Description

PAIRED OPPORTUNITY

How would you like to own a FCF-rich, proven storage technology vendor’s current business at a steep discount to cash flow and its competition, and get a free call option on a business which stands to directly benefit from the rapid growth now underway of a new $15B market* that leverages its core technology and marketing position? The company is Adaptec (ADPT), which will profit greatly from the adoption of low-cost Internet (IP)-based storage networking by small and mid-sized businesses (SMBs) as well as corporate America. By going long ADPT paired with a short of a richly valued company that stands to be hurt from adoption of storage-over-IP, Emulex (ELX), one can hedge out market risk and avoid long-only tech exposure.

MULTIPLE GROWTH OPPORTUNITIES FOR ADPT

Storage over IP:
Storage Area Networks (SANs) help companies reduce the cost and improve the reliability of storing and accessing their data by allowing multiple users to share the same storage resources, consolidate server resources, facilitate remote connectivity and perform easy backup. To date, companies have relied on costly dedicated Fiber Channel (FC) SANs from former highfliers like Brocade and McData, which provide expensive FC storage switches that connect to computing resources by FC host bus adapters (HBAs) sold by vendors like Emulex and Qlogic. These special-use fibre channel storage networks require incremental specialized IT personnel in addition to the special FC switches, HBA’s and dedicated cabling. To date, SANs are so costly only large enterprises have been able to afford them.

But a revolution to deploying SANs on pre-existing, lower cost, and flexible IP (internet)-based Ethernet networks is under way and Adaptec is set to be a prime beneficiary. Using storage-over-IP allows companies to leverage their existing network investment to deploy SANs, using their existing Ethernet routers, switches and IT personnel and resources. Further, incumbent FC networks depend on dedicated cabling which cannot extend over 10km, while storage deployed over the Ethernet network can be accessed at unlimited distances over a WAN or the Internet. Storage-over-IP using iSCSI cuts the cost of SANs in half, which will drive a large increase in the size of the $8B networked storage market.

The iSCSI portion of the SAN market is now growing at a 40% rate quarter to quarter as of Q1 CY 04, after seeing the industry delay volume launch by more than a year in 2002, according to IDC, the leading technology market data firm. Adaptec had expected to see meaningful iSCSI revenues in 2002 but adoption began in late 2003 – one of the reasons ADPT stock has languished over the last few years.

External Disk Arrays and SAN Solutions:
ADPT has also entered the market for external disk arrays, which it intimately understands since its adapters connect to them, in the iSCSI native, low-cost FC, and SCSI interface segments. Sales of these disk arrays, which totaled more than $55m in FY04 give Adaptec another way to benefit directly from the expansion of the low cost iSCSI-enabled storage-over-IP network described above. IDC forecasts the iSCSI array market to grow from $12m in 2002 amount to a $ multi-billion market in 2007. To see the type of growth available to an array vendor that executes price/performance in the low-to-mid-range of the disk array storage market, see Dot Hill (HILL)’s ramp in 2002-2003, achieved as part of a Sun Micro OEM storage solution. HILL grew from $46m to almost $200m revenues in one year partnering with an OEM experiencing declining server market share.

ADPT will also be able to capture more revenue than with adapters alone by addressing the higher value-add SAN market with an end-to-end solution for the mid-market -- its external disk arrays, which when packaged with servers using Adaptec’s iSCSI adapters, comprise a complete storage-over IP-SAN solution. In FY 05, ADPT is integrating the product development and marketing of its flagship Storage Solutions Group (SSG) group responsible for external arrays as well as legacy businesses with those of the iSCSI-focused Storage Networking Group (SNG). Presumably these will be folded into one business unit and reported together. This integration will leverage development and sales efforts to capture more of customer’s total SAN spend via solutions consisting of adapters, storage arrays, and software.

COMPANY BACKGROUND

Adaptec was founded in 1981, pioneered the Small Computer Systems Interface SCSI (pronounced: “scuzzy”) hi-speed storage interface and has long been the leader in the direct access storage (DAS) adapter market (one example is the adapter connecting the hard drive in your PC or notebook). Its growth prospects outside the growth of PC, notebook and server shipments are driven by the new market for adapters for IP-based networked storage, called iSCSI initiators, and Adaptec is the leader. iSCSI is SCSI adapted for IP, and market growth of iSCSI is hitting 40% quarter to quarter.

ADPT sells through all major computer OEMs as well as 115 distributors and thousands of value added resellers (VARs). ADPT traditionally focused on the VAR/distribution channel, and was hurt as server sales migrated from these smaller resellers to large OEMs. ADPT saw a large drop in revenues in 2001 due to a decline in the overall server and reseller server market, a drop- off in SCSI revenues versus lower margin interfaces, a market share stumble in the transition to the latest SCSI standard (losing share to LSI), and delayed market adoption of IP-based SANs and related iSCSI products while IT consultants and OEMs milked the high-margin FC market which ADPT did not focus on. ADPT has since successfully restructured the company to focus on OEM design wins. Demonstrating that success Dell, IBM and HP were all 10%+ customers in FY2003 and IBM and Dell were 10%+ in FY 04, up from no 10%+ OEM customers in FY 2001.

