UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
(Mark One)
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 27, 2013
Or
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from                 to
Commission File Number 000-51333
 
SILICON GRAPHICS INTERNATIONAL CORP.
(Exact name of registrant as specified in its charter)
 
 
Delaware
 
32-0047154
 
 
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)
 
46600 Landing Parkway
Fremont, California 94538
(Address of principal executive offices, including zip code)
(510) 933-8300
(Registrant's telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No   o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes x  No  o 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer   o
Accelerated filer  x
Non-accelerated filer  o
Smaller reporting company   o
 
 
(Do not check if a smaller reporting company)
 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No   x 
As of October 30, 2013, there were 34,258,372 shares of the registrant's common stock outstanding.







SILICON GRAPHICS INTERNATIONAL CORP.
TABLE OF CONTENTS
 
 
 
Page
PART I
Item 1.
 
 
 
 
 
Item 2.
Item 3.
Item 4.
 
 
 
PART II
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
 
 
 







PART I - FINANCIAL INFORMATION

ITEM 1. Financial Statements

SILICON GRAPHICS INTERNATIONAL CORP.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
 
 
Three Months Ended
 
September 27, 2013
 
September 28, 2012
 
 
 
 
Revenue
 
 
 
Product
$
99,219

 
$
128,353

Service
38,076

 
45,408

Combined product and service
10,224

 
19,120

Total revenue
147,519

 
192,881

Cost of revenue
 
 
 
Product
82,629

 
110,935

Service
20,248

 
27,077

Combined product and service
6,394

 
12,659

Total cost of revenue
109,271

 
150,671

Gross profit
38,248

 
42,210

Operating expenses:
 

 
 
Research and development
14,834

 
13,969

Sales and marketing
17,596

 
19,571

General and administrative
12,482

 
14,189

Restructuring
526

 
1,474

Total operating expenses
45,438

 
49,203

Loss from operations
(7,190
)
 
(6,993
)
Total other income (expense), net:
 

 
 
Interest income (expense), net
(7
)
 
(155
)
Other income (expense), net
303

 
(1,107
)
Total other income (expense), net
296

 
(1,262
)
Loss before income taxes
(6,894
)
 
(8,255
)
Income tax (benefit) provision
(71
)
 
425

Net loss
$
(6,823
)
 
$
(8,680
)
 
 
 
 
Basic and diluted net loss per share
$
(0.20
)
 
$
(0.27
)
 
 
 
 
Shares used in computing basic and diluted net loss per share
34,096

 
32,166

 
 
 
 
See accompanying notes.

2





SILICON GRAPHICS INTERNATIONAL CORP.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(In thousands)
(Unaudited)

 
Three Months Ended
 
September 27, 2013
 
September 28,
2012
 
 
 
 
Net loss
$
(6,823
)
 
$
(8,680
)
Other comprehensive (loss) income:
 
 
 
Unrecognized gain on defined benefit plans, net of zero tax
29

 
42

Unrealized losses on derivatives instruments, net of zero tax
(1,045
)
 

Unrealized losses on derivative instruments reclassified into earnings, net of zero tax
86

 

Foreign currency translation adjustment, net of zero tax
(139
)
 
212

Other comprehensive (loss) income
(1,069
)

254

Total comprehensive loss
$
(7,892
)
 
$
(8,426
)






































See accompanying notes.


3





SILICON GRAPHICS INTERNATIONAL CORP.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
(Unaudited)
 
September 27,
2013
 
June 28,
2013
ASSETS
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
160,058

 
$
175,181

Current portion of restricted cash
2,581

 
531

Accounts receivable, net of allowance for doubtful accounts of $1,199 and $1,074 as of September 27, 2013 and June 28, 2013, respectively
82,455

 
59,842

Inventories
55,971

 
61,770

Current portion of deferred cost of revenue
15,110

 
21,204

Prepaid expenses and other current assets
13,325

 
14,094

Total current assets
329,500

 
332,622

Non-current portion of restricted cash
2,072

 
2,853

Property and equipment, net
28,760

 
26,170

Intangible assets, net
3,794

 
4,643

Non-current portion of deferred cost of revenue
7,695

 
7,281

Other assets
34,886

 
34,284

Total assets
$
406,707

 
$
407,853

LIABILITIES AND STOCKHOLDERS' EQUITY
 

 
 
Current liabilities:
 

 
 
Accounts payable
$
58,325

 
$
51,531

Accrued compensation
21,603

 
28,504

Current portion of deferred revenue
88,755

 
86,357

Other current liabilities
36,124

 
35,364

Total current liabilities
204,807

 
201,756

Non-current portion of deferred revenue
49,802

 
50,362

Long-term income taxes payable
10,425

 
10,149

Retirement benefit obligations
11,875

 
11,542

Other non-current liabilities
3,507

 
3,790

Total liabilities
280,416

 
277,599

Commitments and contingencies (Note 22)


 

Stockholders' equity:
 

 
 
Preferred stock, par value $0.001 per share; 12,000 shares authorized; none outstanding

 

Common stock, par value $0.001 per share; 120,000 shares authorized; 35,493 shares and 34,795 shares issued at September 27, 2013 and June 28, 2013, respectively
35

 
35

Additional paid-in capital
517,077

 
510,092

Treasury stock, at cost (1,146 shares at September 27, 2013 and 946 shares at June 28, 2013)
(10,748
)
 
(7,692
)
Accumulated other comprehensive loss
(3,220
)
 
(2,151
)
Accumulated deficit
(376,853
)
 
(370,030
)
Total stockholders' equity
126,291

 
130,254

Total liabilities and stockholders' equity
$
406,707

 
$
407,853

 
 
 
 

See accompanying notes.

4





SILICON GRAPHICS INTERNATIONAL CORP.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 
Three Months Ended
 
September 27,
2013
 
September 28,
2012
CASH FLOWS FROM OPERATING ACTIVITIES:
 
 
 
Net loss
$
(6,823
)
 
$
(8,680
)
Adjustments to reconcile net loss to net cash provided by (used in) operating activities:
 

 
 
Depreciation and amortization
3,591

 
3,498

Share-based compensation
2,976

 
2,511

Other
285

 
353

Changes in operating assets and liabilities:
 

 
 
Accounts receivable
(22,995
)
 
8,500

Inventories
4,533

 
(24,262
)
Deferred cost of revenue
5,608

 
5,038

Prepaid expenses and other assets
742

 
(4,350
)
Accounts payable
4,442

 
18,509

Deferred revenue
2,047

 
4,755

Other liabilities
(7,334
)
 
(1,237
)
Net cash (used in) provided by operating activities
(12,928
)
 
4,635

CASH FLOWS FROM INVESTING ACTIVITIES:
 

 
 
Purchases of property and equipment
(1,710
)
 
(1,047
)
Other
(1,269
)
 
1,479

Net cash (used in) provided by investing activities
(2,979
)
 
432

CASH FLOWS FROM FINANCING ACTIVITIES:
 

 
 
Payment of credit facility

 
(5,000
)
Funding of restricted stock units withheld for taxes
(832
)
 
(202
)
Purchase of treasury stock
(3,056
)
 

Proceeds from issuance of common stock upon exercise of stock options
2,846

 
549

Proceeds from issuance of common stock under employee stock purchase plan
1,996

 
1,736

Net cash provided by (used in) financing activities
954

 
(2,917
)
Effect of exchange rate changes on cash
(170
)
 
213

Net (decrease) increase in cash
(15,123
)
 
2,363

Cash-beginning of period
175,181

 
104,851

Cash-end of period
$
160,058

 
$
107,214

SUPPLEMENTAL DISCLOSURE OF OTHER CASH FLOW INFORMATION:
 
 
 
Income taxes refunded (paid)
$
237

 
$
(513
)
Cash paid for interest
$
34

 
$
167

NON CASH INVESTING AND FINANCING ACTIVITIES:
 
 
 
Property and equipment purchases in accounts payable
$
2,389

 
$
138


See accompanying notes.

5





SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. DESCRIPTION OF BUSINESS
Silicon Graphics International Corp. ("SGI" or the "Company", "we", "us" or "our") is a global leader in high performance computing (HPC). We are focused on helping customers solve their most demanding business and technology challenges by delivering technical computing, Big Data and cloud computing solutions that accelerate time to discovery, innovation and profitability. We develop, market and sell a broad line of low cost, mid-range and high-end scale-out and scale-up servers, enterprise-class storage hardware, differentiating software and designed-to-order solutions for large-scale deployments, coupled with global support and highly experienced professional services. SGI solutions are designed to provide greater flexibility and scalability, with lower total cost of ownership.
The Company's solutions are utilized by scientific, business and government communities to fulfill highly data intensive application needs in petascale environments. Delivering industry-leading computing power and fast and efficient data movement, both within the computing system and to and from large-scale data storage installations, SGI systems enable customers to access, analyze, transform, manage and visualize information in real-time and near real-time. The vertical markets the Company serves include the federal government, defense and strategic systems, weather and climate, physical sciences, life sciences, energy (including oil and gas), aerospace and automotive, internet, financial services, media and entertainment and business intelligence and data analytics. The Company's headquarters is located in Fremont, California and its primary manufacturing facility is located in Chippewa Falls, Wisconsin.

2. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Basis of Presentation. The accompanying unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal, recurring adjustments that, in the opinion of management, are necessary for a fair presentation of the results of operations for the periods presented. These unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (“SEC”) applicable to interim financial information. The results for the interim periods are not necessarily indicative of results for the entire year or any future periods. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the Company's audited consolidated financial statements for the fiscal year ended June 28, 2013, which are included in the Company's Annual Report on Form 10-K filed with the SEC on September 9, 2013.
The preparation of unaudited condensed consolidated financial statements in accordance with generally accepted accounting principles in the United States of America ("U.S. GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses as presented in the accompanying unaudited condensed consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates.
Fiscal Year. The Company has a 52 or 53-week fiscal year ending on the last Friday in June. The current fiscal year 2014 will be comprised of 52 weeks and will end on June 27, 2014. Fiscal year 2013 was comprised of 52 weeks and ended on June 28, 2013.
In fiscal year 2013, the Company's fiscal quarters ended on September 28, 2012 (first quarter), December 28, 2012 (second quarter), March 29, 2013 (third quarter) and June 28, 2013 (fourth quarter).
In fiscal year 2014, the Company's fiscal quarters end on September 27, 2013 (first quarter), December 27, 2013 (second quarter), March 28, 2014 (third quarter) and June 27, 2014 (fourth quarter).
Principles of Consolidation. The unaudited condensed consolidated financial statements include the accounts of the Company and all of its subsidiaries. All intercompany accounts and transactions have been eliminated.

