MILBERG WEISS BERSHAD
HYNES & LERACH LLP
WILLIAM S. LERACH
(68581)
TRAVIS E. DOWNS, III (148274)
600 West Broadway, Suite 1800
San
Diego, CA 92101
Telephone: 619/231-1058
- and -
LISA C. ATKINSON (163320)
222 Kearny Street, 10th Floor
San Francisco,
CA 94108
Telephone: 415/288-4545
SCHIFFRIN & CRAIG, LTD.
RICHARD S. SCHIFFRIN
ANDREW L.
BARROWAY
Three Bala Plaza East
Suite 400
Bala Cynwyd, PA
19004
Telephone: 610/667-7706
SPECTOR & ROSEMAN, P.C.
ELLEN GUSIKOFF STEWART (144892)
600 West
Broadway, Suite 1800
San Diego, CA 92101
Telephone:
619/338-4514
Attorneys for Plaintiffs
[Additional counsel appear on signature page.]
UNITED STATES DISTRICT COURT
NORTHERN DISTRICT OF CALIFORNIA
|
PHILIP ZOVE and SANDRA ESNER, On
Plaintiffs, vs. SILICON GRAPHICS, INC., EDWARD R.
Defendants. |
No. C-97-4393-MHP CLASS ACTION COMPLAINT FOR Plaintiffs Demand A |
1. This is a class action on behalf of purchasers of Silicon Graphics, Inc. ("SGI" or the "Company") common stock between 7/24/97 and 10/6/97 (the "Class Period"), alleging that defendants made false and misleading statements about SGI's business and financial results in order to artificially inflate the price of SGI stock to facilitate the exchange of a new SGI convertible security for $200 million of outstanding zero coupon debentures, while the defendants sold 286,584 shares of their SGI stock, pocketing $7.4 million in illegal insider-trading proceeds. After SGI successfully completed its exchange of convertible debt and after the insiders had sold more than $7.4 million in their own SGI stock, the Company revealed that its strong 4thQ results had been the result of pulling orders in from future quarters and that 1stQ FY98 would suffer a huge revenue shortfall as would later quarters, also revealing that SGI's CEO and Chairman, Edward McCracken, had been fired and that the Company would be restructuring its organization. These revelations resulted in SGI's stock price dropping to less than $14 from its Class Period high of $30-5/16.
2. In 4/97, when SGI reported very disappointing results for its 3rdQ FY97, ended 3/31/97 -- the seventh consecutive below-expectation quarterly performance for SGI -- SGI's stock collapsed by $5 per share -- 28% in one day -- to just $12-5/8 per share, its lowest level in years. Analysts and SGI shareholders were furious over this situation and SGI's top management came under severe criticism. Due to SGI's very poor performance over the prior seven quarters, no SGI executive had received any bonus payments under SGI's management incentive plan and the collapse of SGI's stock greatly reduced the value of their SGI stock options and holdings. SGI also faced an extremely threatening financial situation because $200 million principal amount of its outstanding zero coupon debentures (the "Zeros") had a "put" provision that would force SGI to repurchase those zero coupon debentures for $245 million in 11/98 -- just 18 months from then -- if SGI's stock was not then selling at $33 per share -- which defendants knew was very unlikely to happen given the troubled state of SGI's business. Honoring the 11/98 put of the Zeros would plunge SGI into a cash crisis (if it paid the $245 million in cash) or permanently dilute its earning power (if it paid the $245 million in stock). Defendants also knew that Business Week was working on a searing exposé of SGI, its CEO, Edward McCracken and other SGI managers which, when published, would likely push SGI's stock even lower, compounding all these negative factors.
3. To overcome this critical situation, during the 4thQ FY97, the defendants (SGI's Chairman and CEO (Edward McCracken), CFO (William Kelly) and four other top SGI executives) inflated SGI's revenues, net income and EPS by inducing certain customers to accept millions of dollars of shipments of graphics computer workstations and computer servers before they otherwise would have done so by offering them deep price discounts, extremely generous extended payment terms and even the right to return product they did not want or could not resell. This enabled SGI to report extraordinarily strong 4thQ FY97 results well in excess of analysts' expectations. Defendants did this so that SGI's unexpectedly strong 4thQ FY97 results, when reported, would give credibility to defendants' false and misleading statements that SGI had successfully transitioned into the computer server business and a new generation of graphics workstations ("Octaneô"), that SGI was enjoying strong demand for its servers and graphics computers, that SGI's top executives were successfully executing SGI's revised business plan, that SGI had returned to its historic pattern of strong annual revenue and profit growth and 10% operating profit margins, and SGI would achieve FY98 revenues and EPS of $4+ billion and $1.50, respectively, and 1stQ FY98 revenues and EPS of $900-$950 million and $.20-$.21, respectively.
4. On 7/24/97, the day before the Business Week exposé was going to hit the streets, defendants caused SGI to announce its extraordinarily good 4thQ FY97 results, with revenues and EPS far in excess of what SGI had forecast and the Wall Street analyst community expected -- the first billion dollar quarter in SGI's history, with EPS of $.56, its highest quarterly EPS in history -- spectacular results it attributed to "strong demand" for its server and other products, its "successful" product transition and its management team's excellent "execution." SGI also held a very upbeat conference call with analysts, money managers and SGI shareholders, assuring them that SGI's spectacular 4thQ results were due to extremely strong demand for all its products, that that strong demand had continued during the 1stQ of FY98, that the decline in SGI's backlog to $537 million was due to deliberate action by SGI to lower its backlog to a more manageable level and SGI was forecasting 1stQ FY98 revenues and EPS of $900-$950 million and $.20-$.21, respectively, and full FY98 revenues and EPS of over $4 billion and $1.50, respectively.
5. As a result of SGI's spectacular 4thQ results, SGI's top executives pocketed hundreds of thousands of dollars in incentive bonuses -- the first incentive bonuses they had received in two years. Also, the negative impact of the Business Week exposé was blunted and, instead of falling in the wake of the exposé as would otherwise have been the case, SGI's stock soared by almost 50% on 7/25/97 to $27 per share, its largest one-day advance on its largest one-day stock volume in history, later advancing to a Class Period high of $30-5/16, when SGI held a conference at its corporate headquarters on 9/5/97 for analysts and investors during which SGI executives made extremely positive presentations about SGI's successful product transition, the continuing strong demand for its computer server and graphics workstation products and its management team's excellent execution, while again forecasting 1stQ FY98 revenues and EPS of $900-$950 million and $.20-$.21, respectively, and FY98 revenues and EPS of over $4 billion and $1.50, respectively. As SGI stock soared higher following the release of SGI's surprisingly strong 4thQ FY97 results, SGI quickly completed an offer to exchange the $200 million in outstanding Zeros for a new SGI convertible security without the put feature, thus avoiding the risk of the exercise of the Zeros' 11/98 put option that would have gravely injured SGI's financial condition or permanently diluted its earning power. Also, while SGI's stock was artificially inflated, between 7/29/97-8/29/97, four of the SGI insiders named as defendants also sold off 286,584 shares of their SGI stock at as high as $28 per share -- pocketing $7.4 million in illegal insider-trading proceeds -- each selling 100% of the SGI shares they acquired by option exercise -- while McCracken exercised an option to purchase 48,303 shares of SGI stock for just $3.31 per share, obtaining a huge paper profit of over $1 million.
6. However, on 10/6/97, SGI shocked investors and analysts by revealing that instead of the $900-$950 million in revenue and $.20-$.21 in EPS it had forecast for its 1stQ FY98 ended 9/30/97, SGI would suffer a huge loss of about $36 million -- its largest quarterly loss in history -- because of a grotesque revenue shortfall of at least $150 million due to weak sales of SGI's products, especially its computer server products. SGI's stock instantly collapsed from $27-9/16 to $17-11/16 -- a $10 per share fall and 36% one-day decline, on volume of 16.7 million shares -- the largest one-day stock price decline and stock volume in SGI's history, leaving SGI stockholders and analysts furious with the now apparent deception SGI's insiders had perpetrated to enable themselves to pocket millions in incentive bonus compensation, millions in illegal insider trading profits and pull off the exchange of the Zeros to avoid the risk of the 11/98 put. Then, on 10/29/97, it was revealed that SGI's actual 1stQ FY98 revenues were just $768 million -- resulting in a $37 million or $.20 per share loss -- that SGI would fire some 700-1,000 employees (up to 10% of its work force) and that Edward McCracken (SGI's CEO) and Gary Lauer (head of SGI's sales force) had been forced to "resign" because of their role in this colossal corporate disaster. The chart below sets forth the key events in this fraud:
7. For years, SGI was one of the world's most highly regarded technology companies -- a computer manufacturer noted for its advanced technology and state-of-the-art "hot box" graphics computers, which consistently reported strong annual revenue and EPS growth and enjoyed exceptionally high profit margins due to the premium prices its products commanded. This resulted in a very favorable public image for SGI and its high-profile Chairman and CEO, Edward McCracken ("McCracken"), who epitomized the successful entrepreneurial high-tech executive and became a spokesperson for the high-tech business community in Washington, DC.
8. However, during SGI's fiscal year ended 6/30/96, SGI came upon hard times. Due to mistakes by McCracken's management team which led to component part defects and deficiencies, SGI failed to timely introduce important new computer products in the 2ndQ and 3rdQ of FY96 and suffered a significant erosion of its competitive position vis-à-vis Sun Microsystems and Hewlett-Packard. As a result, SGI reported financial results well below those forecasted, resulting in a substantial decline in SGI's stock, which fell from $45-5/8 per share in 7/95 to $23-1/8 per share near the end of FY96, in 6/96 -- a 50% decline. This resulted in intense criticism of SGI and its top executives by securities analysts and SGI's stockholders, many of whom believed SGI had deceived them about its business and prospects during FY96 and called into question McCracken's leadership of SGI, threatening his continuation as CEO. SGI's stock came under attack by short sellers who believed the Company was fundamentally troubled and its stock price would fall to much lower levels. While McCracken and SGI continued to assure the investment community that the problems affecting SGI were transitory and that the Company was overcoming them, during the first two quarters of FY97 (the quarters ended 9/30/96 and 12/31/96), SGI actually reported losses, as its competitive position in the high-end graphics workstation market continued to erode while its efforts to develop new computer server products were now delayed. Then, on 4/17/97, SGI reported very small EPS for the 3rdQ of FY97, ended 3/31/97 -- far below its public forecasts and the investment community's expectations -- and SGI's stock fell sharply from $17-3/4 to $12-5/8 -- 75% below its mid-1995 high and the lowest level the stock had traded at in years. This resulted in a very adverse reaction among Wall Street analysts, the investment community and SGI's shareholders, who were extremely critical of SGI's consistently disappointing financial performance, its management team's failure to execute and successfully transition to SGI's new graphics workstation and computer server line of products, as well as the inability to meet SGI's publicly forecasted results. SGI's very poor business and stock performance was all the more embarrassing to McCracken and his management team because they came during a time when most other computer manufacturers had done spectacularly and their stocks were performing very well. The two graphs below show the very poor performance of SGI's stock during FY96-FY97 both in absolute and relative terms:
9. A 4/30/97 report on SGI by Lehman Brothers accurately described SGI's quite unhappy situation in the spring of 1997:
Silicon Graphics has been one of the poorer performing technology stocks over the past two years as its share price has declined from . . . $45 per share . . . to $13. . . . Silicon Graphics was a "darling" of Wall Street and commanded a premium multiple to earnings. With its disappointments over the past two years the shares have been hit quite hard.
