Value In Complexity

Value In Complexity
Contributor since: 2011
Thank again for staying engaged in the discussion, Special K.
On bookings growth, I would assert that the company deserves “organic” credit for sales they would have had to a big customer had they not acquired that customer. Although, we do not have to agree on that and I appreciate you making your methodology clear.
I do agree this is a very complicated company to value, which is one of the reasons it is so undervalued today. The argument that each valuation methodology (revenue multiple, Non-GAAP EPS multiple, GAAP EPS multiple, etc.) is inapplicable is an interesting case for overvaluation, but I acknowledge - no doubt – that this is a complex company to value. With regard to my comments on GAAP EPS, I focused on that based on concerns around the applicability of non-GAAP EPS. Please don’t mistake a willingness to make a complicated argument as an intentional muddying of the waters. In fact, I included my original calculations in precise detail to make sure the waters were as clear as possible. I also always make sure the metric I am referencing is clear in explaining why the company is a double digit “grower.”
I will admit that I have been quite surprised – although not concerned – by the price action the last few days (even with a very strong month for the stock, which has hugely outperformed indices over the last few weeks) following such a strong fundamental quarter. The bear case has gone from debating if this was a “1%” grower to an 11% vs. 21% organic grower (following an even stronger fourth quarter), which I think is some confirmation of the strong fundamental performance they have shown over the last two years and particularly the last two quarters. Along with the gross margin growth expansion and $467 million of high-margin revenue visibility, the fundamentals all point to ongoing business health. The company is hiring in support of the ongoing growth driven by their strong product line (and the catalyst of the upgrades from the Intel Romley chipset roll out), and I fully expect to see the growth continue.
Thanks for all the additional comments. I think TechGuy made 2 great points to characterize business growth: Since they reported GAAP, you have to compare it to GAAP… So while the GAAP number was indeed lower than non-GAAP in 1Q FY11, you still have to compare GAAP to GAAP and so the 58.5% revenue growth is quite real. As for all of the comments on long-term profitability and mix, there is one metric that reveals all of this: gross margin. Gross margin increasing (which it clearly did, by 590 bps y-o-y) means that they are selling more of their higher-value products – there is no other viable explanation (commodity costs, manufacturing costs etc. would not explain this). The SGI story is, at its core, not about today’s earnings – it’s about investing in a company that has huge tailwinds and a great product set… Which will drive them to massive earnings in the next 12-24 months as gross margin increases and revenue grows (and SG&A clearly does not grow by 58.5%). One other quick note on GAAP EPS: SGI grew GAAP EPS by $0.29 in Q1. Just annualizing that (and assuming SGI does not grow) would give you $1.16 of EPS growth in a year – to put another way, the stock price is 12.7x the annualized Q1 increase in GAAP EPS! Using Special K’s conservative 8x multiple on the GAAP EPS growth, the annualized earnings growth in FY Q1 was equal to $9.28 of share price value – this is the annualized EPS growth alone, excluding factoring in the value of the business before FY 2012! Using a more realistic multiple for a business that grew >50%, say 15x or 20x, one year of EPS growth (annualizing a seasonally weak quarter, no less) would represent $17.40 or $23.20 of share price value (again this is in addition to the value before FY 2012 started)...
On bookings growth as well, as I noted in my comments to the original write up, in order to measure organic bookings growth, you need to add back sales that would have gone to SGI JP had it not been acquired, which it seems that Special K is not doing. Without adjusting for the sales that would have gone to SGI JP anyway (the analog to the $8.6 million in Q4 of FY11), you get 10.8% organic bookings growth. Correctly applying that adjustment brings organic bookings growth to 17.5% (well above their organic growth guidance/target). Then, the comparable figures should be adjusted for the growth of the business since the time of the last recorded number (for example, the $4 million that JP did in Q1 FY11 would be higher in Q1 FY12 as the business grew rapidly in that time). Making these adjustments brings the apples to apples organic bookings number to 20.8%.
Finally, the long term thesis here is a belief that all enterprises (corporates and labs etc.) will need more computing power over time. As Big Data becomes more ubiquitous and touches more enterprises, it will absolutely become an increasing part of ORCL’s ecosystem. There is no question that the nature and use case of high performance computing is changing, so – while there may be better buyers than ORCL (a good thing!) – the long term thesis on the proliferation of Big Data in the corporate world will both drive this business higher over the long term and also make its IP and product set attractive to a whole host of potential acquirers.
