Description

Dot Hill (HILL), the Company, is a high ROIC investment opportunity with fantastic risk reward characteristics.   Hill is provider of storage solutions to system integrators and OEMs.  We believe the stock could be a double or more with very limited downside risk, as HILL is trading at 85% of its tangible book which is comprised mostly from their cash balance.   The bad news is well known and has been more than priced into the stock.  Near term catalysts are close.   We believe the stock could trade to $4/share or more as the Company continues to move in the right direction and potentially yield even more to a strategic buyer.

The Company is currently operating cash flow negative as a portion of its business to its largest customer, Sun Microsystems is tailing off.  The lost business is being replaced with a more diversified group of customers and many new products.  Having said that, the Sun business was higher margin than the business it is being replaced with.  The good news is that the current product line is current and in demand and much more diversified than its legacy business was. 

The company has $1.95/share in cash.  We conservatively estimate that it will burn no more than $10 million or $0.22/share over the next 5 quarters before a return to profitability.  Since, shares are trading at $2.30/share this implies you can buy the operations for about $0.60/share.  Everything is contract manufactured, so there aren’t many other hard assets. 

For this $0.60/share you get the tail of the SUN business which is finite (currently 50% of sales), but could last for some time.  Plus you get the new product portfolio, IP (70+ patents), customers, relationships etc, and  $180 million in NOLs which I estimate to be worth about $0.35/share (after taking into account only the portion the company is likely to be able to use and discounted to PV).

Valuation

We believe that a return to profitability will occur during 2008 through a combination of reducing SG&A and replacing waning SUN business.  Manufacturing is completely outsourced and hence the business is very scalable.

Historically, operating margins have been in the high single digits.  We do know that the business going forward probably won’t be this good.  Applying a 5% op margin to just $200mm in sales, at 10x op income, and taking into account the cash (and cash burn), that would suggest the stock is worth $4/share.  This would be about 0.25x EV/Sales.  Comps trade at levels well in excess > 1x sales.  M&A transactions have been at even higher multiples – e.g. DELL recently paid $1.4 Billion, or 10x Sales for Equallogic in late 2007.

We don’t have any reason to believe that a sale of the company is on the horizon or not.  There have been rumors on and off for as long as we’ve followed the name.  But, given the enormity of their customers (IBM, Fujitsu, Network Appliances, etc), importance of their products, and the ease at which any of them could buy HILL, the possibility should be considered an additional upside free lottery ticket.  Given my, albeit primitive, understanding of the NOL rules relating to acquisitions, I believe that the right buyer could essentially buy HILL for nothing.

Background

Dot Hill supplies lower-midrange disk storage arrays for resale by server and storage-system vendors.  The company's primary competency is system design, as substantially all manufacturing is outsourced.  Dot Hill was originally formed through the merger of Artecon and Box Hill Systems in 1999.  In May 2002, Dot Hill signed an agreement to supply Sun Microsystems with storage arrays, which Sun sells as the Sun StorEdge 3000-series brand.     Since then HILL has moved to sell mostly through OEMs and System integrators.  SUN was formerly an 85% customer and now is 55%.  The lost sales have been replaced with new OEMs, unfortunately, the biggest of the announced new OEMs, NetApp (16% of Rev) will produce lower margins than the Sun business does.  Management has indicated there is a new Tier 1 customer but have been sketchy on the details.  The analysts believe it to be either IBM or HP, and that it will very good margins.  Hills product portfolio is quite broad and I wont attempt to summarize it here, but rather refer you to the 10-k.   

Hill is a provider of storage systems for organizations requiring high reliability, high performance networked storage and data management solutions in an open systems architecture. Storage solutions consist of integrated hardware and software products employing a modular system that allows end-users to add capacity as needed. Products range from medium capacity stand-alone storage units to complete multi-terabyte storage area networks, provides end-users with a cost-effective means of addressing increasing storage demands without sacrificing performance.  Products and services are sold to end-users primarily through channel partners, OEMs, systems integrators. 

The efficient generation, storage and retrieval of digital data and content has become increasingly strategic and mission-critical to organizations. The volume of this data continues to grow rapidly.   According to IDC, the total storage capacity of all worldwide external, disk storage systems shipped will grow by nearly 56% on a compounded annual basis between 2005 and 2010. 

There are several good presentations available on the Company’s website. 

Business is highly leveragable.   Operating expenses can stay flat as business grows.

Margins are improving - largely from moving manufacturing to a contract manufacturer in China and reducing Opex.  However, growing sales appears to be the real key to profitability.   Management believes that profitability will occur in 2008, when sales are in the $60-70mm/qtr.

Summary

This is an investment opportunity with great risk/return characteristics.  Although we’ve focused on this writeup on the balance sheet, this is not a solely a cash play on a dying company trading at a discount to SOTP.  Hill is a good company in a huge growing industry that has many tier 1 customers that is going through transition.  The return to profitability is logical and signs indicate that it has begun to happen.   The downside in this investment opportunity is limited by the balance sheet. 

Catalyst