* * *
Through fiscal 1995, SGI appeared to be one of the most dynamic companies within the computer industry with revenue growth and overall gross margins far exceeding most competitors. The company's products were featured in all segments of the media . . . and SGI seemed to be fully exploiting its industry position.
[T]he unending momentum began to fade early in fiscal 1996 and proved the beginning of difficult times for SGI. . . . Part of the problem was due to internal difficulties such as delays in certain chips and product rollouts, as well as significant transition issues within its sales force. In addition, competitive pressures increased as other vendors including Hewlett-Packard, Sun, and DEC, as well as PC vendors utilizing 3-D graphics cards, competed more effectively in the marketplace. Accordingly . . . SGI . . . did not meet either internal management plans or expectations of Wall Street. The company has now reported seven consecutive quarters of disappointing results and its shares have languished. In our view, the company must begin to demonstrate renewed growth for investors to again believe in the story.
10. During SGI's 4thQ FY97 to end 6/30/97, SGI, McCracken and his management team were in very serious trouble. They knew that while SGI had a large backlog of orders to ship in the 4thQ FY97 due to previous delays in filling customer orders, SGI's ongoing business was continuing to perform very poorly and well below even sharply reduced internal expectations, as its new computer server products were not being well received by the market, new orders for these products were proving difficult to obtain and SGI's competitive position in the high-end graphics workstation market continued to erode with new orders for these graphics workstations also well below internal expectations. Because of the below-expectation performance of SGI's business in FY96 and its losses and/or minuscule EPS the first three quarters of FY97, SGI's top executives had received no payments at all for seven quarters under SGI's executive incentive program, which created a special hardship for McCracken who had been involved in a protracted and expensive divorce proceeding and forced to borrow to meet his obligations. Also, the value of the SGI stock options and SGI stockholdings of SGI's top executives had been greatly reduced by the collapse of SGI's stock price during FY96-FY97. SGI was also facing a financial time bomb due to the $200 million principal amount of "Zero" debentures it had sold in 11/93 -- at a time when SGI's business was much stronger and more profitable -- and which contained an unusual provision which enabled the holders of those "Zeros" to "put" them to SGI, i.e., force SGI to re-purchase them in 11/98 if SGI's common stock was not then selling at $33 per share -- which put, if exercised, would cost SGI $245 million! SGI could not afford to make such a payment in cash, and could not honor the put obligation with SGI stock without grossly and permanently diluting SGI's earning power. And, to make matters even worse, McCracken and his cohorts knew that due to the poor performance of SGI over the prior two fiscal years and McCracken's questionable leadership, Business Week was working on a major exposé on SGI and McCracken which would be extremely critical of SGI, and McCracken's leadership, as well as the personal behavior of McCracken and other SGI top executives, expose McCracken's extramarital affair with a young SGI employee which resulted in an expensive and protracted divorce which placed McCracken in financial distress, diverted his attention from SGI's business and contributed to the business failures SGI had encountered in recent quarters.
11. Thus, during the 4thQ FY97, McCracken and SGI's other top executives were literally under siege, SGI's stock price had collapsed to its lowest levels in years -- $12-5/8 per share -- greatly reducing the value of their SGI stock options and stockholdings, they had not received any incentive bonus payments for two years, the financial future of SGI was gravely threatened by the risk of an 11/98 exercise of the Zeros' put, and they were facing a major "front page" exposé by one of the country's most important business magazines, which would further tarnish SGI's and McCracken's images in the financial community and push SGI's stock even lower.
12. To overcome this extremely threatening situation, McCracken and other top SGI executives determined to take whatever steps were necessary to cause SGI to report an extraordinarily strong 4thQ FY97 which would greatly exceed Wall Street expectations so they could (i) counteract the onslaught of negative publicity they knew was coming; (ii) cause SGI to meet SGI's internal 4thQ FY97 financial goals necessary to trigger incentive bonus payments to them; (iii) squeeze the short sellers of SGI's stock by forcing them to repurchase SGI shares; and (iv) inflate SGI's stock price to much higher levels so that SGI would be able to successfully undertake an exchange offer to entice the holders of SGI's Zeros to exchange them for a new SGI debenture without the put feature and thus eliminate the risk of the 11/98 put of the Zeros to SGI and so they could exercise their SGI stock options and sell off some of their SGI shares to pocket large insider-trading profits, which they had not been able to do for many months.
13. In order to create the revenue and net income necessary for SGI to report unexpectedly strong -- indeed record -- EPS for its 4thQ FY97, and which would greatly exceed analysts' estimates, McCracken and the other individual defendants pursued a scheme to defraud the market. The defendants knew that SGI's 4thQ FY97 would benefit from "pent up" demand as it shipped millions of dollars of overdue orders it could not ship earlier due to product delays. But they also knew this apparent demand was illusory, as SGI had not been and was not being successful in obtaining new orders to replace these orders and SGI's ongoing business was actually much weaker than its 4thQ FY97 shipment of these overdue orders indicated. Defendants not only caused SGI to ship millions in long overdue orders, but they also persuaded customers to accept millions of dollars worth of computer servers and graphics workstations well in advance of when they needed or wanted them and otherwise would have accepted shipment of them in return for extremely generous and commercially unusual payment terms, including substantial discounts and even promises that they could return the products if they did not resell them or keep them. SGI's insiders thus generated what they knew were artificially high revenues, net income and EPS for SGI in the 4thQ FY97. They did this knowing that this subterfuge would adversely impact SGI's results during FY98, especially in the 1stQ and 2ndQ of FY98, and result in a huge revenue decline and likely losses. When Stanley Meresman, SGI's long-time Chief Financial Officer, and Michael Ramsay, SGI's Senior Vice President for desktop graphics sales, refused to be a part of this conduct, in 5/97, one-third of the way through SGI's 4thQ of FY97, they "resigned," purportedly to "pursue outside opportunities." However, SGI presented these departures as a positive development and part of a corporate reorganization that would enable SGI to operate more efficiently and report consistent EPS growth. Unable to find a CPA/Chief Financial Officer willing to participate in the scheme McCracken and SGI's other top executives were pursuing, McCracken picked as SGI's Chief Financial Officer SGI's long-time general counsel, William Kelly, who was not even an accountant, and who McCracken knew not only lacked accounting training or expertise, but would also do whatever McCracken told him to do. Thus, during the second and third months of the 4thQ FY97 and through the end of the Class Period, SGI -- a NYSE-listed company with revenues of over $3 billion a year -- operated with a CFO without accounting training let alone one who was a CPA -- a virtually unprecedented situation for a billion-dollar NYSE company. SGI's internal accounting functions thus fell mostly on SGI's controller, Dennis McBride, who sold off 156,000 shares of his SGI stock for $3.8 million -- 100% of the stock he acquired by option exercise -- during the Class Period!
14. After the end of SGI's 4thQ FY97 on 6/30/97 and during 7/97, McCracken and SGI learned that Business Week was moving closer toward publishing its highly critical exposé of SGI, McCracken and other SGI executives, and that the piece would be a cover story. In order to blunt the otherwise negative impact of this article, SGI timed the release of its 4thQ FY97 results, which defendants had manipulated to make SGI's business look far more successful and profitable than it actually was, for after the close of trading on Thursday, 7/24/97, as they knew the 8/4/97 edition of Business Week -- with its cover story attacking them -- would hit the streets in the afternoon on Friday 7/25/97. Thus, on 7/24/97, after the close of NYSE trading, SGI announced its 4thQ FY97 results -- results which shocked Wall Street analysts as they were so strong and so far above expectations. SGI reported 4thQ FY97 revenues, net income and EPS of $1.1 billion, $102 million and $.56, respectively, compared to net income of just $10.5 million and EPS of just $.06 in the prior quarter -- an astonishing one-quarter recovery. This was the first time SGI had ever reported over a billion dollars in revenue in a quarter and was its highest net income and EPS for a quarter in its history! In announcing these results, Kelly represented that "servers . . . that's where the growth is for us" and that SGI "is also experiencing strong sales of its new computer graphics workstation line." McCracken proclaimed that "this quarter was all about execution . . . our product transition is complete . . . the new products are finding strong acceptance with customers." Kelly also forecast SGI now expected "mid-teens revenue growth in fiscal 1998 . . . and operating margins of 10%" as "demand in core markets is doing well, especially in the company's fastest growing product category . . . servers." After releasing its 4thQ FY97 results, SGI held a conference call during which McCracken and Kelly made positive presentations about SGI's successful product transition, the strong demand for its computer server and graphics workstation products and SGI's management team's excellent execution, while again forecasting 1stQ FY98 revenues and EPS of $900-$950 million and $.20-$.21, respectively, and FY98 revenues and EPS of over $4 billion and $1.50, respectively. Confronted with this amazingly strong performance by SGI, which by far outstripped analysts' expectations, and SGI's forecasts of strong FY98 revenue and EPS growth, SGI's stock exploded from $18-5/8 on 7/24/97 to $27 on 7/25/97 on 15.8 million share volume, the then largest one-day stock volume in SGI's history as a public company and an unprecedented 50% price increase in just one day.
15. In the afternoon of 7/25/97, Business Week's cover story exposé of McCracken and SGI hit the streets. The cover stated "THE SAD SAGA OF SILICON GRAPHICS -- Its Gee-Whiz Computer Graphics Brought Fame And Fortune, But Now Dogged By Troubles, Its Market Value Has Dropped By Half. Here's The Untold Tale of What Went Wrong. Can CEO Ed McCracken Fix Things?" The article itself was a scathing attack on McCracken and SGI. The article, which, was entitled "The Sad Saga of Silicon Graphics -- What Went Wrong At The Company That Once Made Everybody Say: 'Gee Whiz,'" stated that SGI was going to be "the new Apple," it compared SGI's losses and terrible stock performance over the past two years to the great success of its competitors, asserting "SGI executives got drunk on their own success" and had "lost touch with basic business practices," accusing McCracken of an affair with a young SGI employee which, combined with McCracken's Washington, DC political activities, had resulted in his neglecting SGI's business. The article asserted "SGI's long-term future is in doubt," detailed repeated management "blunders" and a huge exodus of top SGI executives, reporting that "16 of 43 top execs have left or were pushed out." The article reported that McCracken's affair and divorce had left him "struggling to meet expenses" and that he "had to liquidate assets and borrow money to pay expenses." Finally, the article indicated that McCracken was in trouble with the SGI Board of Directors and that if SGI's performance did not dramatically improve soon, his job was in jeopardy. Business Week even ran an editorial attacking McCracken and SGI, stating that "[E]ven in Silicon Valley . . . there is no place for hubris . . . [a]mid . . . challenges, SGI's chief executive was having an office romance while other managers engaged in behavior more appropriate to a frat house than a corporate office . . . bad strategy at SGI combined to pull the company down. . . . It's a sorry tale . . . ."
16. However, by announcing its remarkable and unexpected 4thQ FY97 results on Thursday evening, 7/24/97, and holding the extremely upbeat conference call for analysts, large SGI shareholders and money and portfolio managers during which McCracken and Kelly represented to the investment community that SGI had overcome its product transition difficulties and financial forecasting and other financial control problems and was now back on track to achieve its historical level of revenue and profit growth, SGI had overcome what otherwise would have been an extremely negative impact on SGI's stock from this Business Week article. Instead of falling sharply, SGI's stock exploded on the upside. In fact, in the next edition of Business Week, there appeared a letter from Gary Lauer, SGI's Executive Vice President-Sales and Marketing, taunting Business Week and stating that:
It is ironic that "The sad saga of Silicon Graphics" (Cover Story, August 4) hit the stands the day after the company announced the best quarter in its history: well over $1 billion in revenue and strong profitability.
