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OCZ Technology Group (OCZ), one of the more aggressive players in the solid state drive markets, announced last night that it was not going to meet previous revenue guidance due to a NAND shortage. The firm emphasized that it had seen record bookings and that demand was overwhelmingly healthy, but without the necessary NAND flash coming in to build the drives, the firm will be falling short on revenues this quarter.

After listening to the conference call pertaining to this pre-announcement, there are a number of serious implications surrounding OCZ's business as well as the flash storage industry as a whole that need to be explored.

The NAND Guys Are In Control

It was not too long ago that the industry faced NAND prices in "free fall". This was good for drive vendors such as OCZ that did not produce its own NAND, but terrible for the NAND producers such as Intel (INTC), Micron (MU), Samsung (OTC:SSNLF) and Toshiba (OTCPK:TOSBF). However, in order to prevent an over-supply of the product, a number of firms, most notably Toshiba, cut production. Analysts had warned that with the upcoming iPhone launch, it would make sense to stock-pile some NAND inventory.

However, by cutting production, these NAND producers will see improved margins, especially as NAND flash is the critical component of solid state drives, comprising the majority of the bill of materials. In general, the solid state drive industry is expanding, especially as users demand less power hungry and much faster storage compared to hard disk drives.

The winners from the NAND shortage will be the companies listed above.

OCZ Has Two Choices: High Margin & Low Volume, Or A NAND Deal

There's no two-ways about it: OCZ seriously disappointed investors last night, and I suspect that the stock will continue to see downward pressure until a major positive catalyst can provide some help.

The major issue is that OCZ's management is gunning for market share dominance in the SSD field, focusing on getting out as many drives as possible. This isn't a terrible strategy, but it is clear that without owning the NAND flash fabs or having a supply agreement with such a fab, this is not the way to go for a smaller company looking to grow profitably.

As the NAND producers are now in control of the supply and without an agreement with a NAND producer to procure NAND, it will be harder for the "small guy" to compete with the bigger fish. So OCZ needs to either:

  • Focus on high margin/low volume businesses, sacrifice the "extreme" top line growth and go for solid profitability. Less "glamorous", but healthier in the long term
  • Attempt to secure a NAND deal in order to continue to go head-to-head with the other drive manufacturers in the mainstream business

See, OCZ had actually been trying to do both, which was why the company had been such an attractive investment. Capitalizing on both the high end PCI-E/server business would help to prop up margins while the mainstream drives would eventually ramp in enough volume to add meaningfully to both the top and bottom lines.

I believe that OCZ can spare itself a lot of grief competing in the cutthroat, high volume/low margin consumer SSD business if it would pull a Fusion-IO (FIO) or STEC (STEC) and try to do one or two things really, really well. Competing with NAND producers in the consumer business is tough on gross margins and even tougher when these competitors are also the ones selling you NAND and making a profit from it! The move to an internally designed controller with the upcoming Barefoot 3 should certainly help on the gross margin line, but the big problem is still going to be NAND pricing and availability.

Indilinx, SANRAD, And PCI-E: The Keys To Success

OCZ's management is actually pretty smart, if overly ambitious. The acquisitions of Indilinx and SANRAD were critical and I believe that these can be further leveraged.

OCZ should focus on supplying PCI-E solutions for enterprise use. These are high gross margin products (in excess of 50%) and as Fusion-IO has demonstrated, the market there is nice. Even if OCZ were willing to accept slightly lower GMs than Fusion-IO in order to appeal to a broader market, this would still be incredibly positive. I believe OCZ has in fact been doing this, but more aggressiveness here, especially on the PR front, would be much appreciated.

For the consumer side, OCZ needs to forget about supplying drives in volume. That's right, stop worrying about the low end. OCZ has a way too many SKUs for the consumer SSD market. The firm needs just two lines: Agility and Vertex. Further, these lines should not be ramped aggressively in an attempt to "steal share," but should be a nice demonstration of controller technology.

That's right. OCZ's exposure in the consumer space should be in selling controller designs. The firm's Indilinx has apparently taped out the upcoming "Barefoot 3" controller that is fully internally designed. This puts OCZ in a very small and elite group of firms that have controller technology. Controllers are high gross margin products, and a firm like OCZ will most likely be willing to make slightly less than competitors Marvell (MRVL) and LSI (LSI), but still be wildly profitable.

The addressable market here is huge. OCZ could supply controllers to even Micron and Intel, who both use controllers from Marvell and LSI, respectively, in their newest designs. The other countless drive manufacturers that are fighting for every scrap of pricing power could also find attractively priced OCZ controllers to be an appealing option for gross margin growth. All of this, while OCZ need not worry about NAND flash shortages, increasing competition in a commodity market ruled by the "big boys," and most of all, lack of profitability. It would enjoy a steady stream of profitable sales, even if the "explosive growth" story didn't dominate quarterly reports.

Conclusion

It will be interesting to see where OCZ's direction goes from here, as the firm has the technology to turn the ship around to be solidly profitable by focusing on higher margin, less commoditized businesses.

Source: OCZ Technology Warns On NAND Shortage: What's Next?