3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
There have been no changes in the Company's significant accounting policies for the three months ended September 27, 2013 as compared to those disclosed in the Company's Annual Report on Form 10-K for the year ended June 28, 2013 except as summarized below.

6

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



Derivative Instruments. Derivatives that are not designated as hedges are adjusted to fair value through earnings. If the derivative is designated as a cash flow hedge, the effective portion of the contracts’ gains and losses resulting from changes in fair value is recognized in accumulated other comprehensive income. Amounts associated with cash flow hedges are reclassified and recognized in income when the forecasted transaction occurs or it becomes probable the forecasted transaction will not occur. The ineffective portion of the hedge is recognized in earnings immediately.
As a result of our significant international operations, we are subject to risks associated with fluctuating exchange rates. We use derivative financial instruments, principally foreign currency exchange forward contracts, to attempt to minimize the impact of exchange rate movements on our subsidiaries’ and consolidated balance sheets and operating results. Factors that could have an impact on the effectiveness of our hedging program include the accuracy of forecasts and the volatility of foreign currency markets. These programs reduce, but do not entirely eliminate, the impact of currency exchange movements. The maturities of these instruments are generally less than one year.
Recently Issued Accounting Standards.
Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. In February 2013, the FASB issued guidance for reporting of amounts reclassified out of accumulated other comprehensive income. The revised guidance requires reporting the effect of significant reclassifications out of accumulated other comprehensive income on the respective line items in net income if the amount being reclassified is required to be reclassified in its entirety to net income. For other amounts that are not required to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures that provide additional detail about these amounts. This accounting standard was effective for the Company in its first quarter of fiscal 2014. The adoption of this standard had no effect on the Company's condensed consolidated statement of operations.
Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. In July 2013, the FASB issued an amendment to the accounting guidance related to the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss or a tax credit carryforward exists. The guidance requires an unrecognized tax benefit to be presented as a decrease in a deferred tax asset where a net operating loss, a similar tax loss, or a tax credit carryforward exists and certain criteria are met. This guidance is effective prospectively for annual and interim reporting periods beginning after December 15, 2013 and is consistent with our current practice. This accounting standard update will be effective for the Company beginning in the third quarter of fiscal 2014. We do not expect a material impact to our consolidated financial statements due to the adoption of this guidance.

4. FINANCIAL INSTRUMENTS AND FAIR VALUE
The Company measures its assets and liabilities at fair value based upon the expected exit price, representing the amount that would be received on the sale of an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value reflects the assumptions market participants would use in pricing an asset or liability based on the best information available. Assumptions include the risks inherent in a particular valuation technique (such as a pricing model) and/or the risks inherent in the inputs to the model.
The Company uses a three-level fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below:
Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities;
Level 2 - Quoted prices in markets that are not active or financial instruments for which all significant inputs are observable, either directly or indirectly; and
Level 3 - Prices or valuations that require inputs that are both significant to the fair value measurement and unobservable.
The Company's assessment of the hierarchy level of the assets or liabilities measured at fair value is determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company considers an active market to be one in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis, and views an inactive market as one in which there are a few transactions for the asset or liability, the prices are not current, or price quotations vary substantially either over time or among market makers. Where

7

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



appropriate, the Company or the counterparty's non-performance risk is considered in determining the fair values of liabilities and assets, respectively.
Assets and Liabilities Measured at Fair Value on a Recurring Basis
The following table presents the Company's assets that are measured at fair value on a recurring basis (in thousands):
 
 
September 27, 2013
 
 
Carrying
 
Fair Value Measured Using
Total
 
 
Value
 
Level 1
Level 2
Level 3
Balance
Assets
 
 
 
 
 
 
 
   Money market funds
 
$
20,019

 
$
20,019

$

$

$
20,019

   Investments held by insurance companies
 
5,549

 

5,549


5,549

   Derivative assets
 
871

 

871


871

Total assets measured at fair value
 
$
26,439

 
$
20,019

$
6,420

$

$
26,439

Liabilities
 
 
 
 
 
 
 
   Derivative liabilities
 
$
2,613

 
$

$
2,613

$

$
2,613

Total liabilities measured at fair value
 
$
2,613

 
$

$
2,613

$

$
2,613


 
 
June 28, 2013
 
 
Carrying
 
Fair Value Measured Using
Total
 
 
Value
 
Level 1
Level 2
Level 3
Balance
Assets
 
 
 
 
 
 
 
Money market funds
 
$
20,015

 
$
20,015

$

$

$
20,015

     Investments held by insurance companies
 
5,549

 

5,549


5,549

Derivatives assets
 
69

 

69


69

Total assets measured at fair value
 
$
25,633

 
$
20,015

$
5,618

$

$
25,633

Liabilities
 
 
 
 
 
 
 
   Derivative liabilities
 
$
208

 
$

$
208

$

$
208

Total liabilities measured at fair value
 
$
208

 
$

$
208

$

$
208

There were no transfers between Level 1 and Level 2 of the fair value hierarchy during the three months ended September 27, 2013 and September 28, 2012. The Company’s cash equivalents, consisting of U.S. treasuries and money market funds, are classified within Level 1 of the fair value hierarchy as they were valued using quoted market prices of the identical underlying securities in active markets.
Level 2 assets include investments that are pooled with other investment held by insurance companies within their general funds for our pension plans.  The investments held by the insurance companies are valued by taking the percentage owned by the plan in the underlying net asset value of the insurance company's general fund. The valuation of the underlying net assets of the insurance company's general fund is based on quoted market prices of the investments in active markets or for quoted market prices in active markets of similar assets. The market inputs used to value these instruments generally consist of market yields, reported trades, broker/dealer quotes or alternative pricing sources with reasonable levels of price transparency. Pricing sources include industry standard data providers, security master files from large financial institutions and other third party sources. Our derivative financial instruments are classified within level 2, as there is not an active market for each hedge contract, but the inputs used to calculate the value of the instruments are tied to active markets.
The fair values of accounts receivable, accounts payable, and accrued liabilities, due within one year approximates their carrying values because of their short-term nature.
Assets and Liabilities Measured at Fair Value on a Non-recurring Basis
As of September 27, 2013 and June 28, 2013, the Company had no assets or liabilities measured at fair value on a non-recurring basis.


8

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



5. DERIVATIVES
The Company is exposed to foreign currency exchange rate fluctuations in the normal course of our business. As part of the Company's risk management strategy, we use derivative instruments, primarily forward contracts to hedge economic exposures resulting from changes in foreign currency exchange rates.
Cash Flow Hedges
Beginning in fiscal 2014, we implemented a cash flow hedging strategy to protect anticipated non-functional currency revenues and expenses. The Company uses forward contracts designated as cash flow hedges to hedge a portion of future forecasted non-U.S. Dollar ("USD") cash flows. In general, these foreign exchange contracts, carried at fair value, have maturities between one and twelve months. As of September 27, 2013, the Company has 24 open hedges with an average notional amount in USD equivalent to approximately $1.1 million. The Company currently designates hedges for the Euro, British Pound and the Australian Dollar. These derivative instruments are designated and qualify as cash flow hedges under the criteria prescribed in the authoritative guidance. All amounts related to gains / losses on designated hedges, currently in accumulated other comprehensive income are expected to be reclassified into earnings over the next 12 months.
For derivative instruments that are designated and qualify as cash flow hedges under Accounting Standards Codification ("ASC") No. 815-Derivatives and Hedging, the effective portion of the gain or loss on the derivative is reported as a component of accumulated other comprehensive loss and reclassified into earnings into the same financial statement line as the item being hedged. SGI assesses the prospective and retrospective effectiveness of its hedge programs using statistical analysis. The Company uses the spot-to-spot method to measure ineffectiveness in the hedge relationship. Gains and losses on the derivative representing either hedge ineffectiveness or hedge components excluded from the assessment of effectiveness are recognized in other income (expense), net. For derivative instruments that are not designated as hedging instruments under ASC No. 815 or that have been de-designated following recognition of the hedge item, gains and losses are recognized in other income (expense), net.
Balance Sheet Hedges
Additionally, the Company enters into foreign exchange contracts to hedge monetary assets and liabilities that are denominated in currencies other than the functional currency of our subsidiaries. These foreign exchange contracts are carried at fair value and do not qualify for hedge accounting treatment and are not designated as hedging instruments. Changes in fair value of these derivatives are recognized in other income (expense), net in the condensed consolidated statement of operations, in the current period, along with the offsetting foreign currency gain or loss on the underlying assets or liabilities. As of September 27, 2013, the Company has 8 open non-designated hedges per quarter with an average USD-equivalent notional amount of approximately $1.2 million.
The before tax effect of derivative instruments for foreign exchange contracts designated as hedging instruments and non-designated hedging instruments in our condensed consolidated statement of operations during the three months ended September 27, 2013 and September 28, 2012 was as follows (in thousands):
 
 
Three Months Ended
 
Location
September 27,
2013
 
September 28,
2012
Designated Derivatives
 
 
 
 
Cash Flow Hedges:
 
 
 
 
Foreign exchange contracts (Effective portion)
Amount recognized in AOCI
$
(1,045
)
 
$

Foreign exchange contracts (Effective portion)
Net revenues
(155
)
 

Foreign exchange contracts (Effective portion)
Operating expenses
68

 

Foreign exchange contracts (Effective portion)
Other income (expense), net
50

 

Total
 
$
(1,082
)
 
$

Non-designated Derivatives
 
 
 
 
Foreign exchange contracts
Other income (expense), net
$
556

 
$
566

Total
 
$
556

 
$
566


9

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



The Company's use of derivative instruments exposes it to non-performance risk to the extent that the counterparties may be unable to meet the terms of the agreement. The Company does, however, seek to mitigate such risks by limiting our counterparties to major financial institutions which are selected based on their credit ratings and other factors. The Company has established policies and procedures for mitigating non-performance risk that include establishing counterparty credit limits, monitoring credit exposures, and continually assessing the creditworthiness of counterparties. Therefore the Company does not
consider counterparty non-performance risk a material risk at this time.
A number of the Company's derivative agreements contain threshold limits to the net liability position with counterparties and are dependent on the Company's corporate credit rating determined by the major credit rating agencies. The counterparties to the derivative instruments may request collateralization, in accordance with derivative agreements, on derivative instruments in net liability positions.
The aggregate fair value of all derivative instruments with credit-risk-related contingent features that were in a net liability position as of September 27, 2013, was $1.7 million. The credit-risk-related contingent features underlying these agreements had not been triggered as of September 27, 2013.
As of September 27, 2013, the Company has designated derivatives with notional values of approximately $46.7 million and non-designated derivatives with notional values of approximately $6.9 million in Euro, British Pound, Canadian Dollar, Australian Dollar and other currencies.
Derivative instruments are subject to master netting arrangements and are disclosed gross in the statement of financial position. The gross fair values and location of derivative instruments included in the condensed consolidated statement of financial position as of September 27, 2013 were as follows (in thousands):
Offsetting of Derivative Assets
 
