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Silicon Graphics International (NASDAQ:SGI)

F1Q11 Earnings Call

November 03, 2010 5:00 pm ET

Executives

Jim Wheat - Chief Financial Officer and Senior Vice President

Erik Bylin - Investor Relations

Mark Barrenechea - Chief Executive Officer, President and Director

Analysts

Brian Freed - Morgan Keegan

Tim Quinlisk

Operator

Good afternoon, and thank you for joining us on today's conference call to discuss SGI's First Quarter Fiscal 2011 Earnings Results. [Operator Instructions] At this time, I'd like to turn the call over to Mr. Erik Bylin for opening remarks and introduction. Please go ahead.

Erik Bylin

Good afternoon. Thank you for joining us to discuss our first quarter fiscal year 2011 financial earnings press release this afternoon, which is available on our website, www.sgi.com. I'm Erik Bylin, Investor Relations for SGI, and I'll be managing the call. Joining me on the call today 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'd like to bring the following to your attention. The date of this call is November 3, 2010. This call is the property of SGI, and any recording, reproduction or transmission of this conference call without the expressed 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, 2011 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 risks 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 within 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 September 8, 2010, as updated by SGI's subsequent filings with the SEC, all of which are available at 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. 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 if you would like to download it.

I'm pleased to let you know that we will be presenting at Barclays' Technology Conference in San Francisco on December 8, in Needham's Growth Conference in New York City on January 12. Please join us via webcast if you're unable to attend the conference. I'll now turn the call over to SGI's CEO, Mark Barrenechea.

Mark Barrenechea

Thank you, Erik, and welcome, everybody in today's call. Let me begin by saying how pleased I am with our progress, our overall Q1 results and our start to fiscal year '11. On a non-GAAP basis, we delivered revenues of $130 million, gross margin of 28.3%, operating expenses below $40 million, positive EBITDA and an EPS loss of $0.06%. Of the $42 million in cash used during Q1, $32 million was used to fund customer orders. We also entered Q2 with a strong backlog.

Compared to last quarter, revenues grew by approximately 7%. Gross margin expanded by 435 basis points, and we reduced our loss from $0.55 to $0.06. Combining our solid start for the year with our visibility over the next six months, we are reaffirming our non-GAAP FY '11 guidance of revenue between $550 million and $575 million, gross margin between 27% and 30%, operating expenses between $165 million and $171 million and EPS breakeven.

I would also like to reemphasize what I talked about in our Q4 call. Per our internal plan, we expect profitability in FY '12 and FY '13. In the quarter, non-GAAP revenues for the public sector and cloud markets combined were greater than 75% of our revenue. Manufacturing, oil and gas and telecommunications were the next three strongest markets for us. We are also reporting for the first time the U.S. Government as a greater than 10% customer. 28% of our revenue originated in or was fulfilled through our channel. Our international operations contributed 26%. Service was 31% of our business, contributing 43 points of gross margin on a non-GAAP basis. Our revenue was driven by solid performance within our Rackable and UV product lines. We also had encouraging contributions from our COPAN and LSI offerings. Overall, storage contributed 18% of our product mix.

Let me spend a few moments highlighting our customer successes and the dedication from the SGI team. Our strategic partnership helped Amazon power a world-class cloud offering, and Amazon accounted for more than 10% of revenue in the quarter. This relationship is five years strong. We have been through many technology transitions together, and mutual success exemplifies the type of partnership customers can expect with SGI.

Los Alamos National Laboratories selected our Rackable product lines for their new institutional computing projects. These projects include the climate, ocean and sea ice modeling project for the Department of Energy, Office of Science, and stockpile stewardship for the Advanced Simulation and Computing Program for the National Nuclear Security Agency. Motorola DROID selected the Rackable product line to power their application and content distribution network. This is a mission-critical environment where speed and availability matter. Carbonite, a leading provider of online backup software, has selected the Rackable and InfiniteStorage series to power their service. The cloud is their business and is the strength of SGI.

Tohoku University in Japan, a leading university for computational sciences, selected UV for their next-generation platform of research and science. Professor Stephen Hawking, Cambridge University and the COSMOS Consortium selected UV as their computing platform as they attempt to unlock the mysteries of the origins of life. The research is described in Professor Hawking's most recent book, The Grand Design. Other university and research customers included the University of Manitoba, University of Illinois, Joint Institute for Computational Sciences, the Irish Centre for High-End Computing, Carnegie Mellon in conjunction with the Pittsburgh Supercomputing Center, the Institution for Cancer Research, and the Catalina Supercomputing Center [ph] in Spain.

Our federal system integrated partners including Raytheon, Northrop Grumman, Lockheed Martin, CSC and Level3 all construed to our portal.

The quarter was a balance with a balanced mix of products, industries, distribution, partners and customers. This quarter exemplifies the profile that will help us grow our business, geographically balanced, customer diversity, good mix of products and services and channel contribution.

