Relatively low price multiples create a tempting profile for shares of STEC, Inc. (STEC), the beleaguered producer of solid state drives used in enterprise storage and server systems. Its trailing price-to-earnings ratio of 11.1 is less than half of that of the industry multiple of 27.4 times. My preferred litmus test - price-to-cash flow - at 7.7 times is also just half the industry multiple of 14.8 times.
STEC has had some rough times over the past three years, but fundamental measures suggest things have improved. Revenue growth in the twelve months ending September 2011, grew 17.7% over the previous twelve month period. This is line with industry growth rates in the mid-teens. The gross profit margin in that recent period is lower than the company's peak profits in the high 40s, but remains respectable at 44.4%.
Is this a time to take a long position in STEC? Before investors jump in with both feet, it is worthwhile figuring out why STEC is so out of favor despite the appearance of growth and profits.
Investors are crying foul over the sale of company shares by STEC's chairman and president. It happened over two years ago, but it is apparently still a fresh wound. The registered sale of insider shares through several large investment banks in August 2009 was followed three months later by an announcement of delayed orders from a major OEM buyer of STEC's flagship solid state driver called the ZeusIOPS. The stock had already pulled back by 45% from a record high reached just weeks after the announcement of the insider sale. However, in November 2009, when the company revealed the delayed order and cut guidance for the final quarter of 2009, the stock fell another 39% - all in one day.
Not surprisingly a flurry of shareholder lawsuits followed, charging the company's chairman and president, Manouch Moshayedi and Mark Moshayedi, with all manner of insults and infractions against shareholders. Apparently there is a whiff of concern that they may have known of the impending setback in fortunes and raced to collect profits on their sizeable holdings in STEC before that news spread. The SEC sent a Wells notice to the Company in late 2011, giving the company advance notice that securities charges are underconsideration.
The two senior officers sold a total of 9.0 million shares at $31.00 per share, trimming their ownership in the company between the two of them to 17.4% of total shares from 35.5%. One could make the argument that the duo left quite a bit of money on the table as the stock price climbed by 26% from the $31.00 level where they sold shares to a record $41.84 several weeks later.
Fast forward to 2011, STEC had managed to recover from the customer delay situation, only to stumble again earlier this year as competitors with lower cost products started eating STEC's lunch. Apparently, some of STEC's OEM customers had the temerity to qualify alternative solid state drive solutions to reduce the overall cost of end-user implementations. It seems that there is a price where end-users would give up the performance and latency advantages of STEC's ZeusIOPS solid state drive in order to save on total costs. Now there is a reason to cry foul!
During the third quarter 2011 earnings conference call CEO Manouch Moshayedi - perhaps humbled by the drastically lower value on the 6.5% of the company he still owns - promised action to get STEC back in the game with more competitive product line. First he promised to deliver a lower cost solid state accelerator to the market before the end of 2011. Moshayedi also promised a lower cost version of its flagship ZeusIOPS solid state drive that could be qualified with customers by mid-2012.
So far so good! In mid-November 2011, STEC demonstrated its PCI Express solid state accelerator (PCIe SSA) at the Supercomputing Conference. The PCIe incorporates flash technologies such that data centers equipped with STEC's PCIe SSAs require fewer and lower cost server deployments. STEC sales reps do some fancy calculations that show how this translates into lower total operating cost.
In late November 2011, STEC introduced a new model to its flagship ZeusIOPS solid state drive product line. The new ultra-high endurance model combines STEC's proprietary fourth-generation ASIC-based SSD controller and STEC's proprietary CellCare technology with multi-level cell (MLC) flash. MLC flash is a memory technology that uses multiple levels per cell to allow more bits to be stored using the same number of transistors. In other words enterprise customers who are looking at mushrooming data growth to the zettabytes have some hope of keeping up with data needs at a cost they can afford.
In December 2011, STEC also managed to expand its relationship with Fujitsu by qualifying its entire enterprise-class ZeusIOPS SSDs across Fujitsu's ETERNUS DX storage system portfolio. The company had already extended its partnership with Taiwanese-based Infortrend, a network storage provider, to design STEC's MACH16 SSDs across all of Infortrend's storage systems.
Loss of Confidence
STEC shares are trading at 109.1 times forward earnings. Comparison to the relatively low trailing PE, provides a striking illustration of what analysts think of STEC prospects over the next year - decidedly dismal. Management's promises of a revitalize product line apparently have not carried much weight with analysts. That said, there is clearly some disagreement among published viewpoints. Among the sixteen or so analysts who publish estimates for STEC, the range of earnings estimates is wide, from a loss of $0.25 per share to a profit of $0.47 per share on a non-GAAP basis. There is a less disagreement on the top-line as the range is from a low of $217.7 million to $295.6 million. Yet even the high-end of the sales estimate range represents a substantial decline from the $343.8 million in sales recorded in the twelve-months ending September 2011.
Should you bring your lunch, or walk to school?
This is the story of STEC - a company with a history of disappointment, management that has little credibility with investors, and growth promises that have yet to prove out. Yet, when a stock is beaten down like STEC shares, contrarian investors need to take note ... and devise a strategy to cover all bets.
Bring your lunch ... investors could accumulate with caution during the run-up to the fourth quarter earnings announcement expected in the third week of February 2012. The stock traded downward in early November 2011, even after the company produced an upside surprise in announcing third quarter results. This was largely due to disappointing guidance from management that came in the same announcement. If STEC management now confirms the company is on track with new product introductions, guidance for the second half of 2012 could be encouraging and put a bit of air under STEC wings. Coverage of short positions could add to trading volume. Shares equivalent to 17% of STEC float have been sold short by investors with a negative view on the stock.
Walk to school ... less risk oriented investors are not likely to be left behind by waiting until STEC announces year-end 2011 results and 2012 guidance. STEC shares trade with little momentum and we expect it to take some time for investors to process and accept any change of fortunes for STEC.