Most of the story missed the point of where Silicon Graphics is today. Yes, Silicon Graphics has had problems over the past couple of years. We recognized those problems, accepted responsibility, and our management team has been working hard to address them. Very strong actions have been taken, and we are beginning to see the results, as evidenced by our outstanding fourth quarter.
We are very optimistic about this coming year and beyond. This quarter was a reflection of the new Silicon Graphics' ability to execute. Our product transition is complete. We are shipping our entire product line . . . and, most importantly, the new products are finding strong acceptance with our customers. Our entire organization is aligned to build on this success as we enter the new fiscal year.
Thus, instead of falling further on the publication of the Business Week article, as would have otherwise happened, because of defendants' scheme, SGI stock soared to artificially inflated levels it had not traded at for months, reaching its Class Period high of $30-5/16 in early 9/97.
17. In early 8/97, SGI stock again advanced strongly as information circulated that SGI would make a very positive presentation at the Siggraph trade show for graphical computing in Los Angeles. For instance, on 8/4/97 the following ran on the Dow Jones News Service:
Shares of Silicon Graphics Inc. added 9%, possibly on anticipation of an upcoming trade show in Los Angeles. The company will be presenting this week at Siggraph, a leading trade show for graphical computing. Silicon's chairman and chief executive, Edward McCracken, appearing on CNBC earlier, said the company will be making a series of announcements at the show. . . . The executive also said on CNBC that he hopes for revenue growth of 15% next year, and profits to grow "considerably faster than that."
* * *
Silicon Graphics' NYSE-listed shares were recently up 2-1/4 . . . .
18. On 9/3/97, McCracken publicly reassured investors "we've got our program in good shape," "for the next few quarters, our plan looks really good," "our company is really turned upright for the 1997, 1998 market," and "the momentum is there." On 9/5/97, SGI held a large conference at its corporate headquarters which was attended by analysts, money and portfolio managers, large SGI shareholders and institutional investors. During the meeting, McCracken, Kelly, Lauer and Orton made presentations during which it was stated:
As a result of this extraordinarily positive conference, SGI's stock increased to its Class Period high of $30-5/16 on 9/8/97 -- the first trading day following the 9/5/97 analysts conference.
19. During the first few days of 10/97, SGI issued its FY97 Annual Report to Shareholders. The Annual Report contained a letter signed by McCracken which stated:
Fiscal 1997 was a year of significant change for Silicon Graphics. It was a challenging year in which we reorganized operations to capitalize on new growth opportunities, introduced an all new product line and once again saw the use of high-performance computing bring extraordinary increases in productivity and effectiveness to a greater range of customers than ever before.
* * *
During fiscal 1997, our server business was especially strong. . . . In January we completed the all-new product line with the announcement of the OCTANE family of power desktop workstations. We believe that this new product line, which provides technical and creative professionals with the most advanced high-performance strategic computing technology in the industry, is our strongest yet.
* * *
Also this year we made business process improvements a major focus throughout the company. During fiscal 1997 we've been working to improve our basic procedures, such as forecasting, order administration, inventory control and receivables management. We're already seeing a very positive impact from these efforts.
* * *
The changes we've made over the last year, the technology we're developing and the extraordinary opportunities ahead, give us great confidence as we look forward to 1998.
20. As SGI's extraordinarily positive announcements artificially inflated SGI's stock, defendants moved to exploit the artificial inflation in SGI's stock price by implementing the exchange offer for its outstanding zero coupon debentures they had been planning for several weeks, by offering a new senior convertible note on more favorable terms which enticed the holders of 98% of the outstanding zero coupon notes to exchange them for senior convertible notes without a "put" in the 30-day period between 8/4/97 and 9/4/97, thus eliminating the financial risk of the 11/98 put option of the zero coupon note holders which otherwise would have been exercised with ruinous consequences for SGI.
21. After SGI's stock soared to artificially inflated levels, four top SGI insiders also took advantage of this artificial inflation in SGI's stock price to sell 286,584 shares of their SGI stock between 7/29/97 and 8/29/97 at as high as $28 per share, pocketing $7.4 million in illegal insider trading proceeds, selling 100% of the shares they acquired via the exercise of options during the Class Period:
Shares % Of
Obtained Options
By Acquired/
Shares Aggregate Exercise Shares
Defendant Sold Proceeds Of Options Sold __
Lauer 60,000 $1,605,000 60,000 100%
Coleman 30,000 $ 834,300 22,000 100%
Orton 40,584 $1,136,352 40,584 100%
McBride 156,000 $3,822,000 156,000 100%
TOTALS: 286,584 $7,397,652 278,584 100%
On 7/23/97, the day before SGI announced its spectacular 4thQ FY97 results and its stock soared higher, McCracken exercised an option and acquired 48,303 shares of SGI stock at $3.31 per share, thus achieving a gain of almost $1.2 million in 48 hours.
22. These stock sales were unusual in timing and amount. They were made in just 24 trading days between 7/29/97 and 8/29/97. These sales took place just 30-60 days prior to SGI revealing serious problems with its business and very disappointing financial results on 10/6/97, which caused SGI's stock to collapse to $17-11/16 per share. These stock sales were inconsistent with these individual defendants' prior trading in SGI stock, dwarfing prior sales in both dollar amount and number of shares sold since 2/95 as the charts below show:
23. Before the opening of NYSE trading on 10/6/97, SGI issued a press release and held a conference call to reveal that its 1stQ FY98 results would be horrible -- revenues of only $750-$760 million -- resulting in a loss of $.20 per share -- well below the $900 million in revenues and $.20-$.21 EPS it had forecast just 30 days earlier. In fact, this $36+ million loss would be the largest quarterly loss in SGI's history! SGI's 10/6/97 release stated:
Silicon Graphics, Inc. announced that, based on a preliminary analysis of its results for the quarter ended September 30, 1997, it expects to report revenue of approximately $760 million . . . . The company expects a net loss of approximately $.20 per share . . . .
Edward R. McCracken, chairman and chief executive officer [said] . . . "results were significantly lower than our expectations. Our server business, . . . had a disappointing quarter, especially in the United States."
"[W]e clearly need to intensify our marketing and sales programs . . . we are reviewing our operating expenses in light of current business conditions," concluded McCracken.
24. SGI also held a conference call during which Kelly and McCracken admitted:
Our results for the first quarter fell well short of our expectations and yours . . . . The press release that we just issued contains a revenue estimate of approximately $760 million . . . Based on this revenue forecast, we are forecasting a net loss per share of approximately $0.20 . . . .
* * *
[T]he principal reason for the shortfall was in our server business. . . . The shortfall was especially felt in the U.S. . . . [T]he tools we use to predict how much of the sales funnel will turn into the current quarter revenue -- are no longer as accurate as they need to be. . . . [O]ur strong Q4 probably drained the pipeline to a greater extent than we had realized.
Kelly and McCracken refused to answer any questions during or at the end of this conference call.
25. Securities analysts were furious over these revelations and ruthlessly cut their ratings on SGI, as well as the FY98 revenue and EPS forecasts.
But the recent quarter was only the first time in two years that Silicon Graphics had met, let alone exceeded, Wall Street analysts' estimates, and for many investors today's announcement appeared to shatter whatever credibility the company retained. As of late last month, Silicon Graphics executives were still telling analysts that they would meet Wall Street expectations.
"They don't have a chief financial officer; they demonstrably do not have good internal controls or a coherent forecasting and planning process," said Doug van Dorsten of Hambrecht & Quist.
As recently as Sept. 10, the company had presented an optimistic outlook for the quarter in a conference call with analysts, said Steven Milunovich, an analyst at Merrill Lynch & Co.
* * *
Weak sales forecasting and internal financial controls contributed to the disappointment. The company has operated for two quarters without a Chief Financial Officer, and has not yet found one. We believe that sustained improvement hinges on finding a CFO, implementing a rigorous sales, expense and manufacturing forecasting process, and significantly cutting expenses.
The poor execution in the September quarter is likely to lead to more management changes. . . . Orders were weak -- selling cycles on servers have grown and the company drew down backlog during the quarter, adding concern that the fundamental rate of demand for the products sold by the company is declining. Silicon Graphics has had difficulty achieving any consistent accuracy in sales forecasting, which makes planning for manufacturing, inventory and operating expenses extremely difficult.
Slow server sales, a real concern. Management noted that sales of servers were soft in the September quarter, and that the sales cycle has gotten longer, a rapid and diametrical shift from the results of the June 1997 quarter, and all the more disquieting because of the wide disparity. Slower server sales raise fundamental concerns.
Controls and forecasting; the Achilles' heel. Management has discussed in the past a substantial effort to improve internal processes. The September quarter shortfall graphically illustrates how badly a real success in this effort is needed. We believe the company needs a Chief Financial Officer . . . .
In a sharp reversal of the improving trends that were seemingly underway with the 4Q97 results, SGI announced that it expects to report substantially disappointing 1Q98 results. The company anticipates revenues of approximately $760 million, flat with 1Q97, and a loss of about $0.20 a share. It attributed the shortfall to weakness in domestic server sales and weakness in the workstation area. SGI also noted that the strength in 4Q97 likely drained some 1Q98 demand and that some business had been deferred to 2Q98. It did not refer to any macroeconomic or competitive factors for the disappointment . . . .
26. SGI's stock utterly collapsed upon the shocking revelations of 10/6/97. SGI's stock fell from $27-9/16 on 10/3/97 to $17-11/16 on 10/6/97 and $16-5/8 on 10/8/97. The 10/6/97 decline of $10 per share -- or 36% -- occurred on 16.7 million shares volume -- the largest one-day stock decline on the largest one-day trading volume in SGI's history as a public company.
27. SGI's public stockholders were also enraged by this apparent deception by SGI. Following the revelations of 10/6/97, furious SGI investors posted the following on the Motley Fool/SGI Website, starting immediately after SGI revealed it would suffer a loss of $.20 per share for the 1stQ FY98 -- as compared to the $.20-$.22 per share profit it had been forecasting:
Subject: Re: Question for Ehsjaym?
Date: Mon, Oct 6, 1997 19:19 EDT
From: Caesar91
Now that all of the venting has taken place can anyone provide some insight as to what today's announcement really means, portends, etc.
The news is obviously very bad. I would hope that technically we could get a "dead cat" bounce back to low twenties -- at which point I would sell and move on. The large positive surprise followed by large negative surprise is very unusual, even for a tech stock. I'm going to take a look at some of the insider selling and would like to get a good accountants read on whether they "loaded" the last quarter to jack up the price so they could sell. A slowdown in the server business, as they say, is not enough to justify the wild swing in earnings they announced today. If a company's strategy doesn't play out and they don't do well, I'll take my lumps with everyone else. The activity w/SGI, however, apparently may have been criminal, which is enough to piss me off.
Subject: Re: Question for Ehsjaym?
Date: Mon, Oct 6, 1997 23:30 EDT
From: MD1554
>>The activity w/SGI, however, apparently may have been criminal ...>>
You can bet on it. Anyone with half a brain can see it a mile away.
