STEC Buying Opportunity: Competitive Concerns Are Overblown

STEC, Inc. (STEC) – Buy recommendation

Target price: $60 (up 100%)

Price	Shs Out	Mkt Cap	Float	LT growth	Cash/shr	Oper Mgn
$29.50	50.7MM	$1.5B	63%	50%	$1.85	31%
2008A eps	2009E eps	2010E eps	P/E 09E	P/E 10E	Revs 10E	EV/10Rev
$0.31	$1.67	$3.00	17.7x	9.8x	$598MM	2.3x

Executive Summary:

STEC is the leader in enterprise SSD’s and is one of the fastest growing companies in the technology industry with expected growth of 60%+ in revenues in both 2009 and 2010.With the exception of Netapp, STEC has OEM wins with all the major systems OEM’s such as EMC, HDS, HPQ, IBM, Sun (JAVA), etc. STEC’s solutions have an extremely compelling customer value proposition – according to a recent EMC presentation (STEC’s largest OEM), a STEC based tiered storage solution provides 18% lower storage costs, 60% more disk IOPS, 17% less power and cooling and uses 30% fewer disk drives. With a large market opportunity that is well over $1.5B, compelling customer value proposition, design-win with all the major OEM’s, minimal competition (heavily overblown as discussed below), huge manufacturing capacity to meet the high demand, and low cost operation makes STEC a fast grower for years to come in both revenues and profits. With the stock trading under 10x 2010 earnings of $3.00/share, STEC provides a 100% return potential over the next 12 months. Recommendation: BUY.

My detailed report with a comprehensive revenue and earnings model is available upon request. Here I will address the biggest issue that is weighing on investor’s minds and has knocked the stock down by over 30% in the last few days – competition.

Competitors:

When a market is growing 55% per year in one of the worst economic environments and STEC is making 30% operating margins, it will inevitably attract a lot of competition. As such, there is a lot of noise from a number of companies – both public and private trying to get investor attention. They include Samsung (SSNLF.PK), Intel (INTC), Pliant, SandForce, Fusion-IO, Seagate (STX), Western Digital (WDC), SMART Modular (SMOD), Texas Memory, etc. Here are the reasons why the competitive concern is overblown:

1. More noise than substance: While Intel’s plight is well known, Seagate is probably delayed (more like a Boeing (BA) Dreamliner delay as some have suggested), Samsung is not showing that much enthusiasm in the core enterprise space, and SandForce has only SATA interface. The latest worry that caused the recent panic selling in STEC stock was last week’s product announcement from Pliant Technology, a 3 year old Silicon Valley startup. First of all, Pliant’s product only has an SAS interface, while mission critical enterprise storage that makes up the bulk of sales of STEC’s Zeus IOPS from the leading OEMs is still Fibre Channel (STEC has Fibre Channel, SAS and SATA; also STEC is currently the only company with a FC interface). It is hard for EMC, HDS, etc who dominate storage primarily with Fibre Channel to second source a Pliant solution that does not even have Fibre Channel. Further, Pliant’s SAS interface is only 3Gbit/s while STEC has already announced the faster 6Gbit/s SAS solution. Secondly, Pliant uses a newer technology that does not use cache to improve the performance (as almost every other vendor does). It is going to lengthen the testing period with OEM testers who are inherently highly conservative when testing something as mission critical as a disk drive (or SSD) where losing even one bit of data can be catastrophic. Finally, the Pliant product is just going in for evaluation and as my next point shows that is a long and arduous process.
2. Tier-1 OEM design wins can take a long time: Let’s take EMC as an example because – a) EMC is STEC’s largest customer and thus a competitive situation at EMC affects STEC more than anywhere else, and b) EMC’s market share in mission critical high performance storage for applications such as Oracle (ORCL), Exchange, VMware (VMW), financial services trading, etc (where SSD’s are most deployed today) is considerably higher than even their leadership 20+ something percentage market share in the overall storage market shows. For a third party product to be sold by EMC, it has to be tested and certified by EMC’s Elab, probably the most rigorous testing lab in the industry. Since EMC is always evaluating so many new products and since all the existing products have to be retested with every new version or release, Elab can be backed up by as much as one year – so a new product can take as much as one year just to get to the front of the line. The testing itself can take months and it is a 100% pass/fail – i.e. if you pass 29 out of 30 tests and fail one, the product is rejected and you may have to go back to the end of the line. Even if you do not go to the end of the line, the iterative process will consume months because Elab will test all the tests all over again, not just the one that failed previously. Then there is the OEM negotiation process also which can be long and painful.

