It's not often that I would bet against a company with a large cash position relative to its market price. In fact, one of my favorite metrics to look at when I begin a screen for underappreciated, deep value plays is the net cash relative to market capitalization. My view is that having a stockpile of cash to cushion several quarters of losses is a critical weapon against bankruptcy for a company that is executing a turnaround gambit. While some turnaround plays dilute their way out of a tight spot, this usually severely damages the holdings of current shareholders.
Let me introduce you to STEC (NASDAQ:STEC), a company with no debt, trading at 80% of net cash on its books and likely well below liquidation value, that is executing a turnaround play in an industry that is experiencing very high secular growth.
STEC's Rise (1990 - 2009)
STEC was founded in March, 1990 by Manouch and Mike Moshayedi as Simple Technology, Inc. A few years later, a third brother, Mark, joined the firm. The company began as a provider of computer memory modules. However, that business very rapidly became commoditized and it became next to impossible to make any significant profit margin by selling memory modules.
The company then made the shrewd move to purchase Cirrus Logic's (CRUS) flash controller business, which gave STEC's business new life as a supplier of flash solutions for consumer electronics. As momentum built, STEC managed to pick up flash card vendor SiliconTech in 1998 and soon thereafter launched a 1GB IDE solid state drive. Keep in mind that flash memory was incredibly expensive back then, so this was a niche, high end product.
After its 2000 IPO, STEC purchased Memtech SSD in 2005 and Gnutech in 2006. In 2007, STEC sold off its consumer flash business and became a pure-play enterprise solid state drive vendor. The focus would soon pay off as the company's release of the ZeusIOPS SSD, which was one of the, if not the, world's fastest enterprise-grade SSD in 2008. In 2009, EMC (EMC), a leading provider of enterprise storage systems, announced that it had chosen STEC's SSDs for some of its solutions. Investors, of course, believed that this was the beginning of further design win momentum rather than the short-term burst that it turned out to be.
STEC's Fall (2009 - Present)
After the initial giddiness that the share price saw as a result of the multi-quarter acceleration of revenue growth, shares took a nosedive when it was clear that such high-octane growth was unsustainable. It wasn't just the revenue growth that fell by the wayside, as net income and gross margins tanked as well:
The Market Opportunity Is There...
While it may seem from these numbers that there may be a broader industry-wide slump, STEC's problems are uniquely attributable to STEC. For some context, Research and Markets projects that the market for SSDs will grow from 382,000 units in 2011 to 3.9 million units in 2016 (a CAGR of 59%). Correspondingly, revenues are expected to grow from $582M in 2011 to $3.5B in 2016. While many pure-play flash vendors are private (and thus revenue growth metrics are unavailable), the industry trend is clear:
- EMC, a leader in enterprise storage, has begun aggressively pushing flash solutions (such as its VFCache)
- NetApp (NTAP) has adopted flash caching solutions and has partnered with Fusion-io (FIO) for PCIe flash drives/accelerators
- IBM (IBM) recently picked up Texas Memory Systems in a bid to enhance its considerable server offerings with in-house flash memory solutions
- Intel (INTC) has been aggressively expanding its line of SATA enterprise SSDs and even rolled out a line of PCIe drives
- Micron (MU), a major provider of NAND flash and leader in the consumer SSD market, has also been expanding into the enterprise space with new offerings
- OCZ Technology Group (OCZ), despite its numerous woes, has even aggressively shifted gears in a bid to capture some of the enterprise SSD space (I am, if you are a follower of my coverage of OCZ, not particularly thrilled with this firm's prospects, but they nevertheless compete)
- SanDisk (SNDK) has expanded aggressively into the enterprise SSD market, especially with its acquisition of FlashSoft
In a market that is exhibiting clear secular growth, STEC was unable to maintain its previous revenue levels, let alone grow. What happened?
Intense Competition & Inadequate Marketing Efforts
One of the major reasons that STEC has seen sub-par financial performance over the last year is that, despite the secular growth of the sector in which it plays, competition was able to catch up -- and then surpass -- the company's efforts. In a recent interview, STEC's interim CEO (the official CEO is still dealing with insider trading charges with the SEC) had the following to say:
Question: More than two years ago, STEC was the king of enterprise SSDs and it's not the case anymore. What happened?
Mark Moshayedi (Interim CEO): The competition. We started the enterprise SSD business in 2006. We engaged EMC in 2007 and by January 2008 we made the announcement that flash drive was now qualified for the EMC system. That was the start of the whole enterprise SSD market. It wasn't until October 2011, I believe, that competition was able to create a product that was competitive to our SSDs. As a result, there is a lot of competition, people are now engaged in selling SSDs to the major OEMs which used to be our major customers.
