OCZ Technology (OCZ) is facing very strong headwinds: A declining PC sector, a weak enterprise market, and most importantly the recent notice by NASDAQ to delist the stock. Let's explore how these will affect the company and its turnaround attempts. OCZ is near a 52-week low -- should we pull the trigger on this one and buy it?
PC Sector Shrinks
OCZ derives a large portion of its revenue from sales of solid-state hard drives and a very small amount from PC power supplies. The company is currently in a transition from focusing primarily on consumer SSD sales to a new focus on enterprise. Of course shifting one's R&D takes time and money --two things OCZ is lacking. The decay of the PC sector is going to affect OCZ in both sales of SSDs to the existing PC market and in the new market of new PC sales. As more and more consumers embrace tablets and smartphones, the demand for traditional laptops and desktops is decreasing substantially. Let's look at the evidence of this trend.
IDC reports on lack of PC demand:
"Worldwide PC shipments totaled 76.3 million units in the first quarter of 2013 (1Q13), down -13.9% compared to the same quarter in 2012 and worse than the forecast decline of -7.7%."
"The extent of the year-on-year contraction marked the worst quarter since IDC began tracking the PC market quarterly in 1994. The results also marked the fourth consecutive quarter of year-on-year shipment declines."
Looking at the numbers, we see that Q1 PC shipments were down -13.9%, but wait -- it gets worse. Further down in the report we note that this has been an 'accelerating trend' (one sure to affect OCZ's sales of SSDs and power supplies). This trend of negative growth will affect OCZ's sales projections and definitely create for the company financial headaches.
Hercules Wins Either Way
If the reduction in PC demand were not enough, OCZ has a very limited amount of capital to work with. Wells Fargo recently exited its agreement with OCZ for a credit line but OCZ replaced some of it with a loan and security agreement with Hercules Technology Growth Capital (HTGC). At first glance this looks decent, however, once you pull back for a second and review the old loan from Wells Fargo and compare it to the new loan -- we learn that the terms are pretty harsh. Then again OCZ is in a financial jam so what can you expect? Looking at the 8-K we learn:
1. OCZ has put up the entire company as collateral. In the event of a default, Hercules stands to profit very nicely as it can sell off company assets such as the controller chip, patents, and inventory (among other things).
2. The interest rates are high on the new loan.
Some will say "Hercules has done its due diligence and this must mean they have good reason to believe OCZ will make it!" We are sure they have done quite a bit of diligence, just as Wells Fargo did, but Hercules stands to benefit whether OCZ makes it, gets bought out, or goes bankrupt. Per the 8-K:
"During the first year, the term loan will bear interest in cash at an annual interest rate equal to the greater of 12.50% or prime plus 8.75%. In addition to cash interest, the term loan will accrue payment in kind ("PIK") interest at a PIK interest rate of 3.0% per year."
"The Lender (Hercules) was granted a security interest in substantially all of the personal property of the Company and its domestic subsidiaries, whether now owned or hereafter acquired."
If OCZ makes it Hercules will make 15.5% interest the 1st year and a slightly reduced amount the 2nd year.
If OCZ is bought out, Hercules has stock options they can exercise.
If OCZ goes under they can collect the company for a fraction of what it could cost to buy them out right since the company is collateral for the loan.
Either way you go it's a steal deal for Hercules and worst case it will only cost them $20-30 million.
The Loan -- Not Quite $30 Million
Glancing at the recent PR it appears that OCZ has secured a credit agreement for $30 million. Upon reading the 8-K though -- we learn that while the total amount is $30 million they only have access to $20 million.
Per the 8-K:
"The Loan Agreement provides for an initial term loan advance of $10 million, which closed on March 11, 2013, and an additional term loan advance of up to $5 million, which is contingent upon OCZ being current in its SEC filings and achieving certain revenue levels for two consecutive quarters."