Gross Amount Offset In the Statement of Financial Position
 
Gross Amounts Not Offset in the Statement of Financial Position
 
 
Gross Amount of Recognized Assets
Gross Amount Offset in the Statement of Financial Position
Net Amounts of Assets Presented in the Statement of Financial Position
Financial Instruments
Cash Collateral Received
Net Amount
Derivatives
 
 
 
 
 
 
Foreign currency forward contracts
$
871

$

$

$
(871
)
$

$

     Total
$
871

$

$

$
(871
)
$

$

Offsetting of Derivative Liabilities
 
Gross Amount Offset In the Statement of Financial Position
 
Gross Amounts Not Offset in the Statement of Financial Position
 
 
Gross Amount of Recognized Liabilities
Gross Amount Offset in the Statement of Financial Position
Net Amounts of Liabilities Presented in the Statement of Financial Position
Financial Instruments
Cash Collateral Pledged
Net Amount
Derivatives
 
 
 
 
 
 
Foreign currency forward contracts
$
(2,613
)
$

$

$
871

$

$
(1,742
)
     Total
$
(2,613
)
$

$

$
871

$

$
(1,742
)
The gross fair value and location of derivative instruments held in the condensed consolidated statement of financial position as of September 27, 2013 and June 28, 2013 were as follows (in thousands):

10

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



Fair Values of Derivative Instruments
Asset Derivatives
 
Liability Derivatives
Location
 
September 27,
2013
 
June 28,
2013
 
Location
 
September 27,
2013
 
June 28,
2013
 
Designated Derivatives:
Foreign exchange contracts
 
 
 
 
 
Foreign exchange contracts
 
 
 
 
Other current assets
 
$
635

 
$

 
Other current liabilities
 
$
1,598

 
$

Non- designated Derivatives:
Foreign exchange contracts
 
 
 
 
 
Foreign exchange contracts
 
 
 
 
Other current assets
 
236

 
69

 
Other current liabilities
 
1,015

 
208

 
 
 
 
 
 
 
 
 
 
 
Total derivatives
 
$
871

 
$
69

 
 
 
$
2,613

 
$
208

The following table provides the balances and changes in the accumulated other comprehensive loss (income) related to derivative instruments during the three months ended September 27, 2013 (in thousands):
 
 
Amount
AOCI - Beginning balance of losses or (gain)
 
$

Loss recognized in OCI on derivatives (effective portion) before reclassifications
 
1,045

Loss reclassified to income
 
(86
)
AOCI - Ending balance of losses
 
$
959

See Statement of Comprehensive Loss and Note 4 for more information regarding derivatives.


11

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



6. INVENTORIES
Inventories consist of the following (in thousands):
 
September 27,
2013
 
June 28,
2013
Finished goods
$
13,668

 
$
11,332

Work in process
16,664

 
20,716

Raw materials
25,639

 
29,722

Total inventories
$
55,971

 
$
61,770

Finished goods include inventory in transit, at customer sites undergoing installation, or testing prior to customer acceptance; such amounts were $6.6 million at September 27, 2013 and $2.6 million at June 28, 2013.

7. PREPAID EXPENSES AND OTHER CURRENT ASSETS
Prepaid expenses and other current assets consist of the following (in thousands):
 
September 27,
2013
 
June 28,
2013
Value-added tax receivable
$
5,664

 
$
5,626

Deferred tax assets
282

 
281

Prepaid taxes
1,344

 
1,229

Other prepaid and current assets
6,035

 
6,958

Total prepaid expenses and other current assets
$
13,325

 
$
14,094


8. INTANGIBLE ASSETS, NET
Intangible assets by major asset class consist of the following (in thousands):
Intangible Asset Class
 
Weighted
Average
Useful Life
(in Years)
 
September 27, 2013
Gross
Carrying
Amount 
 
Accumulated
Amortization 
 
Net
Customer relationships
 
5
 
$
6,900

 
$
(6,095
)
 
$
805

Purchased technology
 
5
 
7,800

 
(6,255
)
 
1,545

Customer backlog
 
(a)
 
10,540

 
(9,642
)
 
898

Trademark/trade name portfolio
 
5
 
3,667

 
(3,251
)
 
416

Patents and other
 
2(b)
 
330

 
(200
)
 
130

Total
 
 
 
$
29,237

 
$
(25,443
)
 
$
3,794

Intangible Asset Class
 
Weighted
Average
Useful Life
(in Years)
 
June 28, 2013
 
 
Gross
Carrying
Amount 
 
Accumulated
Amortization
 
Net
Customer relationships
 
5
 
$
6,900

 
$
(5,750
)
 
$
1,150

Purchased technology
 
5
 
7,800

 
(6,000
)
 
1,800

Customer backlog
 
(a)
 
10,540

 
(9,572
)
 
968

Trademark/trade name portfolio
 
5
 
3,667

 
(3,072
)
 
595

Patents and other
 
2(b)
 
330

 
(200
)
 
130

Total
 
 
 
$
29,237

 
$
(24,594
)
 
$
4,643


12

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



(a) The customer backlog intangible asset is amortized as revenue recognition criteria is met for a particular customer order, reflecting the use of the asset.
(b) Includes other intangible asset with an indefinite life.
Intangible assets amortization expense was $0.8 million and $1.0 million in the three months ended September 27, 2013 and September 28, 2012, respectively.
As of September 27, 2013, expected amortization expense for all intangible assets was as follows (in thousands):
Fiscal Year
Amortization
Expense
2014 (remaining nine months)
$
2,309

2015
473

2016
393

2017
489

 
$
3,664


9. OTHER ASSETS
Other assets consist of the following (in thousands):
 
September 27,
2013
 
June 28,
2013
Long-term service inventory
$
15,339

 
$
15,045

Restricted pension plan assets
8,123

 
7,822

Deferred tax assets
5,764

 
5,764

Long-term refundable deposits
3,294

 
3,178

Goodwill
1,531

 
1,531

Other assets
835

 
944

Total other assets
$
34,886

 
$
34,284


10. OTHER CURRENT LIABILITIES
Other current liabilities consist of the following (in thousands):
 
September 27,
2013
 
June 28,
2013
Accrued sales and use tax payable
$
9,833

 
$
9,545

Deferred tax liabilities
5,292

 
5,292

Accrued professional services fees
5,188

 
3,635

Accrued warranty, current portion
3,340

 
3,303

Income taxes payable
528

 
491

Accrued restructuring and severance
2,168

 
3,965

Other
9,775

 
9,133

Total other current liabilities
$
36,124

 
$
35,364



13

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



11. OTHER NON-CURRENT LIABILITIES
Other non-current liabilities consist of the following (in thousands):
 
September 27,
2013
 
June 28,
2013
Accrued warranty, non-current portion
$
2,260

 
$
2,319

Other
1,247

 
1,471

Total other non-current liabilities
$
3,507

 
$
3,790


12. WARRANTY RESERVE
Activity in the warranty reserve, which is included in other current and non-current liabilities, was as follows (in thousands):
 
 
Three Months Ended
 
 
September 27,
2013
 
September 28,
2012
Balance at beginning of period
 
$
5,622

 
$
7,302

Current period accrual
 
672

 
1,200

Warranty expenditures charged to accrual
 
(1,027
)
 
(1,267
)
Changes in accrual for pre-existing warranties
 
333

 
26

Balance at end of period
 
$
5,600

 
$
7,261


13. RESTRUCTURING ACTIVITY
On March 16, 2012, the Company's Board of Directors approved a restructuring action to reduce approximately 25% of the Company's European workforce and close certain legal entities and offices in Europe.
In connection with the restructuring action, the Company expects to incur pre-tax cash charges (including charges recorded in fiscal 2012 and 2013) of approximately $13.0 million, consisting of charges of approximately $12.0 million for employee termination benefits and up to $1.0 million for the planned office and legal entity closures, including contract termination costs and other associated costs. Total expense incurred in connection with this restructuring plan for actions taken through September 27, 2013 was $11.9 million.
The restructuring expense is included in operating expenses in the accompanying condensed consolidated statements of operations. The total restructuring liability was $1.8 million as of September 27, 2013, all of which is classified as current liabilities in the accompanying condensed consolidated balance sheet.
Activity in accrued restructuring for this restructuring action through September 27, 2013 was as follows (in thousands):
 
 
Employee
Terminations
Balance at June 28, 2013
 
$
2,417

Costs incurred
 
526

Cash payments
 
(1,176
)
Balance at September 27, 2013
 
$
1,767



14





14. CREDIT FACILITY
On December 5, 2011, the Company entered into a five-year senior secured credit facility in the aggregate principal amount of $35.0 million. The availability under the credit facility is limited to a borrowing base, subject to meeting certain conditions set forth in the credit facility. The credit facility includes a feature that allows the Company to increase the revolver amount in the first 18 months. The Company exercised this feature, and on May 1, 2012, the revolver amount was increased by $5.0 million to an aggregate principal amount of $40.0 million. On February 25, 2013, the Company amended the agreement and reduced the revolver amount to $25.0 million. The credit facility includes a $10.0 million letter of credit subfacility. See Note 22 "Commitments and Contingencies" for more information regarding the letter of credit.
The availability of the aggregate principal amount under the credit facility will fluctuate, generally monthly, based on eligible domestic accounts receivable and inventory due to a variety of factors including the Company's overall mix of sales and resulting accounts receivable with international and domestic customers, United States governmental agencies and a few individual customer accounts which may result in high concentrations of accounts receivable as compared to the overall level of the Company's accounts receivable. The credit facility contains financial covenants including, under certain conditions, maintaining a minimum fixed charge coverage ratio, as well as other non-financial covenants, including restrictions on declaring and paying dividends, and is secured by substantially all of the Company's assets. The credit facility terminates on December 5, 2016. Borrowings under the credit facility bear interest based on a rate of the Company's choice equal to either: 1) the LIBOR plus a margin of 2.50 percent per annum or 2) the base rate plus a margin of 1.75 percent per annum. The base rate is the greater of (a) the Federal Funds rate plus 0.50 percent, (b) the LIBOR rate plus 1.00 percent or (c) the prime rate of the financial institution. The LIBOR rate and the base rate are determined at the specified date preceding or at the time of the borrowing in accordance with the terms of the credit facility. In addition, unused line fees are payable on the credit facility at rates of 0.25 percent per annum.
As of September 27, 2013, the Company had no outstanding balance owed on the credit facility. As of September 27, 2013, the maximum amount available to be borrowed under the credit facility was approximately $23.0 million, which takes into account a $2.0 million outstanding letter of credit to back the Company's obligation to pay for goods or services to a supplier. The Company was in compliance with all covenants as of September 27, 2013.


