STEC's Promising Future – Part II

I am forecasting STEC Inc. (STEC) to generate $104.5 Million in revenues in Q3 and an EPS of $0.52. This compares to consensus analysts estimate of $96.6 Million and $0.47. For the fourth quarter, I expect STEC to do $119.5 Million and $0.60/share versus consensus of $106 Million and $0.52.

Anecdotal evidence from STEC’s large OEM’s such as EMC (EMC) and IBM (IBM) certainly support the view that Q3 and Q4 will be very good for STEC. While EMC will not release Q3 earnings till October 22, anecdotally, the Symmetrix V-Max storage array has been selling very well and I estimate with a very high attach rate with STEC drives. The financial services industry has also been strong for EMC in Q3 which also bodes well for STEC as this industry tend to buy a lot of Symmetrix and high end Clariion for high performance applications that benefit greatly from SSD’s. Looking out one quarter, EMC and thus STEC will be a big beneficiary from the Q4 budget flush.

As to IBM, on their earnings CC on October 15 [read transcript here], the CFO mentioned that they gained 5 points of share in System p. As I mentioned in my article regarding IBM and STEC, the IBM Power (System p) product line will be a big revenue contributor for STEC. IBM's contribution for Q4 will be even bigger for STEC as you will get the full quarter benefit from the p595 and the introduction of DS5000 series and the new SVC both with SSD support. The IBM CFO also mentioned in the CC that

our hardware business revenue performance should actually improve going from third quarter to fourth quarter.

While SUN (JAVA) sales in general is suffering from the Oracle (ORCL) overhang, IBM is taking a lot of share from SUN and so I believe that sequential revenue loss deceleration from SUN will be more than made up by IBM and others.

Another anecdote that gives me increased confidence comes from increased revenue guidance from Mellanox Technologies (MLNX) announced on October 5. Mellanox is projecting revenues 12% higher than its previous guidance. Mellanox makes Infiniband and 10Gig Ethernet chips that are used in high performance blade servers and high-end switches. Since these systems are used in high performance, low latency applications such as quantitative market data analysis, high frequency trading, etc, it is fairly certain that the storage that is dragged with these systems will have low latency SSD drives.

Mellanox is generally a leading indicator and so this bodes especially well for STEC’s Q4 quarter.

As to margins, I expect overall gross margin to remain around 50% with the increase in NAND prices offset by increased mix of higher margin products and better utilization. R&D spend will continue to ramp on an absolute basis but the operating leverage helps to improve operating margins further.

STEC is expected to report Q3 earnings on or around November 11, 2009.

Notwithstanding the above, the general investor sentiment is that the short term does not matter because STEC will be doomed by competition in the future beginning as early as Q1 or Q2 of 2010. This high risk premium is thus reflected in the uncharacteristically low P/E multiple of just 10x consensus 2010 earnings estimate when consensus 2010 earnings is projected to grow 48% from 2009 and STEC’s underlying market of enterprise SSD’s is projected to grow 55%!

I am reminded of Citrix Systems (CTXS), a similarly high growth company during the mid to late 90’s. Despite quarter after quarter of growing revenue and earnings upsides, CTXS stock perennially traded at a significant discount due to the “impending” competitive product offering from Microsoft (MSFT) that would wipe out Citrix. While it took a few quarters, the market eventually figured out that the Citrix product is years ahead of the competition and over time the discount went away.

I believe that STEC will go through a similar phase. The company has enough upside earnings power for the foreseeable future and as numbers get raised quarter after quarter and when it becomes clear that the competitive dynamics does not affect this earnings power as expected the P/E will start to expand. Why do I believe this?

1. The market is much bigger than anyone is projecting. While an entire article can be written on this topic alone, the simple fact is that in the enterprise there always has been a big gap between the costly, high performance, but non-persistent DRAM cache and the inexpensive, highly persistent, but low performance spinning hard drive. SSD’s fill this gap beautifully. The adoption of SSD’s to fill this gap is a secular shift and we are in the early stages. OEM’s such as EMC, IBM, etc will sell far more than even the best estimates that the market is projecting.

