CAN SILICON GRAPHICS HOLD OFF HEWLETT-PACKARD? ...AND MICROSOFT, INTEL, SUN MICROSYSTEMS, AND OTHERS? SGI HAS PROVED THAT 3-D COMPUTING PAYS. NOW IT'S GOT TO DEFEND ITS TURF.
By MICHAEL S. MALONE RESEARCH ASSOCIATE SHAIFALI PURI

(FORTUNE Magazine) – In the QUICKSILVER world of Silicon Valley, Silicon Graphics has turned into the best example of what happens when you bet the company on one technology and everything goes right. When Jim Clark and six students from Stanford University founded the company in 1982, no one else really cared about 3-D computer graphics. Sun Microsystems, founded at the same time, went for the traditional workstation market, concentrating on number crunching for engineers. Big boys like IBM and Digital Equipment couldn't be bothered with such a piddling thing as painting pretty three-dimensional pictures on your computer.

Fast-forward 13 years. Propelled by Hewlett-Packard refugees like CEO Ed McCracken, SGI is now a $2.2 billion company, leaping ahead: Revenues have grown 26%, 36%, and 45% in the past three years. 3-D computer graphics seems like the coolest stuff the Valley has to offer. Hollywood uses SGI technology to help create the velociraptors in Jurassic Park. More significantly, companies as different as General Motors, Ameritech, and Morgan Stanley use SGI's 3-D software and hyperfast workstations to design cars, illustrate corporate phone-calling patterns, and visualize sudden shifts in the stock market.

SGI's investors scored big: If you bought $100 of SGI stock in 1986, when the company went public, you'd now have a stake worth $1,148. That's a return of 31.2% annually, vs. 10.9% for the S&P 500 index. Not bad.

But this summer the stock seemed to run out of gas. Or at least sputter. After nearly reaching $45 on July 14, it tumbled to $33 as FORTUNE went to press. What gives?

Some of the reasons for the stock drop are mundane. Cowen & Co. analyst Richard Chu, who still rates SGI a strong buy, points out that many technology stocks have wilted in recent months. What's more, SGI stock weakens every summer, when orders for its workstations slow.

Then there's the image thing. Long seen as the most happening company on the information highway, SGI has been upstaged on Wall Street by the kings of the Internet--Netscape, run by SGI's former chairman Clark; and Sun Microsystems, which has enjoyed a 31% rise in its stock price since early August. Also, SGI made an unusual misstep in August, when it rushed to introduce a workstation that wasn't entirely ready for market. Software limitations kept the machine from processing data at anywhere near the speeds SGI intended--a problem the company has since rectified. To observers like Wayne Collier, an industry analyst at D.H. Brown Associates, a Port Chester, New York, technology research firm, SGI's haste was a sign the company was feeling the heat.

Well it should. Silicon Graphics is about to enter the most difficult period of its young life. It's about to take a test every hot Valley company eventually faces: When your technology alone is no longer enough, do you have the character and the business wherewithal to become a long-term survivor? Many companies never get past this stage: Atari faded in spite of having the best technology and an early lead; Apple Computer has yet to overcome its decision not to license its operating system.

For the first time, SGI is facing direct competition from industry powers: in hardware, Hewlett-Packard ($25.0 billion in annual sales)--with some help from Intel ($11.5 billion)--and Sun ($4.7 billion); in software, Microsoft ($5.9 billion). In that company, SGI looks pintsize, potentially a victim of its own success.

Even in the face of that lineup, many at SGI still seem to believe in the salvational powers of technology. President Tom Jermoluk, 39, embodies SGI's can-do faith. Asked whether his new competitors are a real threat, he responds: "The best quote I've read about us recently was from [Intel CEO] Andy Grove. He said that there's nothing Silicon Graphics has that you won't be able to do on a $99 application on a PC two years from now." Jermoluk laughs, "Well, if you want to do it two years from now, then wait around for Intel. Our customers want to be competitive. They want it now."