15

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



15. SHARE-BASED COMPENSATION
During the three months ended September 27, 2013 and September 28, 2012, the Company granted restricted stock units to employees and non-employee directors under its 2005 Equity Incentive Plan and issued shares of the Company's common stock to participating employees under its 2005 Employee Stock Purchase Plan. During the three months ended September 28, 2012, the Company granted stock options to employees and non-employee directors under its 2005 Equity Incentive Plan, however, during the three months ended September 27, 2013, no stock options were granted. Total share-based compensation expense was as follows (in thousands):
 
 
Three Months Ended
 
 
 
September 27,
2013
 
September 28,
2012
 
Cost of revenue
 
$
442

 
$
500

 
Research and development
 
507

 
539

 
Sales and marketing
 
579

 
386

 
General and administrative
 
1,448

 
1,086

 
Total share-based compensation expense
 
$
2,976

 
$
2,511

 
Determining Fair Value
The fair value of share-based awards was estimated using the Black-Scholes option-pricing model with the following weighted-average assumptions for the following periods:
 
 
Three Months Ended
 
 
September 27,
2013
 
September 28,
2012
Option Plan Shares
 
 
 
 
Risk-free interest rate
 
N/A

 
0.7
%
Volatility
 
N/A

 
67.6
%
Weighted average expected life (in years)
 
N/A

 
5.00

Expected dividend yield
 
N/A

 

Weighted average fair value
 
N/A

 
$
3.67

 
 
 
 
 
ESPP Plan shares
 
 
 
 
Risk-free interest rate
 
0.2
%
 
0.2
%
Volatility
 
60.9
%
 
83.0
%
Weighted average expected life (in years)
 
1.25

 
1.25

Expected dividend yield
 

 

Weighted average fair value
 
$
6.08

 
$
4.39










16

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



Stock Option Activity
A summary of stock option activity for the three months ended September 27, 2013 was as follows:
 
Options Outstanding
 
Shares
 
Weighted
Average
Exercise
Price 
 
Weighted
Average
Remaining
Contractual term
in years 
 
Aggregate
Intrinsic
Value
 
 
 
 
 
 
 
(in thousands)
Balance at June 28, 2013
2,281,401

 
$
10.56

 
 
 
 
Options granted

 

 
 
 
 
Options exercised
(354,925
)
 
8.02

 
 
 
 
Options cancelled
(57,440
)
 
25.33

 
 
 
 
Balance at September 27, 2013
1,869,036

 
$
10.59

 
6.52
 
$
11,420

Vested and expected to vest at September 27, 2013
1,786,058

 
$
10.61

 
6.43
 
$
10,733

Exercisable at September 27, 2013
1,224,872

 
$
10.69

 
5.55
 
$
7,588

The total intrinsic value of options exercised in the three months ended September 27, 2013 and September 28, 2012 was $3.0 million and $0.3 million, respectively. The total fair value of shares vested during the three months ended September 27, 2013 and September 28, 2012 was $0.6 million and $0.9 million, respectively.
As of September 27, 2013, there was $1.2 million of total unrecognized compensation cost related to non-vested stock options, which is expected to be recognized over a weighted average period of 1.00 year.
Restricted Stock Unit Activity
The following table summarizes the Company's activity with respect to restricted stock units (“RSUs”) for the three months ended September 27, 2013:
 
Number of
Shares 
Balance at June 28, 2013
1,337,767

Awarded
827,729

Released
(145,426
)
Forfeited
(23,966
)
Balance at September 27, 2013 (203,600 shares subject to performance criteria)
1,996,104

Vested and expected to vest at September 27, 2013
1,510,890

In August 2013, the Company granted time-based RSUs ("executive time-based RSUs") and performance-based RSUs (“executive PSUs”) to members of the Company's executive management team.  The executive time-based RSUs vest quarterly over four years, subject to the recipient's continuous service through each vesting date. The executive PSUs are eligible to vest upon the achievement of certain financial performance criteria for the Company for fiscal 2014.  If the performance criteria are not met, none of the executive PSUs will vest and will be forfeited.  If the performance criteria are met, 25% of the executive PSUs would vest following the Company's public announcement of financial results for fiscal 2014 and the remaining 75% of the executive PSUs would vest in twelve quarterly installments thereafter, subject to the recipient's continued service through each vesting date.  For purposes of reporting and determining the share-based compensation expense as of September 27, 2013, the company estimated that 255,000 PSUs will be awarded.  The Company assesses the achievement of these performance metrics on a quarterly basis. 
As of September 27, 2013, there was $15.7 million of total unrecognized compensation cost related to RSUs, which is expected to be recognized over a weighted average period of 2.81 years.

17

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



RSUs are converted into common stock upon vesting. Upon the vesting of restricted stock, the Company generally uses the net share settlement approach, which withholds a portion of the shares to cover the applicable taxes and decreases the shares issued to the employee by a corresponding value. The withholding tax obligations are based upon the fair market value of the Company's common stock on the vesting date. The number and the value of the shares netted for employee taxes are summarized in the table below (in thousands except share amounts):
 
Three Months Ended
 
September 27,
2013
 
September 28,
2012
RSUs shares withheld for taxes
55,930

 
24,381

RSUs amounts withheld for taxes
$
864

 
$
188

Employee Stock Purchase Plan
At September 27, 2013, the total compensation cost related to options to purchase the Company's common stock under the employee stock purchase plan ("ESPP") was approximately $1.0 million. This cost will be amortized on a straight-line basis over approximately 1.9 years. The following table shows the shares issued and their respective weighted-average purchase price per share, pursuant to the ESPP, during the three months ended September 27, 2013 and September 28, 2012.
 
 
Three Months Ended
 
 
September 27,
2013
 
September 28,
2012
Shares issued
 
253,078

 
256,972

Weighted-average purchase price per share
 
$
7.89

 
$
6.76


16. STOCK REPURCHASE PROGRAM
On January 11, 2013, the Company's board of directors approved a plan for the Company to repurchase shares of its common stock with a market value of up to $15.0 million. The Company's common stock may be repurchased in the open market or through negotiated transactions, including 10b5-1 trading plans that would enable the company to repurchase its shares during periods outside of its normal trading windows. The repurchase program expires December 31, 2014. Purchases will cease if the authorized funds are spent or the program is discontinued. The Company is not obligated to acquire any particular amount of stock, and the program may be suspended or terminated at any time at the Company's discretion.
These repurchases are reflected in our balance sheet as treasury stock and are available for future issuance. The following table shows the total number of shares repurchased during the period (in thousands, except per share amount):
 
 
Treasury Stock
 
 
Number of Shares
 
Amount
 
Average Purchase Price Per Share
Balance at June 28, 2013
 
946

 
$
7,692

 
$
8.13

Repurchase of Treasury Stock:
 
 
 
 
 
 
     Three months ended September 27, 2013
 
200

 
3,056

 
$
15.28

Balance at September 27, 2013
 
1,146

 
$
10,748

 
$
9.38

 
 
 
 
 
 
 
Since the inception of the repurchase plan in January 2013, the Company has repurchased approximately 397,000 shares of its common stock for $5.8 million. As of September 27, 2013, the Company had a remaining authorization of $9.2 million for future share repurchases.


18

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



17. EARNINGS PER SHARE
Basic net income (loss) per common share is computed by dividing unaudited consolidated net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share is computed by dividing unaudited consolidated net income (loss) by the weighted average number of common shares outstanding and dilutive common shares outstanding during the period. The dilutive effect of outstanding options and RSUs is reflected in diluted net income per share, but not diluted loss per share, by application of the treasury stock method, which includes consideration of share-based compensation required by accounting principles generally accepted in the U.S. As the Company had a net loss in both the three months ended September 27, 2013 and September 28, 2012, basic and diluted net loss per share are the same for these periods.
The following table sets forth the computation of basic and diluted net loss per share for the three months ended September 27, 2013 and September 28, 2012 (in thousands, except per share amount):
 
 
Three Months Ended
 
 
September 27,
2013
 
September 28,
2012
Numerator:
 
 
 
 
Net loss
 
$
(6,823
)
 
$
(8,680
)
 
 
 
 
 
Denominator:
 
 

 
 

Weighted-average common shares used in computing basic and diluted net loss per share
 
34,096

 
32,166

 
 
 
 
 
Basic and diluted net loss per share
 
$
(0.20
)
 
$
(0.27
)
The following potential common shares have been excluded from the basic net loss per share calculations, as their effect would have been anti-dilutive (in thousands):
 
 
Three Months Ended
 
 
September 27,
2013
 
September 28,
2012
Options, RSUs, and ESPP
 
4,117

 
5,106



18. RETIREMENT BENEFIT PLAN
Defined Benefit Plans
The Company sponsors defined benefit plans covering certain of its employees in Germany ("German plan") and Japan ("Japan plan").
The net periodic benefit cost of the German and Japan plans were comprised of the following components (in thousands):
 
 
Three Months Ended
 
 
September 27,
2013
 
September 28,
2012
Net periodic benefit cost
 
 
 
 
Service cost
 
$
109

 
$
169

Interest expense
 
129

 
139

Expected return on plan assets
 
(41
)
 
(46
)
Amortization of actuarial losses
 
30

 

Net periodic benefit cost
 
$
227

 
$
262



19

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



19. INCOME TAXES
The Company recorded a tax benefit of $0.1 million for the three months ended September 27, 2013. The tax benefit primarily was comprised of a refund of provincial taxes in Canada of $0.6 million, partially offset by tax liability computed based on the Company’s projected foreign financial results for the year ending June 27, 2014, state taxes, and interest for unrecognized tax benefits. The provincial refund received by the Company was the result of the conclusion of an income tax audit for fiscal years 1996 to 2004 by the Canada Revenue Agency. The effective tax rate differed from the combined federal and net state statutory income tax rate for the three months ended September 27, 2013 primarily due to the tax rate differential of the Company's foreign operations and utilization of net operating losses not previously recognized.
The Company recorded a tax expense of $0.4 million for the three months ended September 28, 2012. The tax expense primarily consisted of the expected tax liability based on the Company's projected foreign financial results for the year ending June 28, 2013, offset by a benefit of audit settlements and reversals of liabilities related to the sale of a subsidiary. The effective tax rate differed from the combined federal and net state statutory income tax rate for the three months ended September 28, 2012 primarily due to the tax rate differential of the Company's foreign operations, utilization of net operating losses, audit settlements and reversals of previously accrued taxes in foreign jurisdictions.
As of September 27, 2013, the Company has provided a partial valuation allowance against its net deferred tax assets. Management continues to evaluate the realizability of deferred tax assets and related valuation allowance. If management's assessment of the deferred tax assets or the corresponding valuation allowance were to change, the Company would record the related adjustment to income during the period in which management makes the determination.
The Company had approximately $5.0 million of gross unrecognized tax benefit as of September 27, 2013, of which $2.2 million will impact the effective tax rate when recognized. The Company recognizes interest expense and penalties related to the unrecognized tax benefits within income tax expense. As of September 27, 2013, the Company also had approximately $8.0 million of interest and penalties attributable to the gross unrecognized tax benefits. It is reasonably possible that over the next twelve-month period the Company may experience an increase or decrease in its unrecognized tax benefits.

