STEC's Promising Future – Part II

by: GARP Investor

I am forecasting STEC Inc. (NASDAQ: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 (NYSE: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 (NASDAQ: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 (NASDAQ: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 (NASDAQ: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 (NASDAQ: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 (OTC:SSNLF) NAND and Marvell (NASDAQ: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 (NASDAQ:NTAP), STEC has OEM wins with all the major systems OEM’s such as EMC, Fujitsu (OTCPK:FJTSY), HDS, HP (NYSE:HPQ), IBM, LSI (NASDAQ:LSI-OLD), 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%)

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Disclosure: Long STEC stock and call options.