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November 30, 2007

SGI Stays the Course Amid Stock Woes

by Michael Feldman

On Nov. 6, SGI held a conference call for its first quarter financial results for fiscal year 2008, which generally put a sunny face on a three month period that was $36 million in the red. The good news was that the company increased Q1 bookings 43 percent compared to Q4 2007, and 19 percent compared to Q1 for fiscal 2007. According to SGI, orders increased in all sectors, especially the industrial sector, and without the benefit of any large individual sales over $5 million. From management’s perspective, the only disappointment was SGI’s storage platform sales, which declined and fell short of expectations.

Most of the increased bookings in Q1 had to do with overachieving Altix server sales. Since emerging from bankruptcy in October 2006, SGI expanded its server portfolio significantly. The addition of the Altix 450 mid-range Itanium blade servers, as well as the Xeon-based Altix XE servers and Altix ICE blade systems, gives the company a much wider range of compute platforms to offer customers. The highly computationally dense ICE blade systems have been particularly popular since their introduction in June 2007. Two weeks ago, SGI snagged the number 3 spot on the most recent TOP500 list with a 14,336-core, 28 terabyte ICE system acquired by the state of New Mexico for the New Mexico Computing Applications Center. While SGI loves the big money deals, in 2008 the company is looking to establish its volume selling strategy, with shorter sales cycles and more predictable profit margins.

Since joining the company as the new CEO six months ago, Bo Ewald has been busy elaborating the new strategy. “Basically our customers do three things over and over again,” said Ewald during the Nov. 6 conference call. “They compute things, they save the results, and they look at the results. Our mission is to provide the best products for each of those three areas and integrate them into a more complete solution than is available from other suppliers.”

That statement points to SGI’s intention to marry its compute platforms with its storage products and the new supercomputing visualization portfolio announced at SC07. Additionally, the company is working on an Industrial Strength Linux Environment, which integrates software on top of the OS to optimize application and system throughput, as well as reduce complexity for the user.

The overall plan of attack is to deepen penetration into established market segments and use that as a base to branch into other verticals. According to Ewald, in 2008 they’ll be focusing on four segments: defense and intelligence, industrial design/manufacturing, research, and high performance business. The defense and intelligence segment is their biggest customer segment today, but with a new portfolio, they foresee a big growth opportunity there. The company is also looking to expand its footprint in the industrial and research segments.

At the other end is the high performance business segment, where customers are looking to rapidly analzye large databases to make time-critical decisions. This is a new area for SGI, but one that it covets, since establishing a presence here would give SGI an entry into the larger enterprise computing space. The company believes its NUMAflex shared memory architecture is ideally suited for such applications, which typically require a lot of globally addressable memory. One of the platforms SGI points to for these types of applications is its Altix 450 system, which recently broke the Oracle Applications Standard Benchmark record, achieving an average response time of less than half a second for 3,000 online users.

The real trick for SGI will be to grow its volume business to the point where the company becomes profitable. Since this business model shifts sales toward lower margin, commodity-based platforms, SGI intends to add higher margin offerings into the mix through increased software licensing, as well as consulting and professional services. At the same time, the company has to keep its costs under control, so spending doesn’t outstrip revenue. SGI management seems confident it can accomplish all of this.

“While we have not yet achieved operating profitability, we are executing to our plan, which for this year is focused on making the investments necessary to drive more business volume,” said Kathy Lanterman, SGI’s chief financial officer. “We feel we’re on the right track with that strategy.”

But the market has its own logic. SGI’s stock, which hovered around $28-30 per share in the spring and early summer, is now trading at between $17 and $18 — around $2 below the initial post-bankruptcy stock offering a year ago. The company’s stock troubles have made some of its shareholders nervous.

During the Nov. 6 conference call, a gentleman from Deutsche Bank raised the issue of the declining stock value, asking the SGI reps on the call why there was a disconnect between the behavior of the stock and management’s own view of the company’s trajectory. “One thing is missing here,” he said. “Either what you guys are doing, the market doesn’t like, or the market doesn’t understand what you’re doing.” From his point of view, it was the latter. But in that case, the Deutsche Bank caller suggested they should be telling their story better and to a wider audience of investors.

The response from CFO Lanterman was that the company is committed to developing long-term value for the shareholders with their current strategy. She also confirmed that SGI recently filed a shelf registration for a possible future equity offering (which would indicate they are not currently interested in looking for a buyer).

Apparently, this stay-the-course strategy was not acceptable to everyone. On Nov. 9, three days after the Q1 conference call, Southpaw Asset Management LP, which holds 5.3 percent of SGI’s stock, filed a letter with the SEC recommending SGI’s board of directors “undertake a thorough review of strategic alternatives, including the sale of the Company.” Southpaw believes the current stock is substantially undervalued compared to SGI’s worth and the sale of the company could unleash some of that value. Furthermore, Southpaw suggested that the company’s 700 patents could be “separated” from SGI’s operating business with minimal disruption.

Southpaw went on to state:

We had originally intended to hold SGI shares as a passive investment. However, the significant decline in the stock price over the course of the past ten months, coupled with the Board’s “business as usual” strategic direction, compels us to become more active. While we are pleased by the Company’s turnaround since emerging from bankruptcy, as evidenced by the recent announcement of a 43 percent increase in bookings, the share price fails to recognize this positive momentum. It is our view that this will continue and that the only way to unlock value for shareholders is through strategic alternatives. For the Board and management to continue to take comfort in a turnaround story that is not being reflected in the stock price is unacceptable. We believe there are currently significant strategic alternatives for the Company and that it is incumbent on the Board to pursue these opportunities and deliver value to shareholders as soon as possible.

To date, no other investors have gone public with misgivings about the company’s direction.

For SGI’s shareholders, the stock nosedive over the last several months may seem foreboding. But it’s doubtful whether they questioned why the stock initially rose so sharply in early 2007. Maybe the people dabbling with SGI stock are the same ones who thought houses were such a bargain in the first half of the decade, and have now decided they’re tremendously overpriced. For the time being, the company seems prepared to let its business plan speak for itself and hopes that its investors give it time to let that that play out.