrenechea

Thank you, Jim. In FY '11, the team is focused on growing the business, margin expansion, gaining efficiency, accelerating our path to profitability, while making key investments to sustain our growth and to create earnings power.

Our FY '11 non-GAAP guidance includes revenue between $550 million and $575 million, gross margins between 27% and 30%, operating expenses between $165 million to $171 million, and EPS break-even.

In support of our FY '11 plan, I would like to highlight that we enter the new fiscal year with $150 million of business already under contract that we expect will turn into revenue during FY '11. We enter FY '11 with a – with new added products such as UV, COPAN, and LSI. We are also participating in the current tech refresh cycle and new cloud infrastructure build-out. With the growing storage business, new products such as UV, service efficiency gains, ongoing business efficiency gains, we expect these elements to contribute to our planned margin expansion.

As you can see from FY '10 results, our quarterly results fluctuate and we expect this to continue throughout FY '11. We will not be providing any quarterly guidance.

With that said, for analysts' modeling purposes only and not for guidance purposes, we would expect a stronger second half to FY '11 when compared to FY '10 results. Looking beyond FY '11 and into FY '12 and FY '13, we are not providing guidance today. But we would like to share our current non-GAAP internal plan. That includes revenue growth of 5% to 10% per year, margin expansion of 100 basis points per year, OpEx growth of 2% to 4% per year, and EPS positive for FY '12 and FY '13. We expect to grow revenue faster than OpEx, while operating profitably in FY '12 and FY '13.

In summary, FY '10 was transformative and I am pleased with our progress, we delivered greater than $0.5 billion in non-GAAP revenues, and we established a solid foundation. But we lost $25 million in FY '10 on a non-GAAP basis, notwithstanding the $21 million in related charges as Jim highlighted, we grew our cash year-over-year.

In FY '11, there are three metrics we are going to measure ourselves against. Number one, revenue growth. Again, we enter the year with an established sales force, $150 million already under contract, new products already in the market, and good industry trends. Number two, margin expansion. We now have a year under our belt operating the business; year-over-year, we hope to gain a point or two of efficiency gains, and to repeat this each year while delivering a favorable product mix shift. Three, non-GAAP EPS break-even. Consider our expected revenue growth, margin expansion, favorable product mix shift, and reduction in one-time expenses we had in FY '10.

We feel strongly about our prospects for growth and profitability. We have confidence our products are differentiated and service a large and relevant market. Our $40 million share repurchase program reflects our confidence in our team, our business, and our long-term prospects.

With that, I will turn the call over for questions.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions). Our first question in queue comes from Brian Freed with Morgan Keegan. Please go ahead.

Brian Freed – Morgan Keegan

Good afternoon. Thanks for taking my question. A couple of questions real quick. First, you mentioned that you shipped Altix UV products to 14 customers in the quarter. And then in follow-on comments, you talked about having $150 million in business under contract for both the high-performance computing, as well as the scale outside. Can you give us any more color in terms of number of orders or value of backlog around the Altix UV product?

Mark Barrenechea

Brian, hi, it's Mark. Thanks for the question. As we said, we shipped UV to 14 customers. Some of the customers we published include HRN, Oak Ridge, PFC, LRZ, Institute of Cancer Research, Oxford with Professor Hawking, as well as shipments into the – into intelligence community. We didn't have UV in our FY '10 plan, many of the shipments were at the – if you will, at the end of the quarter with a variety of acceptances. UV is certainly within our FY '11 plan. We are not breaking out the $150 million, if you will, per product, per service. Certainly within the $150 million under contract, there is certainly UV revenue within there.

Brian Freed – Morgan Keegan

Okay. I guess, I'll ask a different way. Are you happy with the build of orders and backlog around the UV product?

Mark Barrenechea

Extremely happy. We have – we delivered the product to our plan, we have a solid and growing pipeline that's extremely differentiated in the market and being very well received across our installed base and including new prospects. So we are extremely excited and actually feel it's a fundamental catalyst for the company.

Brian Freed – Morgan Keegan

Okay. And then secondly, inventory stepped up on a sequential basis. I assume that was around the buildup of inventories for the UV product and the orders. Can you comment a little bit about if you have a specific inventory target or if you tend to plan that based on the flow of orders you see coming in?

Jim Wheat

Brian, this is Jim. Thanks for the question. So as I said, the inventory did go up in the quarter and principally, that was related to purchases of materials for firm orders for both UV and Rackable products that we have in hand. We do plan inventory – we monitor inventory very carefully and I guess I would note, for the year, inventory was down by almost $28 million.

Mark Barrenechea

Again, we primarily purchase to order at this point, Brian. There are certainly some commodities we will do to forecast but the larger commodities at this point we are primarily purchasing to order.

Brian Freed – Morgan Keegan

Okay, okay. My third question relates to your target. I appreciate the additional granularity in your guidance this year. But just as you look at the various segments, I guess my first question is related to the historic Rackable business. That has in the past seen a lot of struggles at the gross margin line. I wondered with the greater scale and efficiency of the SGI platform, if you have been able to deliver any improvements in the margin profile of that product family.

And then secondly, as you look at your revenue guidance or even kind of your long-term, say, three-year target, do you have a range of where you are shooting for storage software and services as a percentage of revenue?

Mark Barrenechea

Very good. So first part on Rackable products, I would say that we have been able to hold on to our margin profile within the large internet data center customer. So I would say we are being able to hold on and hold steady that margin profile. I would note that we called our eBay on the script as a new customer and we are real pleased with that win and hope to have future business within that account.

And as we bring Rackable products outside of the traditional large IDCs or what I call private clouds, whether that be – well, independent of industry, we are seeing a better margin profile than if we – than in the traditional IDC market – internet data center market. So I would say we have been able to hold steady our margin; two, we have been able to add new customers; and three, in the combined sales force as we bring Rackable products to more industries, we are seeing a better margin profile.

In relation to storage, we are not actually calling out a goal as a percent of our business today, but we are pretty excited about building a large-scale storage business and it's part of our strategic mission is to establish storage as a platform for the company as important as compute is.

And I would call out specifically around cloud storage and persistent data. We think on the persistent data market where we brought COPAN into SGI, our DMF software for a virtualization layer, our partnership with LiveArc for policy management, and a couple of growing relationships around VTL and dedupe, this is going to provide us a pretty differentiated solution in the persistent data market. Jim, I think if I got the numbers right, storage revenue was approximately $80 million in FY '10 or about 22% of product revenues, and Brian, that's definitely going to grow as we get into FY '11, but we are not calling out a specific target.

Brian Freed – Morgan Keegan

Okay, great. And then my final question, as you look at the customers for your Altix UV products, can you give us any kind of color in terms of mix of replacement where they had a, say an Altix 4700 or 4000 family and are upgrading to the UV versus new kind of Greenfield customer wins?

Mark Barrenechea

I would say it's probably split 50-50 kind of down the road right now. We have – certainly those customers with an Altix 4700 on Itanium, and looking to modernize on an Intel Xeon platform, specifically Nehalem or Westmere. Institute of Cancer Research, Professor Hawking, some of the intelligence community wins, I would say are new customers and new installations for us. But it's a pretty good mix now – good mix, about 50-50.

Brian Freed – Morgan Keegan

Okay, thanks.

Operator

Thank you, sir. And at this time, I am showing no additional questioners in the queue. That will complete our Q&A portion of our call. Thank you for your attention this afternoon and participation. This ends today's call.

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