2. The enterprise SSD is not a commodity. The NAND chips that go into an enterprise SSD is a commodity and the hard drive that the enterprise SSD is replacing is a commodity, but the enterprise SSD is not. The intellectual property in an enterprise SSD is in the controller and again, while an entire article can be written about this, suffice it to say that a lot of sophisticated firmware goes into it to realize the right balance of performance and longevity, while ensuring the utmost level of reliability, availability and data integrity.

3. The OEM qualification process is long. As discussed in my September 27 article, while it is certain that every OEM will have a second source, it can take a long time to qualify, test and benchmark a new product at a tier-one OEM.

4. The impact of the second source will be minimal to STEC. This is the most important point I want to cover in this article. Since EMC is STEC’s largest OEM customer and competitive dynamics at this customer will impact STEC revenues the most, let’s try to examine this in more detail.

First of all, any competitive SSD product that needs to be qualified into an EMC Symmetrix or the Clariion CX needs to have Fibre Channel (FC) support and currently none of STEC’s competitors have announced a FC product or even a roadmap for a FC product. While the competition has SAS products, EMC supports SAS drives only in the very low end AX4 storage (which does not and probably will not have SSD support). I expect the CX to support SAS drives sometime in 2010, but I believe that the Symmetrix will remain FC for the foreseeable future. Now, for the sake of argument, let’s suppose that a competitor is overnight able to level the playing field with STEC from an interface standpoint by either getting FC support or by EMC supporting SAS support across the product line. Now let’s imagine how EMC will roll out the competitive SSD:

1. In a round-robin fashion alternate STEC and the second-source SSD in every other Symmetrix or Clariion in the manufacturing line? No chance.

2. Allow the end customer to choose STEC vs. the second-source SSD at the time of ordering? Highly unlikely. Too many marketing and product support issues and EMC will never risk that.

So the most likely scenario when EMC does qualify a competitor is to put it on one of the entry level Clariion arrays. It is too risky for EMC to put the competitor’s SSD on the Symmetrix or the high end CX’s as long as STEC is working and is meeting the roadmap deliverables.

Now let’s examine further the softer side of an OEM relationship. An incumbent such as STEC has a tremendous advantage at an OEM and that has nothing to do with the performance or any such technical factors. A product like STEC is custom built for an OEM which means there is a big collaboration between STEC engineers/testers and engineers at the OEM.

As long as this relationship is strong, the OEM engineers and marketing people will do everything to make STEC successful. The OEM engineers really does not want to do double work. In fact the OEM engineers will probably go out of their way to let STEC know what the competition is doing, thus allowing STEC to remain competitive.

You may now argue that EMC needs to get a second source qualified to drive down STEC price. Unfortunately, as any small company that has tried to negotiate with EMC has learned, there is no such thing as a negotiation with the house that Egan built. When EMC wants a new price with STEC in 2010 they will ask and they will get it. In fact it is probably already built into the master OEM agreement.

The final argument you can throw at me is the recent Sun Microsystems F5100 Flash Array. Sun already has an OEM relationship with STEC and uses STEC drives in products such as the SUN 7000 series storage products. Yet, Sun decided to engineer their own Flash array as I understand using Samsung (SSNLF.PK) NAND and Marvell (MRVL) controllers.

My only response is this is why Sun does not make money and thankfully most of the other OEMs are run by business people. While I am not a hardware systems architect, I cannot understand why a 1RU product with a few SFF STEC drives could not have achieved more or less the same purpose as the highly custom, highly engineered, difficult to service F5100 that now require a whole engineering department to support it.

The Bottom line:

The market is severely underestimating the revenue potential and earnings power of STEC. STEC owns the enterprise SSD space today and even when some competitors finally get qualified in late 2010, STEC as an entrenched player will continue to own 80% of a market that will be $1.5 Billion by 2012.