20. SEGMENT INFORMATION
Commencing in the first quarter of fiscal 2014, the Company started managing its business primarily on a business unit basis versus the geographic basis previously used by management. Accordingly, the Company has determined its operating and reporting segments, which is based on the business unit structure, to be Compute, Storage and Service. The Company's operating segments are determined based upon several criteria including: the Company's internal organizational structure; the manner in which the Company's operations are managed; the criteria used by the Company's Chief Executive Officer, the Chief Operating Decision Maker (“CODM”), to evaluate segment performance; and the Company's availability of separate financial information.
A description of Company's three reportable segments is as follows:
Compute—The Compute solutions segment include our scale-out computing, scale-up computing, software and cloud/web solutions. Compute solutions also include integrated third-party hardware and software products that we sell to provide a single source solution for our customers. Our compute solutions are designed to minimize the number and complexity of interconnects for power and data transfer to improve reliability, speed of implementation and serviceability.
Storage—The Storage solutions segment include both hardware and software offerings to address virtually every type of data storage and management requirement. Products range from entry-level disk arrays to complex storage systems, with innovative technology and hardware, to include the SGI Modular InfiniteStorage™ platform, SGI InfiniteStorage™ gateway and SGI CXFS™ file system. Our storage solutions are designed to provide extreme scale, broad flexibility, and to minimize the cost to store data.
Service—The Service segment is comprised of customer service support and professional services. Our customer support organization provides ongoing maintenance and technical support for our products and some third-party products, as well as contracted maintenance services, hardware deployment services (install and de-install), time and materials-based services and spare parts. Our professional services organization provides value added services associated with technology consulting, project management and customer education, all of which help our customers realize the full value of their information technology investments.

20

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



All historical segment numbers for the three months ended September 28, 2012 have been recasted to conform to the three months ended September 27, 2013.
The Company's CODM evaluates the performance of its operating segments based on revenue and operating profit (loss). Revenues are generally allocated based on the type of products and service provided to our customers. Operating profit (loss) for each segment includes related cost of sales and operating expenses directly attributable to the segment. A portion of the segments' expenses arise from shared services and infrastructure that the Company provides to the segments in order to realize economies of scale and to efficiently use resources. These expenses, collectively called corporate charges, include costs of centralized research and development and other corporate infrastructure expenses. The corporate charges that are directly attributable to the segments are allocated and are reassessed on a periodic basis. The allocations have been determined on a basis that the Company considers to be a reasonable reflection of the utilization of services provided to or benefits received by the segments. The profitability of each of the segments is measured after excluding share based compensation expenses, amortization of intangibles, restructuring charges, general and administration charges, other unallocated corporate charges and other items as noted in the reconciliation below as management does not include this information in its measurement of the performance of the operating segments.
Segment Results
Summary information by operating segment for the three months ended September 27, 2013 and September 28, 2012 is as follows:
 
 
Three Months Ended
 
 
September 27, 2013
 
September 28, 2012
 
 
(in thousands)
Total net revenue
 
 
 
 
Compute
 
$
88,842

 
$
130,800

Storage
 
19,978

 
15,515

Service
 
38,699

 
46,566

Total net revenue
 
$
147,519

 
$
192,881

 
 
 
 
 
Operating profit from reportable segments
 
 
 
 
Compute
 
$
2,201

 
$
3,801

Storage
 
2,022

 
(1,064
)
Service
 
15,075

 
14,948

Total operating profit from reportable segments (1)
 
$
19,298

 
$
17,685

(1) The profitability of each of the segments is measured after excluding unallocated corporate charges, restructuring and severance, amortization of intangibles, share based compensation expenses and other items as noted in the reconciliation below.

21

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)




The following table reconciles segment results to our total company results from operations before taxes:
 
 
Three Months Ended
 
 
September 27,
2013
 
September 28,
2012
 
 
(in thousands)
Total reportable segments' operating profit
 
$
19,298

 
$
17,685

All other corporate charges:
 
 
 
 
Unallocated operating expenses
 
17,770

 
19,311

Restructuring and severance
 
929

 
1,884

Amortization of intangibles
 
835

 
972

Share based compensation
 
2,976

 
2,511

Excess and obsolescence inventory charges
 
3,242

 

Other
 
736

 

Total all other corporate charges
 
26,488

 
24,678

Loss from operations, as reported
 
$
(7,190
)
 
$
(6,993
)
The Company derives the results of the business segments directly from its internal management reporting system. The presentation of our revenue for segment information purposes differs from the accompanying unaudited condensed consolidated statements of operations. The segment information is presented on the basis which the Company's CODM evaluates the performance of its operating segments. The combined product and service revenue is allocated to product and service revenue on a contractual basis for segment information purposes.
The Company's assets are located primarily in the United States and are not allocated to any specific region. The Company does not measure the performance of its business segments on any asset-based metrics. Therefore, reportable segment information is presented only for revenue and operating profit (loss).
Customer information
For the three months ended September 27, 2013, various agencies of the United States government, excluding system integrators (collectively, U.S. government), accounted for approximately 30% of the Company's revenue. For the three months ended September 28, 2012, one customer accounted for approximately 18% of the Company's revenue and various agencies of the United States government (collectively, U.S. government) accounted for approximately 14% of the Company's revenue.
At September 27, 2013, one customer accounted for approximately 11% of the Company's accounts receivable. At June 28, 2013, one customer accounted for approximately 20% of the Company's accounts receivable.

22

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



Geographic Information
The following table presents revenue by geographic region for the three months ended September 27, 2013 and September 28, 2012 (in thousands except percentages):
 
Three Months Ended
 
2014 over 2013 Change
 
September 27, 2013
 
September 28, 2012
 
 
 
 
 
 
 
Americas
$
102,212

 
$
123,385

 
(21,173
)
     As a percent of total net revenue
69.3
%
 
64.0
%
 
5.3
 %
EMEA
21,041

 
25,062

 
(4,021
)
     As a percent of total net revenue
14.3
%
 
13.0
%
 
1.3
 %
APJ
24,266

 
44,434

 
(20,168
)
     As a percent of total net revenue
16.4
%
 
23.0
%
 
(6.6
)%
Total revenue
$
147,519

 
$
192,881

 
(45,362
)
The Americas geographic region includes both North and South America. The Europe geographic region ("EMEA") includes European countries, as well as the Middle East and Africa. The Asia-Pacific geographic region ("APJ") includes Australia, Japan and all other Asian countries.
International sales to Japan, the only single foreign country which accounted for 10% or more of total revenue, were $16.8 million or 11% for the three months ended September 27, 2013. For the three months ended September 28, 2012, our international sales to Japan, the only single foreign country which accounted for ten percent or more of revenues, were $36.3 million or 19% of revenues. No other individual foreign country's revenue accounted for 10% or more of revenues in the three months ended September 27, 2013 and September 28, 2012.

21. FINANCIAL GUARANTEES
The Company has issued financial guarantees to cover rent on leased facilities and equipment, to government authorities for value-added tax and other taxes and to various other parties to support payments in advance of future delivery on goods and services. The majority of the Company's financial guarantees have terms of one year or more. The maximum potential obligation under financial guarantees at September 27, 2013 was $4.9 million for which the Company has $4.7 million of assets held as collateral. The full amount of the assets held as collateral are included in short-term and long-term restricted cash in the accompanying unaudited condensed consolidated balance sheets.

22. COMMITMENTS AND CONTINGENCIES
Letter of Credit
The Company's credit facility includes a $10.0 million letter of credit subfacility. As of September 27, 2013, the Company has a $2.0 million outstanding letter of credit to back the Company's obligation to pay or perform when required to do so pursuant to the requirements of an underlying agreement or the provision of goods or services to a supplier. See Note 14 for more information regarding the credit facility.

23

SILICON GRAPHICS INTERNATIONAL CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(UNAUDITED)



Indemnification Agreements
The Company enters into standard indemnification agreements with its customers and certain other business partners in the ordinary course of business. These agreements include provisions for indemnifying the customer against any claim brought by a third party to the extent any such claim alleges that the Company's product infringes a patent, copyright or trademark, or misappropriates a trade secret, of that third-party. The agreements generally limit the scope of the available remedies in a variety of industry-standard methods, including, but not limited to, product usage and geography-based limitations, a right to control the defense or settlement of any claim and a right to replace or modify the infringing products to make them non-infringing. The Company has not incurred significant expenses related to these indemnification agreements and no material claims for such indemnifications were outstanding as of September 27, 2013. As a result, the Company believes the estimated fair value of these indemnification agreements, if any, to be immaterial; accordingly, no liability has been recorded with respect to such indemnifications as of September 27, 2013.
Contingencies
The Company may, from time to time, be involved in legal proceedings and disputes that arise in the normal course of business. These matters include product liability actions, patent infringement actions, contract disputes, domestic and international federal, state and local tax reviews and audits and other matters. The Company also may be subject to litigation and/or adverse rulings or judgments as a result of certain contractual indemnification obligations. The Company records a provision for a liability when management believes that it is both probable that a liability has been incurred and it can reasonably estimate the amount of the loss. The Company believes it has adequate provisions for any such matters. The Company reviews these provisions at least quarterly and adjusts these provisions to reflect the impact of negotiations, settlements, rulings, advice of legal counsel and other information and events pertaining to a particular case.
Third parties in the past have asserted, and may in the future assert, intellectual property infringement claims against the Company, and such future claims, if proven, could require the Company to pay substantial damages or to redesign its existing products or pay fees to obtain cross-license agreements. Litigation may be necessary in the future to enforce or defend the Company's intellectual property rights, to protect the Company's trade secrets or to determine the validity and scope of its proprietary rights or the proprietary rights of others. Any such litigation could result in substantial costs and diversion of management resources, either of which could harm the Company's business, operating results and financial condition. Further, many of the Company's current and potential competitors have the ability to dedicate substantially greater resources to enforcing and defending their intellectual property rights than the Company.
Additionally, from time to time, the Company receives inquiries from regulatory agencies informally requesting information or documentation. There can be no assurance in any given case that such informal review will not lead to further proceedings involving the Company in the future.
The Company is not aware of any pending disputes, including those outlined above, that would be likely to have a material adverse effect, either individually or in the aggregate, on its consolidated financial condition, results of operations or liquidity. However, litigation is subject to inherent uncertainties and costs and unfavorable outcomes could occur. An unfavorable outcome could include the payment of monetary damages, cash or other settlement, or an injunction prohibiting it from selling one or more products. If an unfavorable resolution were to occur, there exists the possibility of a material adverse impact on the Company's consolidated financial condition, results of operations or cash flows of the period in which the resolution occurs or on future periods.
Other Commitments
For a description of significant leases and purchase commitments see Note 23 of the Company's Annual Report on Form 10-K filed with the SEC on September 9, 2013.