Our margins improved sequentially, and we continue to see opportunities to expand our margin over time for three reasons. One, selling a higher margin product mix; Two, more service revenue and greater efficiency in delivering those services. Three, continuous improvement in our operations. For these three reasons, we expect margin to expand year-over-year and continue that expansion into future years. In Q1, we saw these three elements come together. We sold higher margin products with Altix UV and COPAN, Services contributed a non-GAAP gross margin of 43% and good operational execution was evident in sequentially lower operating expenses. Once again, this resulted in a quarter-to-quarter gross margin improvement of 435 basis points.

Q1 was the first of all quarter of Altix UV shipment. We shipped Altix UV to 49 customers in the quarter, and the initial feedback has just been stellar. It was our first full quarter with our new LSI partnership with many great wins. We also delivered COPAN 400T VTL [Virtual Tape Library] in the quarter. Shared memory, cloud computing and persistent data are fundamental catalysts for our business. With that, I'll turn the call over to Jim.

Jim Wheat

Thank you, Mark. Let me start with our use of non-GAAP financial measures, which appeared in our press release and reconciliation tables today. 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.

Moving to an overview of our quarterly results. Our revenue for the first fiscal quarter was $112.9 million, and our non-GAAP revenue was $130.3 million. We had two greater-than-10% customers, Amazon and the U.S. Government. In our non-GAAP revenues, public sector contributed 62% and cloud computing contributed 16% of revenue. Manufacturing was 5%, telecommunications was 4% and oil and gas was 2%. We are particularly pleased with how our Rackable product line performed across all of these industries.

Starting in Q1 and for fiscal year '11, we have adopted the new accounting standards for revenue recognition. Non-GAAP results are not affected by the new accounting standards. Gross margin for the first quarter was 27.5%, and non-GAAP gross margin was 28.3%. Gross margin beyond the change in accounting trended up quarter-over-quarter due to shipments of Altix UV, a higher margin offering.

Operating expenses for the first quarter were $42.1 million, and our non-GAAP OpEx was $39.9 million. We are not changing our OpEx guidance at this time. We had a good Q1 and came in under plan on OpEx. To the extent we continue to see and execute on opportunities for cost control throughout the year, this will provide us with some buffer against the other variables that are essential to making our fiscal year '11 plan.

SGI's loss for the first fiscal quarter was $11.2 million, and our non-GAAP loss was $1.8 million. There was a favorable impact of $1.6 million in foreign exchange during the quarter. We ended the quarter with cash, cash equivalents, restricted cash and long and short-term investments of $98.9 million, down $41.9 million for the quarter. $32.3 million of the decrease was used to fund customer orders, including a $15.4 million increase in inventory and a $16.9 million increase in accounts receivable. These were a direct result of strong order activity in the quarter. We also recognized a loss of $1.2 million on auction rate securities due to accounting.

In addition, we purchased 176,000 shares or 1.3 million as we relaunched our share repurchase program. The repurchase program remains active. When we feel the market is not fairly valuing our business, we will be opportunistic in purchasing our shares.

Though we are not providing guidance on our cash balances, we expect our cash and investments balance to grow slightly during the second quarter and for the rest of the fiscal year. Quarter-over-quarter, accounts receivable increased by $16.9 million to $96.3 million. This increase is primarily due to large shipments late in the quarter. We would expect this level to decline in future quarters. Our accounts payable were down $1.2 million to $48 million from the prior quarter.

Continuing on the balance sheet, our inventory increased $15.4 million to $105.4 million due to an increase of $14.9 million in shipped products that are waiting for acceptance, which we call shipped but not invoiced or SNI. This was principally related to Altix UV shipments. Our ending balance for SNI was $43.5 million. As you know, we do not provide quarterly guidance.

On our last call, Mark discussed that the second half of fiscal year '11 would be stronger than the second half of fiscal year '10. I would like to reiterate those remarks at this time.

At the end of the first quarter, total employee headcount, including temporary labor was 1,305. With that, I would like to hand the call back to Mark for concluding remarks.

Mark Barrenechea

Thank you, Jim. SGI is focused on technical computing. We are delivering compute solutions for shared memory with Altix UV and large-scale, high-performance scale-out with Rackable and Altix ICE. We deliver storage solutions for cloud computing, high-performance environments and persistent data needs with our InfiniteStorage servers, RAID products and COPAN.

We complement our offerings with expert services and select software offerings. We announced today our SGI Management Center, a single software package to manage our hardware. Management Center accelerates t the time from procurement to production and, once in production, reduces human errors, reduces power consumption and increases uptime. A recent customer went from bare metal to booting a 1000-note compute system in less than 10 minutes. Our new software-based power capping features can reduce power usage by up to 30%.