The agreement also provides the Company access to a $10 million revolving loan facility which must be repaid in full on April 1, 2016. An additional $5 million of the revolving loan facility will be available to the Company upon the Company obtaining additional financing of at least $10 million.
OCZ currently has access to $20 million with an additional $10 million if they meet the additional requirements.
Dilution or High Interest Debt
OCZ has to raise $10 million no later than May 31, 2013 or be in violation of the terms of the agreement which will trigger an additional 2% interest rate to be tacked on top of the 15.5% for a grand total of 17.5% interest! (source once again is the March 11th 8-K)
"Per the financial covenants, the Company must raise a minimum of $20 million in new equity or subordinated debt no later than January 31, 2014, of which $10 million in new equity or subordinated debt must be raised no later than May 31, 2013."
"Upon the occurrence and during the continuation of an event of default under the Loan Agreement, the interest rate applicable to all obligations thereunder (including the term loan and the revolving loans), shall be increased by 2% per annum."
Once again, this is a great deal for Hercules. Either way they win. If OCZ makes it -- Hercules will collect some high interest rates and fees. If OCZ goes under -- they can collect all of the company's assets which are obviously greater than the $20 million loan.
As far as the $10 million required financing, OCZ will have to regain compliance with NASDAQ to issue new shares to the public before May 31st or take on subordinated debt. Subordinated debt is "debt which ranks below other debts with regard to claims on assets."
This is Hercules way of placing any debt OCZ takes on below the debt that Hercules lent OCZ. In the case of bankruptcy, Hercules will be paid before this subordinated debt.
Of course whoever lends money the $10 million is taking on additional risk and with that will come high interest rates. Just ask the question -- If you were lending OCZ money and you have little if any collateral (Since OCZ signed it all way to Hercules) would you give OCZ a loan for a low interest rate? Heck no! Any future financing deal is going to require a high interest rates to offset the risk given the lack of collateral.
Has OCZ captured some enterprise sales? If we can believe the CEO -- then yes. It is most likely they have won a few contracts. OCZ might be holding off on announcing them in order to use the news as a form of damage control, if and when they announce earnings. We saw evidence of this the very day after the delisting notice per a hardware qualification press release. OCZ was trying to take some of the sting out of the delisting news. We can assume OCZ has a few of these cards left to play but in the face of delisting and the much delayed earnings numbers we think the effect will be minor unless the news is material.
Enterprise Sales Are Showing Near Term Weakness
We can look no further than Fusion-io (FIO) and STEC (STEC) for evidence of weak sales. This temporary reduced demand will affect OCZ enterprise sales as it is a broad issue and not simply OCZ just stealing away business from the competition. Some of this might be attributed to the economy or the Federal sequestration affecting sales of servers to the government. According to Forbes.com:
"Federal government IT purchases are facing possible reductions of up 5% to 7%. Hardware purchases will probably fall even more than that, because these are easily delayed or deferred."
Even IBM is experiencing a slow down via its 5% revenue miss.
"The troubles seem to be in units that sell industry-standard data center computers, typically powered by Intel chips, and larger data center computers that use I.B.M.'s Power chips."
Yet, in all of this, more hands are starting to pry into the enterprise cookie jar and competition is heating up.
8000 Pound Godzilla Rises from the Deep Blue
Like a leviathan rising from the dark depths, IBM has announced it is going to invest $1 billion… yes $1 billion into solid state development. While we could have said it was an 800 pound Gorilla an 8,000 pound Godzilla seemed fitting compared to OCZ and its $10 million loan.
IBM (IBM) said it is investing $1 billion in research and development to design, create and integrate new flash-based products in its expanding portfolio of servers, storage systems and middleware. This might trigger an interesting response from competitors such as EMC (EMC). We doubt they will sit around idle and not ramp up SSD R&D as IBM is a major competitor to EMC and others.