28. On 10/27/97, SGI reported its 1stQ FY98 results reporting revenue of just $768 million, a 34% reduction from the 4thQ of FY97. The press release stated that SGI "expects this quarter to implement a program to reduce its operating expenses to a level consistent with current business conditions," effectively admitting that the 4thQ FY97 results were an aberration and that 1stQ FY98 were more indicative of SGI's current business prospects. Upon these later revelations, the price of SGI stock dropped further to less than $14 per share, a 55% reduction from the Class Period high of $30-5/16 just seven weeks earlier.
29. On 10/29/97, SGI announced that McCracken would resign as CEO and Chairman of SGI, later revealing that McCracken had been fired, and Gary Lauer resigned as Executive Vice President of Sales and Marketing. SGI also announced a restructuring program that would eliminate up to 1,000 positions. In a Wall Street Journal article on 10/31/97, SGI admitted that its positive 4thQ FY97 results were not the result of a "fundamental improvement in demand, but simply customers accelerating purchases from the next period."
30. Each of the positive statements about SGI's business during the Class Period was materially false and misleading when issued, and failed to disclose, inter alia, the following adverse information which was then known only to defendants due to their access to internal SGI data:
(a) SGI's fantastic 4thQ FY97 results were not due to effective "execution" by SGI's management team, nor were they due to "strong demand" for SGI's new graphics workstation and server products; but rather, were the result of SGI inducing customers to prematurely accept shipments of millions of dollars of graphics workstations and servers before those customers wanted or needed them, by offering them special sales incentives including price discounts, extended payment terms and the right to return the products if they did not want them or could not resell them;
(b) It was not true that SGI was enjoying "strong demand" for its new product family, nor were those products finding "strong acceptance" with customers as, in fact, both SGI's Octaneô desktop workstations and its Origin200ô and 2000ô servers were encountering very weak customer acceptance and soft demand due to customer resentment over prior shipping delays by SGI and the success of competitive products which offered better performance at lower prices and, in order to induce customers to accept shipment of its Origin and Octaneô products, SGI was forced to offer customers significant sales incentives including steep price discounts, extended payment terms and the right to later return merchandise if unsold or unwanted;
(c) Demand for SGI's Octaneô workstations and Origin200 and 2000ô servers softened materially during 4thQ FY97, due to the success of competitors' products and due to customer dissatisfaction with SGI's prior delays in shipping products, such that in order to achieve over $1 billion in sales for 4thQ FY97 and conceal the softening demand for its products, SGI was forced to grant customers special sales incentives and terms, including steep price discounts, extended payment terms and the right to return merchandise if they were dissatisfied with it or if it could not be resold;
(d) It was not true that Origin2000ô server sales were "very strong" during the 4thQ of FY97 as, in fact, new sales of those products which were not already in backlog and being shipped on a delayed basis were very slow during the 4thQ FY97, as SGI was having a very difficult time closing sales of these products, especially in the United States;
(e) It was not true that Octaneô workstation sales were very strong during the 4thQ of FY97 as, in fact, sales of those products which were not already in backlog and being shipped on a delayed basis were very slow during the 4thQ of FY97, as SGI was having a very difficult time closing sales of these products, especially in the United States;
(f) It was not true that SGI had deliberately worked its backlog down to what were more manageable or acceptable levels as, in truth, a significant part of the backlog reduction was involuntary, due to the failure of SGI to obtain new orders for its products in the 4thQ to replace orders shipped out of backlog, which situation was the result of the softening demand for SGI's Octaneô workstations and Origin2000ô servers;
(g) It was not true that SGI's improved internal budgeting and forecasting procedures were leading to more dependable forecasting of SGI financial results as, in fact, SGI's internal budgeting and forecasting systems were in disarray and were not capable of generating accurate or reliable information as to SGI's orders and sales or current expenses and thus defendants knew that they had no basis to make the forecasts they were making and that the actual information they were obtaining directly from sales representatives, distributors and the like confirmed that, in fact, new orders for SGI's Octaneô workstations and Origin2000ô servers were plummeting to very low levels during the 4thQ FY97 and SGI's expenses were escalating upward out of control;
(h) It was not true that SGI's near-term outlook had improved as, in fact, SGI's conduct in the 4thQ of FY97 of draining out its backlog and pre-shipping millions of dollars of product to customers meant that SGI's 1stQ FY98 would be a disaster, showing a huge decline in revenues from the 4thQ FY97 which would be at such low levels that SGI would suffer a large loss due to its high expense levels which it could not control;
(i) As a result of the foregoing negative factors which were actually known by each of the defendants, they knew that SGI's forecasts of 1stQ FY98 revenues of $900-$950 million with EPS of approximately $.20 were false when made and could and would not be achieved;
(j) As a result of the foregoing negative factors which were actually known by each of the defendants, they knew that SGI's forecasts of quarterly growth in EPS throughout FY98 were false when made and could not be achieved;
(k) As a result of the foregoing negative factors which were actually known by each of the defendants, they knew that SGI's forecasts of 15%-20% growth in FY98 with 10% operating profit margins were false when made and could not be achieved; and
(l) As a result of the foregoing negative factors which were actually known by each of the defendants, they knew that SGI's forecasts of FY98 revenues of $4 billion and EPS of $1.50-$1.55 were false when made and could not be achieved.
31. The charts below show the increase in SGI stock while defendants were issuing their false and misleading statements, and the stock's collapse as the true facts became publicly known, and illustrate that, when compared to an index of similar stocks, the movement of SGI stock was largely due to company-specific information as opposed to industry or market factors:
32. Jurisdiction exists pursuant to §27 of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. §78aa, and 28 U.S.C. §1331. The claims asserted arise under §§10(b) and 20(a) of the Exchange Act, 15 U.S.C. §§78j(b) and 78t(a), and Rule 10b-5.
33. Venue is proper in this District pursuant to §27 of the Exchange Act and 28 U.S.C. §1391(b). Many of the acts giving rise to the violations complained of occurred in this District.
34. In connection with the wrongs complained of, defendants used the instrumentalities of interstate commerce including the U.S. mails and the facilities of the national securities markets.
35. (a) Plaintiff Philip Zove purchased 400 shares of SGI stock on 9/16/97 at $28-3/16 per share and was damaged thereby.
(b) Plaintiff Sandra Esner purchased 200 shares of SGI stock on 8/6/97 at $27-5/8 per share and was damaged thereby.
36. Defendant SGI is headquartered at Mountain View, California and sells desktop graphics workstations and multi-processor servers. SGI stock trades in an efficient market on the New York Stock Exchange.
37. (a) Defendant Edward R. McCracken ("McCracken") was Chairman of the Board and CEO of the Company until he resigned in late 10/97. Because of defendant McCracken's position with the Company, he knew the adverse non-public information about its business, finances, products, markets and present and future business prospects via access to internal corporate documents (including the Company's operating plans, budgets and forecasts and reports of actual operations compared thereto), conversations and connections with other corporate officers and employees, attendance at management and Board of Directors' meetings and committees thereof and via reports and other information provided to him in connection therewith. On 7/23/97, the day before SGI announced this spectacular 4thQ FY97 results and its stock soared higher, McCracken exercised an option and acquired 48,303 shares of SGI stock at $3.31 per share, thus achieving a gain of almost $1.2 million in 48 hours.
(b) Defendant Gary L. Lauer ("Lauer") was Executive Vice President, Sales and Marketing of the Company until he resigned in late 10/97. Because of defendant Lauer's position with the Company, he knew the adverse non-public information about its business, finances, products, markets and present and future business prospects via access to internal corporate documents (including the Company's operating plans, budgets and forecasts and reports of actual operations compared thereto), conversations and connections with other corporate officers and employees, attendance at management meetings and via reports and other information provided to him in connection therewith. During the Class Period and as part of the fraudulent scheme, defendant Lauer sold 60,000 shares of SGI stock at artificially inflated prices of $26.50-$27.00 per share based on inside information, pocketing over $1.6 million. Lauer exercised options to purchase those 60,000 shares at $11.84 per share and sold the shares immediately upon exercise.
(c) Defendant Kenneth L. Coleman ("Coleman") was, during the Class Period, a Senior Vice President of the Company in charge of Administration. Because of defendant Coleman's position with the Company, he knew the adverse non-public information about its business, finances, products, markets and present and future business prospects via access to internal corporate documents (including the Company's operating plans, budgets and forecasts and reports of actual operations compared thereto), conversations and connections with other corporate officers and employees, attendance at management meetings and via reports and other information provided to him in connection therewith. During the Class Period and as part of the fraudulent scheme, defendant Coleman sold 30,000 shares of SGI stock at artificially inflated prices of $27.81 per share based on inside information, pocketing $834,300. Coleman exercised options to purchase 22,000 shares at $5.25 per share and sold the shares immediately upon exercise.
(d) Defendant David E. Orton ("Orton") is a Senior Vice President, Advanced Systems of the Company. Because of defendant Orton's position with the Company, he knew the adverse non-public information about its business, finances, products, markets and present and future business prospects via access to internal corporate documents (including the Company's operating plans, budgets and forecasts and reports of actual operations compared thereto), conversations and connections with other corporate officers and employees, attendance at management meetings and via reports and other information provided to him in connection therewith. During the Class Period and as part of the fraudulent scheme, defendant Orton sold 40,584 shares of SGI stock at artificially inflated prices of $28 per share based on inside information, pocketing $1.1 million. Orton exercised options to purchase these 40,584 shares at $5.25-$11.84 per share and sold the shares immediately upon exercise.
(e) Defendant Dennis P. McBride ("McBride") is a Vice President, Controller of the Company. Because of defendant McBride's position with the Company, he knew the adverse non-public information about its business, finances, products, markets and present and future business prospects via access to internal corporate documents (including the Company's operating plans, budgets and forecasts and reports of actual operations compared thereto), conversations and connections with other corporate officers and employees, attendance at management meetings and via reports and other information provided to him in connection therewith. During the Class Period and as part of the fraudulent scheme, defendant McBride sold 156,000 shares of SGI stock at artificially inflated prices of $24.50 per share based on inside information, pocketing $3.8 million. McBride exercised options to purchase these 156,000 shares at $4-$11 per share and sold the shares immediately upon exercise.
(f) Defendant William M. Kelly ("Kelly") was Senior Vice President and General Counsel and Secretary of the Company until 5/5/97, when he became CFO of SGI. Because of defendant Kelly's position with the Company, he knew the adverse non-public information about its business, finances, products, markets and present and future business prospects via access to internal corporate documents (including the Company's operating plans, budgets and forecasts and reports of actual operations compared thereto), conversations and connections with other corporate officers and employees, attendance at management meetings and via reports and other information provided to him in connection therewith.
(g) The individuals named as defendants in ¶34(a)-(f) are referred to as the "Individual Defendants."
38. Defendant McCracken, by reason of his position as CEO and Chairman of SGI's Board of Directors, was a controlling person of SGI and had the power and influence, and exercised the same, to cause SGI to engage in the conduct complained of herein.
39. During the Class Period, each Individual Defendant occupied a position that made him privy to non-public information concerning SGI. Because of this access, each of these defendants knew that the adverse facts specified herein were being concealed. Notwithstanding their duty to refrain from selling SGI stock while in the possession of material, non-public information concerning SGI, four of the Individual Defendants sold 286,584 shares of the Company's stock at artificially inflated prices, thus personally profiting from their illegal insider trading which was part of their fraudulent scheme.