In the coming quarters, we are focused on driving adoption of our new products and expanding the market opportunities. Adoption is being driven through our direct sales force, our channel partners and our system integrators. Expanding the opportunity means targeting new industries, customer workloads and greater support for packaged software providers. For example, with UV, we recently announced the support for Oracle's 11g database. We expect to add more operating system and more packaged software support to expand the opportunity for UV. We also announced last quarter new wins and initiatives within BioSciences including the Institute of Cancer Research, Merck, Biogemma and GenomeQuest.

On the storage front, we recently delivered COPAN 400T with virtual tape library support. Our first customer wins were within financial services, telecommunications and the U.S. Government. We expect to deliver in Q2 a native-made COPAN 400M solution supporting disk-to-disk feature enabled by third-party software providers. This will expand the opportunity for COPAN within our installed base.

Q1 was a solid start to our fiscal year. Our new products have been well received, and we are focused on executing to our plan while widening our opportunity in the marketplace.

I'd like to end with reiterating our non-GAAP EPS breakeven guidance for FY '11 and our internal plan of operating profitably in FY '12 and FY '13. Reducing our quarter-to-quarter non-GAAP loss from $0.55 to $0.06 is a fair step to achieving profitability.

With that, we'd like to open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first questioner in queue is Brian Freed with Wunderlich Securities.

Brian Freed - Morgan Keegan

So first, you mentioned the positive trend in gross margin was driven in part by mix shift toward UV. And I know it's hard to give exact metrics, but as you look at the UV platform relative to the prior generation, how much better is the gross margin in a broad sense?

Mark Barrenechea

Brian, I'll probably start with some of the differences between the previous Itanium generation and the current Xeon platform. One is we're supporting -- we're able to support a more standard operating system and more standard tools because of the support for Linux and x86. They're so much narrower software stack than Itanium. So this will allow us to combine more software packages and more professional services in our deployment. So without kind of doing a gross margin-to-gross margin comparison, I would simply say that we could command more margin on UV because we are able to package a larger solution with the software stack in our professional services.

Brian Freed - Morgan Keegan

I mean, when you look at it, I guess where I'm driving, is it a couple of points higher gross margin or kind of 10 to 12 points higher gross margin? I mean, I guess I'm just trying to determine if it's a -- obviously, it's positive but kind of magnitude of the materiality of it over time.

Jim Wheat

Well, I think we've discussed before sort of mix over margin. UV is in the upper right-hand quadrant of our largest gross margin contributor. It's right next to service.

Brian Freed - Morgan Keegan

The second question I have is somewhat of a housekeeping item. As you mentioned, your revenue from market segments, I believe you used cloud. I think last year you used Internet vertical. Are those interchangeable?

Mark Barrenechea

Yes.

Brian Freed - Morgan Keegan

And then the third, and this kind of comes back to the Altix UV. As you look at your installed base of Itanium systems, and again just trying to understand a sense of what the market opportunity is for UV, do you have any metrics in terms of how many millions of dollars worth of installed base or how many thousands of systems in rough terms that you guys currently still support that would be potential upgrade over, say, the next five to seven years?

Jim Wheat

We haven't published our installed base numbers for Itanium. But I can -- we can be assured that we are calling every Itanium customer to either one, add more capacity to their current Itanium environment or two, augment or deploy new shared memory systems on Altix UV. Now the 4700 series was really a scientific platform. Altix UV is both a HPC and scientific platform. But the new opportunity for us is to expand into large data environment with strong support of industry-standard operating systems beyond Linux. So I'd encourage everyone to watch this base as we include more OS support. Two, announcing Oracle 11g support, widens the opportunity for us. And we're going to keep driving for more database work in the market. And then, three, more application support from the technical community that will be more likely to support the environment because of standard x86 base versus Itanium. So we see the market much wider for UV than we do for Altix 4700 where Altix 4700 was primarily an HPC and research environment, or Altix UV is a research and HPC environment, but also a big data environment with database and more operating system and packaged tools support.

Brian Freed - Morgan Keegan

So if you look at the legacy Itanium products, would you say that the vast majority of the products you've sold in the last five years are still in production, well the SGI sold in the last five years?

Jim Wheat

Yes. I think based on the data we've seen, yes.

Mark Barrenechea

The systems tend to have a long life.

Brian Freed - Morgan Keegan

So if I wanted to try and come up with an addressable market, it would be rational to look at the systems sold over the last five years plus some given the new market opportunities?

Mark Barrenechea

Sure thing.

Brian Freed - Morgan Keegan

And then the last question relates to your storage. It looks like it increased something like 26% year-over-year, I mean sequentially if my math is correct. I wanted to see if my math was indeed correct, one. And two, if you could give me some of the particulars that drove that sequential uptick?

