The Cloud Conundrum: SGI Scales Back on Cloud Sales

SGI-InfiniteStorage-17000

Amazon is among the customers for SGI's Infinite Storage. Some units are shown above.

Could cloud giants like Amazon buying $139 million a year in hardware from a vendor be a bad thing? That's the question facing SGI, the hardware vendor with a long legacy in the hyperscale market, which has recently been focusing its business on the technical computing market.

SGI's recent earnings illustrate the challenge the hyperscale market presents for server vendors. Cloud builders like Amazon, Microsoft and Facebook buy an enormous number of servers. But they also use their purchasing power as leverage in obtaining volume pricing from their vendors, and that's usually not good for profit margins.

SGI never mentioned Amazon by name in last week's earnings call. But executives noted that the company saw surprising revenue growth from its "largest legacy cloud customer," which saw its sales soar to $139 million, or 18 percent of SGI's total revenue.

"This significantly exceeded our expectations entering the year, reflecting a high rate of demand growth for this particular customer," said Jorge Luis Titinger, the CEO and President of SGI. "While the top line achievement was positive, continuing to grow in this segment requires committing to an aggressive cost-down trajectory that is increasingly unattractive.

Scaling Back on Cloud Deals

"Our strategic focus is to invest in verticals where we can provide differentiated value that commands gross margins in line with our business model and to pull away from market segments that are commoditizing," he continued. "We therefore are planning on significantly lower revenue in the public cloud infrastructure going forward. However, we expect to more than offset the margin contribution of this segment with growth from higher-margin products and verticals."

Shrinking margins have been a historic concern for SGI. As Rackable Systems, the company was an early innovator in the hyper-scale computing space, developing half-depth servers deployed in back-to-back racks, and later "micro-slice" servers and the CloudRack, which pioneered concepts that have subsequently been adopted by the Open Compute movement. This helped Rackable build business among the largest Internet companies, including Microsoft, Yahoo, Facebook and Amazon.

But it soon felt the heat from other server vendors, most notably Dell's Data Center Solutions unit. Rackable continued to win deals, but saw its margins shrinking. So the company changed course, acquiring Silicon Graphics and shifting its focus to technical computing market, including HPC and supercomputing.

But Amazon has continued as a customer, and the spectacular growth of its cloud storage infrastructure has boosted its business with SGI, which has previously acknowledged Amazon as a customer of its Infinite Storage hardware. Amazon represented more than 10 percent of the company's business as of early 2011, and saw sales growth further in 2012.

SGI says that discussions in the last month have made it clear that sales to its "legacy cloud customer" will decline, and the company has reduced guidance on cloud infrastructure sales by $25 million to $30 million this quarter. While that has short term implications for its revenue guidance, the company says it expects to make up that lost revenue with higher margin deals in the technical computing space, a strategy that has boosted the company's fortunes since it rebranded as SGI.

"To the extent that it starts to displace potentially larger-margin business, it strategically makes sense for us to consciously not want to pursue it with the kind of enthusiasm, perhaps, that one might want to chase just for the size of the revenue dollar itself," said Robert Nikl, SGI's Chief Financial Officer, on the earnings call.

SGI isn't alone among server vendors wrestling with margins on high-volume deals with cloud customers. Dell and HP have been meaningful players in this market, but have also expanded into cloud hosting, using its cloud-optimized designs to power direct services to their own customers - a strategy that likely offers a better return on cloud hardware than highly-competitive bulk sales to cloud builders.