Description

OVRL is an undervalued situation which has significant upside potential in the event of an operational turnaround and limited downside risk based upon a cash balance of $5.15 per share and a current hostile takeover effort that has been undertaken by competitor ADIC.

Overland Storage is a market leader in data storage solutions. The company’s legacy business has been delivering tape automation libraries to small and mid-size businesses. Overland distinguishes itself as being one of the only competitors selling through an indirect channel that has embraced both tape and disc solutions. OVRL sells private label through its OEM channel and Overland-branded products through its value-added reseller (VAR) channel. In FY05, OEM sales represented 60% of total revenues, of which one customer (HP) represented 90% (or 54% of total revenue).

OVRL is trading at more than a 50% discount relative to where it was at the beginning of calendar 2005 due to two issues. The first issue was that the company began having disappointing earnings reports. Beginning in 3Q05, which ends March 31, 2005 (OVRL has a July fiscal year) OVRL reported flat year-over-year sales growth and EPS of $.14 vs. $.26 in 3Q05. 4Q05 was another poor quarter, with sales up 1% year-over-year and another negative comparison EPS of ($0.07) vs. $0.16 due to supplier delivery issues, high R&D spending, and weak sales. 1Q06 was also disappointing with sales down 2% year-over-year and EPS of ($0.12) vs. $0.13. The second issue which has weighed on the stock was the August disclosure that HP decided to engage an alternate tape supplier beginning in 2007. While HP will continue to carry OVRL’s products, it will focus on the alternate supplier and management has conservatively written the business to zero beginning in 2007.

The poor performance and bad news surrounding its largest OEM customer has inevitably led to suspicions that either OVRL’s base tape business is in secular decline relative to next generation disc technology or that OVRL’s tape offering is losing ground to competitive tape solutions.

Although tape is a mature technology whose growth prospects are challenged by disc based solutions, it would be a mistake to think that tape is going away. Tape is a cheaper medium and is far more physically durable than disc. There is a general consensus among experts that tape will be around for the foreseeable future, particularly for remote storage needs. This has been confirmed in conversations with both customers and resellers.

Management has indicated that 2006 is an investment year. Management claims that the significant investments to be made in FY06 will pay off in high branded sales growth in FY07 and FY08. The current operational guidance is for ($0.10) in EPS in FY06, $.20 of EPS in FY07 and $.50 of EPS in FY08. Revenue guidance is for $250 million in fiscal 2006, $230 million in fiscal 2007 and $230 million in 2008. The reason for optimism and the reason why EPS should be improving even as guidance for revenue is flattish over the next two years is that the mix will be shifting towards higher gross margin branded sales and away from OEM sales. During this mix shift period, revenue guidance for HP is expected to be $100 million in 2006 and $40 million in 2007 and zero in 2008, while non-HP revenue will be $109 million million in 2005, $150 million in 2006, $190 million in 2007 and $230 million in 2008. Reflecting this mix shift toward higher margined branded sales is the upward guidance for gross margins. Guidance for gross margins is for 25% in fiscal 2006, 32% in fiscal 2007 and 35% for fiscal 2008. The expected increase in gross margin and an expected moderation in R&D spending should drive operating margins to historic highs.

What will drive the growth in branded business? Management’s plan is offer a primary, secondary and tertiary storage solutions that are integrated. These solutions will combine the high functionality of disc for primary storage and the cost effectiveness and ruggedness of tape for secondary and tertiary platforms. The nature of the integration is such that once data is saved onto the primary platform it will be automatically saved the remaining platforms. This new strategy involving multiple platforms using different technologies was rolled out in October 2005.

This strategy will compete most directly with Network Appliance. OVRL’s management believes that it can compete effectively for two reasons. One reason is that its overall solution is dramatically less expensive that the Network Appliance solution. The second reason is that OVRL’s strategy is to pursue the indirect channel, which has been thirsting for more and better product. (Network Appliance has a direct sales force.)

Ultimately it is an uncertainty as to whether OVRL will be successful in its ambitious plan to dramatically increase its branded sales, and, in the process, increase its gross and operating margins. However, considering that net cash per share is $5.31 and that ADIC is attempting a hostile takeover at $7.90 per share, I believe the risk/reward is highly favorable. In its filings ADIC indicated that OVRL was significantly undervalued at current prices and that it was exploring a potential business combination. OVRL mgmt responded with a poison pill provision and there has been no activity to date. In the event management is successful, it is not unreasonable that the stock would easily get back to $15 per share- considering the top line growth and operating leverage that will still be available at that time; in the event that it is not a takeover at current levels or better is more than likely.

Catalyst

continued growth in branded sales
improvement in gross margins