Sphere 3D's Future Clouded In Uncertainty

| About: Sphere 3D (ANY)

Summary

Losses, borrowing and share issues have piled up at Sphere 3D.

Despite some tepid signs of stabilization, Sphere 3D isn't out of the woods.

While the financial situation is bad but crystal clear, its capabilities and future are shrouded in uncertainty.

Sphere 3D (NASDAQ:ANY) is a combination of four firms. The original Sphere 3D, with its virtualization product Glassware 2.0. It bought VDI provider V3 Systems in 2014 and it merged with Overland Storage (which itself had bought Tandberg) at the end of 2014.

Some 15 months ago, we thought it had "substantial upside" due to:

  • A raft of deals at the end of 2014.
  • The merger with Overland opening up a worldwide reseller network for Sphere's offerings (Glassware and a VDI solution from the acquired V3 Systems).
  • The promise of break-even in early 2015 for the overall company, mostly based on a $22M synergy benefit from the takeover of Tandberg.
  • The company issued a goal of achieving a $160M yearly run rate by Q4 2015.

We also deemed that Sphere's virtualization product, Glassware 2.0, was "interesting," at least that's how we put it at the time. Glassware promised a raft of interesting possibilities claimed by the company and others.

It would be able to virtualize any application on any device in six steps, and it would do so with higher efficiency (addressing more users per server) than existing solutions.

There was a modicum of support for this as some US school districts and the medical image company Novarad seemed to like the product.

As 2015 progressed, the raft of deals dried up and the existing deals didn't produce any tangible progress in terms of actual sales, despite the 16,000 reseller network and all these deals.

Instead of break-even, the losses continued unabated, the sales kept on shrinking, and Glassware 2.0 kept on being virtually a mystery product. It has received next to no attention in the IT press, let alone an independent review or benchmarking effort we clamored for some eight months ago.

It still doesn't seem to be selling much (if at all), all of which are reasons why we take a much dimmer view on the capabilities of this technology now. It is difficult to escape the conclusion that there are some serious limitations.

We have to admit that much of this remains guessing due to the fact that there is little independently verifiable information available about Glassware, but that alone isn't a good sign.

The company and some of its backers made some big claims about Glassware, but so far, all we can say that little of that has been verified. It's unlikely that Glassware is useful beyond a very limited set of circumstances, is our best guess.

Other promises have fared little better. The $160M yearly run rate isn't in sight. The company has been able to cut EBITDA losses but there is a serious run-up in the share count and debt.

These developments are so serious that one could have considerable doubt whether the company is going to survive. There are a few tentative signs of a modicum of stabilization though:

  • The first quarter non-GAAP gross margin increased from 31.9% in Q4 2015 to 33.3% in Q1 2016.
  • In comparison to Q1 2015, adjusted EBITDA losses have shrunk from $6.1M in Q1 2015 to $3.1M in Q1 2016

However, there are still a number of downright ugly figures (details in the 6K reports, which you can find here). Without being exhaustive:

  • Net loss, at $8M was 41.1% of net revenue (although down from 47.4% in Q1 2015).
  • The share count increased from 35M to 49M, and is set to increase much more, for instance through paying the 8% interest on its $24.5M convertible note held by FBC Holdings in shares. The conversion price has been decreased from $7.50 and $8.50 to $3 with 500K in warrants. There are lots of these warrants outstanding. In Q1 alone, there were 3.5M shares issued on exercise of warrants but there are still 9.97M outstanding. Then there is the convertible loan and the restricted stock from stock-based compensation.
  • Revenue looks to be stabilizing as it declined only from $20.1M to $19.6M but this is also due to the acquisition of the RDX business from Imation (for 1.77M shares, including the exercise of warrants and $2M in other settlements) in August 2015. They were doing $14.5M in revenue a year before the acquisition.
  • There was $2.6M in stock compensation and $1M in interest cost on $45M of debt.

There are a few other developments that could contribute to further stabilization:

  • Deal with Microsoft's (NASDAQ:MSFT) Azure, their inclusion in and validation for the Azure cloud government infrastructure. They will submit Glassware 2.0 for inclusion here as well.
  • Reactivation of at least some of the resale channel partners (there are 4-day training sessions ongoing).
  • Reactivation of the VDI business with a renewed agreement with VMware (NYSE:VMW).
  • Without specifying, they talk of an increasing pipeline of deals and "some sequential growth in the second half of this year."

It seems that the business is now heavily dependent on VDI and the ability to simply implement hybrid cloud solutions for customers. It is not straightforward to assess the real opportunities and risks here. Some considerations:

  • The original V3 Systems (which is where the VDI business comes from) was not successful (they went bankrupt).
  • Most of the value added will be for VMware, as they provide the engine of the solutions, so margins are not likely to be great.
  • Concerns about the ability of Sphere 3D to survive might very well make it more difficult to acquire new customers, which will have plenty of alternatives.

On the other hand:

  • The company claims to have a competitive advantage with DCO (Desktop Cloud Orchestrator) in terms of ease of implementation and use.
  • It argues that it has been able to fit Glassware 2.0 with an existing VDI and RDSH budgets and it can deliver application sessions from within a VMware environment or from Azure. The company claims that this reduces cost by increasing the density of users.

The upshot

Is this enough to offer a perspective that the losses will end and the vicious cycle of increasing share count and debt will grind to a halt?

We don't think this is likely. Almost certainly not in the near future, perhaps in a more distant future. On what do we base this?

  • The company isn't giving any guidance.
  • The margins on the products and services are rather low, so the company really needs a big ramp up in revenues to move needles meaningfully with respect to generating profits and cash.

We are a year on from the quarter which the company promised to be break-even (one of the reasons for us to write the initial bullish article), and this still isn't in sight. Let alone a $40M quarterly run rate (which is roughly, what they'll need to get out of the hole, if they can generate that without a big ramp-up in cost).

There are too many broken promises so perhaps that's why the company isn't making any new ones. Perhaps that sets them up for a positive surprise. We can't exclude that, but it really is no basis to buy the shares.

Some improvement is likely, but whether that's enough for shareholders to recoup losses, or even for the company to survive, is very uncertain. We wouldn't touch the shares without much more clarity and a much better picture.

We have to add that we wouldn't go short either, for various reasons:

  • It's very difficult to borrow shares and it tends to be very expensive.
  • While the financial picture is pretty clear (and pretty ugly and would in itself warrant a short position), the picture is so muddied with respect to the capabilities of the technology and possible improvements that it's not worth the trouble, even if we think it's more likely the shares will go down, rather than up.

But when a company has many broken promises, doesn't provide guidance, and there is little or no independent assessment of some of their once promising tech, it's better to stay clear.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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