Seeking Alpha
Deep value, special situations, contrarian, event-driven
Profile| Send Message|
( followers)  

Last night OCZ Technology (NASDAQ:OCZ) decided after months of waiting to provide "preliminary estimates" on the status of the accounting issues. The numbers are quite shocking. In this article we will first explore the numbers and what they mean to investors. After that we will be looking at the challenges OCZ faces in the consumer segment and the enterprise segment. Lastly, we will explore why a buyout is the only hope for OCZ to survive.

The Preliminary Estimates

OCZ stated last night:

"The following preliminary estimates are subject to further review by the Company and its auditors. The Company estimates that its quarterly revenue will range between $65 million to $85 million in each quarter for the second and third fiscal quarters of 2013."

$65 to $85 million, that is quite a lot of range for an estimate! The analysts were guiding a "tad" higher.


(Click to enlarge)

Dilution

OCZ's CEO Mr. Schmitt stated during the December 19th conference call:

05:23 [We] need to raise capital in order to get to cash flow positive state.

While we knew dilution was on the way, tonight's numbers confirms that dilution is now certain. OCZ will simply have to issue more shares once the accounting issues are reported and they are back in compliance with the NASDAQ rules.

(Authors Note: While OCZ has since then taken down the conference call we can point readers out to one of our past articles that has many of the December 19th conference call highlights as evidence for the above quotes.)

Cash Reserves

The first thing that we want to know is what are the cash reserves?

Per the release:

"The Company estimates that inventory charges primarily due to product discontinuance and market prices will be approximately $15 million in the second fiscal quarter and approximately $30 million in the third fiscal quarter.

As of the end of December, certain balance sheet items were estimated to be at the following approximate levels: cash of $9 million, trade receivables of $35 million, with related day sales outstanding of 55, bank debt of $7 million, and trade payables of $30 million."

Now this 9 million in cash might be a problem. Per the 8K from January. The Wells Fargo line of credit agreement states:

(6) OCZ agreed to not permit Liquidity (as defined in the Credit Agreement) to be less than $10,000,000 for more than one consecutive day.

We are not sure how trade receivables factor into the credit agreement but if they are not counted towards liquidity, OCZ could be in default.

What Can OCZ Do?

OCZ has the technology and the people but they lack the financial resources to do battle with the big boys. In this article we will point out the few positive things the company has accomplished. Also we will shed light on the many uphill challenges OCZ faces in order to prove the point that:

A): OCZ will fail in the consumer market in the long term.

B): Enterprise is an uphill battle.

C): The company needs to shop itself around as a buyout candidate.

Positives

The company has incurred some positive developments though. Vector is a new SSD from the company that boasts higher gross margins and an increase in reliability. The performance is also pretty awesome.

(Vertex leading the way)
(Click to enlarge)

The old Vertex line (of which we owned every model) was kind of famous for failing. Review sites have stated that Vector is much more reliable. Vector's controller chip is an in-house design called Barefoot 3 which reduces costs. If OCZ were smart, it would start licensing out Barefoot 3 ASAP, but as of yet we have not seen or heard anything to hint that they are considering that.

The 8-K Broken Down

Recently OCZ Technology released an 8-K which contained some very interesting information. OCZ gave away part of the company to Wells Fargo (NYSE:WFC). On top of this, the line of credit with Wells Fargo has changed. Let's look at the contents of what's inside the 8-K.

Most of the 8-K is dealing with the terms of the loan and finances, things which might well bore all but the most hardcore financial nerds; however, one glittering gem is included in this: OCZ is giving away part of the company for free.

Let's break apart the 8-K and examine each segment.

In addition, OCZ agreed to certain additional terms and conditions, including the following: (1) OCZ does not have the right to exercise the LIBOR option with respect to its loans until WFCF delivers written notice to OCZ expressly agreeing to reinstate the LIBOR option. Without the LIBOR option, loans under the Credit Agreement bear interest at the Base Rate (as defined in the Credit Agreement) plus a spread, with the effect that the interest rate increases by approximately 2%.

Pretty easy one, basically the interest rate of the loan has increased by 2%. Not a good thing for OCZ (since it is dependent upon the loan for working capital), but not a massive blow either. More like ... death via one thousand cuts. It should be noted that in the 8-K Wells Fargo changes liquidity level monitoring to "weekly rather than monthly monitoring of the minimum liquidity levels." That is not exactly a vote of confidence.