Says Collier: "Silicon Graphics seems to have the feeling the whole world will be irresistibly excited about its neat technology. They seem to forget that in the end it is business acumen that wins."

Hewlett-Packard may now have more of that business savvy than anyone in the industry. Over the past few years, H-P has been on a hot streak, invading market after market and staking out lucrative positions. Most recently it took aim at personal computers for the home market, putting its first line of PCs into stores in January. H-P now ranks as the fourth-leading manufacturer of PCs for the home in the U.S., behind only Compaq, Apple, and Packard Bell.

Now H-P has set its sights on 3-D. The company is already the No. 2 manufacturer of workstations, behind Sun (SGI ranks third overall but first by a wide margin in the market for 3-D). H-P sells most of its powerful systems to manufacturing companies doing high-level engineering computations. "Hewlett-Packard is moving very rapidly in visualization," warns Bernard Guidon, the aggressive Frenchman who directs H-P's computer systems group.

H-P wants SGI's business for more than just the high margins the company gets on workstations; it also wants to master the underlying technology. Like many computer experts, Guidon and his technologists believe that visualization of data--using computerized color and graphics to interpret numbers--will become increasingly important. The logic is simple: It's easier to understand a picture than interpret a table of numbers. So stockbrokers employ sophisticated software that illustrates stock movements with dramatic three-dimensional spikes.

Guidon says 3-D represents an "internal revolution" at H-P. The company plans to integrate 3-D graphics in the full range of devices it manufactures--not just computers but medical diagnostic equipment, gas and liquid chromatographs, testing devices, and set-top boxes for interactive television.

IT IS NO SMALL IRONY that Hewlett-Packard poses the first great threat to SGI. Both companies are descendants of the company started by David Packard and Bill Hewlett in a Palo Alto garage 57 years ago.

Ed McCracken, 51, fled H-P 11 years ago. Then president of an H-P division as big as SGI is now, McCracken was heir apparent to President John Young. But H-P was a bureaucratic dinosaur. McCracken says he was so anxious to get out that he took a pay cut "by a factor of three" to move to fledgling SGI.

There he turned a technically brilliant but disorganized outfit into a real competitor. Says McCracken: "Our strategy is always to call our own shots. And that means to lead the industry in innovation." His faith that the best technology will win out has also served as a powerful management tool: SGI's talented force of engineers is among the most focused in the Valley.

McCracken has fostered a work environment opposite to the one he left behind at H-P. SGI is as freewheeling in style as any high-tech company. At SGI's Mountain View campus, the cafeteria sells sushi and Silicon Graphics polo shirts. Employees ride balloon-tired bikes between buildings. SGI sponsors lip-sync contests and exhibitions of the latest 3-D art. You get the picture.

As SGI grew, Hewlett-Packard awoke from its funk by putting itself through a grueling transformation. CEO Lew Platt now runs a lean giant growing 23% a year--among the top 30 companies in the FORTUNE 500, only Motorola is growing faster.

For H-P, attacking SGI seems a natural way to expand. The companies share many customers. While SGI gets most of its press clips by helping make possible velociraptors and special effects, entertainment accounts for just 15% of SGI's revenues. Most of its workstations go to clients like GM and Ameritech. The same kinds of customers look to Hewlett-Packard for their high-end computing and engineering workstations.

Recently, H-P has started pushing those clients to buy its 3-D technology too. The company tries to persuade them to ignore SGI's glittering image and turn instead to H-P for a fully integrated workstation package. The pitch is starting to have an effect--customers like Ford Motor now get some of their 3-D computing from H-P.

But Silicon Graphics invented the market, and it has solid defenses in place. SGI offers the best and the broadest family of products, ranging from $5,000 desktop workstations to $1 million supercomputers. It also owns the rights to the basic software tools that corporate programmers use to customize 3-D software for designing everything from movie images to minivans. Says Morgan Stanley analyst Steve Milunovich: "SGI is still the most focused company in visual graphics."

