SGI announced earnings for its second fiscal quarter (FY2009) last Thursday, reporting lower revenue and higher losses when compared with Q1, and citing the tough economic climate as a primary cause. As has been the case with many of its recent earnings announcements, the company reported both figures created according to Generally Accepted Accounting Principles (or GAAP results), and non-GAAP results. HPCwire had a chance to talk with SGI Chief Financial Officer Greg Wood after the earnings call, and he walked us through the company’s financial results and explained to us why non-GAAP measures are important, and meaningful indications of the company’s performance.
SGI’s financial results from the second fiscal quarter (ended Dec. 26, 2008) didn’t have the company popping champagne corks at its Sunnyvale, Calif., headquarters.
Revenue for the second quarter was $82.8 million, compared to $92.8 million in the previous quarter and $90.1 million in the second quarter of the prior year. The company’s net loss for the quarter was $49.2 million, or $4.24 per share, versus a net loss of $33.7 million or $2.91 per share last quarter and $42.2 million or $3.78 per share in the second quarter of the prior year.
During the earnings call, company CEO Bo Ewald talked about the challenging financial climate during the quarter and its effect on some of its core markets. SGI’s media customers were feeling pressure from dropping revenues as their clients pulled back on air time for splashy advertising campaigns, and business from the federal customers slowed from what SGI reckons as the impact of a continuing resolution and the uncertainty surrounding the new administration.
Despite the dismal business climate, the company did report an increase of $10 million in bookings during the quarter, rising from $58 million in Q1 to $68 million. Ewald characterized these bookings as fairly broad-based: there were no large deals in that figure, with largest orders being at most in the $6-7 million range. 18 of the top 20 orders were with from the government or from government-funded customers, with the last two being million dollar orders for storage from the media sector and (interestingly) SGI’s new visualization offering in the aerospace sector.
Ewald did mention that the company is working on a large deal that didn’t close in time for Q2, but which it expects to be announcing soon. CFO Greg Wood ascribed SGI’s decrease in margin during this quarter (down to 26 percent from 32 percent in Q1) to a draw down of the company’s cash reserves in order to service this deal, and to adverse foreign exchange rate impacts. As the company moves forward, Ewald described the company’s strategy to grow the business around its Industrial Strength Linux Environment (ISLE), the visualization offering, and its new Ultraviolet compute platform.
Digging into the results a little further, operating expenses for Q2 were down from Q1, reflecting savings from a Q1 headcount reduction. SGI started this fiscal year with 1,632 employees, and during Q1 eliminated 75 positions. Additional headcount reductions of 270 or so following an additional restructuring in December have brought SGI staff down to 1,287 today. The Q2 results include the charge for that action (termination of leases, employee severance packages, and so on) but not the benefits, which Wood estimated on the earnings call will be about $30 million annually.
Wood and Ewald also discussed an agreement SGI reached with creditors in December to delay repayment of outstanding debts, which had been due to enter repayment at the end of last year. While they noted that this was a positive outcome for the business in the short term, both Wood and Ewald touched on their goal to achieve a comprehensive restructuring of the company’s debt moving forward.
As has been the case with all recent earnings announcements, SGI also highlighted non-GAAP results during the call.
Pro forma revenue, a non-GAAP measure, for the second quarter was $89.3 million, compared to $117.5 million in the previous quarter and $109.1 million in the second quarter of the prior year. Pro forma revenue excludes the effect of Statement of Accounting Position 97-2, which requires the deferral of revenue in certain circumstances under software revenue recognition rules and is useful when considered in connection with revenue as calculated under GAAP.
I’m an engineer, not an accountant, which means that I’m curious enough to look up what GAAP stands for, and to be suspicious when someone reports non-GAAP results. So, what gives? I talked with Greg Wood following the earnings call to try and get a handle on what’s going on here.
