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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. Still, the stock, even after bouncing up from its low of 12 7/8 last April to 18 3/4 on July 23, is at less than half of its value 24 months ago. Dubbed ''the gee-whiz company'' by BUSINESS WEEK three years ago, SGI is scrambling to stay off technology's long list of has-beens. Concedes McCracken: ''If we can't produce good quarters, we're not going to have a future.''

Gee whiz! What happened? A classic Silicon Valley tragedy, that's what. Like so many highfliers, SGI rocketed to fame and fast fortune on the wings of a snazzy new technology--in this case, powerful computer workstations and servers with 3-D graphics so realistic that they became the computer of choice for Hollywood filmmakers, engineers, and scientists.

But 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 on 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. Until recent months, poor planning often led to the company shipping products that generated a staggering 80% of its quarterly revenue in the last month of the quarter--leaving no margin for error. And like Apple, SGI gorged on fat profit margins, ignoring the lean, savagely aggressive personal-computer makers that were churning out ever more powerful machines and starting to steal SGI's customers. The company's share of the $12.7 billion workstation market has slipped to 12% in the first quarter of 1997, vs. 14% in 1995.

Perhaps most stunning are the missed opportunities. In early 1995, SGI was a front-runner on the Net, with its servers running such Web sites as HotWired and Virtual Vineyards. But by sticking too long with ill-fated interactive TV, it lost its Internet standing. Now, SGI is a Web also-ran, forced to watch as SGI co-founder James H. Clark cashes in with his Netscape Communications Corp. Just last year, SGI blew yet another opportunity: When its stock was one-third higher than today's price, say insiders, McCracken didn't pursue initial feelers from acquisition-minded Sun Microsystems, which stole SGI's panache and profits by turning its own interactive-TV efforts into the popular Net software Java.

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.''

Widely respected for helping SGI become one of the world's leading computer makers, 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?'''

Such distractions have not been limited to McCracken. Former President and Chief Operating Officer Thomas A. Jermoluk, once the charismatic leader who guided SGI through its go-go days, came under criticism for his freewheeling, work-hard, play-hard style.

Especially the play-hard part. While Jermoluk was the quintessential startup leader who even manned the manufacturing lines during crunch times, he was not one for structured, big-company business processes, or even a corporate demeanor. Jermoluk helped set the frat-house tone at SGI early. Jermoluk, for example, admits he and several colleagues once mooned SGI employees at one of the company's annual lip-synch contests. And on one occasion, says a former manager, Jermoluk was drinking and threw up at a poolside sales meeting in Hawaii.

For Jermoluk's part, he says he does not recall the incident. ''Am I guilty of getting drunk a few times?'' he asks. ''Sure. Probably inappropriately at times? Yeah. Did I party hard? Sure.'' But he also adds: ''Was I leading a wild life? No. I was working too hard, man.'' Even Jermoluk's critics say this never impaired his job performance, but such overindulgence by the company's No.2 rattled some employees' confidence. ''People aren't used to seeing the president get drunk,'' says a former executive.

Nor are they accustomed to seeing SGI flounder. What now? To be sure, SGI's computers still do things no others can match. Its most powerful graphics workstations, accounting for nearly a third of its sales, are still the front-runners for the most demanding 3-D animation. And its technical servers and supercomputers, which generate 35% of revenues, are tops for serious number-crunching.

Now, with long-delayed products finally starting to ship in volume, SGI may be on the road to recovery. In the latest quarter, reported on July 24, SGI showed decent improvement for the first time in nearly two years. By making progress on longstanding execution problems and finally shipping a backlog of orders for its bread-and-butter computers, SGI reversed its slide. With the stock far below its peak, analysts say that could boost the share price in the next few months.

What's more, McCracken thinks new business processes now being put in place, such as streamlining the time from quoting an order all the way through to shipping it, will pay even bigger dividends in coming quarters. Longer-term, he says, the Internet will spur more demand for powerful servers like SGI's to serve as commercial ''network hubs.''