Recommendation 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 (NTAP), STEC has OEM wins with all the major systems OEM’s such as EMC, Fujitsu (FJTSY.PK), HDS, HP (HPQ), IBM, LSI (LSI), SUN, 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 here), 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.

Target price: $60 (up over 100%)

Price	Shs Out	Mkt Cap	Float	LT growth	Cash/shr	Oper Mgn
$24.19	50.7MM	$1.23B	63%	50%	$1.85	31%
2008A eps	2009E eps	2010E eps	P/E 09E	P/E 10E	Revs 10E	EV/10Rev
$0.31	$1.70	$3.00	14.2x	8.1x	$598MM	1.9x

Disclosure: Long STEC stock and call options.

Read: Promising Future for STEC – Part I

Comments

[Duude:]

The amount of testing time competitors still have ahead of them is clearly not figured into the discounting of STEC's year ahead. I reckon the real story is how attractive STEC's small float is to an army of short sellers. All arguments against STEC are short seller talking points A nice blowout quarter would make for a great squeeze.

Oct 19 11:53 AM

[Reali_STEC:]

Given the MASSIVE volume that has traded over the last month+, I think there is a pretty decent amount of manipulation, momentum trading, and daytrading going on. There also happens to be a lot of misinformation and confusion about the true high-end nature of STEC's products. GARP seems to be one of the precious few who gets it.

Oct 19 12:58 PM

[Robert0713:]

A couple of points: from what I've read MRVL's controller is no great shakes, the SandForce one is; qualification times will shrink as vendors figure out what to test, same thing happened with HDD when they went "commodity". In all, yes STEC is under attack from shorts. Whether it can justify $30+ share won't really be known until Q3 earnings. In the past, when The Family had lots of shares, there were PRs during the run to earnings. Now that their stake is considerably smaller, much less in the way of PR. Other STEC clients, CML, PAR report next week.

Oct 19 02:51 PM

[Reali_STEC:]

I guess we'll see come November's earnings whether the lack of a pre-earnings announcement meant one thing or another. Historically, the company has not pumped up PR in the face of a declining share price. Drops have happened in the past, and the company has bought back shares (at $7.75 and <$4 IIRC), but hasn't overly hyped the stock using the marketing department.

That said, it is interesting that they raised guidance last quarter, leading up to the offering....while this quarter they have been radio silent. I suspect that some of the drop in sp may be attributable to a presumption that they won't beat (or won't beat significantly) because they didn't guide higher before the call. Personally, I expect a significant beat Q3. Guidance was only like $93mm, and $60mm or so of that was the $120mm EMC deal.

EMC's earnings should be another interesting barometer this week.

Oct 19 11:46 PM

[ain't no fo...:]

I won't pretend to say I know anything about the fundies here, but the technicals do suggest some things to me.

This stock did a 5 bagger on unremarkable volume over a 5 month period. Selling volume has now ramped up significantly the past month+ and there's been a nearly 50% retracement from the highs... that's a lot of distribution and it was undoubtedly heavy on the institutional sell side. Whether its because some connected people "know" something, or it was just a big consolidation move I certainly don't know. It happened during a period of market strength however.

Technically the stock needs to start basing here as it approaches its 200 day EMA... would like to see the trajectory flatten and see some evidence that "smart" money is accumulating. This could be finishing up the left side of a flat or more likely cup-shaped base, but the way it keeps getting walked down below its declining 9 day moving average suggests more constructive work is needed.

All in all, well worth keeping on a watch list.

Oct 20 09:24 AM

[Alan Young:]

A clearer (to me, at least) analysis is here:
blogs.barrons.com/tech...
Some analysts believe that STEC's day as a leader in the flash drive market are over. But I tend to favor Ain'tNoFo's view that after this big correction, the short-term upside could be huge.