First, a little background. GAAP stands for Generally Accepted Accounting Principles, and we’ll make a quick trip to the Wikipedia for a definition
Financial accounting information must be assembled and reported objectively. Third-parties who must rely on such information have a right to be assured that the data are free from bias and inconsistency, whether deliberate or not. For this reason, financial accounting relies on certain standards or guides that are called “Generally Accepted Accounting Principles” (GAAP).
Exactly what the principles are is contained in a body of documentation called the International Financial Reporting Standards (IFRS), which is established and maintained by the International Accounting Standards Board.
The part of this body of information that affects SGI is called Statement of Position 97-2 “Revenue Recognition of Software Products.” Issued in 1997, 97-2 governs how companies that provide software products as a significant part of the value of their solution “recognize” (or report) the revenue from those sales. The rule says that if you don’t have a generally recognized and relatively invariant process by which you price the various elements of a solution that includes significant value from software, you cannot recognize the full revenue from the sale until the end of the delivery period. Huh?
OK, an example. Consider that you buy a $50 million storage solution from SGI, which includes both hardware (tapes, disks, servers, etc.) and software (DMF, CXFS, and so on) as well as a four year maintenance agreement. You install the solution, run it for 30 days during which it performs fine and you write SGI a check for $50 million. Now the maintenance period begins, and each month you write SGI a check for the service portion of your contract. So SGI has a check for $50 million from you, which they have put in the bank and are free to spend. But at the end of the quarter they have to make a determination about whether they can report that $50 million as income. The answer lies in whether 97-2 applies.
From an accounting point of view you cannot use the hardware you bought without the storage software that came with it, so the software is a significant part of the value of the solution. Therefore, 97-2 applies and even though they have definitely deposited your $50 million check and can use it in the daily operation of the business, they cannot report the income in that quarter’s results. Pretty non-intuitive, which is probably why I’m not an accountant.
So how do they get to report the income? In this case SGI would recognize both the monthly money from the service contract in the quarters in which it occurs and a pro-rated portion of the purchase price of the hardware. In our example we have a four year service contract, so each month SGI would recognize (which means report as part of that period’s earnings) 1/48 of $50 million.
Why is this such a big deal? The problem is that SGI wasn’t always considered (for accounting purposes) a software company. For most of its history it was a hardware company, and 97-2 didn’t apply to its sales. Starting a couple of years ago, SGI’s auditors determined that the software really was an important part of SGI’s solutions, and this meant that the company suddenly had to start pushing revenue forward in its reporting statements. This had the effect of the appearance of a dramatic revenue decrease, at least in the short term.
But SGI still has the money today from these deals as customers accept hardware, even though it can only report it gradually over time. So, if you look at only the GAAP results, it’s hard to tell how much money the company actually has in the bank. Enter the non-GAAP, or pro forma, revenue results in this quarter’s results press release. The pro forma results are higher, and offer an indication of money they put in the bank this quarter and have on hand to run the business.
Does all of this mean that SGI is really a fabulously-healthy company and the mean old accountants are forcing them to look bad? No. Q2 pro forma (non-GAAP) revenue was $89.3 million, only about $6.5 million more than the GAAP revenue. The company is still in a challenging business position, and really does have its work cut out for it. But reporting non-GAAP results also doesn’t mean that the company is playing around with the numbers and trying to hide something. Both GAAP and non-GAAP results are important, and both should be studied to get an accurate picture of the health of the business.
The good news is that SGI likely won’t always face these challenges. There are a set of tests related to pricing of services and software that, if passed, will enable SGI to recognize hardware revenue after a system is accepted rather than having to amortize it over, say, the life of a multi-year service contract. This will have the effect of SGI being able to report its income closer to how you’d think of reporting income for your family — when did you get a check, and how much was it for. How long will it take for SGI to be able to establish new business practices that will enable it to pass these tests? “I’d love to get there by the beginning of the next fiscal year,” says Wood. “But that may be challenging.”