Despite the latest quarter's improvement, SGI's long-term future is in doubt. McCracken's big dilemma: He either sticks to SGI's high-performance niche and gives up the chance for big spurts, or he radically changes SGI's business model to compete with commercial computer makers like Sun and the PC makers. But so far, SGI has produced no convincing answer to the PC threat. And Sun, IBM, Hewlett-Packard, and others have a big, perhaps unbeatable, headstart on selling to Corporate America. Co-founder Clark, who resigned in a huff three years ago, offers a bleak assessment: ''I think the company is headed for a potential disaster. SGI has squandered its advantage. Now, the PC has won. Game over.''

FADING STAR. McCracken and his team couldn't disagree more. Overall, McCracken says SGI can grow 15% to 20% a year--not bad, but a big comedown from the years of 36% and 45%. That's why SGI execs have spent the past nine months working with high-powered consultants such as Connecticut marketing wiz Jack Trout to craft a vision for SGI's future. ''Our marketing has sucked for 15 years,'' says McCracken. Yet beyond a me-too focus on large servers to run networks and a vow to listen more closely to customers, McCracken's vision is fuzzy.

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, helping craft government policies on communications technologies. Just a few weeks later, Clark--frustrated with his repeated failure to persuade McCracken and Jermoluk to come out with cheaper workstations--resigned to start the company that was soon to become Netscape. That left much of SGI's operations to Jermoluk, 37, who was appointed president on Feb. 2, 1994.

T.J., as he is known, seemed up to the task. A crack engineer at HP and Bell Laboratories, the hard-charging Jermoluk had quickly worked his way up SGI's ladder after joining as an engineer in 1986. Blond and lanky, Jermoluk soon proved a magnetic leader, whipping the troops into a frenzy at the company's frequent ''all-hands'' meetings. Says Pavan Nigam, former director of SGI's interactive TV project with Time Warner Cable: ''His macho, can-do, aggressive style got the whole company stomping its feet.''

Good thing--because he and McCracken were about to up the ante. At a posh seaside resort in Monterey, Calif., in May, 1994, some two dozen top executives huddled to set plans for the next fiscal year, starting on July 1. After the first day of discussions, McCracken and Jermoluk made the case that they should seize the chance to build a large company while they still could. At the time, Sun was moving away from SGI's niche engineering stronghold to workstations and servers for large corporate networks and IBM and Digital Equipment Corp. were struggling. Moreover, the Information Superhighway promised SGI fresh opportunities. ''Ed said to think out of the box and figure out how to grow 50%,'' recalls former Vice-President Way Ting, founder and CEO of software startup Pictra Inc.

That set off feverish activity within SGI to reach that goal, which quickly led to burnout and worse: Key evangelist John R. Mashey says he suffered a heart attack amid the constant travel. He has recovered, but the grueling pace left no time to look ahead. By December, 1994, when Time Warner and SGI finally launched a downsized digital cable-TV trial in Orlando eight months late, cable companies already were realizing that interactive TV wouldn't pay off. ''Interactive TV was dying, and the Internet was taking off,'' says John Danner, an SGI manager who left in 1995 to start Net advertising software startup NetGravity Inc. ''But SGI was still gung ho on I-TV.''

SGI didn't ignore the exploding Web. But after initial success running busy sites and selling the first dedicated Web servers starting in early 1995, SGI didn't invest much. By spring of 1996, there were fewer than a dozen business people in the division. And while Sun has made its Java software into a broad standard for creating Net applications, SGI's 3-D Net software has been slow to take off because of networking bottlenecks. As a result, SGI lost momentum to Sun, now the darling of the Net.

The Internet's singular potential should have been more obvious to Jermoluk than to anyone. In late summer, 1994, Clark had offered him the CEO spot at Netscape. But McCracken didn't want to lose Jermoluk, least of all to Clark. So to keep him, SGI offered the young president a new compensation package valued at $10 million-plus over four years. He stayed.

By then, SGI was facing a more fearsome challenge: the omnipresent PC. Souped-up desktops with off-the-shelf Intel chips and Microsoft's business-strength Windows NT were starting to do more of the complex graphics jobs that workstations using Unix software, such as SGI's, routinely tackled. But SGI, at Jermoluk's insistence, refused to support NT--he says it didn't offer SGI a way to set itself apart.