VALUATION: LARGE DISCOUNT TO FCF AND COMPETITION

Excluding a large one-time settlement gain, some smaller acquisition-related goodwill and R&D write-offs, and gains and losses on one-time items for note repurchases, APDT did EPS of 17 cents/share in FY 2004. But the value of ADPT’s current businesses lie in their FCF generation. The current portfolio of business is stable and provides free cash to fund small acquisitions, which bolster ADPT's offerings for future products.

Valuation of Current Business (on reported FY 2004 results):
$ Millions, FY 2004
Market Cap 845
Cash+MS 663
Debt 264
EV 445
EBITDA 65
Shares 110.7
EV/EBITDA 6.8x

Levered FCF 61
Unlevered FCF 47
EV/Unlevered FCF 9.4x

Unlevered FCF excludes net interest earnings of $14m. All FCF numbers exclude-one time items.

The current business should be valued at least 10x FCF assuming no growth. The company grew revenues more than 10% in FY 2004 and returned to profitability, so 10x is a conservative multiple. .43 in FCF*10x multiple = 4.30. Add 3.60 of net cash = $7.90, above the current quote.

The current ADPT valuation is reasonable for its DAS adapter/connectivity and RAID businesses alone. ADPT is a leader in SCSI adapters and sells successfully into a multiple storage-related markets, including RAID controllers (which control the operation of Redundant Arrays of Independent Disks, a type of external storage) for which it has a +80% share in US distribution. The adapter business should stabilize as ADPT launches products for new interfaces such as Serial SCSI and builds up its Serial ATA RAID business, a cheaper interface standard that has been taking market share from faster SCSI. As ADPT continues to build up its focus on OEM design wins, a recovery underway in computing unit volume could help (PC unit growth will be over 10% in 2004 according to Piper Jaffray, IDC, and others). The current business comprises SCSI adapters, RAID controllers, desktop connectivity products such as USB, Firewire, Serial ATA (the slower interface to SCSI), iSCSI, FC, SCSI and Serial ATA external storage arrays and the SNG group focused on the iSCSI adapter business. Some of ADPT’s higher-end external direct access storage business may be cannibalized due to its offering of low cost external IP networked storage. But the internal DAS business will not – internal storage will always be required to load software and carry mobile data. The DAS business should grow with the PC/notebook/entry level server market while as the iSCSI SAN business explodes.

STEEP DISCOUNT TO COMPETITION
To put it in perspective, the market values the free cash flow of Emulex (ELX), one of the companies who stand to get hurt from margin compression of its FC HBA business by the adoption of storage-over-IP, at more than 3 times the FCF of Adaptec:

Emulex (ELX)
(TTM)
EV/EBITDA 11.8x
EV/Unlevered FCF 33.1x


HEDGING WITH ELX

For those who wish to hedge out market risk or for those uncomfortable with long-only tech exposure I recommend a short of ELX. Core HBA revenue growth is slowing: from 23% YoY to 16% to 12% over the last 3 quarters. Over the last 4 quarters, ELX has seen its GM’s drop from 66 to 63% while its R&D + SGA have gone up from 30 to 34% as demand for its costly FC products softens. In a preview of the future, OEM revenue fell 7% q to q in the last period while distribution revenue went up 34% to compensate. OEM business is currently 62% of ELX business, and OEM design wins and shipments generally preview future overall demand for system-integrated tech products. ELX is heavily dependent on EMC, IBM, and HPQ, which comprise almost all of its OEM revenue.

ELX and QLGC cornered the FC HBA market by basically beating internal OEM design teams to market. But there is no more market share to take for ELX and QLGC in this business – the two companies share has peaked at 85%. The only place to go to grow is downmarket to the SMB market where iSCSI has a huge cost advantage in product cost and IT support costs, and cost is a much bigger driver in the SMB market.

Further, ELX’s top customer, EMC, has an important program to drive down the cost of HBAs and Dell has now shipped its first low-end HBA, traditionally a harbinger of margin correction. ELX’s valuation is very dependent on keeping its margins high since it has a relatively small revenue and customer base. A strong new competitor, AMCC, has entered the heretofore-cozy FC HBA duopoly of QLGC and ELX, pressuring margins. The competitive pressure is showing up in the financials -- ELX cut guidance in April (interestingly ADPT raised guidance in April).

Going forward, as low cost iSCSI SANs deploy and large corporations delay FC deployments as they test storage-over-IP, ELX has much less room to maneuver as iSCSI takes away some high- margin SAN installations from its cash cow FC business. ADPT on the other hand, has the ability to grow its margins up from FY 04’s 42% level by migrating its business up the food chain from lower margin DAS and desktop areas to the higher margin SAN with its end-to-end iSCSI SAN offerings.

It is rare to be able to purchase a company with a solid history and bright future like ADPT to such a steep discount to its competitors, especially when the company just raised guidance in April while the rest of the storage sector was flat and Wall Street darlings ELX, QLGC and MCDTA were actually cutting guidance. Shorting ELX against ADPT is a compelling pairs trade given the current inflection point in the storage market.