23. SUBSEQUENT EVENTS
On September 30, 2013, the Company acquired certain assets of FileTek, Inc., a global provider of Big Data storage virtualization, large-scale data management, and Active Archive solutions for a purchase price of $9.2 million in cash. This acquisition expands the Company's storage solutions by enabling customers to manage data assets efficiently and lower the cost and administration of high-volume storage. Under the terms of the agreement, SGI acquired FileTek's StorHouse and Trusted Edge software, worldwide customers, engineering team, and services and support resources.

24





ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. All statements included or incorporated by reference in this Form 10-Q other than statements of historical fact, are forward-looking statements. Investors can identify these and other forward-looking statements by the use of words such as “estimate,” “may,” “will,” “could,” “anticipate,” “expect,” “intend,” “believe,” “continue” or the negative of such terms, or other similar expressions. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. Forward-looking statements also include the assumptions underlying or relating to such statements.
Our actual results could differ materially from those projected in the forward-looking statements included herein as a result of a number of factors, risks and uncertainties, including, among others, changes in the anticipated amounts and timing of restructuring charges to be incurred and cost savings expected to be realized from our restructuring actions in Europe, our ability to successfully execute our strategies, the risks discussed in this Part I, Item 2 -"Management's Discussion and Analysis of Financial Condition and Results of Operations,” the risk factors set forth in Part II, Item 1A- "Risk Factors” and elsewhere in this Form 10-Q, the risk factors set forth in our Annual Report on Form 10-K for the year ended June 28, 2013 filed with the Securities and Exchange Commission (the “SEC”) on September 9, 2013 (our “Annual Report”), and the risks detailed from time to time in our future reports filed with the SEC. The information included herein is as of the filing date of this Form 10-Q with the SEC and future events or circumstances could differ materially from the forward-looking statements included herein. Accordingly, we caution readers not to place undue reliance on these forward-looking statements. Unless required by law, we expressly disclaim any obligation to update or alter our forward-looking statements, whether as a result of new information, future events or otherwise. All subsequent written or oral forward-looking statements attributable to SGI or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. Readers are urged to carefully review and consider the various disclosures made in this report and other documents we file from time to time with the SEC to advise interested parties of the risks and factors that may affect our business.
The following discussion and analysis should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto in Part I, Item 1 in this Form 10-Q and with our financial statements and notes thereto for the year ended June 28, 2013 contained in our Annual Report.
Overview
SGI is a global leader in high performance computing ("HPC"). We are focused on helping customers solve their most demanding business and technology challenges by delivering technical computing, Big Data and cloud computing solutions that accelerate time to discovery, innovation and profitability.
We develop, market and sell a broad line of low cost, mid-range and high-end scale-out and scale-up servers, enterprise-class storage hardware, differentiating software and designed-to-order solutions for large-scale deployments, coupled with global support and highly experienced professional services. SGI solutions are designed to provide greater flexibility and scalability, with lower total cost of ownership.
SGI solutions are utilized by scientific, business and government communities to fulfill highly data intensive application needs in petascale environments. Delivering industry-leading computing power and fast and efficient data movement, both within the computing system and to and from large-scale data storage installations, SGI systems enable customers to access, analyze, transform, manage and visualize information in real-time and near real-time.
Our goal is to accelerate time to results in key markets including federal government, defense and strategic systems, weather and climate, physical and life sciences, energy (including oil and gas), aerospace, automotive, internet, financial services, media and entertainment and cloud services.
Management has implemented a strategic plan which will drive changes in three major areas. First, we expect market growth in our core markets of high performance computing, storage and Big Data. We believe that these are the markets that will provide the biggest growth opportunity and where we expect to gain share. We are continuing to target our investments towards key vertical markets and horizontal solutions where we can provide the highest value to our customers and differentiate our offerings to gain both market share and margins in line with our business model. Second, we have a strong suite of products and go-to-market strategy aligned with these growing opportunities. During fiscal 2013, we introduced new products for storage, new configurations for our Rackable, ICE X and UV compute platforms and have increased our portfolio of software partners. Third, management continues to focus on opportunities to enhance operational efficiency and costs, most notably through our contract manufacturing initiative that we recently announced, but also through consolidation of additional legal entities and the realization of a full year of savings from our restructuring activities. We believe that this strategic plan will help create a strong foundation for our business results in the long-term.

25





Our revenue mix by geography shows that we continue to have strong international presence with 34.1% of total revenue from sales outside of the U.S. in the three months ended September 27, 2013 and 38.0% of total revenue in the three months ended September 28, 2012. In addition, our customer base continues to expand in various sectors, including the public, cloud and manufacturing sectors.

Results of Operations
Summarized below are the results of our operations for the three months ended September 27, 2013 as compared to the three months ended September 28, 2012.
Financial Highlights
Our total revenue for the three months ended September 27, 2013 was $147.5 million, a decrease of $45.4 million or 23.5%, from the comparable period in fiscal 2013. The decrease was due primarily as a result of lower sales for our legacy cloud products. This is consistent with our strategic decision to withdraw from low margin commodity service infrastructure and to focus our investments in strategic areas of HPC, Big Data, storage and services. In addition, we were also negatively impacted by the spending freeze instituted by the federal government prior to its shutdown.
Our overall gross margin increased by 4.0 percentage points from 21.9% in the three months ended September 28, 2012 to 25.9% in the three months ended September 27, 2013. The favorable change in the overall gross margin in the three months ended September 27, 2013 was primarily driven by a more profitable mix compared to the comparable quarter last year as we were impacted by a few significant low margin deals during the first quarter of fiscal 2013 in Europe and Japan. This was partially offset by higher excess and obsolete inventory charges incurred during the first quarter of fiscal 2014 compared to the first quarter of fiscal 2013 for inventory primarily related to our withdrawal from the legacy cloud business. Our service margins increased by 7.1 percentage points in the three months ended September 27, 2013 largely as a result of a more profitable mix compared to the comparable quarter last year as we were impacted by the low margin deals discussed above. In addition, we benefited from the reductions in headcount resulting in lower compensation and related expenses, as well as lower bonuses and commissions.
Our research and development and selling, general and administrative expenses were $44.9 million in the three months ended September 27, 2013 compared to $47.7 million in the prior year comparable quarter, a decrease of $2.8 million. A primary driver of this decline was the decrease in compensation and related expenses due to reductions in headcount. Total headcount as of September 27, 2013 was 1,316, which reflects a reduction of 179 employees or approximately 12%, from 1,495 as of September 28, 2012 due to the restructuring actions and attrition that occurred over the last twelve months. The savings from the headcount reductions, along with lower bonus and commissions, contributed to the reduction in expenses. We have been controlling our costs across all functions in order to streamline our operations and reduce operating expenses and have also benefited from lower charges for the amortization of intangible assets as these assets are nearing full amortization.
We incurred restructuring expense of $0.5 million and $1.5 million in the three months ended September 27, 2013, and September 28, 2012, respectively, as part of the fiscal 2012 restructuring action primarily focused on cost reductions in Europe.
We recognized net loss for the three months ended September 27, 2013 of $6.8 million compared to net loss of $8.7 million in the comparable quarter last year. The $1.9 million decrease in our net loss for the three months ended September 27, 2013 compared to the comparable quarter last year was mainly driven by the headcount reductions described above as well as reduced spending as part of operational efficiencies put into place. This was partially offset by the lower gross profit due to the lower volume of revenue.
We are continuing to streamline our operations and maintain tight controls over our spending in order to help achieve our long-term operating target goals.


26





Revenue, cost of revenue, gross profit and margin
Net Revenue
 
Three Months Ended
2014 over 2013 Change
 
September 27,
2013
 
September 28,
2012
 
($ in thousands)
 
Net revenue from products:
 
 
 
 
     Compute
88,842

 
130,800

(41,958
)
         As a percent of total net revenue
60.2
%
 
67.8
%
(7.6
)%
     Storage
19,978

 
15,515

4,463

         As a percent of total net revenue
13.5
%
 
8.0
%
5.5
 %
                  Net revenue from products
108,820

 
146,315

(37,495
)
Net revenue from services
38,699

 
46,566

(7,867
)
         As a percent of total net revenue
26.2
%
 
24.1
%
2.1
 %
Total net revenue
147,519

 
192,881

(45,362
)
Revenue. We derive revenue from the sale of products and services directly to end-users as well as through resellers and system integrators. Product revenue is derived from the sale of mid-range to high-end computing servers and data storage systems as well as software. We enter into sales contracts to deliver multiple products and/or services. In accordance with our revenue recognition policy, certain sales contracts are deferred and recognized over the service period. Service revenue is generated from the sale of standard maintenance contracts as well as custom maintenance contracts that are tailored to individual customers' needs. We recognize service revenue ratably over the service periods. Maintenance contracts are typically between one to three years in length and we actively pursue renewals of these contracts. We also generate professional services revenue related to implementation of and training on our products.
We continuously make revisions to our product offerings and improvements of our product's performance and data storage capacity. Accordingly, we are unable to directly compare our products from period to period, and are therefore unable to quantify the changes in pricing of our products from period to period. We believe that our on-going revisions to product offerings and product feature improvements help mitigate competitive pricing pressures by shifting the competitive landscape to differentiated value rather than price. Among other things, the timing of our revenue is primarily dependent upon the funding and implementation schedule of our customers. A significant portion of our revenue relates to large IT projects, which can have long sales cycles and long build-out and acceptance schedules.
The following table presents revenue by geographic region for the three months ended September 27, 2013 and September 28, 2012 (in thousands except percentages):
 
Three Months Ended
 
2014 over 2013 Change
 
September 27, 2013
 
September 28, 2012
 
 
 
 
 
 
 
Americas
$
102,212

 
$
123,385

 
(21,173
)
     As a percent of total net revenue
69.3
%
 
64.0
%
 
5.3
 %
EMEA
21,041

 
25,062

 
(4,021
)
     As a percent of total net revenue
14.3
%
 
13.0
%
 
1.3
 %
APJ
24,266

 
44,434

 
(20,168
)
     As a percent of total net revenue
16.4
%
 
23.0
%
 
(6.6
)%
Total revenue
$
147,519

 
$
192,881

 
(45,362
)
The Americas geographic region includes both North and South America. The Europe geographic region ("EMEA") includes European countries, as well as the Middle East and Africa. The Asia-Pacific geographic region ("APJ") includes Australia, Japan and all other Asian countries.
Revenue generated in the Americas represented 69.3% of total revenue during the first quarter of fiscal 2014, or an increase of 5.3 percentage points, from 64.0% during the comparable quarter last year.