Thanks again for the thoughtful response, Special K. Given the new data we have as of this afternoon’s earnings, I’ll focus most of my comments on the recent results:
Quick note on SGI JP: As I noted in my write up above, I agree that some of the revenue in 4Q from relocated workers would not recur (I estimated 25% of the services and 100% of the product revs in 4Q). As such, the sequential SGI JP drop but overall strength (particularly in services) makes sense as SGI employees came back from JP. Also, a little background on the acquisition: SGI was the only eventual buyer for SGI JP for obvious strategic reasons. Given this, it is no surprise that SGI got good value buying from the current diverse 3rd party consortium investor group and that it was able to improve the operations quickly.
1Q FY12 Overview: This was obviously quite a strong quarter both in terms of tone and financial results vs. expectations. Headline growth of +54.5% Y-o-Y translates into +44.1% Y-o-Y organic growth (excl. $28 million of SGI JP - $33MM in the quarter in JP, less the $4 million in PY with SGI JP - plus revs that would have gone to SGI JP pre-acq, all adjusted for the relevant growth rates from assumption period; note the results as reported are both in GAAP). Unsurprisingly, organic (adj for SGI JP) bookings growth is also very, very strong at +20.8% Y-o-Y; roughly double the annual organic growth guidance. Long term margin expansion was also corroborated with GM of 29.4%, up both sequentially (+197 bps) and Y-o-Y (+590 bps). Management was very bullish on the call both about the current quarter and the likelihood of ongoing strength. Guidance was reaffirmed (customary not to raise full year guidance in Q1). I’ll spare you a summary of the press release/transcript here, but I do want to highlight a few points:
-Backlog/Deferred Revenue: The $467 million of aggregate backlog and deferred revenue is an obvious bullish callout. This is all signed business and, more importantly, as the sales cycle is very short on the Rackable products, we know that it is all high margin HPC and services revenue that is waiting in the wings to be recognized (and drive up GM).
-Romley: As noted in my original write up, the upgrade to UV 2000 and ICE X with the coming Romley chipset is a big deal from a product and competitive perspective. While management would not disclose the exact amount of Romley sales, their importance was clear. Management cannot recognize revenue on those systems, some of which were delivered this quarter, until Intel makes the chipset “Generally Available” which will likely happen in Q2 (Q3 latest), so this is likely part of the reason for the backlog and inventory increase – and it will hit revenue in the next 1-2 quarters.
-Market Share Gains: The Company noted that it was taking share and growing at above market rates. As this is before even the performance upgrades are fully rolled out, it reflects as well on the Company’s sales force as it does on their products. With the upgrades, they should be able to take even more share from a “troubled” HP (their chief competitor) and others.
-Looking for Trouble: Management clearly new the hot-button issues going into the call - federal spending, HDD supply/cost, pipeline size, revenue “linearity” (sequential growth assumptions), and long-term profitability – and directly addressed all of them. Half way through this quarter, all indicators are that management was bullish across all of those barometers (with the exception of appropriate conservativism on HDDs), even recognizing that in some cases their optimism is contrary to the macro theme
Takeaway: Perhaps the most important comment on the call was a jab at the “bloggers” that management is not focused on growing “organic bookings, adjusted for SGI JP growth, with addbacks etc. [paraphrase…]” as we talk about here. As an investor, I’m encouraged when I dig, make the adjustments and discover the positive underlying trend in the organic business, as I did here. As a long term shareholder, however, I am also happy to see management undistracted from the task of growing overall value quickly, efficiently and through all available means. The Company demonstrated a second consecutive quarter in a long term trend of growth in revenue (+54.5%), bookings (+20.8%), and gross margin (+590 bps) and SGI has a product set positioned for years of ongoing growth and profitability. This was another great quarter and I believe there is still significant growth ahead.

Thanks a lot for the comments, Special K. Your write up was a clearly quite successful and is a big part of the reason I decided to post. I’m happy to answer your questions
In response to your comment that this is “sub 5% growth,” since you don’t give a specific methodology or metric (revenue, bookings, gross margin) that is growing at sub-5%, I will do my best to address this comment by looking at overall “growth” in the business. With regards to this being a single digit top line grower, I agree that in FY2011, bookings did grow single digits as I show here: 9.5%. Importantly, the bookings growth saw material acceleration in the fourth quarter of FY 2011. Bookings growth (adjusted for SGI JP, of course) is the best way to look at organic top line strength as bookings make irrelevant any noise from the accounting change. I calculate, through assumptions that I very clearly lay out in the table, 35.7% growth Y-o-Y, which is an impressive number representing business momentum. As for profitability, I absolutely cede that the business is not consistently profitable yet. However, the trend is clearly favorable, with gross margin increasing every quarter vs. prior year, due changes in product mix. The combination of the ongoing gross margin improvement (another 100-300 bps forecast in FY2012), increasing fixed cost operating leverage, and inorganic revenue growth set earnings growth well above the ~20% projected revenue growth.