The competition was not only able to release competitive products, but one particularly fierce enterprise SSD competitor -- Fusion-io -- was notably able to out-market STEC (in addition to having a "better" product). The following excerpt from the aforementioned interview speaks volumes:
Mark Moshayedi (Interim CEO): When we started, the only place where people could really use SSDs was the enterprise storage, not server side. It required a lot of hooks for the server side to pick up. And that may be one of the mistake that we've made. We focused so much on enterprise storage that we didn't pay much attention to the enterprise server side. Fusion-io came in and they purely focused on the server side. These accounts require a lot of hand-holding. From what I understand today, Fusion-io has 180 sales people that just sell to enterprises. We have today less than 10. We're adding a lot of sales and marketing people to be able to engage with those customers. We have the products, we need to go to those customers now.
These statements are confirmed as we look at the trend in SG&A over the last several quarters:
A little concerning, however, is that management actually seems to be cutting a bit into R&D to fund the sales team expansion:
Mark Moshayedi (Interim CEO): Over the last three years, STEC has been building its engineer organization. As you hire you get a lot of good people. Over the next few quarters we're looking at reducing that. It's a normal business practice, right-sizing your business for the amount of sales that you have.
This has not yet manifested itself in the R&D numbers as of the most recently reported quarter, but this number should be eyed in the upcoming earnings release (and questions should be asked if R&D doesn't stabilize/come down):
The tricky part of this circus act, though, is that if a company cuts into R&D too deeply, the products become uncompetitive, and no matter how great of a sales team it has, the products simply won't sell (unless they are offered at significantly lower gross margins than those of peers). Interestingly enough, compared to PCIe leader Fusion-io, STEC's R&D isn't too far behind in dollar terms. The catch, though, is that Fusion-io is a pure-play PCIe/software focused group while STEC is trying to offer alternatives to Fusion-io's software solutions in addition to numerous SATA/SAS solutions, which could dilute the competitiveness of the offerings.
Further, Fusion-io's sales are growing and its gross margins are much healthier than STEC's, so it is also not clear if STEC could maintain a long-term competitive position at current revenue/margin levels.
STEC Is Tweaking Its Business Model
Despite intense competition in this field, I believe that STEC's product line-up is finally where it needs to be in order to be competitive. The firm now has a PCIe flash caching solution (that is currently being tested by customers), its next generation of SATA/SAS drives qualified with its key customers, and, as noted above, is operating in a market that is undergoing explosive secular growth.
One thing that is critical to point out is that STEC has fundamentally changed its business model. Previously, STEC only supplied products purely to OEMs. That meant that companies such as EMC, NetApp, IBM, and the like bought STEC's products for inclusion in their own products. The problems with this business model are fairly clear:
- What if a customer wants to build his/her own storage system and simply wants to buy drives, rather than a full package from the aforementioned storage solution OEMs? This leaves a significant amount of business on the table.
- What if one of the OEMs decides to move to a competitor's solution (or build one in house)? This dependence on OEMs (~70% in the most recent quarter) is a source of non-trivial vulnerability.
Management has very clearly expressed its desire to have a 50/50 mix shift of OEM/direct enterprise customers, and on the most recent call, interim CEO Mark Moshayedi was actually optimistic that the mix could be even more skewed to direct customers than half of the business by 2H 2013:
Rich Kugele - Needham & Company
Okay. And, then just lastly, how long do you think it will take for this transition to be, call it, half your business?Mark Moshayedi
We hope that by second half of next year it's actually larger than half of our business.
Not only does this mix shift reduce the risk profile of the business, but it also leads to significantly shorter qualification times, which leads to a shortening of the time between a design win to sales and recognition of the revenue from said sale. This will lead to a more consistent business with better visibility.
However, despite these restructuring plans to position the business more in-line with the realities of the market, the compelling "buy" case comes from the relative safety of this speculative play as afforded by the company's tangible assets.
Trading Near Cash Value, Below Liquidation Value
STEC's market capitalization as of the most recent close came out to $242M. The net cash on STEC's books (the company has no debt) comes out to $186M. While the company has been posting net loss after net loss, cash burn has actually been fairly modest.
With the company's new product cycle, coupled with its business model changes, I believe that we will see perhaps another quarter or two of cash burn at the ~$20M level before the company is able to get back to a cash-flow neutral-or-better state.
More importantly, this does not include any property or patent assets, which could be worth considerably more than the current market valuation suggests. In fact, according to the interview with the interim CEO, the company, in addition to its $187M in cash, has $200M in other assets. Even if he is exaggerating the value of the "other" assets by a factor of 2, the company is still trading far below liquidation value, and certainly very close to tangible book.
Another truly stand-out positive is the insider buying over the last several months:
The insider purchases signal management's confidence that the business could actually turn around and succeed. As the old saying goes, there are many reasons for an insider to sell, but only one reason for an insider to buy: because he/she thinks there's money to be made.
