Seeking Alpha
Profile| Send Message| ()  

If there is one company for whom things have gone horribly wrong in the last two months when it's largely been good news for most Tech stocks, it's got to be STEC Inc (Nasdaq: STEC). The crux of the recent class-action shareholder lawsuits against its principal officers (Co-Founders Mark and Manouch Moshayedi) is that they withheld 'material information' related to risks regarding their largest supply contract as of date with EMC. The main accusations are that:

  • Management withheld certain information about the risks related to the contract like (1) the bulk purchase reducing revenue potential in 2010 and (2) Major customers can and will switch to other suppliers of Solid-state disks (SSDs) as they are evaluating such options
  • Management sold their personal holdings in the secondary offering in Aug-Sep09 at artificially high prices (STEC reached its life-time high of $42.5 in Sep09) by withholding information on such risk factors from the secondary offering prospectus

Huge Volatility And Quick Changes In Management Outlook Raises Questions

STEC stock dropped to $11.2 a piece days after the class-action suits were announced and closed last at $16.76 (Dec 29,09). Another disappointment was the company's fourth-quarter (Dec09) look of ~$101-103M of revenues which was well below expectations. The company indicated in its Sep09 earnings release that it got preliminary indications from EMC, its largest customer (~38% of revenues in Jun09 quarter), that SSD adoption is slower than anticipated and so its orders might be less than expected till the first quarter of 2010.

Naturally, the expectations of top-line growth are less fanciful now after this rude awakening.

(Click to enlarge image)

Source: Gridstone Research

A look at the inventory and accounts receivables for the last few quarters also (see graphic below) points to possibilities of over-billing to EMC (another accusation in the lawsuit) especially when STEC mentions that it has initiated a joint-marketing promotion to increase SSD adoption. This raises suspicions of STEC being aggressive in revenue recognition while future risks/costs associated with this billings accruing later.

EMC Contract Has Increased Receivables

(Click to enlarge image)

Source: Gridstone Research

Did the $120M supply agreement with EMC have other conditions like more lenient payment terms and conditions related to jointly promote 'SSD adoption'. In the Sep09 earnings release, STEC mentions that it has accrued $1.5M as joint marketing costs for this purpose. (Source: STEC Earnings Release Nov 03,09). It has also guided for allocating $2.4M as reserves for the fourth quarter of 09 which will be netted off against gross revenue. As mentioned earlier, this seems to be a case of costs following revenues with a lag and if the management did have some prior information on this, it should have been disclosed at the earliest.

So in effect, the following sequence of events do raise some questions (while not necessarily implying any wrong-doing):

  • June 16,2009: STEC revises Q2 (Jun09 qtr) revenue guidance upwards by ~20% from $68-70M to $82-84M (Stock ends at $22.8)
  • June 17 to July 7,2009: Manouch Moshayedi sells nearly 1 Million shares at prices in the range of $22-24
  • July 13,2009: STEC announces a $28M supply agreement related to a defence contract (at $26.73)
  • July 16,2009 : STEC announces EMC supply agreement worth $120 M for the supply of SSDs in 2H09 ( $32.59)
  • August 3,2009: STEC announces Q2 results which come in above revised guidance and also announces the secondary stock offering ($35.5)
  • August 6,2009: STEC announces pricing of secondary offering at $31/share ($29.15) which is effective a share sale by Mark and Mike Moshayedi
  • Nov 3,2009: STEC announces Q3 results and the possible inventory overhang at EMC ($14.42)

I also went through the secondary offering prospectus (Read here) and there is no mention of the EMC agreement and its details. In the risk factors, STEC mentions that the increasing revenue share of EMC is a risk while it does not mention that there is a possibility that potential revenue from EMC might be lower in the future periods and the $120M agreement could be a one-off. Another question was as to why STEC had to have such a secondary offering in the first place when (1) no cash accrued to STEC from this offering and (2) STEC bore $275K of the $675K expenses related to the offering. Technically, it seems that the promoters could have sold in the open market as it was their 'personal ' holdings and not any 'additional' equity which is being raised by the company for growth prospects.

Board Could Do With More 'Independent' Directors


A little bit of history and credentials of the Board of Directors at STEC also raises a lost of questions. Some of the odd events which I noted were:

The appointment of Chris W. Colpitts, a Deutchse Bank (DB) investing banking official to STEC's board in Mar 2009. Deutsche Securities was one of the managers of the secondary offering, which followed later in Aug09. Prior to this, Matthew Witte of Marwit Capital was appointed to the board in January 2009. Both these appointments followed the resignation of two board members for less than pleasant reasons. The two earlier board members, Jim Peterson (Former Microsemi (MSCC) CEO) and Vahid Manian (Former Broadcom (BRCM) Official) resigned after reports that they had lied about their educational credentials. (Source: Read newsource here and here)

What makes it worse is this...A quote attributed to STEC CEO Manouch Moshayadi after these incidents were reported:

"I am sure that Vahid went to UCI and graduated -- he was there with my brother,” Manouch Moshayedi, STEC’S chief executive officer, said in a telephone interview. Both Manian and Peterson are “extremely competent,” he said. STEC, based in Santa Ana, California, makes memory chips.

(Source: Bloomberg)

Clearly, having college buddies as Independent directors (who lie about their credentials) is not exactly corporate governance at its best. To top it all, the current head of the board's audit comittee and former STEC CFO, Dan Moses was a Pricewaterhouse Coopers (PWC) auditor prior to joining STEC in 1992. Guess what...for as early as I could access 10-K filings (till 2001), PWC has been STEC's auditors and continues to be so.

STEC Should Have Revealed More On Its EMC Contract and Joint Marketing Efforts Proactively

The sequence of events does suggest that STEC should have disclosed additional details of its supply agreement with EMC prior to its secondary offering in the interests of investors and existing shareholders alike. It could also have been more conservative while listing out the risk factors in its secondary offering prospectus.

Related-Party Transactions Also Add A Bad After-Taste

STEC leases office space from MDC LLC which is owned by the Moshayedi brothers, Mark, Mike and Manoush. MDC LLC has no other business other than owning these properties and leasing them to STEC (Source: 2008 10-K filing section 11). For the last three fiscals MDC has earned ~$0.6 M as rental income from STEC in 2006, '07 and '08. These transactions have been a regular feature since the late 1990s as the older 10-K filings also report similar transactions between MDC LLC and STEC.

STEC also bough testing services from QualCentre, another firm controlled by the Moshayedi brothers. (Source: 2008 10-K filing section 11).

In summary, the class-action lawsuits point to a lack of transparency in communications with shareholders/investors from a company which has been publicly listed for almost a decade. While financial performance (see comparison with other Top Tech Small-caps below) and growth prospects seem rosy for STEC, a more inquisitive look into its operations and governance structure raises serious questions.

Strong Financial Performance Among The Top Tech Small-Caps BUT...

(Click to enlarge image)

Source: Gridstone Research

Disclosure: No Positions

Source: STEC: Shareholder Lawsuits Point to Larger Problems