40. Each defendant had the opportunity to commit and participate in the fraud. The Individual Defendants were the top officers of SGI and they controlled its press releases, corporate reports, SEC filings and its communications with analysts. Thus, they controlled the public dissemination of, and could falsify, the information about SGI's business, products, results and prospects that reached the public and impacted the price of its stock.
41. Each of the Individual Defendants also had the motive to commit and participate in the fraud. In recent years, SGI's stock traded at a price-earnings multiple reserved for premier growth companies with track records of meeting the investment community's expectations for high profit growth. This stock performance enabled SGI's corporate executives to exercise stock options and sell stock at large profits and enabled SGI to grow by using its stock to make acquisitions of other companies. SGI's apparent success and its stock's performance also contributed to the high profile of McCracken, SGI's Board Chairman and CEO, who acted as spokesperson not only for SGI but for industry groups as well. For all these reasons, maintaining SGI's image of strong growth and its high stock price was extremely important to SGI's top executives. Defendants also wanted to cover up the problems with and deterioration in SGI's business (and their own mistakes and acts of mismanagement).
42. SGI and its insiders were motivated to falsely make it appear that SGI had successfully demonstrated its product transition to server sales, was successfully executing its new business plan and was back on track for 20% annual revenue and EPS growth and 10% gross profit margin, thus artificially inflating the price of SGI common stock. This was a necessary step to successfully bring about an exchange offer for its outstanding zero coupon notes and avoid the risk of a disastrous 11/98 "put" of those debentures to SGI, which would have had a disastrous impact on SGI's financial position or earning capabilities, to allow SGI executives to collect large incentive bonuses based on SGI's extraordinary 4thQ FY97 performance, the first bonuses they had received in two years, to increase the value of the insiders' options to purchase SGI stock, the value of which had been greatly reduced by the collapse of SGI stock in FY96-FY97 so that certain of the Individual Defendants could then exercise some of their stock options and illegally insider trade in SGI stock to pocket millions of dollars of illegal insider-trading proceeds, thus personally benefiting from their deliberate and dishonest acts, as they had been unable to sell off any significant amount of their option shares for many months, due to the depressed price of SGI stock.
43. In 11/93, when its business and prospects appeared very strong, SGI sold approximately $200 million principal amount of zero coupon convertible debentures due in 2013, which, upon maturity, would cost SGI approximately $455 million to satisfy. These "Zeros" also contained a "put" option that provided that if in 11/98 SGI's common stock was not selling at $33 per share, the holders of the "Zeros" could put those notes to SGI, i.e., force SGI to purchase them, which would cost SGI approximately $245 million in cash or stock. Defendants knew, given the fundamental deterioration of SGI's business since the zero coupon notes had been sold and the serious problems actually adversely affecting SGI's business, that it was extremely unlikely that SGI would ever be able to pay the $455 million to retire them in 2013. SGI's cash position had deteriorated seriously during FY96-FY97, as the chart below shows:
44. They knew, even more certainly, that given the actual condition of SGI's business, SGI's stock would not be trading above $33 per share in 11/98 and thus, the put options would be exercised, placing SGI in a very precarious position, as it did not have the cash resources to be able to pay $245 million for the put in cash and if it was forced to issue common stock to pay for the put, it would have to issue so many millions of shares of SGI common stock that it would grossly dilute SGI's earning power going forward. Thus, finding a way to eliminate the risk of the exercise of the 11/98 put option of the zero coupon debentures was a matter of intense concern to McCracken, Kelly and SGI's other top executives.
45. In order to eliminate the risk of the 11/98 put options, it was necessary for the defendants to make it appear that SGI had regained its historic record of profitable growth so that its common stock would again appear to be an attractive long-term investment vehicle and to push SGI's common stock up to a price near enough to the $33 put option price so that the holders of the zero coupon convertible debentures could be enticed to exchange those debentures for other SGI convertible notes which did not contain such a threatening put provision for SGI.
46. During the 4thQ FY97, when SGI's top executives were taking steps to inflate SGI's reported 4thQ results, which they knew would have a very negative impact on SGI's FY98 results, especially in the first two quarters of FY98, Kelly and McCracken were already actively planning the exchange offer and working with Morgan Stanley, an investment banking firm, to structure the exchange offer to get rid of the zero coupon convertible debentures as soon as possible after they had driven SGI's common stock to a high enough level to make the exchange offer feasible. Then, just 10 days after SGI announced its surprisingly strong 4thQ FY97 results on 7/24/97, and its stock enjoyed its biggest one-day increase in history, climbing by 50% in one day to $27 per share, SGI quickly commenced the exchange offer for the zero coupon debentures it and Morgan Stanley had been planning and working on for several weeks.
47. SGI's Treasurer, Bob Seltmarsh, admitted that "We decided not to wait until November 1998 when someone had a gun to our head," and that the exchange offer "is a prudent thing to do given . . . that we could have a put exercised in November 1998." An analyst observed, "The purpose of the exchange deal is to refinance the zeros and make a preemptive offer to take away the risk of the Company's having to pay the put to holders in November of 1998." Moody's noted that "The company has commenced the tender and exchange to . . . avoid the related cash outlay and/or dilution that may occur if it becomes obligated to repurchase the zeros at accreted value as early as Nov. 2, 1998 under the terms of a put option reserved to the holders."
48. Because of the strong performance of SGI stock during the 8/4/97 and 9/4/97 exchange-offer period when the stock traded between $24-13/16 - $29-15/16 per share, the exchange offer was a tremendous success -- 98% of the zero option debentures containing the dangerous put provision were exchanged for the new SGI convertible debentures without the put provision. This exchange offer could not have been successfully pursued or concluded absent the apparently successful turnaround of SGI's business as evidenced by the 7/24/97 announcements and the resulting sharp increase in SGI's stock to close to $30 per share.
49. Due to the poor and below expectation performance of SGI's business during FY96 and the first three quarters of FY97, SGI's top executives had not received any payments under the SGI executive incentive plan which provides for bonus payments to executives dependent upon SGI's financial performance meeting certain predetermined levels of revenues and/or profits. After SGI suffered losses during its first two quarters of FY97, i.e., the 9/30/96 and 12/31/96 quarters, in 1/97, SGI significantly lowered the target level of performance for SGI's 4thQ FY97 so that SGI's top executives would be able to collect large incentive bonus payments for themselves when they artificially boosted SGI's results for that quarter to levels well above the newly lowered targeted levels they had set. As a result, McCracken, Lauer, Coleman and Kelly received incentive bonus payments of $203,438, $138,600, $63,875 and $64,094, respectively, based on SGI's apparently very strong 4thQ FY97 results. In fact, the 4thQ FY97 was the only time period during which SGI's top executives, including the Individual Defendants, received any payment whatsoever under the SGI executive incentive plan during the prior two years!
50. The Individual Defendants held options to purchase hundreds of thousands of shares of SGI stock, and some of them also owned SGI stock. However, the value of their options and SGI's stockholdings had been greatly reduced by the large decline in SGI's stock that had occurred in FY96 and FY97. As a result, between 1/1/96 and 7/24/97 -- a 19-month period -- only two of the Individual Defendants sold any shares of SGI stock -- and they sold a total of only 5,000 shares for $142,000. By artificially inflating SGI's stock during the Class Period, the Individual Defendants restored significant value to their stock options and shares and four of the six Individual Defendants (Lauer, Coleman, Orton and McBride) then undertook to illegally trade on inside information and personally profit from the artificial inflation in SGI stock by selling off 286,584 shares of SGI stock, pocketing $7.4 million in illegal insider-trading proceeds -- each selling of 100% of the SGI stock they acquired during the Class Period! These defendants would have sold more shares if they could have; however, because they knew that the San Jose Mercury News reports the insider selling of public companies in that area each Monday morning and many online services now track and report the stock transactions of insiders, they realized that if they sold any significant amount of shares, their selling would likely attract attention and generate negative comment as being inconsistent with the apparent business and financial recovery of SGI and its improving prospects for the future, and likely undermine the scheme they were pursuing. Given the intense scrutiny on McCracken and the fact that Kelly had just become CFO of SGI, neither of them sold stock during the Class Period, as to do so would clearly attract negative attention and be seen as inconsistent with the strong future for SGI they were forecasting.
51. The statutory safe harbor provided for forward-looking statements under certain circumstances does not apply to any of the allegedly false forward-looking statements pleaded in this Complaint at ¶¶62-69, 74, 76, 78, 80 and 81. Nor was it stated that actual results "could differ materially from those projected." Nor did meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statements accompany those forward-looking statements. To the extent that the statutory safe harbor does apply to any forward-looking statements pleaded in ¶¶62-69, 74, 76, 78, 80 and 81, the defendants are liable for those false forward-looking statements because at the time each of those forward-looking statements was made the speaker actually knew the forward-looking statement was false and the forward-looking statement was authorized and/or approved by an executive officer of SGI who actually knew that those statements were false when made.
52. Each of the defendants is liable as a participant in a fraudulent scheme and course of business that operated as a fraud or deceit on purchasers of SGI stock, including false and misleading statements and/or concealed material, adverse facts. The scheme: (i) deceived the investing public regarding SGI's business; (ii) artificially inflated the price of SGI stock; (iii) caused plaintiffs and other members of the Class to purchase SGI stock at inflated prices; (iv) permitted four of the Individual Defendants to sell approximately 286,000 shares of SGI stock at as high as $28 per share, pocketing some $7.4 million in illegal insider-trading proceeds; (v) permitted the Individual Defendants to receive hundreds of thousands of dollars in executive incentive bonuses based upon SGI's apparently very strong 4thQ FY97 results; and (vi) successfully brought about the exchange of 98% of the outstanding zero coupon debentures with their 11/98 put feature for new SGI debentures without that put feature.
53. For years, SGI was viewed as one of the world's most highly regarded high-technology companies -- a computer manufacturer noted for its advanced technology and state-of-the-art "hot box" graphics computers, which consistently reported strong annual revenue and EPS growth and enjoyed exceptionally high profit margins due to the premium prices its products commanded. This resulted in a very favorable public image for SGI and its high-profile Chairman and CEO, McCracken, who epitomized the successful entrepreneurial high-tech executive and emerged as a spokesperson for the high-tech business community in Washington, DC.
54. However, during SGI's fiscal year ended 6/30/96, SGI came upon hard times. Due to management mistakes which led to component part deficiencies, SGI failed to timely introduce important new products in the 2ndQ and 3rdQ of FY96 and suffered a significant erosion of its competitive position vis-à-vis Sun Microsystems and Hewlett-Packard. As a result, SGI reported financial results well below its forecasted expectations, resulting in a substantial decline in SGI's common stock, which fell from $45-5/8 per share in 7/95 to $23-1/8 per share near the end of FY96, in 6/96. This caused increasing criticism of SGI and its top executives by securities analysts, many of whom believed SGI had deceived them about its business and prospects during FY96 and called into question McCracken's managerial competence and his leadership of SGI. While McCracken and SGI continued to assure the investment community that the problems affecting SGI were transitory and that the Company was overcoming those problems, during the first two quarters of FY97, SGI actually reported losses, as its competitive position in the high-end graphics workstation market continued to erode while its efforts to develop new computer server products were now delayed. Then, on 4/17/97, SGI reported its results for the 3rdQ of FY97, ended 3/31/97. SGI reported EPS of only $.06 -- far below its public forecasts and the investment community's expectations -- and SGI's stock fell sharply from $17-3/4 to $12-5/8 on 10 million shares volume -- a 28% one-day collapse -- to the lowest level the stock had traded at in many years. This resulted in a very adverse reaction among Wall Street analysts, the investment community and SGI's shareholders, who were extremely critical of SGI's consistently disappointing financial performance, its management teams, failure to execute and to successfully transition to SGI's new server line of products, as well as its inability to meet SGI's publicly forecasted results.