GROWTH OF BUSINESSES:
The cost-attractiveness of networked storage to SMBs for the first time and attractiveness of increased SAN deployments in larger companies due to the much lower cost of iSCSI versus Fibre Channel is driving rapid iSCSI growth. In FY04 Adaptec’s Storage Networking Group (SNG), did only a few million in iSCSI adapter business compared to the company’s total $452m in FY04 revenue. The overall iSCSI SAN market is growing at 40% clip q to q. As the leading iSCSI adapter vendor partnered with the leading iSCSI solution vendor (Network Appliance with a 48% share), it is safe to assume ADPT’s iSCSI business will grow considerably faster than the iSCSI SAN market.

The current w/w market for networked storage is almost $8 billion/year including FC, iSCSI and mainframe (IDC). Assuming a total iSCSI SAN market of + $125 m for 2004, up from $12m in 2002, over $400m for 2005, and $1.5B in 2006, ADPT, as the #1 iSCSI adaptor vendor with plug and play external disk array up-sells for the end-to-end SAN solution, is well positioned to maintain a leading share of the adapter market and capture a greater piece of the total SAN dollar. ADPT can grow profitability faster than sales since ADPT is leveraging many of the same design resources and sales channels they have today and integrating SNG into a solutions structure.

DCF VALUATION
I assume ADPT will capture at least 25% of the iSCSI storage market thru FY 2007, not a bad assumption since only ADPT and NTAP have a real market focus today. At gross margins falling next year to 41% and then rising to 48% by 2007 as ADPT addresses growth markets (GMs were 52% in 2002) and with R&D and SGA levels around FY 2000 levels, it is reasonable to assume ADPT will be throwing off an incremental free cash flow of $225m by FY 2007, back to FY00 levels. Factoring in a share count of a conservative 146m shares, I get a DCF valuation of about $23/ share using a discount rate of 10%.

SHREWD ACQUISITIONS AND DIVESTMENTS

ADPT management has a record of accretive and strategic acquisitions at a discount to revenue and has been good allocators of shareholder capital in the restructuring of the company.

Eurologic accounted for $55m in FY 04 revenue. It was acquired for $27 million in 2003 for cash plus option dilution of 500k shares to bolster the DAS and FC server storage business.

ICP Vortex accounted for $20m in FY 04 revenue. It was acquired in 2003 for $15 million in cash from Intel to bolster RAID data protection solutions, including SCSI, Serial ATA and FC products.

In 2001, ADPT purchased Platys for $109m including $50m in cash plus 3.1m total shares of option dilution, which formed the technology basis for ADPT’s market-leading iSCSI solution, which is driving the accelerated growth of the company. (SNG division)

It is also worthy to note that ADPT management generated a $49m gain in 2003, $31m in cash and the rest in a reversed holdback for a 1999 acquisition of DPT which did meet conditions.

The spin off of Roxio in 2001 was likewise shrewd and well timed, divesting the company of a distracting digital media business and giving shareholders the option to liquidate their exposure to it. The performance of ROXI since has borne out ADPT mgt’s decision to spin it off.

In Feb. 2004, ADPT purchased Elipsan for $18.7m to strengthen its RAID offering. The Elipsan portfolio will help ADPT sell across different types of RAID installations.

On the negative side, management did approve an employee stock option exchange program in 2001. 7.6 m shares were turned in from prices of $9 to $59 per share for 7.0 m at an exercise price of $15.29 per share. But mgt. has not done an exchange program since, and they sharply reduced the number of stock option grants as the stock hit its lows (other than the Platys acquisition –related share issuance at a very low exercise price).

COMPETITION

Adaptec competes directly with QLGC in the SCSI DAS adapter market, the FC adapter incumbents ELX and QLGC indirectly, LSI and others in the iSCSI adapter market. ADPT competes with, HILL, LSI, MXO, DSS, NTAP, Iomega, captive OEM in house projects, Digi-Data, Wasabi and other startups in the external disk array market,. It competes with AMCC, INTC, Promise, Infotrend and some of the companies competing in the other segments in the RAID controller market. Clearly there is real competition in each segment, thus many may prefer to do this as a pairs trade. However, ADPT’s current valuation discounts zero growth from the iSCSI market, contrary to my expectation that ADPT will maintain iSCSI adapter market share leadership as the space explodes. The company is clearly positioned to grow strongly in the disk array business both in concert with the SAN business and as part of its DAS offerings.

Catalyst

CATALYST
-Increased awareness and adoption of cost effective storage-over-IP SANs
-Margin compression of fibre-channel dependent HBA vendor ELX
-Storage market leader EMC deployment of iSCSI (now in testing)
-Launch of iSCSI native systems by EMC, HPQ, IBM and continued adoption of the iSCSI standard
-Certification of iSCSI by PC and low-end server OEMs now that Microsoft certification and support of iSCSI standard complete
-Increased availability of Linux and Novell iSCSI storage software
-Coverage pickup on ADPT by major brokerage. ADPT covered by 4 analysts while 19 firms cover ELX.
-ADPT low valuation