The Second Amendment keeps the line of credit available for a period (the "Second Amendment Period") commencing January 15, 2013, and ending on the date which is the earliest of:

(1) February 15, 2013, or such later date as Agent and WFCF may agree to in writing, in their sole discretion.

(2) Upon the expiration or termination of the Second Amendment Period, WFCF will have no further obligation to make loans under the Credit Agreement.

Wells Fargo can terminate the line of credit with no further obligation by February 15 if they want to AND get a chunk of the company.

Giving Away Parts Of The Company

Here we see Wells Fargo taking a controlling interest in OCZ's South Korean controller chip company Indilinx. OCZ has publicly stated before that they are closing down operations in South Korea and moving them to the United States.

OCZ agreed to deliver pledge agreements and appropriate financing statements pledging to the Agent (Wells Fargo) 65% of the voting equity interest of Indilinx Co, OCZ's Korean subsidiary (the "Korean Sub").

Strangely, OCZ is transferring the Korean assets to the parent company. It really makes you wonder what Wells Fargo is actually getting with its controlling interest in Indilinx other than the 100k that OCZ paid them to alter the terms of the line of credit.

(8) OCZ agreed to cause the Korean Sub to transfer to OCZ as soon as practicable (but in no event later than February 28, 2013) all of the material assets of the Korean Sub, including, without limitation, its intellectual property and intellectual property licenses;

A Losing Battle (Consumer)

Long term, OCZ will lose the battle in the consumer segment. The company knows this and they are retreating from the low-end SSD market.

Per the former CEO Mr. Petersen:

During the September 13th dbAccess 2012 conference, Mr. Peterson stated (at 05:21 into the call) "Long term, as a company, we really do need a strategic arrangement with a NAND flash Manufacturer. Without that we can't play in the broader market. We end up becoming a specialized enterprise-only player."

A deal with a NAND manufacturer is very unlikely given the lower volume of NAND OCZ uses now. The plan for now is to try to compete in the high-end SSD market while buying time and shifting resources to the enterprise market. They hope to carve out a beach head upon which to expand.

Long term, it will be forced out of the consumer SSD market due to pricing pressures. SSD's require NAND to store data, and the various NAND manufactures, like Micron (NASDAQ:MU), will always have the cost advantage when it comes to this because they make the very NAND flash that SSD's require. With vast financial resources these players can close any technology gap given time, and most of them now have their own controller chips. If they don't have them, they are working on them, while using Sandforce controller chips from LSI Corporation (NASDAQ:LSI).

An Uphill Battle

In an ideal world OCZ would just waltz into the enterprise sector, but the world they are entering is white h-o-t with competition. They face entrenched players with vast resources of talent, experience, and most importantly -- deep pockets:

Fusion-io (NYSE:FIO), International Business Machines (NYSE:IBM) via the acquisition of Texas Memory Systems, EMC (NYSE:EMC), and to a lesser extent STEC (NASDAQ:STEC): just to name a few. Also Seagate just announced its heating up the battle via its investment in Virident.

(Fusion-io and Apple Co-founder Mr. Wozniak)
(Click to enlarge)

The Future

While this article may come off as negative, it is all about how you play the game. Profits can be made on both sides of the coin, long or short. If we know that long term OCZ cannot win in the consumer side and that the enterprise side is going to be one heck of a fight, what can OCZ do? Easy ... sell the company or merge it into a powerful company. That is the silver lining to all the doom and gloom!

Various companies that are cash rich would love to have a turn-key solution along with the patents, controller chips, and tech know-how that OCZ possesses ... and OCZ needs the financial backing. No one is going to touch OCZ until the numbers are exposed for the accounting issues. After that they are fair game for any company that might be interested. Of course OCZ can keep trying to ice skate uphill against the NAND producers and enterprise giants, but remember the former CEO's comments:

"Without that (a NAND deal) we can't play in the broader market. We end up becoming a specialized enterprise-only player."

With the cash position that OCZ has and the market challenges they face, OCZ simply needs to ally via a buyout with a cash rich company.

The way to play this is to let the news sink in for at least a few days and then buy a few cheap calls in case you think OCZ will get bought out down the road. It is the least risky play in this speculative stock.

As always, bulls and bears profit, pigs get slaughtered.

Source: OCZ: Doom And Gloom Or Buyout Candidate?