Hewlett-Packard could try to neutralize such SGI advantages by waging a price war. But Guidon and company plan instead to wear down SGI over the long run. Says Guidon: "Right now we are working on new technologies that will produce significantly different products in two to four years--none of which SGI will be able to do."

Guidon is referring to a carefully guarded project announced by Intel and H-P last year. Together the companies are designing a microprocessor architecture to supersede Intel's existing line, the most recent version of which is the Pentium. The project could change the economics of the workstation market. Today companies like Sun, Digital Equipment, H-P, and SGI put their own specially designed chips into the workstations they sell. But the Intel/H-P venture could spew forth loads of high-performance, low-cost chips--rendering SGI's chips prohibitively expensive. The venture capital magazine The Red Herring recently published an open letter to McCracken, urging him to explain how he plans to counter the H-P/Intel challenge. "With [chip] volumes in the tens of thousands, not the tens of millions, how can SGI compete?" the magazine asked.

SGI has tried to forestall any such crisis by pushing into low-cost, high-volume markets. Its chips now power Nintendo game machines and the set-top boxes that control the interactive televisions in Time Warner's Orlando Full Service Network. To broaden its markets still further, SGI has lined up a portfolio of A-list partners besides Nintendo and Time Warner, teaming with Steven Spielberg's DreamWorks SKG (to develop a so-called digital studio), AT&T (interactive digital networks), and Nippon Telegraph & Telephone (multimedia information services).

Besides trying to repel a hardware challenge from H-P, SGI must fend off a push into 3-D graphics by Microsoft. Its network operating system, Windows NT, has been gaining market share on networks of workstations. Says Collier: "Windows NT already does a good job with graphics, and everybody in the business should be afraid of it." Microsoft is spending a fortune to enlist some of the world's top 3-D graphics programmers. It recently bought Softimage, a Canadian developer of graphics software, for $130 million.

BESIDES MICROSOFT, H-P, and Intel, SGI also faces a major challenge from Sun Microsystems. Sun's customers use their workstations to do things in two dimensions: doctors swapping X-rays, for example. Now Sun will try to get its customers to upgrade to workstations based on a new chip it will soon introduce: a chip specifically designed to handle 3-D graphics with ease.

Critics like Robert Herwick, who follows the company for his eponymous investment firm, think the greatest threat to SGI may be overconfidence. "This is a company with tremendous youthful enthusiasm that is not as self-thoughtful and self-critical as it should be," says Herwick. "It needs to look beyond the immediate project to delivering solutions to the customer. At H-P, Lew Platt is totally solution oriented. I don't think SGI has reached that point."

Aside from McCracken, 51, many top SGI executives are like Jermoluk--techno-idealists. Jermoluk truly believes that SGI can continue to thrive via its traditional focus on producing the best technology. He also knows what can go wrong if the technology-first strategy fails. Says he: "If margins drop, we won't be able to fund our R&D, and if we cut R&D, that's a death spiral. Maybe a Compaq can have a business model with just over 20% margins. But that's not the business model for us. We have a bunch of people who are evangelist marketers. I don't think we keep those people if we lose that business model."

It's dangerous for any company to count on defying gravity on its income statement forever. One SGI executive preparing for leaner days is Ken Coleman, 53. Coleman, who heads the company's human resources division, is another H-P refugee--he arrived at SGI a couple of years after McCracken. His work force has one of the lowest turnover rates in the industry, but the employees have never faced a serious slowdown. "It's something I worry about all the time," says Coleman.

"God didn't will us to grow at 45% a year forever," says Coleman. "The real test comes when you hit the wall, when you're only growing at 10%--or when you drop 5%. That's when you find out what a company is made of. Great companies, like H-P or Intel, have passed that test and proven they have it. We haven't yet."