The Upside Drivers & Price Target
While I believe the case for strong valuation support at the $4-$5 level, the stock still needs an upside catalyst. For the current year, analysts estimate that STEC will lose $1.00/share (which means a $0.32 dent into the $3.99/share in cash the company has), and then in 2013, analysts estimate the losses widen to $1.05/share.
These estimates seem far too pessimistic, and any indication that the current fiscal year will be better will likely relieve the downward pressure on the shares. For instance, the revenue growth for the next year is expected to come in at $17M, or a mere 9% from 2012 levels.
My belief is that, in addition to the structural changes noted above, the following major upside drivers will allow STEC to grow much more in line with the broader enterprise flash industry as a whole.
PCIe Solution Can More Than Account For Projected Growth
STEC, as noted previously, has a viable PCIe flash accelerator hardware + software stack is now available and in the hands of customers for testing and/or qualification. Given that Fusion-io alone is projected to see ~$425M/yr in sales for CY2013 (there are other players here too, such as OCZ, LSI, and Intel), it is possible that the company may recognize ~$30M in high margin sales as soon as CY2013, assuming very modest market share (~10%) goals, that are purely incremental to the existing revenue base from this product offering alone. Sales of this product are purely incremental as STEC does not offer a PCIe solution today.
Quantifying The Direct-To-Enterprise Opportunity
The company expects non-OEM sales to comprise ~50% of sales by 2H 2013. Assuming even a conservative view that sales to OEM partners sees no growth, this would imply that the OEM sales would increase from the ~$51M/yr that we see today to more along the lines of a $119M/yr run rate, which would help push estimates far past the $188M/yr that analysts expect for the year ending in December 2013.
Margin Expansion More Than Likely
The growth areas are particularly focused on software as a differentiator, which means that ~10% market share in PCIe, assuming all other areas fixed and further assuming a 50% GM (below FIO's ~55-60%) could contribute as much as 200bps to the blended gross margin line. The long-term target of 40% gross margins are quite reasonably achieved as the business adds higher gross margin products to the lineup. A ramp in volumes will also dilute the impact of the various fixed costs that exist, which should further prove to be a tailwind during this recovery.
Wider Loss For 2013 Seems Pessimistic
If we see a cutback in R&D spend, and if we don't see too much more expansion on the SG&A line, then improving GMs coupled with improving sales make the analyst estimates of a $1.05/share net loss for 2013 seem unrealistic in light of the $1.00/share loss for 2012.
More broadly, according to management, STEC needs a ~$70M/quarter run rate at ~40% gross margin to achieve breakeven. On one hand, this is a near doubling of revenues from the current $35M - $40M base, but the broader market is growing at ~40% CAGR and, more importantly, STEC has had to "sit out" with outdated products. This is no longer a problem, and it seems very plausible that by the fiscal year starting in 2014, the company will meet/exceed the breakeven level.
Finding A Price Target
At that point, STEC would be doing ~$280M+/yr in sales, which, even assuming a full $1.05 loss in 2013, would value the company at $3/share in cash + $2-$4/share in "other assets" + EV = 1x sales ($6/share using a share count of $46M) = $11 - $13/share. This implies 140% potential upside with worst-case downside to $3/share in the next 12 months, assuming the market values the business at $0 and the company truly ends up burning $1/share in cash during CY2013. This further excludes the value of any patents, property, plant, and equipment that could be liquidated and returned to shareholders.
Of course there are risks. This is very much a turnaround play that hinges on three major factors:
- STEC's ability to put out competitive products
- STEC's ability to market said products in an environment of fierce competition
- STEC's ability to keep cash burn at a minimum during this transition period
Should the situation not play out as expected, STEC could conceivably keep burning cash as its patents become less and less relevant by the day, ultimately resulting in bankruptcy. I do expect that if the turnaround effort doesn't look like it's going to succeed from organic growth, the company will throw shareholders a line and announce that it is looking into "strategic alternatives." This could very well include the outright sale of the company or a sale of critical patents and then the subsequent liquidation of the company and return of cash to shareholders.
The reason this story is so compelling is that the company could choose to shut everything down, return the cash to shareholders, sell its patents, buildings, and such and then shareholders at today's price would end up ahead. I believe that there's a lot of growth to be had in enterprise storage solutions, especially as in this space, the primary differentiators are in the software.
The risk/reward for STEC is nearly the best available in this market with ~$1-$2 of downside for $6-$7 of upside. It is very difficult to say no to such a rare opportunity, and as such plan to pick up shares immediately.
Disclosure: I am long INTC. 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.
Additional disclosure: I may initiate a long position in STEC over the next 72 hours.
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