A post-bankrupt company, with a strong brand, incomprensible financial statements, and no analyst coverage. What’s not to like?

The above succintly describes why we are bullish on Silicon Graphics (Nasdaq: SGIC), and we think you may want to take a closer look at the stock.

Business Background and Recent Changes

If you’ve followed technology long enough, we’re sure you’re familiar with Silicon Graphics, and so we’ll spare you all the details here. What you may not know is that SGIC emerged from a bankruptcy about six months ago, and is now valued, on an enterprise basis, at about $300 million. Quite a markdown from the days when the company was a tech darling and was fetching over $7 billion.

Of course, much has changed at SGIC over the years, and the company is now quite different than it once was. As such, we encourage you to read thru the links below to get a good understanding of the past problems and the current revival:
http://www.hpcwire.com/hpc/655167.html

http://www.businessreviewonline.com/blog/archives/2006/07/will_sgi_become.html

http://www.computerworld.com/action/article.do?command=viewArticleBasic&articleId=9000369

Finally, just two days ago the company announced that it hired Robert Ewald as the new CEO. For a good appreciation of Mr. Ewald, we provide you with this link:

http://www.taborcommunications.com/hpcwire/features/people05/

Quick quote from the article above:

“In basic terms, we keep an eye on Bo because we’ve been watching him for so long; he’s an industry legend. As a user, he was one of the original Cray-ons — way back in the 1970s — and he’s been a key mover at both Cray Research Inc. and SGI. Aside from being a motivational leader, Bo brings a wealth of insider knowledge to up-and-coming LN. “

While we saw nothing wrong with SGIC’s most recent CEO who navigated the company thru bankruptcy, clearly the board, wanted an industry and former company insider to help drive SGIC into a new growth era. As the Chairman said,

“Bo’s leadership skills and extensive experience in a range of high-performance computing and storage markets make him the right CEO to lead SGI to success, not only in the traditional technical and scientific HPC market, but also in new enterprise HPC segments where SGI’s technologies have significant potential.”

Low Downside Risk
As is the case with all our tech stock picks, we like SGIC because the company’s stock price is at historically depressed levels, and yet the company is undergoing some significant and positive changes. From our perspective, the downside appears very limited at current prices, while the upside potential could be substantial, i.e. 100%+, over the next year or two.

Briefly, your downside is protected by:

• Strong Balance Sheet. The company’s financial condition is currently solid, with the company sporting a net cash position for the first time in many years.
• Large and Recurring Base Business. The company has a large customer base (see articles above) that generates a substantial service revenue stream of over $200 million. The revenue stream is, in theory, a cash-cow, especially in the hands of a potential competitor or private equity shop, who would not need to use the cash coming in for growth investments.
• Strong Brand. Despite the bankruptcy, SGIC’s brand remains strong in the tech community.
• Low Valuation. The company’s valuation is quite low, with an Enterprise Value to Sales ratio, well beneath 1, and a normalized EV/EBITDA ratio of about 5, in our estimation. In other words, the stock price already reflects alot of pessimism or should we say skepticism about a true revival at SGIC.
• M&A Potential. Depending how you look at it, M&A potential either protects your downside or provides the upside. In the case of SGIC, we think the company will prove valuable to many companies, especially if SGIC is able to start penetrating the enterprise market. Furthermore, the company could be cheaper to acquire than fight in court (see below about patent lawsuits).

Upside and Hype Potential

Because the SGI story has been rehashed so many times, it’s difficult, at first, to see what Wall Street can potentially use this time around to sell the SGIC story to investors. However, we’ve come up with a few positives.

• New Sustainable Growth. Hidden from most investors is that under a completely new management team, SGIC’s backlog is finally growing again, the business has turned cash-flow positive, and several new products will be introduced in the coming year that could have an ongoing positive impact on the top and bottom line. A couple of clean quarters of growth and some traction with new products, should get a few funds excited about this name again. It’s important to remember that given SGIC’s large customer base, the potential for successfully upselling new solutions in quite large. It shouldn’t require more than a good product and of course excellent marketing.
• Patent Profits. In addition, as a former tech leader, SGIC has an extremely strong patent portfolio and potential settlements+royalties on these patents could send the stock soaring. One notable patent lawsuit can be read about here. Interestingly, Nvidia supposedly licensed this same patent for over $50 million+ over 8 years ago, when NVDA was a relatively small company and the graphics card industry was still developing. The implication is that this patent is substantially more valuable today given the growth in the industry since the original NVDA license. Besides, this one there are other far-reaching patents that SGIC is supposedly looking to license.
• Analyst Coverage. No analysts cover the company yet. However, we expect that once SGIC’s financials become a bit more comprehensible (i.e. there are still alot of accounting adjustments in the financials due to the recent emergence from bankruptcy) later this year and next, that Wall Street will begin covering the company again. With the increased exposure given by Wall Street research, the stock should rise.In fact, our research indicates that the company could be worth between $60 to $90 based on comp. multiples.

Back-of-the-Envelope Valuation

A valuation of SGIC is extremely difficult because the financials are somewhat incomprehensible due to GAAP Fresh Start accounting, and it’s next to impossible to value the company’s intangible assets, such as patents.

However, if you use management’s “adjusted” numbers, you get $536 million in Revenue for 2007, which pretty much matches the $550 million the company was projecting in its bankruptcy report. The problem, though, is that some of that revenue is from legacy business, which are next to worthless.

In any case, revenue multiples in the industry are from 1X to 1.5x, which seems fair and, in truth, the entire industry seems quite cheap when compared to other areas in tech. EV/EBITDA ratios for SGIC’s comps. are in 10X to 12X range.

SGIC has about 11 million shares out, so we have about a $330 million market cap. Taking out net cash, gives a $300 million value for an EV/Sales of 0.57, which is clearly cheap given the recurring nature of a large portion of revenues in combination with the gross margin situation. SGIC’s internal forecasts call for 2008 revenue of $600 million, implying a forward EV/Sales ratio of 0.5X. Upside at 1X sales is therefore $55 to $60, or about a double.

Valuing the company on the EBITDA front is a bit trickier, since the company’s EBITDA margins are currently quite depressed for a wide variety of reasons. For instance, the company’s internal estimates given during bankrupty proceedings call for called for EBITDA of $40 million next year, which implies a price of $40 to $45. But it’s possible that the EBITDA figures here are way off. EMC has nearly 20% EBITDA margins and others are at 8% to 10%. So it seems possible to do 10% EBITDA margins here, for EBITDA of $55 to $60 million, which again implies a stock price of $55 to $60.

Additional Considerations and Risks

• Strong Government Focus

As the company states:

“A significant portion of our revenue is derived from sales to the U.S. government, either directly by us or through system integrators and other resellers. Sales to the government present risks in addition to those involved in sales to commercial customers, including potential disruptions due to changes in appropriation and spending patterns. Our U.S. government business is also highly sensitive to changes in the U.S. government’s national and international priorities and budgeting”.

• Declining Legacy Business

As the company states:

“Future revenue growth from our newer product families is especially important because revenues from our traditional MIPS and IRIX products and maintenance business are expected to continue to decline. Our ability to achieve future revenue growth will depend significantly on the market success of these newer product families in servers and storage as well as our ability to generate sales to match or replace revenues generated from large sales transactions in prior periods. If one or more of the product lines were to fail in the market, it could have an adverse effect on our business and liquidity. “

Disclaimer:

We own shares in SGIC. This site may include market analysis and we may own shares in the stocks mentioned in our reports. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.