27





Cost of revenue and gross profit
Cost of revenue and gross profit for the three months ended September 27, 2013 and September 28, 2012 were as follows (in thousands except percentages):
 
 
Three Months Ended
 
Change
 
 
September 27, 2013
 
September 28, 2012
 
$
 
%
 
 
 
 
 
 
 
 
 
Total cost of revenue
 
$
109,271

 
$
150,671

 
$
(41,400
)
 
(27.5
)%
 
 
 
 
 
 
 
 
 
Total gross profit
 
$
38,248

 
$
42,210

 
$
(3,962
)
 
(9.4
)%
 
 
 
 
 
 
 
 
 
Total gross margin
 
25.9
%
 
21.9
%
 
 
 
4.0
 %
Cost of revenue consists of costs associated with direct material, labor, manufacturing overhead, shipment of products, inventory write downs and share-based compensation. Cost of revenue also includes personnel costs for providing maintenance and professional services. Our manufacturing overhead and professional services personnel costs are fixed or semi-variable. Our gross margins are impacted by changes in customer and product mix, pricing actions by our competitors and commodity prices that comprise a significant portion of cost of revenue from period to period. In addition, when certain sales contracts are deferred in accordance with our revenue recognition policy, the related cost of revenue is deferred and recognized upon recognition of revenue.
Our cost of revenue and gross profit are impacted by price changes, product configuration, revenue mix and product material costs. Our service cost of revenue and gross margin are impacted by timing of support service initiations and renewals, and incremental investments in our customer support infrastructure.
Overall gross profit decreased by $4.0 million to $38.2 million in the three months ended September 27, 2013 from $42.2 million in the three months ended September 28, 2012 due to a decrease in revenue volume primarily related to lower sales for our legacy cloud products. This is consistent with our strategic decision to withdraw from low margin commodity server infrastructure and to focus our investments in strategic areas of HPC, Big Data, storage and services. However, our overall gross margin increased to 25.9% in the three months ended September 27, 2013 from 21.9% in the three months ended September 28, 2012. We benefited from the reductions in headcount resulting in lower compensation and related expenses, as well as lower bonuses and commissions. This was slightly offset by higher excess and obsolete inventory charges during the three months ended September 27, 2013 compared to the three months ended September 28, 2012 as a result of our strategic withdrawal from the legacy cloud business. In addition, during the first quarter of 2013, our gross margins were negatively impacted as a result of the low margin deals in Japan and Europe, impacting both our product and service margins.
Operating Expenses
Operating expenses for the three months ended September 27, 2013 and September 28, 2012 were as follows (in thousands except percentages):
 
 
Three Months Ended
 
Change
 
 
September 27, 2013
 
September 28, 2012
 
$
 
%
 
 
 
 
 
 
 
 
 
Research and development
 
$
14,834

 
$
13,969

 
$
865

 
6.2
 %
Sales and marketing
 
17,596

 
19,571

 
(1,975
)
 
(10.1
)%
General and administrative
 
12,482

 
14,189

 
(1,707
)
 
(12.0
)%
Restructuring
 
526

 
1,474

 
(948
)
 
(64.3
)%
Total operating expense
 
$
45,438

 
$
49,203

 
$
(3,765
)
 
(7.7
)%
Research and development. Research and development expense consists primarily of personnel and related costs, contractor fees, new component testing and evaluation, test equipment, new product design and testing, other product development activities, share-based compensation, and facilities and information technology costs.

28





Research and development expense increased $0.9 million or 6.2% to $14.8 million in the three months ended September 27, 2013 from $14.0 million in the three months ended September 28, 2012. The slight increase in research and development expense is primarily due to an increase in third party provider and non-recurring engineering costs of approximately $0.9 million and higher depreciation of $0.2 million as we continue to invest in new product introductions and development activities. This was partially offset by $0.6 million of third-party funding received during the first quarter of fiscal 2014.
Sales and marketing. Sales and marketing expense consists primarily of salaries, bonuses and commissions paid to our sales and marketing employees, amortization of intangible assets, share-based compensation, and facilities and information technology costs. We also incur marketing expenses for activities such as trade shows, direct mail and advertising.
Sales and marketing expense decreased $2.0 million or 10.1% to $17.6 million in the three months ended September 27, 2013 from $19.6 million in the three months ended September 28, 2012. This decrease was primarily due to a decrease in our compensation and related expenses as a result of decreased headcount as well as lower commissions and bonus expense reflecting lower than expected achievement of sales commission targets and performance metrics compared to last year. This decrease was slightly offset by higher discretionary spending for travel and conferences, as well as higher stock based compensation expense.
General and administrative. General and administrative expense consists primarily of personnel costs, legal and professional service costs, depreciation, bad debt expense, share-based compensation, and facilities and information technology costs.
General and administrative expense decreased $1.7 million or 12.0% to $12.5 million in the three months ended September 27, 2013 from $14.2 million in the three months ended September 28, 2012. This decrease was primarily due to a decrease in our compensation and related expenses as a result of decreased headcount as well as lower bonus expense reflecting lower than expected achievement of performance metrics compared to last year. We reduced our professional fees, including legal related expenses and other third party consulting fees by approximately $0.8 million, primarily through control measures. This was partially offset by an increase in share-based compensation expense of $0.4 million.
Restructuring. Total restructuring expense related to our restructuring action in fiscal 2012 was approximately $0.5 million for the three months ended September 27, 2013 and $1.5 million for the three months ended September 28, 2012. As a result of the restructuring actions taken in Europe described above, we have incurred approximately $11.9 million of cumulative expense through September 27, 2013. We estimate that we will incur pre-tax cash charges (including charges recorded in fiscal 2012 and 2013) of approximately $13.0 million consisting of charges of approximately $12.0 million for employee termination benefits and up to $1.0 million for the planned office and legal entity closures, including contract termination costs and other associated costs.
Total other income (expense), net
Total other income (expense), net for the three months ended September 27, 2013 and September 28, 2012 were as follows (in thousands except percentages):
 
Three Months Ended
 
Change
 
September 27, 2013
 
September 28, 2012
 
$
 
%
 
 
 
 
 
 
 
 
Interest income (expense), net
$
(7
)
 
$
(155
)
 
$
148

 
(95.5
)%
Other income (expense), net
303

 
(1,107
)
 
1,410

 
(127.4
)%
Total other income (expense), net
$
296

 
$
(1,262
)
 
$
1,558

 
(123.5
)%
Interest income (expense), net. Interest income (expense), net primarily consists of interest earned on our interest-bearing investment accounts which include money market funds and U.S. treasury bills, as well as interest expense relating to our credit facility and to certain tax payments.
Other income (expense), net. Other income (expense), net during the three months ended September 27, 2013 consisted of foreign exchange gains (losses) as a result of the exchange rates primarily for the Euro, British Pound and Canadian dollar against the U.S. Dollar. We have a hedging strategy that is intended to mitigate the effect of exchange rate fluctuations on certain foreign currency balance sheet accounts and cash flows.

29





Income tax (benefit) provision
Income tax (benefit) provision for the three months ended September 27, 2013 and September 28, 2012 were as follows (in thousands except percentages):
 
Three Months Ended
 
Change
 
September 27, 2013
 
September 28, 2012
 
$
 
%
 
 
 
 
 
 
 
 
Income tax (benefit ) provision
$
(71
)
 
$
425

 
$
(496
)
 
(116.7
)%
We recorded a tax benefit of $0.1 million for the three months ended September 27, 2013. The net tax benefit was primarily comprised of a refund of provincial taxes in Canada of $0.6 million, partially offset by tax liability computed based on the Company's foreign projected financial results for the year ending June 27, 2014, state tax, and interest for unrecognized tax benefits. The provincial refund received by the Company was the result of the conclusion of an income tax audit for fiscal years 1996 to 2004 by the Canada Revenue Agency. The effective tax rate differed from the combined federal and net state statutory income tax rate for the three months ended September 27, 2013 primarily due to the tax rate differential of the Company's foreign operations and utilization of net operating losses not previously recognized.
We recorded a tax expense of $0.4 million for the three months ended September 28, 2012. The tax expense was primarily comprised of tax liability computed based on the company's foreign projected financial results for the year ending June 28, 2013 offset by a benefit of audit settlements and reversals of liabilities related to the sales of a subsidiary. The effective tax rate differed from the combined federal and net state statutory income tax rate for the three months ended September 28, 2012 primarily due to the tax rate differential of the Company's foreign operations, utilization of net operating losses, audit settlements and reversals of previously accrued taxes in foreign jurisdictions.
As of September 27, 2013, we have provided a partial valuation allowance against our net deferred tax assets. Based on all available evidence, on a jurisdictional basis, including our historical operating results, and the uncertainty of predicting our future income, the valuation allowance reduces the majority of our deferred tax assets to an amount that is more likely than not to be realized. The amount of the valuation allowance is attributable to U.S. federal, state and certain foreign deferred tax assets primarily consisting of net operating loss carryovers, tax credit carryovers, accrued expenses, and other temporary differences. We continue to evaluate the realizability of deferred tax assets and related valuation allowance. If our assessment of the deferred tax assets or the corresponding valuation allowance were to change, we would record the related adjustment to income during the period in which management makes the determination.
Segment Operating Performance
Commencing in the first quarter of fiscal 2014, the Company started managing its business primarily on a business unit basis versus the geographic basis previously used by management. Accordingly, the Company has determined its operating and reporting segments, which is based on the business unit structure, to be Compute, Storage and Service. The Company's operating segments are determined based upon several criteria including: the Company's internal organizational structure; the manner in which the Company's operations are managed; the criteria used by the Company's Chief Executive Officer, the Chief Operating Decision Maker (“CODM”), to evaluate segment performance; and the availability of separate financial information.
The Company's CODM evaluates the performance of its operating segments based on revenue and operating profit (loss). Revenues are generally allocated based on the type of products and service provided to our customers. Operating profit (loss) for each segment includes related cost of sales and operating expenses directly attributable to the segment. A portion of the segments' expenses arise from shared services and infrastructure that the Company provides to the segments in order to realize economies of scale and to efficiently use resources. These expenses, collectively called corporate charges, include costs of centralized research and development and other corporate infrastructure expenses. These corporate charges are allocated to the segments and are reassessed on a periodic basis. The allocations have been determined on a basis that the Company considers to be a reasonable reflection of the utilization of services provided to or benefits received by the segments. The profitability of each of the segments is measured after excluding share based compensation expenses, amortization of intangibles, restructuring charges, general and administration charges, other unallocated corporate charges and other items as management does not include this information in its measurement of the performance of the operating segments.
All historical segment numbers for the three months ended September 28, 2012 have been recasted to conform to the three months ended September 27, 2013.