Bottom line:

Yes, there will be competition and yes, every OEM will eventually find a second source, if for nothing else but to keep STEC honest. However, it will be a long time, at least a year, before that happens, and by then STEC will be entrenched. As we have seen with every technology (INTC with microprocessors, MSFT with operating systems, [[CSCO]] with routers, etc) the 70% rule applies – i.e. the leader gets 70% of the market share, the next company gets 70% of the remaining 30% (21%), and so forth. So whether the market is $1.5B or $4B, 70% of either number is a huge number ($1B to $3B) compared to STEC’s current revenues.

STEC knows that, which is probably why they went ahead and created a manufacturing facility that can produce 125,000 enterprise SSD’s per quarter (around 5 to 6 times the manufacturing capacity compared to the 20,000 or so enterprise SSD’s they sold last quarter). If STEC did not know it was possible to do that much sales and needed that much manufacturing capacity, EMC probably told them that (EMC has one of the most aggressive sales organizations in the history of technology – remember VMware – EMC took it from around $100 Million in sales at the time of acquisition to $2 Billion in a matter of few years). As to margins, yes, prices will come down (absolutely necessary to make enterprise SSD’s as ubiquitous as FC hard drives, which at one point used to cost as much today’s enterprise SSD’s), but so will costs, thus enabling STEC to maintain the 50% gross margin.

Short term outlook:

While STEC will beat Q3 consensus, Q4 will be an absolute blowout with EMC and IBM benefiting from the financials services industry end of year budget flush.

Disclosure: Long STEC stock and call options.

Comments

[Tech_analyst:]

STEC is leader in SSD/FC, but the problem is that the storage array server contains 3 to 4 tiers, and only tier 1 is using SSD/FC and the the rest of tires are not moving in SSD at least by a decade, because of high cost, and waiting the price comes down like SSD equal to HDD $/IOPS. There are a few companies that targeting SSD/SAS and SSD/FC including Intel/GST, Pliant, and Sandforce. The market of SSD in storage array enterprise is about 500 million for the next 3 to 4 years, and STEC has 10% of market and by coming new players STEC's market will shrink to 5% and the STEC with 20X highest compare with peers, the stock price will not get more tha $20~25. It may fluctuate a little till the other players send products out, but this is a short time.

Sep 27 11:53 AM

[User 90153:]

You mention in your analysis, which is very interesting, that you have a more detailed report on STEC, which I would like to obtain. Could you please let us know how we can contact you to receive this report?

Thank you.

Sep 27 02:33 PM

[GARP Investor:]

Tech_analyst:
Some clarifications to your comment:
1) Tiers: There are at this point around 4 tiers in enterprise storage -
Tier-0: SSD
Tier-1: FC or SAS
Tier-2: SATA
Tier-3: Tape

Tier-0 or SSD's are meant to solve the IOPs problem as opposed to wholesale replace FC, SATA, etc. You still need the rest of the tiers for the capacity.

2) SSD prices have already come down from a $/IOPs basis to be better than that of HDD's. From Slide 9 of the EMC presentation referred in my article, SSD is 5000 IOPS/disk, FC is 167/disk and SATA is 80/disk. Apples to apples, a SSD drive costs about 6x more than a FC drive, but generates 30x more IOPs.

3) The market: According to IDC, the enterprise SSD market will grow from $246Million in 2009 to $1.4Billion in 2013.

