STEC (STEC), maker of enterprise flash solutions, reported earnings earlier this week. The solid state drive market is booming, and in the midst of such explosive sector growth the company has managed to see its revenues and margins decay at an alarming rate. Is this a stock that could represent a bargain at current prices, or is the risk/reward ratio unfavorable? Let's take a look.
An Expected Mediocre Report and Gloomy Outlook
The company reported FQ2 2012 earnings on Aug. 7 and, yet again, investors were treated to an unsurprisingly mediocre report. Revenues for the second quarter were $40.7 million, a staggering 50.7% decrease from the year-earlier period of $82.5 million and at the low end of the firm's guidance. Gross margins shrank from 44.7% to 36.6% year over year. Finally, the company suffered a diluted loss per share of $0.23 vs. earnings of $0.18 in the year-ago period.
While the swing to an operating loss is not encouraging, it's the reasons behind the drop that are the true red flags: revenue and gross margin contraction. I suspect that longer qualification times, due to the firm's focus on the enterprise market, coupled with strong competition in the sector have led to very significant market share loss.
The company looks even more unattractive when one looks at the earnings history over the last 12 months. The company has been very consistently seeing shrinking profits for six straight quarters, so it is very prudent to remain skeptical that the firm's fundamental issues are nearly over. Couple this with the fairly mediocre revenue guidance of $40 million to $42 million and a non-GAAP loss of between $0.27 and $0.31 per share, and the deal starts to look even worse.
Valuation: Cash and Peers
At STEC's current market capitalization of roughly $320 million, it's interesting to note that the company has slightly over $200 million in cash on its books, which is what I suspect will help provide a solid floor for the stock price. Backing out the cash, the company will be trading at less than 1 times trailing 12 months revenues, but it is unclear how safe that cash position is in light of the consistent quarterly losses.
Until STEC starts growing revenues and/or stepping up margins, I would be hesitant to assign a price/sales (ex-cash) of over 1, especially since peer OCZ Technology Group (OCZ) is trading at roughly 1 times past revenues (and a little over 0.5 times forward revenues) while growing sales and gross margins. Fusion-IO (FIO) commands a high price/sales multiple, but it has solid gross margins in excess of 50%, has won an excellent number of high-profile design wins, and has a number of uniquely differentiated products.
I would not recommend shorting STEC because it already has a high short interest and is very likely to squeeze on any unexpected positive news. Furthermore, I suspect acquisitions and mergers in this nascent industry could very well be lurking in the near to medium term, which could catch short sellers incredibly off guard.
It's also risky as a long investment, given the execution failure in the face of strong competition. But if management can find a way to turn the business around, I suspect STEC will be able to ride the secular solid state drive wave to revenue, margin, and profit growth in the medium to long term.
Disclosure: I am long OCZ.