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Volume 3, Number 18 -- May 11, 2006

Silicon Graphics Files for Chapter 11 Bankruptcy

Published: May 9, 2006

by Timothy Prickett Morgan

After years of struggling to try to catch the wave in high performance computing with its Linux-based and Itanium-based Altix supercomputers, server maker Silicon Graphics this week filed for chapter 11 bankruptcy protection. The filing for protection from creditors, which is intended to allow SGI to get its financial house in order, follows some tumultuous months for the company, which has killed off products, spun off units, and changed upper management in an effort to right itself.

SGI has not been trading on the New York Stock Exchange since November 2005, and has been trading on the Over The Counter market. In Monday morning trading, the company's stock fell nearly 81 percent to 6.2 cents a share, giving it a market capitalization of a mere $16.6 million. This is an astoundingly low value, making SGI a more than prime target for a takeover--provided the buyer wants to assume some debts and obligations that are considerably larger. There are some obvious candidates for a takeover.

SGI filed its bankruptcy protection papers in the U.S. Bankruptcy Court for the Southern District of New York early Monday. The filing was for the U.S.-based portion of the company only; in a statement, SGI said that its subsidiaries in Europe, Canada, Mexico, South America and Asia were not included in the filing, and therefore will continue to operate as usual. SGI said further in that statement that it will file a plan of reorganization "shortly" and that it expects to emerge from bankruptcy protection within six months. SGI has hired Weil, Gotshal & Manges as its counsel.

While SGI did not host a conference call this week explaining its plans and giving some insight into the bankruptcy filing, it did release some details as well as reporting its financial results for its third fiscal 2006 quarter. SGI plans to hold a conference call today after the market closes to give Wall Street a chance to ask some questions.

Dennis McKenna, who displaced Bob Bishop as SGI's chairman and chief executive officer at the end of January, went to great pains in the press release to try to paint a picture of SGI operating normally even thought it has called time-out on paying its bills. "We want to assure our customers, our employees and our communities that SGI is operating--business as usual," McKenna said in the statement. "Our customers can continue to rely on SGI for its mission-critical products, services, and support."

McKenna went on to say that since taking the helm, the company has hired a new chief financial officer and added other experienced executives to the management team, closed "significant sales" that reflected continuing demand for SGI products, did a restructuring that yielded $100 million in annualized cost savings with work underway to chop another $50 million in costs. McKenna added that SGI has identified ways to cut operation costs and improve manufacturing efficiencies, and repositioned the company's products and increased its focus on core HPC markets.

But, this has not been enough for SGI to keep going without seeking bankruptcy protection, as its third quarter financial results show. SGI had sales of $108 million, down 32 percent from the year ago quarter and down 25 percent from the $144 million in sales the company posted in its fiscal second quarter ended December 31, 2005. Product sales fell by 43 percent to $44.9 million, not including $3.8 million in sales through the SGI Japan unit.

The SGI Japan unit is a partnership of Japanese server maker NEC and SGI; in March, Sony and Softbank took stakes in SGI Japan and this entity acquired the European broadcast unit of SGI and created a new company, controlled by SGI Japan, called Silex Media, which will resell SGI gear aimed at broadcast and media companies. SGI Japan was formed in 1987, and NEC bought a 40 percent stake of this unit in 2001, when SGI, like many other server makers, fell on hard times. In late March, when SGI reported sales would be off big time in the third quarter, the company killed off its standalone visualization system products, which are based on the Altix servers.

For the fiscal third quarter, SGI posted a net loss of $43 million, or 16 cents per share, compared to a net loss of $45 million, or 17 cents a share in the year-ago period. For the nine months ended March 31, SGI had sales of $442.1 million, down 24 percent, and a net loss of $106.2 million. At the end of the quarter, SGI had $54.3 million in cash, $40.6 million in short-term restricted investments, and $601,000 in short-term saleable investments.

SGI has not posted an annual profit since 1997, despite the successful transfer of its NUMAflex clustering technology from its Origin Unix servers to Linux-based servers based on Itanium processors from Intel. The resulting Altix servers have a very large, shared memory space that offers significant performance benefits compared to plain vanilla Linux clusters, but for whatever reason, sales of the Altix machines continue to be disappointing. This fact has been particularly painful for SGI since in the time it has been making the transition to Linux, the HPC industry has done the same and, more startlingly, the HPC server market has been exploding. According to analysis from IDC, the HPC server market grew by 23 percent in 2005, hitting $9.1 billion in worldwide sales. HPC server sales were up by 50 percent in 2005 compared to 2002, and the benefits of that growth have not translated into sales and profits for SGI.

Hence, the bankruptcy filing this week. As part of the reorganization, SGI said that unspecified holders of its senior secured notes have provided the company with a $70 million credit facility; SGI said further that the senior secured notes represented a majority of SGI's outstanding debt. Using this credit facility, cash from operations, and cash on hand, SGI will pay down some of its pre-bankruptcy debt and pay suppliers, employees, and keep the company running. SGI "contemplates" that those holders of the senior secured debt will convert that debt into new stock offering at some future date, and that under the deal, these debt holders have the right to purchase $50 million in additional equity. This will obviously dilute the value of SGI's current outstanding shares. Nonetheless, with the bankruptcy reorganization plan it is working on, SGI says it will be able to reduce its debts by approximately $250 million. As the third fiscal quarter ended, SGI had $297.3 million in current liabilities--payroll, bills, taxes, current debts and deferred revenues--as well as $253.1 million in long-term debts, $48.5 million in deferred revenues, and $65.4 million in other liabilities.

"We regret the effect that this will have on SGI's shareholders and other unsecured creditors," McKenna explained in the statement. "SGI plays a critical role in the world's infrastructure. This needs to be preserved."

The bankruptcy protection and SGI's very low market capitalization relative to its sales makes the specter of a takeover by another server maker seem possible. Hewlett-Packard and NEC are both sellers of Itanium-based servers, and might be interested in picking up SGI for its NUMAflex technology and HPC contacts. Hitachi and Fujitsu might be interested, as they support Itanium as well. However, there is another possibility: Some server maker interested in deploying high-end NUMA clusters based on Xeon and Opteron processors might step up after the reorganization is approved and SGI emerges from bankruptcy protection to take NUMAflex and make the technology more broadly appealing. For all we know, SGI plans to do this itself as part of its future product roadmap.

RELATED STORY

HPC Server Market Explodes to $9.1 Billion in 2005

Struggling SGI Replaces Chairman, Stirs Up Some Midrange Biz



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Editor: Timothy Prickett Morgan
Contributing Editors: Dan Burger, Joe Hertvik,
Shannon O'Donnell, Timothy Prickett Morgan
Publisher and Advertising Director: Jenny Thomas
Advertising Sales Representative: Kim Reed
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