Mark Barrenechea

Well, Jim is looking for the precise percentage. I'll let him look at the tables we have hear. What drove it was two things, LSI and COPAN. This was our first full quarter of our LSI relationship, and we had good contribution from LSI. And it was our first full quarter of COPAN, and we delivered our new COPAN 400T into the market. So those are the two product areas that contributed to our storage numbers.

Brian Freed - Morgan Keegan

If you think of linearity last year, the December quarter was by far the strongest quarter. And in your commentary, you mentioned that you expect the back half to be stronger. Is there a reason why the December quarter would potentially not be the largest quarter in this fiscal year?

Jim Wheat

Brian, this is Jim. I just want to reiterate, yes, I did say in my remarks the second half of fiscal '10 we expect to be a stronger -- sorry, fiscal '11 to be stronger than the second half of fiscal '10, which was consistent with what we have said in our August 31 call.

Brian Freed - Morgan Keegan

And can you give any color around what market dynamic you're seeing or if it's product cycles that would tend to result in a December not being the strongest quarter given budget flush and the like that would typically be when I would expect to see the most strength?

Jim Wheat

I'm not seeing anything unusual in terms of a market dynamic. We have a couple of elements of seasonality in our business. We certainly have the cloud market, the Internet market. For those environments that build toward back to school or the holidays, they're putting the infrastructure in place before that big buying season. We certainly have an end of calendar element given the size of our Public Sector business, there's also U.S. federal budget end of the year. And calendar Q1, our Q3 is typically impacted just by seasonality in the manufacturing and the component industry sector. So we're seeing more of a typical seasonality in our business.

Jim Wheat

I see Q4 as usually stronger, calendar Q4.

Operator

Our next question in queue is Tim Quinlisk with Mayo Capital.

Tim Quinlisk

I'm trying to understand the interplay between the balance sheet and the sales cycle related to Altix UV particularly as it relates to the sort of the use of cash for the quarter as well as trying to understand the deferred revenue. Is the sales cycle or the a revenue recognition cycle, should I be thinking about this in terms of quarters or is it months? Or can you -- help me understand that better, so I can understand the balance sheet impact here.

Jim Wheat

Tim, this is Jim. You did mention cash and let me just talk about that for a second. So as I mentioned, we explained why cash decreased in the quarter and frankly, there's not a better use of cash for us than to fund orders. We're winning business and we have a backlog to fulfill and the $32 million that I spoke of in the cash decrease to fund these customer orders, a lot of which is in the SNI that I've talked about in for UV. We expect that to be paid in the short term. Having said that, in terms of cycles, the UV orders were at the end of the quarter. And typically, those tend to be running in an acceptance cycle that kind of ranges from between 30 and 90 days.

Mark Barrenechea

And let me just add a little bit of the business mix to that as well. It was a great first quarter for UV. We had 49 customer shipments, very good revenue and gross margin contribution in the quarter. Pipeline is growing, and clearly, a backlog of orders that we've delivered and will get accepted and collect cash. We also have orders to deliver. So I really can't imagine a better first quarter of a full first quarter of a new product cycle in UV.

Tim Quinlisk

And then Mark, just another question, what do you need to do to position the Altix UV in your historic HPC capability? To really transition and the opportunity on the Cloud side or on the commercial database side? How difficult is that transition?

Mark Barrenechea

I think when we're asked to speak to customers and our team, there's an enormous amount of confidence in UV within our installed base in our traditional HPC and research environment. To expand that opportunity, we're looking towards a handful of industries and a new software support. So last quarter, building new strength for us in biomedical is an example of widening the opportunity. An industry that we haven't been in for a while, and began to win customers like Merck, GenomeQuest, Institute of Cancer Research, I think previous quarter we announced the National Institute of Health. So focusing on those industries and the sales force focus there on getting wins, building confidence, some partnerships, and I'm repeating that across a handful of industries. Second, is on packaged support. We support Linux today. We like to support more operating systems and we're working on that. Two, getting more packaged support for databases. Historically, we've only supported my sequel in times 10, so now having certified our platform Oracle 11g to enable our sales force and customers to buy regular Oracle, install it on Linux and run it on UV. So we have more databases we'd like to support and then more packaged applications on that. So one is an industry focus. We're highlighting biomedical today. Second, is more packaged support. And with that, we think we will very much widen the opportunity for UV outside of traditional HPC and research.

Tim Quinlisk

And then Jim, just one final question. You indicated how much stock you bought back in the quarter. Were you guys after the quarter repurchasing shares? And if you were, would you care to share that?

Jim Wheat

Yes. We have been active and again the comments that I made is when we feel our stock is undervalued, we'll continue to be opportunistic. What we'll intend to do is share whatever we repurchased in the December quarter when we do the December earnings call.

Operator

[Operator Instructions] With no further questions, that completes the Q&A portion of our call. Thank you for your attention this afternoon and participation. That ends today's call.

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