4) STEC definitely has way more than 10% market share: Just taking the Zeus and Mach8 revenues alone, based on their 10Q's and conference calls, they did around $93Million in the first half and based on their guidance for 3Q, they will do around $170Million in the first 9 months. If you annualize the $170MM, that is around $227 Million which is about 92% of IDC's $246Million. It is intuitive that STEC should have about 90%+ market share because all the Tier-1 OEMs currently shipping SSD's are using STEC.

5) In terms of comparable valuation analysis, it is not a good idea to use trailing multiples for fast growing companies - if you use forward multiples, STEC is not that expensive.

On Sep 27 11:53 AM Tech_analyst wrote:

> STEC is leader in SSD/FC, but the problem is that the storage array
> server contains 3 to 4 tiers, and only tier 1 is using SSD/FC and
> the the rest of tires are not moving in SSD at least by a decade,
> because of high cost, and waiting the price comes down like SSD equal
> to HDD $/IOPS. There are a few companies that targeting SSD/SAS and
> SSD/FC including Intel/GST, Pliant, and Sandforce. The market of
> SSD in storage array enterprise is about 500 million for the next
> 3 to 4 years, and STEC has 10% of market and by coming new players
> STEC's market will shrink to 5% and the STEC with 20X highest compare
> with peers, the stock price will not get more tha $20~25. It may
> fluctuate a little till the other players send products out, but
> this is a short time.

Sep 27 09:46 PM

[Reali_STEC:]

Two random thoughts here:

1) To Tech_analyst: You claim that the enterprise SSD market is only 500mm, but ONE STEC customer (EMC) placed a $120mm order for 6 months, so that alone is $240mm, presuming no growth from Q3/Q4 09. And of course STEC has many, many other customers signed up. STEC CEO said in the WSJ that the market would approach 3-4 billion within a few years.

2) To the author: You have the total outstanding STEC shares as 50.7mm. It is actually something like 48.5mm.

Sep 27 10:25 PM

[GARP Investor:]

Reali_STEC:
As to the shares outstanding, we are both right - it is just a matter of definition. Since 1998, public companies have to report two numbers - 1) basic common shares outstanding and 2) fully diluted shares outstanding. FD shares outstanding includes in addition to the basic common shares, all other shares that WILL have to be issued in the future from the effects of exercises of stock options, warrants, conversion of preferred stock, convertible bonds, etc. For instance, in Q1-2009 STEC had 48.434Million basic and 49.063 Million FD, while in Q2, they had 48.871MM basic and 50.702MM FD shares (all from the STEC 10Q's). As is typical on Wall Street, I always use FD shares and FD eps as it is more conservative and realistic. With STEC stock up so much all their options and warrants will get exercised - so might as well assume they will get exercised and use the conservative FD numbers. So I use FD shares for mkt cap, P/E, EV/Rev calculations, etc.


On Sep 27 10:25 PM Reali_STEC wrote:

> 2) To the author: You have the total outstanding STEC shares as 50.7mm.
> It is actually something like 48.5mm.

Sep 28 02:09 PM

[danmaven:]

GARP Investor,
Excellent analysis. I'm interested in the full report you mentioned. How might I obtain it?

Oct 01 07:44 PM

[Techfounder:]

I worked in the disk drive industy for 15 years and watched our quarterly volumes go from 100,000 to 1 million to 10 million, to 40 million. Disk drive shipments were 540 million in 2008. If SSD drives penetrate 1% of the market that's 5.4 Million units per quarter. The adoption of this technology has clearly started, and on a broad scale, from notebooks to enterprise. My prediction: STEC will max out their factory this quarter or next and be adding more capacity. People really don't have a clue how big this market is. STEC's patents will also be difficult to work around. Keep in mind they've been working on this stuff for over 10 years.

Oct 06 01:47 PM

[villageidiot:]

GARP Investor. Thanks for sharing your thoughts. I am interested in the detailed report/models that you mentioned. Thank you

Oct 08 11:25 AM

[villageidiot:]

GARP Investor, thanks for the analysis. I am interested in receiving the detailed report/models that you mentioned. Thanks

Oct 08 11:29 AM