We did our initial report on SGI on February 10, 2010 at around $8.87 per share. Since then it has been our worst preforming stock in the High Cash Stock Portfolio. In many ways SGI has executed well and in our opinion currently presents an even higher value than our first article.
Silicon Grahic’s (SGI) has an extremely low valuation. Firstly, make a mental note that it has $4.60 per share in cash and no debt. That creates an enterprise value or a value of the ongoing company as a going concern of $2.88 per share(based on a market price of $7.48). When you subtract out the cash from the enterprise, while remembering that SGI has no debt, their enterprise value of $86 million is actually extremely small for a company that just completed fiscal year with over $525 million in pro-forma revenues. The $525 million was above managements guidance of $500 million for the 2010 fiscal year. SGI is now forecasting revenues of $550-570 for the fiscal year 2011.
This makes the business value only about 1/7 the recently completed fiscal year revenues, even though the company executed well and beat their revenue guidance by 5%. This is remarkably low for a leading computer company with a run rate well above $525 million in revenues.
Since restructuring, SGI has been steadily increasing its revenues. At the same time, and often overlooked, SGI has significantly increased its deferred revenues which are currently around $229 million plus showing real growth form the prior years balance of $84 million. This is a 172% increase. Accounting principles guide SGI to spread revenue recognition over the period of the contract term, thus SGI books revenue over the life of the contract. This often provides cash up front while revenue flow through the income statement over the length of the contract. This partially explains why their cash balances have been growing while negative earnings have been reported. When we valued SGI, we found that the deferred revenues of $229 million alone are about 3 times higher than their entire enterprise $86 million. This creates another metric that demonstrates SGI’s low value.
SGI board has approved and initiated a $40 million dollar stock buyback. As of August 31, 2010 the company has authorization to repurchase $39 million in stock. At a price of $7.48 per share this equates to 5.4 million shares on a float of $30.7 million or over 17% of outstanding shares. The stock purchases are designed to increase the value of the company. The purchasing activity, if executed, will reduce the large cash position SGI currently retains.
Rackable and SGI valuation combined:
- Rackable purchasing legacy SGI for $42 million. The Legacy SGI produced $235 million in sales in the 2010 fiscal year.
- Rackable revenues were $ 290 million in the same 2010.
- Property owned in Wisconsin estimated value of $7 million.
- The company has $140 million in cash.
A purchasing company at today's prices would buy the above two enterprises for around $86 million, or even lower per dollar in revenue than Rackable claimed. Needless to say, Rackable received a great deal with the purchase of the legacy SGI.
Many leading architectural standard-setting companies that we have followed over time have traded at absolute premiums to their peers. SGI is trying to achieve an recognized architectural leadership position in the markets they server.
SGI is in an outstanding strategic position, one that could become the architectural standard and execution leader. In the fast growing cloud and server concentric markets, they are building the company based on an Intel-based processors and open software platforms while using best in class interchangeable solutions.
The use of open platforms allows SGI to provide remarkably low cost solutions and leverage off the many advantages that both Intel (INTC) and Redhat (RHT) bring such as:
- Extremely large footprint of established open source software
- Numerous off the shelf and test hardware solutions based on Intel architecture
- The ability to improve both hardware and software performance each cycle allowing each possessor to double its speed in less than 2 years--- Moore’s Law
- SGI can leverage its ability to add more processors to their systems.
The combinations of leverage, flexibility, and scalability brings tremendous performance advancements while actually lowering the overall costs. These evolutions are creating a disruptive new cloud computer model, one that is better at utilizing tomorrow’s Internet based computing. With that said, SGI has a very compelling strategic position, but this does not in any way guarantee success, due to the fact that they have very large and entrenched competition. Most of the established firms have high cost and more burdensome proprietary solutions.
Often architectural leaders become execution leaders, when they were still unproven enterprises such as Redhat (RHT) and Citrix (CTXS) they were also valued at over half their cash as they were building their businesses. These companies have performed providing architectural and execution leadership for years, thus gaining high premium valuation to their peers, and tremendous returns for our client's.
3 Par comparison:
A storage and memory cloud computing company named 3Par (PAR) recently agreed to be purchased by Hewlett-Packard (HPQ) at a rate of 10 times sales. 22% of SGI’s business consists of products similar to 3Par’s storage and memory supporting cloud markets. If SGI storage and memory sales revenue alone achieved the same 10 times sales that 3 par achieved in the buy out, giving the remaining 78% of SGI business a zero value, the stock value would work out to be around $38 dollars a share. In the above scenario not only the majority of the business given an zero value, the $4.60 cash per share would have no value.
