Promising Future for STEC

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Includes: DVMT, IBM, STEC
by: GARP Investor

STEC Inc. (NASDAQ:STEC) announced yesterday the results of a SPC-1 benchmark that delivered an impressive 300K IOPS performance utilizing STEC drives from an IBM Power 595 system, considered the fastest Unix system in the market. Getting past the marketing hype, the press release and the references from it provided some significant clues into STEC’s future earnings power and its sustainability that will be very rewarding to STEC investors into the future.

The benchmark IBM Power 595 system was configured with 14 storage drawers each with 6 69GB SSD drives (they are actually 128 GB STEC drives that IBM formats to 69GB for wear leveling) for a total of 84 SSD drives. IBM’s list price per drive is $13,235 and was shown with a typical 35% discount equating to an end-user price of around $8,600. While I have no idea about STEC’s transfer price to IBM, I am going to assume that IBM is making about 50 to 65% gross margin on these drives now (why not?) and STEC gets say, $3000 per unit. That works out to $252,000 in total revenues to STEC for a similarly configured Power 595 system. (If you are curious the total end user cost of the benchmark system was $3.2 Million, with the SSD’s costing $722K or 22% of the total system and STEC’s net using my assumptions around 8% of the total system.)

The IBM Zeus opportunity: Most of STEC’s recent high margin Zeus IOPS revenues have mostly been coming from EMC. However, I believe IBM can start adding significantly to this over the next couple of quarters providing tremendous upside potential.

According to IDC’s 2Q09 quarterly server tracker, IBM posted a 53.3% leadership share of the $4.7B non-x86 server market. The new Power systems are certainly helping IBM in the high end. Interestingly, IBM made two field announcements recently that will continue to drive market share for IBM in this segment. One, they announced that customers who buy the Power6 machines today will have upgrade protection to the Power7 machines coming next year. Two, they announced in August a Power 595 server trade-in program that will give customers up to $240,000 if you trade in a Sun Fire F15K for example.

Note that the Power systems got SSD support only in the tail end of Q2 and the Power 595 only in Q3 (though many of the 595’s were probably sold attached to the high end DS8000 storage arrays that had STEC SSD support). So the IBM Power related revenues to STEC started trickling in only in Q3 and it will be probably in Q4 that we will start seeing meaningful impact. Just to get a sense of the total opportunity, if every IBM non-x86 server is sold with 8% of STEC SSD content (whether direct attached like in the above configuration or SAN attached as with a DS8000), the total opportunity is $200Million/quarter. Even if it is only 10% of that, the $20Million/quarter is a meaningful addition for STEC now. To put it another way, if IBM sells just 40 Power 595 in Q4 with fully configured 8% STEC content, that is $10Million (note, that is only $3 Million x 40 = $120 Million of total Power 595 system sales, which is fairly conservative for IBM to do in Q4 where enormous budget flush will take place). If IBM sells another $10Million with the rest of Power 520, 550, 560, 570, etc, that is a total of $20 Million. This does not even take into account the LSI Engenio based mid-range storage arrays that IBM will announce with STEC SSD support. Where I am going with this is that my non EMC Zeus IOPS assumption for Q4 is only $22Million and that is starting to look very conservative (and my total revenue projection for Q4 is already $10 Million above consensus). Just FYI, all of the analysis above does not include revenues from Mach8 that goes into the IBM System x servers.

The Bottom Line:

The market (myself included) is severely underestimating the revenue potential and earnings power of STEC. Just looking at the enormous amount of collaborative development and optimizations that OEMs such as EMC and IBM did with STEC, the unit testing and application testing, and the benchmarking and marketing specific to STEC drives means that STEC is entrenched and their earnings power and growth is probably sustainable for a long time. STEC owns the enterprise SSD space today and even when some competitors finally get qualified in late 2010, STEC as an entrenched player will continue to own 80% of a market that will be $1.5 Billion by 2012.

Recommendation Summary:

STEC is the leader in enterprise SSD’s and is one of the fastest growing companies in the technology industry with expected growth of 60%+ in revenues in both 2009 and 2010.With the exception of Netapp, STEC has OEM wins with all the major systems OEM’s such as EMC, HDS, HP (NYSE:HPQ), IBM, LSI, SUN (JAVA), etc. STEC’s solutions have an extremely compelling customer value proposition – according to a recent EMC presentation (STEC’s largest OEM), a STEC based tiered storage solution provides 18% lower storage costs, 60% more disk IOPS, 17% less power and cooling and uses 30% fewer disk drives. With a large market opportunity that is well over $1.5B, compelling customer value proposition, design-win with all the major OEM’s, minimal competition (heavily overblown as discussed here), huge manufacturing capacity to meet the high demand, and low cost operation makes STEC a fast grower for years to come in both revenues and profits. With the stock trading under 10x 2010 earnings of $3.00/share, STEC provides a 100% return potential over the next 12 months. Recommendation: BUY.

Target price: $60 (up over 100%)

Price
Shs Out
Mkt Cap
Float
LT growth
Cash/shr
Oper Mgn
$27.75
50.7MM
$1.41B
63%
50%
$1.85
31%
2008A eps
2009E eps
2010E eps
P/E 09E
P/E 10E
Revs 10E
EV/10Rev
$0.31
$1.70
$3.00
16.3x
9.3x
$598MM
2.2x

Disclosure: Long STEC stock and call options.