SILICON GRAPHICS POSTS 80% DROP IN NET INCOME
Silicon Graphics Inc. once again missed earnings expectations by a wide margin, posting an 80% drop in quarterly profit because of problems in shifting to a new computer line.
* * *
Silicon Graphics, which has missed analyst targets for several quarters, blamed the latest disappointment on the transition to a new line of high-performance computers, called Octane. . . .
"The most unfortunate part is that their credibility is once again severely damaged," said Daniel Kunstler, an analyst at J.P. Morgan Securities. "This is a major setback, and I'm not sure if investors are going to forgive them."
"Where is the revenue and where are the earnings?" asked one agitated analyst after seeing the earnings report. "This is how many quarters in a row (of disappointments)?"
* * *
Silicon Graphics . . . has been struggling for more than a year to regain its financial footing . . . .
* * *
"Nobody really has any faith in this company," one analyst said. "Nobody has any expectations."
The company has missed its quarterly earnings forecasts for more than a year as it struggles to make the new workstations, said Peter Lieu, an analyst at Adams, Harkness and Hill.
* * *
"This is the fourth consecutive major shortfall by SGI in the last year," Salomon Brothers analyst John Jones said in a note published this morning. Jones slashed his estimate for the fourth quarter in half, to 30 cents from 60 cents, and cut his investment rating on the stock to "hold" from "buy."
J.P. Morgan analyst Daniel Kunstler cut his rating to "market perform" from "buy," while Laura Conigliaro at Goldman Sachs cut her rating to "market perform" from "recommend list."
55. Many other analysts commented negatively on the credibility and competence of SGI's management:
Silicon Graphics $0.09 EPS result -- far short of the $0.27 consensus and our $0.33 -- is a crushing setback on the road to recovery of the company's earnings power. . . . In short, the company's credibility has been dealt a severe blow. Also, SGI is now two full quarters behind in crossing our most critical milepost: a resumption of strong revenue and earnings momentum with the transition woes relegated to history. Accordingly, we are downgrading Silicon Graphics' stock . . . .
Another very disappointing P&L performance suggests that management must reestablish P&L credibility . . . .
[W]e remained concerned about SGI's ability to execute against its plan. Operational issues such as product transitions, sales force reorganizations, and manufacturing ramp-ups have hurt them in recent quarters. . . . We are reducing our estimates for FY97 from $0.85 to $0.50 and for FY98 from $1.45 to $1.30. . . . [W]e are maintaining our wait-and-see approach at this point owing to a series of operational hitches over the past two years, which have resulted in a stream of cuts in earnings estimates.
-- SGI reported exceedingly poor F3Q results of $0.09 in EPS on $909M in revenue, markedly missing our and Street estimates.
* * *
-- We are lowering our estimates for FY 1997 to $0.50 EPS down from $0.90 and for FY 1998 to $1.25 from $1.75, based on revenue and margin concerns. . . .
* * *
-- Manufacturing issues continued to be a key cause of the miss. New core midrange Octane product was released to manufacturing late in quarter, and the Company was unable to ship units to original forecast. International markets were also weak.
* * *
We also remain concerned about management's inability to forecast near-term (or longer-term) financial models . . . .
-- SGI blew another quarter, in our view, as execution problems continued and demand softened overseas.
* * *
-- The company's strategic position has weakened, forcing the inevitable comparison to Apple . . . .
* * *
SGI has frittered away a year in which demand was good but the company couldn't get products to markets. As execution gets fixed (we suggest CEO Ed McCracken could use a tough COO), strategic issues arise.
Conclusion: SGI did it again, which is to say they didn't meet expectations for revenues or earnings.
* * *
[W]e are sharply reducing our 4Q97 and FY98 estimates and downgrading the rating to Hold from Buy. . . . [W]e believe the issue goes beyond the numbers to one of no longer being able to give the company the benefit of the doubt based on its products and historically good franchises.
56. In late 4/97, Lehman Brothers described this situation in a report:
Silicon Graphics has been one of the poorer performing technology stocks over the past two years as its share price has declined from a high of $45 per share, two years ago to today's price level of $13. Heading into fiscal 1996, Silicon Graphics was a "darling" of Wall Street and commanded a premium multiple to earnings. With its disappointments over the past two years the shares have been hit quite hard.
* * *
Through fiscal 1995, SGI appeared to be one of the most dynamic companies within the computer industry with revenue growth and overall gross margin far exceeding most competitors. . . . At that point in time, it appeared that the 3-D graphics and visualization market offered unending dynamic growth, and SGI seemed to be fully exploiting its industry position.
As it turned out, the unending momentum began to fade early in fiscal 1996 and proved the beginning of difficult times for SGI. The growth that management anticipated did not occur. Part of the problem was due to internal difficulties such as delays in certain chips and product rollouts, as well as significant transition issues within its sales force. In addition, competitive pressures increased as other vendors including Hewlett-Packard, Sun, and DEC, as well as PC vendors utilizing 3-D graphics cards, competed more effectively in the marketplace. Accordingly . . . it . . . did not meet either internal management plans or expectations of Wall Street. The company has now reported seven consecutive quarters of disappointing results and its shares have languished. In our view, the company must begin to demonstrate renewed growth for investors to again believe in the story.
57. SGI's stock collapsed upon SGI's announcement of its very disappointing 3rdQ FY97 report, falling from $17-3/4 on 4/18/97 to $12-5/8 -- a 28% one-day drop on 10 million shares volume, the largest one-day stock drop and largest one-day stock volume in SGI's history up to that point. SGI stock was selling at the lowest levels it had sold at in years. In an effort to stem the decline in SGI's stock following the release of its very disappointing 3rdQ FY97 results, on 4/28/97, McCracken began a campaign to try to reassure analysts and investors. For instance, he attended the huge Hambrecht & Quist Technology Conference in San Francisco, California and made a presentation to the assembled securities analysts, money and portfolio managers, brokers, institutional investors and stock traders. McCracken stated:
Reuter's Financial Services reported McCracken's remarks on 4/28/97:
Silicon Graphics Inc.'s 1998 revenue could rise 20 percent, led by strong server sales, in 1998, the computer maker's chief executive said.
Silicon Graphics' operating income will grow by better 10 percent in the same period, Ed McCracken, chief executive officer, told investors at the Hambrecht and Quist Technology Conference here.
* * *
"We have the opportunity to grow our (server) business 50 to 100 percent in the next few years" McCracken said. Supercomputers and desktops will not grow as fast. "You average those out, we can expect a 20 percent rate in 1998," he said.
58. On 5/5/97, Stanley J. Meresman, SGI's long-time CFO (eight years), resigned. So did Michael Ramsay, SGI's Senior Vice President in charge of desktop graphics sales. They supposedly left the Company to pursue other interests. SGI presented these resignations as part of a corporate restructuring that was positive for SGI and would lead to a streamlining of SGI's management team and more efficient operations. On 5/5/97, Reuter's Financial Service reported:
Silicon Graphics Inc. chief executive officer Edward McCracken said he expects nice growth in revenues for this year's fourth quarter over last year's fourth quarter.
* * *
"We've had some issues with product transition. About 80 percent of what we're shipping is new. I think we're coming out of the other end," McCracken said.
59. On 5/15/97, McCracken again spoke to Reuter's Financial Service. His interview was reported:
McCracken said the company, which has reported a string of quarterly earnings disappointments amid a major product transition, now appeared to be picking up steam.
"We are gaining momentum," he said.
The CEO, who last week told Reuters he expects nice growth in revenues for this year's fourth quarter compared with the company's year-ago levels, declined to elaborate.
60. During SGI's 4thQ FY97, especially after Meresman left the Company in early May, McCracken and his cohorts exhorted SGI's sales personnel to push every possible product out the door before the end of the 4thQ so that SGI would be able to report extraordinarily strong revenue, net income and EPS for the 4thQ that would greatly exceed the prevailing forecasts, knowing that this would enable SGI to meet its internal and recently downwardly revised 4thQ financial targets necessary to trigger payments under SGI's executive incentive program and would also cause SGI stock to soar to artificially inflated levels. In order to achieve this end, McCracken and the other Individual Defendants arranged for many of SGI's customers to accept shipment of SGI servers and graphics workstations products well in advance of when they were scheduled to accept those products, promising them that in return for such early acceptance, SGI would give them large price discounts or very generous payment terms, stretching out payments much longer than would otherwise have been the case. In some instances, SGI also promised its distributors and other customers that in return for accepting larger shipments of SGI products than they wanted or needed, they would not have to pay for those products if they decided they did not want to keep them or they were unable to sell them and that, in any event, they did not have to pay for those products if and until they resold them.
61. At the same time that McCracken and the other Individual Defendants were manipulating SGI's 4thQ financial results upward, they began to work very closely with the investment banking firm of Morgan Stanley to prepare to quickly pursue an exchange offer to get the holders of the zero coupon debentures to exchange them for a new SGI debenture without a put provision as soon as they could after the 4thQ FY97 results were announced and SGI's stock soared higher. As SGI began to prepare to announce its 4thQ FY97 results in mid-7/97, it learned that the Business Week exposé on McCracken and SGI was nearing publication, would be a cover story and that it would appear in the 8/4/97 edition which they knew would hit the streets on Friday afternoon, 7/25/97. Thus, McCracken and the other Individual Defendants timed the release of what they knew were going to be extraordinarily strong 4thQ FY97 results to occur after the close of NYSE trading on Thursday, 7/24/97, so that those results, and the extraordinarily positive conference call McCracken and Kelly would hold with securities analysts after the release of SGI's results on Thursday afternoon -- would all occur in front of the Business Week exposé and thus dilute the otherwise very negative impact that exposé would undoubtedly have on SGI's common stock.
62. On Thursday, 7/24/97, after the close of NYSE trading, SGI reported its 4thQ 1997 results via a release that stated:
SILICON GRAPHICS REPORTS FIRST BILLION DOLLAR QUARTER; NEW 'O SERIES' PRODUCT LINE FUELS REVENUE GROWTH
Silicon Graphics, Inc. . . . today announced results for its quarter and fiscal year ended June 30, 1997.
The Company's $1.2 billion in revenues marked its first billion dollar fiscal quarter and represented a 28% increase over the quarter ended March 31, 1997. Revenue growth was balanced across the company's business units and was especially driven by the success of the Octaneô workstation and Originô 2000 scalable server families.
"This quarter was all about execution," commented Edward R. McCracken, chairman and chief executive officer. "Our product transition is complete . . . most importantly, the new products are finding strong acceptance with customers. We are entering the new fiscal year with our entire organization aligned to build on this success and we are encouraged by our prospects for fiscal 1998."
* * *
Net income for the quarter increased to $102 million, or $0.56 per common share, compared with a net loss of $49 million or net loss of $0.30 per common share in the year ago quarter.
