The Long Case For Fusion-io And Enterprise Flash

| About: Fusion-io, Inc. (FIO)

After mentioning Fusion-io (NYSE:FIO) as one of my top five investment themes here, there were some misconceptions and skepticism about the company's rich valuation at 160 times earnings. Stock prices are based on future expectations though so let's dig deeper into the forces at play, which will reveal promising prospects for the company and industry moving forward.

Fusion-io’s investor relations material states that "Our solutions enable enterprises to increase the utilization, performance and efficiency of their data center resources and extract greater value from their information assets." In a nutshell they provide solid state flash hardware and software solutions that accelerate the performance of enterprise servers. This makes it possible for end-users to access data faster, which is vital in an increasingly data-driven world.

Fusion-io benefits from first-mover advantage as it was founded in 2005 and focused on developing cutting-edge products for the enterprise side of the market. One notable name on the executive team is Apple (NASDAQ:AAPL) co-Founder Steve Wozniak, who has served as Chief Scientist since 2008. As a tech visionary, Wozniak saw the potential of the company early on and wanted to be a part of it. Overall, the company is believed to have a 1-2 year technological advantage and has an unrivaled tech support infrastructure. Just last week the company announced an industry-first milestone of 1 billion IOPs, which compares with achieving 1 million IOPs just over two years ago.

The company went public in June 2011 at $19 a share and closed at $22.50 after its first trading day. The stock proceeded to rally to the $40 level in November before pulling back to $22 on the heels of a secondary offering priced at $33. It currently trades at $28. In August the company announced a key acquisition of virtualization software provider IO Turbine for $95 million, which integrated nicely with its existing products.

Competitors in the SSD space include STEC (NASDAQ:STEC), OCZ Technology Group (NASDAQ:OCZ), and Micron Technology (NASDAQ:MU). These companies have traditionally catered to the consumer side of the market where competitive pricing has pressured profit margins and “commoditized” the product. The companies are moving into the enterprise market and ramping up in an attempt to reap higher profit margins and erode FIO’s 80% market share (according to Morgan Stanley). The closest competitor in terms of technology is privately held Texas Memory Systems.

Commoditization is a concern and something the whole consumer memory market has been suffering through recently. More entrants are attracted to the profits of the enterprise SSD market and will ultimately increase pricing competition. However, Fusion-io currently stands differentiated with better proprietary technology and positioning in the market.

Independent research firm Gartner estimates 2012 IT spending will grow 3.7% to $3.8 billion globally. IDC estimates the enterprise flash market itself will grow from $1.5 billion in 2011, to $4.5 billion in 2015. Morgan Stanley is even more aggressive with its forecast of the market tripling in 2012 and growing to $20 billion over time based on the CIO survey. Servers in general have been steady growth drivers the past decade but there is no question about the exciting potential of the enterprise flash market segment as cloud computing applications accelerate.

The industry could also be shaken up by consolidation as a server manufacturer like IBM, HP (NYSE:HPQ), DELL, EMC or NetApp (NASDAQ:NTAP) steps in to purchase a flash provider instead of trying to build on their own. Traditional hard drive makers like Western Digital (NYSE:WDC) and Seagate (NASDAQ:STX) could also be interested in diversifying their offerings to enterprise flash storage. Along these lines, SanDisk (SNDK) made a purchase of Pliant Technology for $327 million in May 2011, LSI-OLD acquired SandForce in October 2011, and Apple scooped up Anobit for about $400 million. These companies recognize building the technology from the ground up can be more costly and time consuming than acquiring the existing intellectual property and marketable product of an existing company.

Unlike competitors, Fusion-io has also cultivated favorable relationships with channel partners HP, IBM, Dell, and Supermicro (NASDAQ:SMCI). These outlets sell Fusion-io products as an add-on whenever they make server sales, similar to how consumers are offered accessories when purchasing a build-to-order computer. These relationships are key because they passively drive sales growth and are helping the company gain traction with new customers. Existing strategic relationships with tech giants Apple and Facebook are also important to maintaining a steady revenue stream while serving as clout for winning new business. Eventually as the sales mix diversifies, Fusion-io will be less reliant on its largest customers.

At first glance the valuation looks extreme at 160 times trailing earnings but you need to keep in mind the company is just entering a hyper-growth stage. Over the last three quarters EPS has grown 229%, 147%, and 200% year over year. 2012 revenue growth guidance was raised from 40% to 55% during the last earnings release and gross margin is estimated to be 56%. These could prove to be conservative if their channel partners accelerate sales and more big accounts are added. A name like Google (NASDAQ:GOOG) or Microsoft (NASDAQ:MSFT) could be potential suitors.

Analysts are mixed on Fusion-io with one buy, six holds and two sells. Last week Morgan Stanley put out a report modeling a $16 bear case, $30 base case, $40 bull case, and $62 extreme bull case while the stock is currently at $28. While it’s hard to quantify exactly how much FIO will earn in the next 2-5 years, the fact remains that it is at the forefront of an incredible industry while trading at just a $2.3 billion valuation. Tech companies are some of the most cash-rich in the world so spending on improving their server infrastructure or even acquiring a company with game-changing technology outright isn’t out of the question. Some of the consumer flash players like STEC also look attractive as their stocks have been hit from the decline of profitability in consumer flash.

Looking forward, the next catalysts to move FIO are earnings due out in early February, which will provide color on earnings growth, and the February 15 lockup expiration of 43.1 million shares, which represents about half the 86 million total shares outstanding. The company is well positioned in a rapidly growing market with further upside remaining as it continues to focus on core technologies and growing the business while the enterprise flash industry evolves and plays catch up.

Disclosure: I am long FIO, AAPL.