30





Compute:
Our compute solutions segment include our scale-out computing, scale-up computing, software and cloud/web solutions. Compute solutions also include integrated third-party hardware and software products that we sell to provide a single source solution for our customers. Our compute solutions are designed to minimize the number and complexity of interconnects for power and data transfer to improve reliability, speed of implementation and serviceability.
Operating results for our Compute segment for the three months ended September 27, 2013 and September 28, 2012 were as follow (in thousands except percentage):
 
 
Three Months Ended
 
Change
 
 
September 27, 2013
 
September 28,
2012
 
$
 
%
 
 
 
 
 
 
 
 
 
Net revenue
 
$
88,842

 
$
130,800

 
$
(41,958
)
 
(32.1
)%
 
 
 
 
 
 
 
 
 
Operating profit
 
$
2,201

 
$
3,801

 
(1,600
)
 
(42.1
)%
 
 
 
 
 
 
 
 
 
Operating margin
 
2.5
%
 
2.9
%
 
 
 
(0.4
)%
Revenue for our Compute segment decreased $42.0 million or 32.1% to $88.8 million in the three months ended September 27, 2013 from $130.8 million during the three months ended September 28, 2012. This decrease was due primarily as a result of lower sales for our legacy cloud products. This is consistent with our strategic decision to withdraw from low margin commodity server infrastructure and to focus our investments in strategic ares of HPC, Big Data, storage and service. In addition, we were also negatively impacted by the spending freeze instituted by the federal government prior to its shutdown, which led to the delays in project acceptance.
Despite the significant decrease in revenue, overall operating profit for our Compute segment only decreased by $1.6 million to $2.2 million in the three months ended September 27, 2013 from $3.8 million in the three months ended September 28, 2012. The Compute segment generated higher gross margins due to the favorable mix as a result of the decrease in legacy cloud products which typically are less profitable. In addition, during the three months ended September 28, 2012, our gross margin was negatively impacted by a few low margin deals that occurred in the first quarter of fiscal 2013 in Japan and Europe. During the first quarter of fiscal 2014, we also benefited from the reductions in headcount discussed above resulting in lower compensation and related expenses, as well as lower bonuses and commissions.
Storage:
Our Storage solutions segment include both hardware and software offerings to address virtually every type of data storage and management requirement. Products range from entry-level disk arrays to complex storage systems, with innovative technology and hardware, to include the SGI Modular InfiniteStorage™ platform, SGI InfiniteStorage™ gateway and SGI CXFS™ file system. Our storage solutions are designed to provide extreme scale, broad flexibility, and to minimize the cost to store data.
Operating results for our Storage segment for the three months ended September 27, 2013 and September 28, 2012 were as follow (in thousands except percentage):
 
 
Three Months Ended
 
Change
 
 
September 27, 2013
 
September 28,
2012
 
$
 
%
 
 
 
 
 
 
 
 
 
Net revenue
 
$
19,978

 
$
15,515

 
$
4,463

 
28.8
%
 
 
 
 
 
 
 
 
 
Operating profit
 
$
2,022

 
$
(1,064
)
 
$
3,086

 
290.0
%
 
 
 
 
 
 
 
 
 
Operating margin
 
10.1
%
 
(6.9
)%
 
 
 
17.0
%
Revenue for our Storage segment increased $4.5 million or 28.8% to $20.0 million in the three months ended September 27, 2013 from $15.5 million in the three months ended September 28, 2012. This increase was due primarily as a result of higher revenue generated by increased demand in our storage infrastructure products compared to the same period a year ago.

31





Overall operating profit for our Storage segment increased by $3.1 million to $2.0 million in the three months ended September 27, 2013 from a $1.1 million operating loss in the three months ended September 28, 2012. We benefited from the reductions in headcount discussed above resulting in lower compensation and related expenses, as well as lower bonuses and commissions. We also experienced higher margins for some of our third party products that we sell to customers which also contributed to the higher profitability. In addition, during the three months ended September 28, 2012, our gross margin was negatively impacted by a few low margin deals that occurred in the first quarter of fiscal 2013 in Japan and Europe.
   
Service:
The Service segment is comprised of customer service support and professional services. Our customer service support organization provides ongoing maintenance and technical support for our products and some third-party products, as well as contracted maintenance services, hardware deployment services (install and de-install), time and materials-based services and spare parts. Our professional services organization provides value added services associated with technology consulting, project management and customer education, all of which help our customers realize the full value of their information technology investments.
Operating results for our Service segment for the three months ended September 27, 2013 and September 28, 2012 were as follow (in thousands except percentage):
 
 
Three Months Ended
 
Change
 
 
September 27, 2013
 
September 28,
2012
 
$
 
%
 
 
 
 
 
 
 
 
 
Net revenue
 
$
38,699

 
$
46,566

 
$
(7,867
)
 
(16.9
)%
 
 
 
 
 
 
 
 
 
Operating profit
 
$
15,075

 
$
14,948

 
127

 
0.8
 %
 
 
 
 
 
 
 
 
 
Operating margin
 
39.0
%
 
32.1
%
 
 
 
6.9
 %
Our service revenue will typically fluctuate due to timing of when services were performed on consulting and product integration services. Our service revenue is typically recognized ratably over the respective service periods. Revenue for our Service segment decreased $7.9 million or 16.9% to $38.7 million in the three months ended September 27, 2013 from $46.6 million in the three months ended September 28, 2012. This decrease was primarily due to timing of professional services provided as well as a deterioration in customer service maintenance contracts. In addition, we experienced lower support revenue as our new products replace our installed base of older generation.
Despite the decrease in revenue, overall operating profit for our Service segment only decreased slightly in the three months ended September 27, 2013 compared to the three months ended September 28, 2012. The Service segment was more profitable on lower revenue as we benefited from the reductions in headcount discussed above resulting in lower compensation and related expenses, as well as lower bonuses and commissions. During the three months ended September 27, 2013, we experienced a more favorable mix as we sold less third party products which typically have lower margins. In addition, during the three months ended September 28, 2012, our gross margin was negatively impacted by a few low margin deals that occurred in the first quarter of fiscal 2013 in Japan and Europe.

32





Liquidity and Capital Resources
We had $160.1 million of unrestricted cash and cash equivalents at September 27, 2013 and $175.2 million at June 28, 2013. As of September 27, 2013, $62.9 million of cash was held outside the United States. Historically, we have required capital principally to fund our working capital needs. If we invest any of our cash outside of non-interest-bearing operating accounts, it is our investment policy to invest in a manner that preserves capital, provides liquidity, maintains appropriate diversification and optimizes after-tax yield and return within our policy's framework and stipulated benchmarks. Adherence with our policy requires the assets to be liquid on and before their maturity dates. This liquidity requirement means that the holder of the assets must be able to pay us, upon our demand, the cash value of the assets invested.
At September 27, 2013, we had short-term and long-term restricted cash of $4.7 million that are pledged as collateral for various guarantees issued to cover rent on leased facilities and equipment, to government authorities for value-added tax (“VAT”) and other taxes, and to certain vendors to support payments in advance of delivery of goods and services.
As described further below under the section entitled "Contractual Obligations and Other Commitments," in December 2011, we entered into a five-year senior secured credit facility in the aggregate principal amount of $35.0 million, which was increased to $40.0 million on May 1, 2012. On February 25, 2013, the Company amended the agreement and reduced the revolver amount to $25.0 million. The credit facility is intended to be used primarily to fund working capital requirements, capital expenditures and operations to the extent that cash provided by operating activities is not sufficient to fund our cash needs. As of September 27, 2013 and June 28, 2013, we had no outstanding balance owed on the credit facility. We had a $2.0 million outstanding letter of credit under this credit facility to back the Company's obligation to pay for goods or services to a supplier. As of September 27, 2013, the maximum amount available to be borrowed under the credit facility was approximately $23.0 million.
At September 27, 2013, we believe our current cash and cash equivalents, in conjunction with the funds that may be drawn down under our credit facility, will be sufficient to fund working capital requirements, capital expenditures, stock repurchase, and operations for at least the next twelve months. We have implemented processes to more effectively monitor our working capital. We have intensified our cash management processes related to monitoring, projecting and controlling procedures to operate our business and are more broadly requiring advance and milestone payments for certain large projects that would otherwise involve a significant lag between our payments to vendors for equipment and materials and the installation, acceptance, billing and collection from the customer. We intend to retain any future earnings to support operations, to finance the growth and development of our business and to fund our stock repurchase program. We do not anticipate paying any dividends in the foreseeable future. In June 2013, we signed a lease for a new headquarters facility and expect to incur approximately $10.8 million for capital expenditures less approximately $5.8 million in lease incentives.
The adequacy of these resources to meet our liquidity needs beyond the next twelve months will depend on our growth, operating results and capital expenditures required to meet our business needs. If we fail to generate cash from our operations on a timely basis, we may not have the cash resources required to run our business and we may need to seek additional sources of funds.
If we require additional capital resources to expand our business internally or to acquire complementary products, technologies and businesses at any time in the future, we may seek to sell additional equity or debt securities or obtain other debt financing. The sale of additional equity or debt securities could result in more dilution to our stockholders. Financing arrangements may not be available to us, or may not be available in amounts or on terms acceptable to us.
The following is a summary of cash activity (in thousands):
 
Three Months Ended
 
September 27, 2013
 
September 28, 2012
Consolidated statements of cash flows data:
 
 
 
Net cash (used in) provided by operating activities
$
(12,928
)
 
$
4,635

Net cash (used in) provided by investing activities
(2,979
)
 
432

Net cash provided by (used in) financing activities
954

 
(2,917
)
Effect of exchange rate changes on cash and cash equivalents
(170
)
 
$
213

Net (decrease) increase in cash
$
(15,123
)
 
$
2,363

 
 
 
 

33





Operating Activities
Cash used in operating activities was $12.9 million for the three months ended September 27, 2013. Our net loss was $6.8 million for the three months ended September 27, 2013. Non-cash items included in net loss consisted primarily of depreciation and amortization expense of