63. Also, after the close of trading on 7/24/97, SGI held a conference call for securities analysts, large SGI shareholders, money and portfolio managers and institutional investors during which McCracken and Kelly made presentations:
64. On 7/24/97, the Dow Jones News Service, after interviewing McCracken and Kelly, reported:
Silicon Graphics Sees "Mid-Teens" Rev Growth in FY98
Silicon Graphics Inc. saw rebounding fourth-quarter business in its server and workstation lines, as it appears to have worked through its transition to new products.
The Mountain View, Calif., computer maker also said it anticipates "mid-teens" percentage revenue growth in fiscal 1998. The company's fiscal 1998 goal as well is an operating margin of 10%, down slightly from 11.7% in the fourth quarter.
Demand in core markets is doing well, especially in the company's fastest growing product category -- business, or enterprise, servers -- said William Kelly, acting chief financial officer.
65. On 7/24/97, Bloomberg Financial Service reported:
Silicon Graphics, Inc. said fiscal fourth-quarter profits from operations rose 52.5 percent, beating analysts' expectations, on strong sales of new computer lines. . . . [P]rofit . . . rose to . . . 59 cents a share, in the quarter ended June 30 . . . . Silicon Graphics was expected to earn 35 cents a share . . . .
The company said revenue rose 19 percent from a year ago on strong demand for its new work stations and server computers. Higher sales in part reflect growth in demand for top-of-the-line servers among Internet service providers and other telecommunications companies, the company said.
"Servers that can handle huge amounts of data -- that's where the growth is for us," said Bill Kelly . . . acting chief financial officer.
Silicon Graphics is also experiencing strong sales of its new graphics work station line to manufacturers that use computer-aided design, the company said.
"The new products are finding strong acceptance with customers," said Edward McCracken, the company's chairman and chief executive, in a statement.
66. The morning edition of The Wall Street Journal on 7/25/97 reported:
Silicon Graphics Inc. blew past analysts' expectations with quarterly results that gave strong evidence that the computer maker has finally pulled out of a lengthy slump.
* * *
Investors responded quickly to the news, bidding up Silicon Graphics' shares by $3.88 in the first few minutes of after-hours trading following release of the report. Before the numbers were released, the stock surged 24%, or $4.50, to $23.25 in composite trading on the New York Stock Exchange.
Silicon Graphics is a onetime Wall Street darling . . . . But the company lost much of its luster in recent years, first when its growth rate slowed and later as it consistently missed sales and profit forecasts. It also stumbled in delivering a new line of machines, called Octane, much later than expected.
As a result, Silicon Graphics' stock is well off its all-time high of about $45, which was reach in mid-1995.
The most recent quarter was a success in large part because the new Octane systems finally began shipping in volume, though the company said that all of its other systems also did well. "This quarter was all about execution," Edward R. McCracken, the company's chairman and chief executive, said in a statement. "We are shipping our entire product line without significant constraints," he said, adding that the company was "encouraged by our prospects for fiscal 1998."
Another indication of the company's strong position is that the company had amassed a $537 million order backlog at the end of the quarter.
67. Early in the day on 7/25/97, Kelly was interviewed on the Bloomberg Forum and stated:
This is David Zielenziger of . . . . Bloomberg Forum. Talking to us is Bill Kelly, the acting Chief Financial Officer of Silicon Graphics Inc.
* * *
David: Silicon Graphics has reported that it seems to have turned a corner in the fiscal 1997 that ended on June 30th. Do you think that the company will be able to sustain the momentum both in the billion dollar quarter revenues and also keep making money?
Bill: Well, we think so. We have completed the product transition that has been occupying us for most of the last year. . . . and that's what enabled us to grow our revenues so strong and meet the customer demand. So, as we head into fiscal '98, we think we are moving into the right part of the product cycle and although our business is subject to some seasonal fluctuations and we're certainly not going to beat a billion dollars in the September quarter, we are on a year-on-year basis looking for a good growth rate in fiscal '98.
David: How about profitability? . . . Will profitability continue as we go ahead?
Bill: Uh, we believe it will. . . . [I]n the 4th quarter just concluded, we returned to what for us are more of our historical levels of profitability in the neighborhood of 12%. We set for ourselves a minimum sort of 10% operating profit target for fiscal '98 as a whole and we believe that's achievable.
68. During the morning of 7/25/97, Bloomberg reported:
Silicon Graphics Inc. expects to stay profitable because of strong demand for its computers, especially those that manage data on networks of PCs and the Internet, said William M. Kelly, acting Chief Financial Officer.
"We returned to what for us are more like our historical levels of profitability . . ." he said.
* * *
As a result, the computer company aims to boost its operating profit, or revenue left after the cost of doing business, to 10 percent of sales in the new fiscal year, said Kelly. He'd like to exceed it.
* * *
"We're looking for a very good growth rates in fiscal '98," said Kelly, the computer maker's senior operations vice president who was named acting CFO on May 5.
69. The morning edition of the San Francisco Chronicle on 7/25/97 reported:
Silicon Graphics shocked Wall Street yesterday with earnings far above expectations, sending its stock soaring . . . .
* * *
Acting Chief Financial Officer Bill Kelly called the fourth-quarter results "the first in a series of steps that will go a long way to repairing the credibility of the company."
Asked how SGI could have pulled such a stunning earnings surprise, . . . Company officials said . . . sales were spurred by strong demand for powerful servers and high-end desktop workstations.
70. As a result of SGI's extraordinarily strong 4thQ FY97 results, and its extremely upbeat conference call on Thursday afternoon, 7/24/97, with securities analysts, during the morning and early afternoon of 7/25/97, several major securities firms issued reports and advisories on SGI upgrading the stock and increasing the forecasted FY98 results for SGI. For instance:
Very Strong F4Q Results -- Smooth Execution, Strong Product Cycle Demonstrate Recovery Under Way -- Increasing FY 1998 and FY 1999 Estimates - Upgrading Rating to "Buy"
FY June: 1997A 1998E 1999E
1Q $0.07 $0.20 NE
2Q 0.01 0.32 NE
3Q 0.09 0.35 NE
4Q 0.56A 0.68 NE
Fiscal Year $0.73 $1.55 $1.85
SUMMARY
-- F4Q performance exemplary: SGI results of $1.16B (sales) and EPS of $0.56 far exceeded our estimates of $985M and $0.32. No execution miscues, ramping new product cycle and strong GM expansion provided the "high octane" punch this quarter.
-- Overall, sales (pro forma Cray) were up 19% Y/Y; Cray business and manufacturing verticals strong; graphics workstations recovering at high end.
-- Major gross margin expansion to 48.6%, 280 bp above our forecast on full production volumes and process improvements. Possible upside in further business process gains.
-- Increasing our EPS estimates based on clear business execution improvements with more likely to come. F1Q98 to $0.20 (from $0.12); FY98 to $1.55 (from $1.25); FY99 established at $1.85; CY97 to $1.17; CY98 to $1.65.
Fiscal Earnings/Share
6/98 1Q/98
1.56E $0.21E
Previous 1.25E $0.16E
Silicon Graphics had a superb quarter -- its first in recent memory -- coming in at EPS of $0.56 versus our $0.27 estimate and the Street's $0.35. While we have always maintained that demand was not at issue for the quarter, the $1.2 billion revenue number surpasses our wildest expectations. Also, SGI performed well up and down the P&L, turning in vast improvements in revenues, gross margins and expense control. So a big round of applause for SGI.
*** We are upgrading our rating on SGI . . . to Attractive: with strong demand for servers, the company reported better results than expected, showing significant operating leverage and executing better than it has in two years, leading us to raise our EPS estimates -- with the potential for further upside -- and our investment opinion. As we have seen with Sun, IBM, Compaq and other computer companies, demand for servers has been strong -- a trend which has extended to SGI after several quarters of shortfalls owing to problems with execution. Moreover, the company appears committed to improving its business processes and its balance sheet -- we are encouraged by its acknowledging these problems and committing to address them.
*** SGI reported a big upside EPS surprise in 4Q97 of $0.56 vs. $0.32 a year ago, well ahead of our estimate of $0.35 and the First Call average of $0.34 reflecting the completion of its product transition to the MIPS R10000 processor across the product line; strong enterprise server and high-end workstation sales (which carry higher margins); and well-managed operating expenses.
* * *
*** The company was quite optimistic about its outlook -- particularly in its ability to execute and sustain profitability. Management said that they are aiming for mid-teens revenue growth and operating margins at 10% for FY98. In the quarter just reported, the company exceeded that showing 19% revenue growth and 11.9% operating margin.
*** We raised our estimate for FY98 to $1.50 from $1.30 and initiated an estimate for FY99 of $2.00 reflecting our expectation that the company may be able to achieve its goals of mid-teen revenue growth and 10% operating margin going forward. Moreover, the company seems to have good control of operating expectations.
* Silicon Graphics reported EPS for the June 1997 quarter of $0.56, well above the street consensus of $0.34. Sales came in at $1.16 billion, also above consensus estimates.
* Improved availability of new workstations and servers allowed the company to meet prior demand, achieving higher sales volume and much better profitability. Bookings lagged sales; the book to bill ratio for the quarter was .84. Backlog dropped to a more manageable level.
* Management gave sales and operating profitability guidance for fiscal 1998 well above our forecast. As a result, we are raising our FY98 EPS estimate to $1.50 from $1.10.
SGI reported notably stronger than expected results, with revenues of $1.162 billion, up 19%, and earnings of $0.56 a share, as compared with our estimates of $1.024 billion and $0.30 a share. We had assumed that the company could exceed our earnings estimates with a better gross margin (which they did based on a good product mix), but, in addition, SGI experienced substantially better sequential strength in its high-end graphics systems and in its server lines. While part of the strength in the quarter was undoubtedly the result of catching up on previous delivery difficulties, such as for the Octane, new orders in absolute terms showed a $125 million sequential gain to about $975 million and the company has begun to get its hands around the execution issue, which had been a main factor in the prior seven quarterly disappointments. . . . The company expects to make further improvements in the areas of forecasting, accounts receivable, order administration, and "quote-to-collect."
Total product revenues of $1.012 billion, up 21%, exceeded our forecast of $875 million, while service revenues of $150 million met our estimate. During the quarter, the company reduced backlog from 3Q97 by $172 million to $537 million, more than $300 million of which is shippable in 1Q98. SGI stated that its objective is to maintain backlog within a range of $300-$500 million, the bulk of which should be comprised of servers.
* * *
For FY98, we have increased our forecast to revenues and earnings of $4.33 billion, up 18% and $1.65 a share, from a prior estimate of $4.28 billion and $1.50 a share (during its conference call last night, the company guidance for FY98 reflected "mid-teens" revenue growth, a 49% gross margin, and a 10% operating margin for the year). In addition, we have initiated an FY99 estimate with revenues and earnings of $5.05 billion, up 17% and $1.95 a share. . . [T]he results were too good to ignore, and we have restored the Buy rating on SGI . . . .
The transitions are finally over and management is very focused on executing to a profitable business model in fiscal 1998, which, given the recent past and conservative guidance, should provide plenty of room for upside surprises.
The official guidance on the conference call for fiscal 1998 indicates revenue growth of 15%, 49% gross margin, and 10% pretax operating margin goals, yielding EPS of $1.45 . . . given the strong demand for the high-margin Origin 2000 servers and Octane power desktops . . . .
* * *
Better management execution should produce reasonable growth of 15%-20% over the next several years. Management is upgrading its business process and improving asset management efficiency.