Regarding the SGI JP assumption, there’s likely no disagreement that the $9.6 million (per the 10K) that SGI would have sold to SGI JP had they not acquired it should be added back. You’ll note that I don’t assume any of the growth in product revenue above run rate was attributable to organic growth. However, through my non-financial diligence, I learned about the SGI services labor force redeployment to Japan in the 4Q. As noted, the overall services revenue trajectory also supports this assertion. Based on this, I gave the Company credit for the productivity of its employees but not at 100%, as their deployment to Japan was likely due to a particularly strong opportunity there. It is further worth noting that even excluding 100% of this revenue (therefore all SGI JP revenue except the $9.6 mentioned above), bookings still organically grew 22% Y-o-Y in the fourth quarter of FY 2011. As I mentioned, my assumptions and calculations are laid out in the table above for transparency.
The value of the NOLs is clearly a very, very small point, so I’ll be brief. I simply assumed the relevant federal, state and international tax rates less a 10% discount for potential changes in tax policy. To be clear, the NOLs will be a nice EPS perk as they become cash benefits over the next 5-6 years, but are largely tangential to the thesis of ongoing business strength. If you believe the business will never have taxable income, you’re correct: the NOLs will have no value (except in a sale). In that case, however, I would imagine the core driver of the short thesis has more to do with the lack of growth than the value of the NOLs… I believe the company will generate taxable income in the near future.
There are many precedents for high tech companies being valued based largely on revenue multiples, particularly high-performance niche businesses which are bought by larger industry players, as would be the case here. Two high-fliers that come to mind are 3Par (10.9x trailing revenue) and Compellant (6.1x trailing revenue), both of which happened to also be similarly unprofitable at the time of acquisition. I acknowledge that SGI likely will not draw the lofty multiples of the prior two examples, but they do serve as convenient case studies for unprofitable, niche buyouts apparently valued based on revenue.
I do agree (as does management) that the old Rackable business is not a very good one, aside from providing purchasing and fixed cost leverage, and should therefore be de-emphasized. I believe where we most fundamentally differ is in the assessment of the computing business. I understand from your comments that you may believe SGI’s products are commoditized and/or overly niche and do not have market traction. My work, however, points to technology and results to date that show very real and accelerating strength (I won’t repeat the discussion of the disruptive products and growing technology leadership I outlined above). And this is corroborated by the strong bookings growth and continued margin improvement. As I mentioned explicitly in the write up, these are not the products they were selling when the old SGI went into bankruptcy; these are new, high margin, differentiated products which have been growing quickly since they were introduced in FY 2009 and FY 2010. The Company estimates their TAM at $17 billion (growing to $23 billion in 2014), so even at a fraction of that there is plenty of runway before the TAM becomes constrained.
With regard to IR, I would assert it would have been a better IR policy for the company simply to state everything clearly and avoid the intrigue of short sellers. In response to what appears to be an insinuation (accusation?) that I am in some way connected to the company, I can absolutely assure you that I am not, although I do take it as a compliment regarding my understanding of the business model. The earnings tomorrow were – admittedly – a nice catalyst for making me finish up my work on SGI and publish this write up (my first on Seeking Alpha)…
Overall, I think the most important point here is not if organic bookings grew at 9.5% or 8% or even 5% (it seems we’ve thankfully moved on from 1% or 2%) in FY 11 or if SGI grew bookings at 36% or 22% in FY11 4Q. What really matters here is that all the data points (including but not limited to financial performance) indicate business health and momentum. Hiring, strength in federal, bookings acceleration, strong guidance, performance above internal plans, great product feedback from customers, huge TAM and a prolonged trend of margin expansion all point to ongoing strength and momentum. There that is no question in any given quarter the business can be lumpy – as the short thesis pounced on in 3Q FY11, and as the Company notes as the reason it only issues annual guidance. A specific and comprehensive analysis of the fundamental data though points to strong, sustainable top and bottom line growth with meaningful runway as Big Data scales and the “high end” of data analysis becomes ubiquitous in the enterprise.
Thanks for participating in the dialogue.