Below are some metrics on the four market leaders in high performance computing, all also have been very active in the merger and acquisition market place. Currently, it is less costly to buy companies such as an SGI than to organically grow a high performance computer solution from the ground up. With all the major players sitting with over $12 billion in cash, purchasing SGI would be a nonevent to any of their balance sheet.
International Business Machines Corp. (IBM)
Market Cap: $162.74B
Enterprise Value: $177.87B
Enterprise Value/Revenue: 1.83
Total Cash: $12.25B
Hewlett-Packard Company (HPQ)
Market Cap: $90.05B
Enterprise Value: $91.48B
Enterprise Value/Revenue: 0.74
Total Cash: $15.38B
Dell Inc. (DELL)
Market Cap: $24.25B
Enterprise Value: $16.76B
Enterprise Value/Revenue: 0.29
Total Cash: $12.44B
Oracle Corp. (ORCL)
Market Cap: $128.37B
Enterprise Value: $122.40B
Enterprise Value/Revenue: 4.56
Total Cash: $18.47B
Companies like Cisco (CSCO) also come to mind, even though they are not a direct competitor. They could view SGI as a natural step for them into high end computing. Cisco has around 40 billion in cash.
Why is SGI's value so low?
We believe there are three reasons why value is suppressed:
1) Lack of profits.
SGI has just released a break even forecast of profit for 2011. They have also earned a reputation of promising little and delivering more than what they say. With this in mind, I believe SGI is on track to eliminate their largest concern.
SGI has three strengths that currently ensure their survivability :
- Positive cash flow
- Large amount of cash
- No debt
In my 20 years of market experience, I have not seen an insolvency, as long as companies meet these three basic criteria.
2) Rackable to SGI path is confusing:
Rackable purchased SGI when it was in bankruptcy with the goal of integrating the solutions and achieving synergies between the two companies. Rackable, after the purchase of SGI, assumed the name of SGI. Since the purchase, it appears that not only the leadership of Rackable/SGI is executing well, but also that Rackable made an incredible purchase for the low price of only $42 million. The legacy SGI contributed $235 million of revenue in the first combined operating year ended June 25, 2010. Even though it is confusing, it appears a very favorable move, execution, and price paid in hind-site. Time and execution should put the past confusion to rest.
3) Hard to understand the business
Bankruptcies, mergers, cloud computing ---Three items that seem to have numerous definitions and subplots. Many of my more sophisticated business clients have a hard time understating the Rackable/SGI model, especially when you add on the high-margin ancillary services like storage and memory. Thanks in part to the Dell (DELL) and Hewlett-Packard (HPQ) bidding war over 3Par (PAR), even though SGI has a questionable and confusing merger, people are starting to understand that the next tidal wave in IT is the server concentric or cloud computing. The cloud computing model is very low cost, with high horse power, providing very fast low cost internet-based services, that leverages the smart, mobile, and shared document markets making it very disruptive to the widely used PC model.
Summary: We believe SGI has value, execution and a balance sheet like past technology companies that fit our model that we reported on---e.g.Tollgrade Communcations(TLGD) Tessera Technologies Inc. (TRSA), O2Mirco International Limited (OIIM), Sonus Nerworks (SONS), and DivX (DIVX). We're still optimistic that SGI, in time, will believe their execution and value are similar, if not better, knowing other technology companies that fit this model have performed extremely well. SGI has completed an strong revenue growth year. Coupled with synergies between to two franchises and the growth in cash and market share, SGI is well positioned . Knowing that SGI’s new company has now completed a year of joint business history. Using the first fiscal years performance, we ran the following traditional valuations of SGI to put a value on the new company:1. Revenue Based
|Price to: |
Price to Enterprise sales
If you value SGI based on sales at a multiple of 3.09 (The Zack’s computer diversified industry average) and base it on last years completed sales of $525 million, this would give you a enterprise market value of $1,622 million market or $53 dollars per share. This is excluding the $4.60 in cash currently on the books which would make the stock have even higher potential value. Even those is an very optimistic scenario, it does demonstrate the risk to reward potential when SGI stock is trading at $7.48 with its cash and investment at $ 4.60 . Though the price of SGI stock has declined since we first put SGI into our portfolio, extrapolated from our sale based model, the potential value has increased from $46.50 including cash to today’s analysis of $53 without cash. Either way, today we believe SGI is more compelling being value about 85% below it industry peers. The titans of the industry are all adding (through company acquisitions) more services and moving aggressively into cloud computer, memory, and storage. Knowing SGI strong strategic position, very low value, and expected break even profit, they shares could now add value as a potential buy out target.
Disclosure: Durig Capital and its clients currently do have positions in Silicon Graphics International (SGI)