IN THE CROSSHAIRS. By mid-1995, however, none of those simmering problems had yet spilled onto the income statement. A week after its stock hit an all-time high of 44 7/8 on July 17, SGI reported a 58% jump in profits on a 45% rise in sales, to $2.2 billion, for fiscal 1995. To reward employees, SGI spared little expense: It hired Huey Lewis & the News for an all-hands meeting at the company in July and gave all 6,300 employees bonuses or a Swiss watch worth several hundred dollars. That still left plenty of cash to keep hiring 500 people a quarter and investing in new ventures--such as a $50 million joint digital studio with Steven Spielberg's DreamWorks SKG.

Success put SGI squarely in nearly every computer maker's gunsights. HP introduced higher-performance 3-D graphics workstations, and Sun wasn't far behind. So SGI had to run even faster. 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 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.

Worse, SGI's product divisions were so independent that they didn't bother coordinating introduction schedules. ''Things always got slammed into manufacturing in the last three weeks of the quarter,'' says a former manager. By the end of the year, the new workstation and server products stacked up, and manufacturing was overwhelmed. ''My team was quite frankly pissed off,'' says Stephen A. Goggiano, senior vice-president for worldwide manufacturing. Says Jermoluk: ''It was like trying to shove a pig through a snake.'' What came out wasn't pretty: December-quarter sales grew only 22%. Investors dumped the stock, driving it down 16%, to 23 1/4.

Customers were getting angry, too. One longtime SGI loyalist, Tektronix Inc.'s Color Printing & Imaging Div., dropped SGI and bought 100 new Sun workstations instead. Why? Engineering Support Manager Andrew Finkbeiner didn't believe SGI salespeople's insistence that they would ship on time. Up until then, says Finkbeiner, SGI's machines were so much better that he put up with late delivery, frequent breakdowns, higher prices, and steep maintenance costs. Now, he says, ''there's no reason to put up with those things anymore.'' Meanwhile, Sun was going Hollywood. The company stole some of SGI's Tinseltown thunder by persuading Steve Jobs's Pixar Animation Studios to use 117 Sun computers, in addition to SGI machines, to help create the graphics in Toy Story.

Still, Jermoluk continued to run SGI as if it were a startup. Executives manned the factory late into the night the last day of each quarter, scrambling to get shipments out the door. ''I was there at the end of every single quarter until midnight,'' recalls Jermoluk, who did everything from soldering wires on computer boards to putting disk drives into systems to banding boxes for shipment.

LOOSE REINS. The hands-on management style that had worked for a much smaller company was slowing things down. Instead of changing the way components were supplied to SGI's product divisions to match the company's size, complexity, and sales, Jermoluk simply made all the decisions on which units would get which parts and when. ''I just used to do the whole thing myself because I could do it quicker,'' says Jermoluk. The board began to notice. ''Ed should have reined him in,'' says Kramlich. ''He was not disciplined with T.J., and that was a bad error.''

McCracken had other things on his mind. In early 1996, insiders say, Sun CEO Scott G. McNealy--fresh from trying to buy Apple Computer a few weeks earlier--contacted McCracken to discuss buying SGI. Neither will comment, but talks dissolved quickly. One SGI insider says that no formal offer was made, but SGI execs thought the company could fetch $65 a share; Sun was leaning toward $45 a share.

McCracken clearly preferred to play predator himself. On Feb. 26, SGI announced the purchase of supercomputer pioneer Cray Research Inc. for $767 million. In one stroke, SGI became the top supplier in the business of high-speed computing, gaining a seasoned sales force and a new customer base. But few people--especially inside SGI--thought the move really improved SGI's prospects. Analysts worried that the market for supercomputers was shrinking and that Cray would take a long time to digest without providing many new customers or addressing SGI's key challenge, ''Wintel'' workstations. ''Why buy a company that was doing poorly in a shrinking market?'' asks one exasperated former executive. McCracken says Cray has turned around and also provides SGI with leading-edge technology to trickle down into other SGI machines. But Cray quickly proved distracting at a time when SGI execs had their hands full getting their own house in order.