Delisting and Timelines
OCZ cannot win long term in the consumer realm due to its lack of any NAND manufacturing. They will not get a NAND deal either due to a lack of volume required to secure such a deal. Thus they will always be at a cost disadvantage compared to the NAND manufacturers such as Micron (MU) and Samsung.
The company knows this and has adjusted the research and development to focus on enterprise rather than consumer products. Now one might ask…"well, if enterprise is going to be such a battle ground against giants like IBM, EMC why would OCZ focus on this". Easy -- it's the only hope for the company. Right now the strategy is to get every dime out of consumer while they can and funnel that into enterprise development. They hope to create enterprise software and hardware that line up the company for an acquisition.
This will line the pockets of the management via stock options and allow the company to continue its work via a sugar daddy corporation. A prime example of a company doing this would be a small outfit called PhysX. They created some innovative technology involving graphics cards and were acquired by Nvidia (NVDA). OCZ hopes to sell out to the highest bidder.
The problem that is slowing down any buyout is delayed earnings and the financial ruckus that comes along with them. OCZ has to get its books ironed out before anyone is going to sign the dotted line to acquire them. Given the stock is near a 52 week low, it's tempting to buy some stock in them for a pure gamble. Yet we would much rather wait and see if OCZ gets an extension to the delisting announcement. OCZ has 7 days from the day of the announcement to submit an appeal. Thus OCZ must submit its appeal on April 18th. Once submitted NASDAQ will meet with OCZ (on average) within 20 to 40 days to listen to OCZ's plan to regain compliance. A decision to delist or not will be made on average 1-3 weeks after the hearing with OCZ. (Note: We obtained the time line by directly calling NASDAQ)
If OCZ is delisted, the stock (according to this research paper) should experience a 20% drop in stock price on average on day 1, followed by a general downward slope over the next 60 days.
(Chart showing average reaction to delisting over 60 days)
The paper goes on to provide some interesting details on what happens to stocks once delisting occurs.
"We examine 1,098 Nasdaq firms delisted in 1999-2002 that subsequently traded in the OTC Bulletin Board and/or the Pink Sheets. Market quality deteriorates significantly after delisting: share volume declines by two-thirds; quoted spreads almost triple from 12.1 to 33.9 percent; and effective spreads triple from 3.3 to 9.9 percent. Volatility triples from 4.4 to 14.3 percent, but quickly reverts to slightly elevated levels. Deterioration is significantly larger for more severe violations (e.g. bankruptcy) than for lesser infractions (e.g. minimum bid price)."
A common argument that we see a lot is "OCZ is hiring! They have to be doing well." OCZ could be hiring because they are in fact growing and doing well or they could be replacing people who have jumped ship. Most likely they are keeping the hiring roster full to give the appearance of health. This will help convince consumers and vendors that all is well. It's a standard tactic. If OCZ were to remove all the jobs it would signal to vendors that things are not going well and this could impact sales. Thus companies typically keep the hiring roster full to appear healthy. A great example of this is THQ who recently went bankrupt and are selling off the company piece by piece. However THQ's web site shows they are hiring. Once again, a standard tactic.
Putting Things In Context
Many things in life sound great until you put them in context. Such is the case with OCZ and its recent PR. Clearly designed to try to take some of the sting out of the delisting announcement yet it does not show the context of the data. Rather it paints a rosy picture. Let's explore what OCZ presented but first we need to look at an older statement from OCZ.
From the Feb. 6th conference we are told:
3:30 We are going to have an inventory write down. We had built up inventory north of $100 million which is way too high for a company of our size. We are now down to about 60 million of inventory. We are going to write off over 2 quarters about 45 million in inventory.
We had built up a ton of inventory in the channel as well. Have been working with partners to move that inventory. Down to $50 million in inventory in the channel today.
5:50 $50 million in inventory is about a quarters worth of inventory and that is still too high. We should be in the neighborhood of 8 weeks.