Oct 20 03:19 PM

[Wisdom vs. ...:]

after SNDK, i think it is pretty obvious solid drives are kicking a**

Oct 20 08:22 PM

[Reali_STEC:]

Two more developments in the SSD world:

1) Samsung invested "millions" in Fusion IO. Sure suggests that SSD is, as the above comment says, are kicking a**.

2) Teradata unveils the Blurr. See:

www.theregister.co.uk/.../

www.storagenewsletter....

GARP--you think this has STEC drives because it's an LSI device?

Oct 21 04:32 PM

[GARP Investor:]

Answer to Reali_STEC (comment #1):
I do not think it will be a significant beat in Q3 (revenues) primarily because SUN probably went down sequentially and so they had to use some of the cushion from IBM, EMC to make up for that. If they come in at my estimate of $104.5MM (against $96.6MM consensus) that is only 8% beat, which is not material enough to pre-announce. As to margins and earnings I think they have considerably more ability than my 50%, but if they have any sense they will keep it at the 50% level so that they can smooth it in the future when they need it.
They have a much better chance for blow-out revenues in Q4. VMW numbers tonight certainly look good for STEC.

Oct 21 08:40 PM

[GARP Investor:]

Answer to Reali_STEC (Comment #2):
Teradata (TDC) OEMs all their storage from LSI (Engenio division) and their partnership goes back 15 years from the NCR days. I believe the Extreme appliance 4555 TDC just announced is using the LSI Engenio 7900 that was announced couple of weeks back. The great thing is that TDC's prices their solution so high that their customers will not even notice (cost wise) it if they have a few dozen STEC drives in them. Business Intelligence/Analytics will be a big opportunity for SSD and STEC will benefit greatly from IBM, Teradata, etc. I actually think even the Oracle customers will probably use EMC or IBM than the untested Flashfire F5100. Netezza (NZ) will have SSD support in the not too distant future and I hope they pick STEC.


On Oct 21 04:32 PM Reali_STEC wrote:

> 2) Teradata unveils the Blurr. See:
>
> www.theregister.co.uk/.../
>
> www.storagenewsletter....
>
>
> GARP--you think this has STEC drives because it's an LSI device?

Oct 21 08:56 PM

[Reali_STEC:]

Thanks for your insights. Curious as to where you are getting the info about the drop in SUN sequential rev.

Also, I assume you saw this--STEC in IBM DS8700:
searchstorage.techtarg...#

www.enterprisestoragef...

Finally, a recent IBM announcement refers to 8gbps support for FC in the SVC:
www-03.ibm.com/press/u...

Can currently-announced STEC SSDs provide this throughput?

Oct 24 11:07 AM

[GARP Investor:]

Reali_STEC:
1) The SUN revenue traction is purely anecdotal and my speculation because many customers are frozen/delayed on SUN purchases due to the Oracle-SUN deal uncertainty and general feeling (despite Ellison's assurances to the contrary) that Oracle will kill or sell some of the SUN hardware. IBM, HP, etc are definitely taking advantage of the situation and so I do not think it will hurt STEC.
2) The introduction of the IBM DS8700 is great in my opinion because that will provide some uptick in sales from the customers who were holding off purchases waiting for this. STEC will have great contribution from IBM in Q4 from all the new products with STEC support - DS8700, SVC appliance, p595, etc.

3) The need for 8G is really for the storage controllers, the HBA's and the switches and is necessary for the aggregate bandwidth the SSD's can deliver. However, each SSD drive is at most doing 200MBps, so even a 4G drive interface is overkill at the individual drive level. Also, 8G FC can autonegotiate down. (Remember, the initial 4G FC EMC DMX was using 2G drives).