SGI's growing turmoil was taking a toll on many employees, who bailed out in droves. Two big departures at the senior vice-president level: Wei Yen, who ran the products and technology group, now at NCI Inc., an Oracle subsidiary, and Robert Burgess, who headed the Alias/Wavefront operation, now president of Macromedia. Meanwhile, other employees spied golden opportunities at Net startups that offered more attractive stock options and a brighter future. By spring, 1996, turnover had doubled, to nearly 20%. McCracken says it has since fallen to under 10%. However, at 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. Still, he says, he talked about it with other managers. ''We certainly spent a lot of time after that meeting discussing what is appropriate behavior,'' he says. ''It's really important that people trust the management of the company.''

Jermoluk wasn't the only executive employees were buzzing about. 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 split 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.

McCracken defends the relationship. ''I've done nothing to hide it from anybody,'' he says. After it started, he says, the woman switched to another job at SGI so she would be less involved in current employee matters. However, some employees say the relationship has eroded their trust and confidence in McCracken since she's still with the company.

To some staffers, it was one more sign that executives had lost their way. Indeed, after two more bum quarters, it was clear Jermoluk was having trouble getting the company back on track. On July 31 of last year, he left to become CEO of @Home Corp., a cable Net service. Jermoluk admitted his heart wasn't in SGI anymore: ''I'm a builder, less a sustainer.''

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.

That was just one sign that the company's basic processes--like quality control--were in tatters. Even SGI's new strategy to broaden its market by courting commercial buyers--such as Procter & Gamble and PepsiCo--was troubled. As it turns out, those customers tend to be conservative, preferring to wait until new products have been in the market for some time.

OVERWHELMED? Amazingly, SGI's demand-forecasting model hadn't factored that in, says manufacturing chief Goggiano. The result: So many customers bypassed the new machines and kept buying the older ones that SGI ran out of those by Thanksgiving. The shortfall put salespeople under even more pressure--with one glaring result. Late in 1996, SGI sold four powerful servers worth $650,000 to a Russian facility that designs nuclear warheads. Salespeople didn't bother to check out the well-known facility, which had simply changed its name to All-Russian Scientific Research Institute for Technical Physics. Assuming it was a research institute, SGI didn't apply for the normal government clearances. The company says it is cooperating with an ongoing federal investigation.

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. At its regular April meeting in Eagan, Minn., Cray's headquarters, they canceled a planned tour of the facilities to nail down financial goals. ''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, president of Chrysler Corp. ''The company was continually overwhelmed by events. At some point, things have to improve.''

McCracken didn't take long to set the new agenda. On May 5, he announced a reorganization that shook up his management team. Out the door: 11-year veteran Michael Ramsay and eight-year Chief Financial Officer Stanley J. Meresman. Now, all computer engineering and manufacturing--once split among several groups, each fighting for resources--is under the command of Executive Vice-President Robert H. Ewald, former president of Cray and a possible successor to McCracken. The goal: better coordination between research and development and manufacturing--a big source of SGI's problems.

Now, McCracken and Ewald have a chance to avoid Apple's fate. SGI's high-end graphics are still unbeatable. The Jet Propulsion Laboratory is using SGI supercomputers and workstations to process images from the Mars Pathfinder landing, and SGI computers were pivotal in the recent Jurassic Park sequel, The Lost World. ''There's still a large productivity gap between what you can do on an SGI workstation and on a PC,'' says Martin Plaehn, CEO of Viewpoint Software Inc. in Orem, Utah.

SGI is even swallowing its pride and working on a workstation that will use Intel chips and Windows NT. But it may be a year before it's ready. Says former SGI Vice-President Kirk Loevner, an Apple alumnus and now CEO of Internet Shopping Network: ''They thumbed their noses at Apple for getting blindsided by Microsoft, but SGI got blindsided even worse.''

Indeed, whether McCracken's effort will be enough to return SGI to its former glory is doubtful. In most of these new commercial markets, SGI's machines don't offer much more than machines from IBM, Sun, and HP. And it's far less experienced in selling to those customers. ''For Silicon Graphics to pull that off now is going to be very difficult,'' says Morgan Stanley, Dean Witter, Discover & Co. analyst Steven M. Milunovich.

The toughest job for SGI--the company that pioneered visual computing--will be visualizing a new future for itself.

By Robert D. Hof in Mountain View, Calif., with Ira Sager in New York and Linda Himelstein in San Francisco



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