Comparing what OCZ gave us today to the CEO's statements we see that OCZ has reduced its inventory by 1/6th or $10 million yet we do not see this show up in the cash on hand per today's statement. Where did it go? Simple... OCZ burned through it and that is understandable given they are trying to enter the intense enterprise sector. It does take money after all to fund research and development.
This strategy is nothing new for OCZ as CEO Ralph Schmitt talked about discounting inventory at 18:15 minutes into the Feb. 6th conference (linked above):
"We tried to monetize as much inventory as we can in order to help fund the company as long as we can. I think we have kind of run that close to the ground at this point. We clearly need some infusion of capital at this point. We have been trying to wait on doing something until after the financials are out in the market. It's not clear to me that we are going to be able to do that. We have looked at everything from strategic money, private equity, PIPES, converts, all the things that you would normally look at. We want to keep the dilution factor to our shareholders kinda minimal as possible."
Next is channel inventory, we can assume a lot of this is older products. It is best to work with vendors of the old inventory rather than have vendors return it. OCZ really cannot afford to take on any returns because they announced they are taking a charge of $4 million. This is not exactly chump change for cash strapped OCZ given the various shareholder lawsuits continue as well as an SEC inquiry. The company only has a mere $10 million in cash and that is only because they borrowed it from Hercules at a very high interest rate.
Feel The Burn Rate
OCZ did not provide any updates on current debt levels yet we know from Feb 6th that cash on hand was $9 million. Debt to Wells Fargo was $7 million. Inventory reduction was $10 million from Feb 6th to last week. The Hercules loan was $10 million.
$9 in cash - $7 WF loan = $2 million in cash
liquidated inventory of $10 million + $10 million Hercules loan = $20 million. Grand total = $22 million yet...
Per the OCZ PR from this week we see OCZ has a mere $10 million in cash. This is not healthy and cause for an ongoing concern if this burn rate keeps up.
OCZ goes on to say that key vendors are current but what about non-key vendors?
Concerning gross margins we have seen people make wild estimations that are all over the chart. Let's base our estimate of gross margins on the Feb. 6th calls which would place it at the mid teens to low 20's for the most recent quarter with quarters before that being negative.
8:15 into the call OCZ stated "Gross margin level, let's say, a target level of the mid 20% level which we had been at the company before."
Break Even Targets
The company has quite a ways to go to get to break even. OCZ estimates revenue at $65-70 million for last quarter compared to OCZ estimates at the ROTH Conference (March 19th) that break even will occur at $100-110 million per quarter.
Per OCZ's April 17th press release:
"Unshipped backlog for the fourth quarter was approximately $18 million, as NAND flash supply constrained revenue in the quarter and suppliers are allocating certain NAND flash products. NAND supply is expected to affect our first quarter of fiscal 2014 as well. The Company's strategy to diversify NAND vendors has helped during this timeframe and is planning for and expects the supply of flash to continue to be tight throughout calendar 2013."
One has to wonder if OCZ has played the NAND shortage card one time to many. While it looks like it could be a valid excuse, we doubt it is the 100% truth. Money talks, if OCZ could make a profit on this back log rest assured they would pay the extra cash to acquire the NAND on the open market. More likely these are toxic sales held over from former CEO Ryan. To produce them now would result in money lost per product sold. To speculate, we might assume OCZ is holding out on producing them in hopes that vendors will simply give up and cancel orders as the hardware ordered become obsolete.
While OCZ certainly has some technology (such as the controller chip Barefoot 3) that would be of value, we do not see this as the time to jump feet first into OCZ. Rather we will wait and see if the stock is delisted and wait for the delayed earnings to be aired out and presented.
After we know all the facts, we will reassess the company and its prospects. Granted, we might pay considerably more (or less) for the company but at a greatly reduced risk and far more insight into how things are with OCZ. Be patient and wait is our advice. Worst case, if you just have to be in this (long or short), roll the dice with a few stock options.
Additional disclosure: I own a small amount of PUTS to play a very possible delisting. After any delisting is determined I may revise my position.