On Oct 24 11:07 AM Reali_STEC wrote:

> Thanks for your insights. Curious as to where you are getting the
> info about the drop in SUN sequential rev.
>
> Also, I assume you saw this--STEC in IBM DS8700:
> searchstorage.techtarg...#
>
>
> www.enterprisestoragef...
>
>
> Finally, a recent IBM announcement refers to 8gbps support for FC
> in the SVC:
> www-03.ibm.com/press/u...
>
>
> Can currently-announced STEC SSDs provide this throughput?

Oct 26 09:07 PM

[Techfounder:]

In 2008 the disk drive industry shipped 540 million hard drives, and the CAGR is about 5%. Now that SSD has finally achieved a price/performance advantage over hard drives, and will only improve over time as MLC matures, the SSD market will take a larger and larger chunk of the hard drive market. STEC is predicting volumes of 200k-300k in the next year, which is .03%-.06% of the overall disk drive market. Imagine if SSD grew to 1-2% market share, or even higher. If STEC maintains their formula for quality, reliability and performance, they will be hard pressed to meet demand for years to come, along with all their competitors as well.

Oct 27 02:26 PM

[seekingtruth77:]

You said " With the stock trading under 10x 2010 earnings of $3.00/share,"

moneycentral.msn.com/i...

shows stec 2010 EPS of 2.2

how can you claim such a high EPS compared moneycentral?

Oct 31 07:20 PM

[seekingtruth77:]

Zacks estimates
www.zacks.com/research...

Next Year Estimate 2.23

GArp-investor credibility is 0 for giving a 2010 estimate of 3.0. Who should we trust zacks or Garp-investor?


On Oct 31 07:20 PM seekingtruth77 wrote:

> You said " With the stock trading under 10x 2010 earnings of $3.00/share,"
>
>
> moneycentral.msn.com/i...
>
>
> shows stec 2010 EPS of 2.2
>
> how can you claim such a high EPS compared moneycentral?

Oct 31 07:30 PM

[user1010101:]

I guess we all now know where GARP was getting his borrow from.

Nov 03 05:07 PM

[DW Reid:]

Any opinions on what to do with STEC now that it has dropped a mere 30% AH?

Nov 03 05:37 PM

[ain't no fo...:]

Chart was screaming to stay cautious until there were signs of institutional accumulation, which never happened... that little 4 day bear flag into the 200 day EMA after it broke below that oscillator was a tell to stay away.

Look at all those high volume big red volume bars from mid-September on - that was smart money getting out in droves... as usual, somebody got the word ahead of time, and it wasn't Joe Q. Retail.

My thought here is that bad news comes in bunches... there may be a reflex rally at some point, which would be a good place to lighten up if you're still long here.

stockcharts.com/h-sc/u...

Nov 04 09:21 AM

[doreen:]

If STEC is facing this issue; I wonder if their competitors are going through. Seems like a doozy for everyone.

Nov 04 03:41 PM

[doreen:]

Thank you Jim Cramer for recommending this stock. Just want to put us in a black hole.

Nov 04 03:55 PM

[quinn and sean:]

Well Garp we now have law suits and a tarnished reputation to contend with. Any thoughts on whether STEC will ever see the potential you spoke of in your shining recommendation? I am patient but I am stunned as well. Is this crash a function of the technical elements being debated on this forum or all emotion and fear owing to the CEO's sale in August?

Nov 08 10:28 AM

[drbob66:]

Bought some STEC for first time last week....avg. price for me now is $13.50. I'll hang on and monitor the situation closely...who knows where this stock will bottom if the author's analysis is flawed (or we have any more news "surprises"). Seriously, the author's credibility has to be pretty low now after this massive decline in share price. The world according to GARP...indeed! I guess he's no worse off than the other analysts covering STEC...most seem to have maintained their buy recommendations (albeit with much lower target prices than the author's $60). Talk about being blindsided...

Now, apparently, management has scheduled an analysts' Day on Nov. 17...I imagine this stock should see interesting action on the 18th. Hopefully $13 will hold as the floor for this stock.

Nov 12 05:49 PM