71. Later in the afternoon of 7/25/97, the 8/4/97 edition of Business Week, containing the cover story exposé of SGI and McCracken, hit the streets. The cover of Business Week stated:
THE SAD SAGA OF SILICON GRAPHICS -- Its Gee-Whiz Computer Graphics Brought Fame And Fortune, But Now Dogged By Troubles, Its Market Value Has Dropped By Half. Here's The Untold Tale of What Went Wrong. Can CEO Ed McCracken Fix Things?
The article was headlined and stated:
THE SAD SAGA OF SILICON GRAPHICS
What went wrong at the company that once made everybody say: "Gee Whiz"
Back in July, 1995, no computer maker was flying higher than Silicon Graphics Inc. Its dazzling three-dimensional graphics computers had a starring role animating the fearsome dinosaurs in Jurassic Park. Nintendo was using the same technology to give the Mario Brothers a face-lift and to design a new generation of arcade-like game machines. And sales were soaring. For the fiscal year ended that June 30, revenue skyrocketed 45%, to $2.2 billion -- far outpacing all rivals. To top it off, CEO Edward R. McCracken was a White House regular, hobnobbing with Bill Clinton and Al Gore. SGI's sexy image prompted a Wall Street analyst to label it "the new Apple."
Sadly for SGI, that may prove all too true. Now, like Apple Computer Inc., the Mountain View (Calif.) company is a stark anomaly in booming Silicon Valley. While rivals such as Sun Microsystems Inc. ride the Internet wave and even IBM enjoys a comeback, SGI has been mostly an onlooker at the tech party. After racking up losses of $35 million in the first half of this year, the company managed to carve out a profit for the 1997 fiscal year ended in June, thanks to a strong fourth quarter. . . .
Gee whiz! What happened? . . .
. . . SGI executives got drunk on their own success. They dashed into glitzy new markets such as supercomputers, interactive cable TV, and digital film studios while barely tending to their bread-and-butter computer business, which produced machines late, incomplete, or dead or arrival. And basics such as marketing, inventory management, and quality control were far too mundane for the company that whipped up computer-animated raptors and a Tyrannosaurus rex.
Indeed, interviews with more than 85 people inside and outside SGI reveal a company that lost touch with basic business practices.
* * *
STERN WARNING. Now, McCracken is on the hot seat. At a board meeting last January, directors urged him to restore SGI's momentum. They didn't set a deadline, but insiders say the board is growing impatient with the stream of quarterly disappointments. "The buck has to stop with Ed," says board member C. Richard Kramlich, managing general partner at venture capitalist New Enterprise Associates. "If Ed's not qualified to lead the company, we'll know very soon."
. . . McCracken took his eye off the ball during his 1994 Washington sojourns. Then early last year, after his 11-year marriage began to sour, he began a public relationship with a young SGI employee. Their displays of affection shocked some workers. Says a former colleague: "When people are walking around in a funk, and Ed is walking around with stars in his eyes, they say, 'What's going on here?'
* * *
. . . SGI's long-term future is in doubt. . . .
* * *
How did SGI get to this sorry place? The roots of the company's ailments stretch back more than three years, when business was humming, SGI was the star of Silicon Valley, and high tech was a hit in Washington. On Jan. 6, 1994, McCracken--an introspective former Hewlett Packard Co. exec who likes to practice and teach meditation--was named co-chair of Clinton's National Information Infrastructure Advisory Council. Soon, he was deep into Washington politics, . . .
* * *
In July, 1995, out came the Indigo2 IMPACT workstation line for the technical market, and SGI boldly predicted it would feed $1 billion into company coffers. At the same time, engineering teams were scrambling to ready a slew of workstations and servers for its biggest product introduction ever, planned for January, 1996. But the path to the new-product introduction ever, planned for January, 1996. But the path to the new-product introduction took a nasty turn. On Oct. 19, SGI announced lower-than-expected revenues for the first fiscal quarter. McCracken said the problems were temporary, blaming them on a sales-force shakeup and assuring analysts that he expected sales to grow 40% for the fiscal year.
The real problems ran far deeper. Even at $2.2 billion, SGI was a corporate adolescent. For one thing, engineers and salespeople constantly pushed the envelope--and sometimes tore it. For instance, SGI tapped Toshiba Corp. to make key graphics chips for the Indigo machine, though Toshiba had never made them before. What's more, Toshiba execs say the chips required leading-edge design and manufacturing technologies. The result: The chips took longer than expected to produce, leaving big shortages.
* * *
SGI's growing turmoil was taking a toll on many employees, who bailed out in droves. . . . By spring, 1996, turnover had doubled, to nearly 20%. . . . [A]t least 16 of 43 top execs have left or were pushed out in the past two years. One executive recruiter stopped trying to tap talent from SGI four months ago. "There's nobody left," he says.
Why the big exodus? Managers and employees who thrived on SGI's go-go culture--and others who joined because it was hot--saw a brighter future at hordes of Internet and other startups. Others tired of what one former employee called the frat-house atmosphere. That side of SGI's culture reached a nadir, insiders say, at a July, 1996, European sales conference in Mallorca that attendees are still buzzing about. Several eyewitnesses say a number of managers and executives had too much to drink and caroused late into the morning.
McCracken heard the tales, too. He says he looked into the incident but never determined whether anything untoward happened.
* * *
In the spring of 1996, McCracken separated from his 48-year-old second wife, whom he had met in SGI's human-resources department before they were married in 1985. The split left both struggling to meet expenses, according to court filings. McCracken, who didn't get a bonus last year, had to liquidate assets and borrow money to pay expenses before the divorce became final this past June 18.
But what made the slip news inside SGI was McCracken's new relationship. McCracken began to date a young woman, who, as his wife once did, worked in SGI's human-resources department. McCracken did not try to hide their involvement: They displayed each other's photos on their desks and were kissing at an SGI party for customers and employees at last summer's Siggraph graphics industry conference in New Orleans.
* * *
Once McCracken took over daily operations, he realized how bad the problems were. In July, SGI started getting alarming calls from customers: Their new SGI computers would sometimes shut down without warning. Engineers found a flaw in the new microprocessors and traced it to a production problem at the maker, Japan's NEC Corp. NEC says it replaced every one of the chips--which were scattered around the world in some 4,000 systems. Still, it cost SGI a cool $10 million to send out field engineers to make the replacements.
* * *
Now, it seemed, SGI was in free fall. After reporting another poor quarter on Apr. 17, the stock plummeted 24%, to 12 7/8, its lowest point in more than four years. SGI's board had had enough. . . . "You bet your life that as time has been going on we've been asking harder and harder questions," says board member Robert A. Lutz . . . . "The company was continually overwhelmed by events. At some point, things have to improve."
72. The 8/4/97 edition of Business Week even contained a negative editorial about SGI, which stated:
In Silicon Valley (to paraphrase Leo Tolstoy), successful companies are all alike, while every unsuccessful company is unsuccessful in its own way. . . . Look at Apple Computer Inc., . . . which has had a long and painful corporate unraveling that recently was capped by CEO Gilbert F. Amelio's departure. Equally startling is the abrupt free fall at Silicon Graphics Inc. Here was a company that had everything going for it: cutting-edge workstations, ballooning revenues as recently as two years ago, and a chief executive who was a White House regular. . . .
But . . . even in Silicon Valley, . . . there is no place for hubris in a hotly competitive, constantly evolving marketplace. Flexibility, adaptability, and nimble shifts in strategy assure success. While SGI sold its vaunted workstations, PC makers were making more and more powerful machines, which are catching up fast with a lower-cost business model. And while SGI waded into new markets such as interactive TV, the Internet revolution was capturing the attention of dozens of neighboring companies in the Valley. Amid these challenges, SGI's chief executive was having an office romance, while other managers engaged in behavior more appropriate to a frat house than a corporate office. . . . [B]ad strategy at SGI combined to pull the company down . . . . It's a sorry tale, and a cautionary one.
73. Because SGI had timed the release of its manipulated 4thQ FY97 results for the day before the negative Business Week exposé hit the streets, the defendants not only blunted what otherwise would have been the very negative impact of that story on SGI's stock but they also drove the stock higher to inflated levels which was a key part of their scheme. On 7/25/97, SGI's stock exploded on the upside, reaching $27 per share, up $8-3/8 per share from its low of $18-5/8 on 7/24/97 -- a 45% one-day price increase on 15.8 million shares volume -- the largest one-day stock price increase on the largest one-day stock volume in SGI's history as a public company.
74. Now the defendants kept up their drumbeat of favorable publicity about SGI to support the stock price. The 8/11/97, edition of Business Week -- issued a week later -- contained a letter from Lauer that stated:
It is ironic that "The sad saga of Silicon Graphics" (Cover Story, August 4) hit the stands the day after the company announced the best quarter in its history: well over $1 billion in revenue and strong profitability.
Most of the story missed the point of where Silicon Graphics is today. Yes, Silicon Graphics has had problems over the past couple of years. We recognized those problems, accepted responsibility, and our management team has been working hard to address them. Very strong actions have been taken, and we are beginning to see the results, as evidenced by our outstanding fourth quarter.
We are very optimistic about this coming year and beyond. This quarter was a reflection of the new Silicon Graphics' ability to execute. Our product transition is complete. We are shipping our entire product line . . . and, most importantly, the new products are finding strong acceptance with our customers. Our entire organization is aligned to build on this success as we enter the new fiscal year.
75. The enormous, unprecedented increase in SGI's stock price in late 7/97 was the key step in defendants' scheme. Just a few days after the startling announcement of 7/24/97, on 7/30/97, SGI revealed it would pursue an exchange offer to exchange new senior convertible debentures for the $200 million of its currently outstanding zero coupon convertible subordinated debentures. On 8/7/97, the formal exchange offer commenced, to expire 9/4/97. Defendants worked to keep the SGI stock price inflated during the exchange-offer period.
76. In early 8/97, SGI stock again advanced strongly as information circulated that SGI would make a very positive presentation at the Siggraph trade show for graphical computing in Los Angeles. For instance, on 8/4/97 the following ran on the Dow Jones News Service:
Shares of Silicon Graphics Inc. added 9%, possibly on anticipation of an upcoming trade show in Los Angeles. The company will be presenting this week at Siggraph, a leading trade show for graphical computing. Silicon's chairman and chief executive, Edward McCracken, appearing on CNBC earlier, said the company will be making a series of announcements at the show. . . . The executive also said on CNBC that he hopes for revenue growth of 15% next year, and profits to grow "considerably faster than that."
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Silicon Graphics' NYSE-listed shares were recently up 2-1/4 . . . .
77. As SGI's stock soared higher in the wake of SGI's extraordinary 7/24/97 announcement and forecasts, on 7/29/97 and 8/4/97, McBride and Lauer sold 156,000 and 60,000 shares of their SGI stock, respectively, at between $24-1/2-$27 per share, immediately after acquiring those shares via option exercise, thus cashing in on the inflation in SGI's stock price which their false statements and manipulative conduct had caused. Then, as SGI's stock moved higher in anticipation of what SGI's insiders "whispered" to analysts would be an extremely positive analysts conference on 9/5/97 at SGI's headquarters, Orton and Coleman on 8/28-29/97 sold off 40,584 and 30,000 shares, respectively, of their SGI stock at $27-$28 per share, pocketing $1.1 million and $834,300, respectively, selling off all the shares of SGI stock they a