Description

QTM is a special situation with multiple near-term catalysts and 50-140% upside over the next 6-18 months.  An accomplished tech activist (Starboard) filed a 13-D and recently purchased 10% of the company at prices as high as 30% above where the company currently trades.  Starboard also purchased over 40% of the company’s recent convertible offering, with a strike price of $1.65, which further bumps their economic interest closer to 16% of the company.  Due to a particularly friendly charter & a very disgruntled shareholder base, we expect Starboard to have little trouble taking control of the company in the next 4 months and quickly begin the process of unlocking the meaningful sum-of-parts value that exists here.  Starboard has given no indication of their plans or thinking publicly, but given their track record and generally philosophy, their intentions are reasonably easy to guess here.  We expect Starboard to potentially become more public with their views in the next few weeks with the nomination deadline for new board members looming May 15^th.  As investors and Sellside analysts begin to do the sum of parts math here (which we outline below, and is not particularly easy to do from public docs), as Starboard takes control of the company, and as a couple currently weak operating segments stabilize, the stock should begin to approach something closer to its sum of parts value. 

Brief background

Quantum is historically known as a leading provider of tape back-up drives.  Tape back-up is a profitable business for QTM, but is in secular decline.  Like many companies facing obsolesce, QTM has for the past several years been plowing all its cashflow from its tape business into what amounts to basically VC type investments in the storage space.  In the meantime, tape has continued to decline, and the newer, growing business have grown topline but have proven not to be as profitable as the declining tape business.  The company gives some breakout of revenues, but gives no breakout of segment profitability, making it difficult without primary research to get a sense of the sum of parts value here.

The company has received overtures in the past by Netapp, among others, interested in acquiring their “sexy” growth businesses.  But in the past, management has not been opening to selling the pieces, just the whole, and nothing is less sexy in tech than anything that is declining topline in tech.  The stock traded as high as $4 on bid spec as recent as late 2011 (v. $1.22 today).  For reasons we will discuss later, we think a sale is more likely now than at any other time in the company’s history.

Below is our sum of parts value, which we will discuss in more detail in the following sections:

Note that the company has convertible debt at a strike price of $1.65, which we adjust for in the above calcs when the target price is greater than $1.65. 

Tape Business and Royalty Stream

QTM is one of the leading providers of tape storage products – they compete primarily with HP, IBM, Dell in this space.  According to the Santa Clara Consulting Group (sccg.com), which has very good data on the tape industry, tape unit sales have been declining over the last 3 years at a 5% CAGR, and are expected to continue to decline at a similar pace for the foreseeable future.  Bears and current consensus argue that tape is dead – tape is increasingly being displaced by disk storage, which is more expensive but allows for much faster access times and write speeds.  Although we acknowledge that tape is likely to continue to shrink, we think the pace of the decline (~20% in the last couple quarters) is not the right decline rate.  The decline rate in automation systems has been hurt due to people delaying purchases until the launch of LTO-6. LTO-6 media and systems were released in December 2012.  On the royalty side, royalties are tied to overall tap catridge sales levels.  In the 1-2 quarters leading up to (and in the 1 quarter after) a new product cycle, pricing for the previous product (in this case, LTO-5) falls meaningfully, resulting in sharp industry revenue declines that are temporary.  This also impact's QTM royalties, as the company incurs a step-down in their royalty / tape on the old product before the new product is launched (at a higher royalty rate):

 Source:  Proprietary analysis using Santa Clara Conuslting Group Data

A couple quarters after launch, the new version captures meaningful share, at much higher prices, blended pricing stabilizes (or increases slightly) and tape goes back to growing / declining at the rate of unit volumes (which again, is low single digits declines).  We expect tape revenues & royalty revenues to have one more bad quarter before eventually stabilizing as the LTO-6 launch ramps.  We would also note that the LTO-5 upgrade cycle was particularly weak, leading people to speculate that LTO-6 upgrade might be stronger as people upgrade from LTO-4 to LTO-6 systems.  LTO-6 offers triple the storage and a 33% increase in write speeds, so the performance improvement should be meaningful.

Tape serves a very specific function – think of tape as being the file archive in the basement with all the files you never use but that you may need one day.  For this function, tape is generally better than disk – it is less prone to breaking (v. disk which has more moving parts and is more susceptible to that), it is cheaper to buy (about 1/3^rd the price), and uses less energy, reducing maintenance costs.  Google, for example, is the largest purchaser of tape in the US, and uses tape to back-up gmail files.  New cloud back-up services (e.g. Amazon Web Services), also utilize tape.  So, in short, this business is declining, but did about $333M in revs on an LTM basis and is not going away.  Based on conversations with industry participants, we believe this should easily be a 10% EBITDA margin business and potentially as high as 15-20%.  We ascribe a 4x EBITDA multiple to this business @ 10% EBITDA margins.

QTM also receives royalty payments on tape products incorporating DLT and LTO standards.  QTM pioneered the DLT standard (being replaced by LTO), and receives 100% of the royalties on products using that technology.  LTO was developed by QTM, HP, & IBM – QTM receives 1/3^rd of the royalties from this technology.  QTM’s royalty payment formula is complicated, but generally is driven by overall tape sales and mix of LTO v. DLT sales.  The royalty is nearly 50M on an LTM basis and is basically 100% margin.  The only expense associated with the royalty stream is the salary of 10-15 R&D staff who are required to do various research around new iterations of the LTO standard.  We think the royalty long-term should decline somewhere between 5-10% a year, although management argues it may start to stabilize and potentially even grow slightly.  We conservatively apply 4x to the royalty stream to derive our value.  We believe investors are ignoring the substantial value of this royalty stream in particular, and are essentially writing off the entire tape business as worth little to nothing (e.g. some Sellside reports suggest the entire tape business, including the royalty, is worth .1x revenues).

Disk Systems & Software

DXi’s growth businesses are all in this segment.  There are two that we believe have significant value:

DXi: This is QTM’s disk de-duplication and disk data archiving solution (the new product category that is predominately taking share from tape).  QTM’s motto here is “twice the performance at half the price”.  We’ve heard great things about the technology, but the business has really struggled to gain any traction as part of QTM, for a variety of reasons.  In short, QTM just doesn’t have the scale and channel presence to compete with EMC.  We estimate this business is losing on the order of 50-60M a year and that, in the hands of a larger company, would likely be marginally profitable.  More important that the profit contribution, the product line is valuable to a potential strategic because it allows them to more effectively sell an entire solution of storage products.  EMC, for example, has a largely end-to-end storage solution, whereas as someone like Netapp has a couple holes (including a big one in back-up storage).  There have been several buyouts of DXI’s competitors in this space at very lofty multiples of revenue, mostly in late 2010:

Since these deals, a bit of the luster has come off this portion of the market – growth has moderated to the teens and the space has become more competitive.  An arms race mentality drove the multiples and that is less at force today.  More recently, in January 2013, Imation bought Nexsan for 1.5x revenues.  While not a perfect comp, this is probably a more conservative estimate of what Dxi should go for today. We assume DXi should fetch 1.5x revs in our base case, but also contemplate scenarios where it is worth almost nothing, and as much as 3x revs.

Stornext:

Stornext is arguably the crown jewel of the QTM portfolio.  Stornext is software that allows users to consolidate very large files across multiple platforms for better performance.  It has become the industry standard for managing very large file types, primarily in the media and entertainment industry.  The software is still relatively early in its adoption and has little competition in its space.  Stornext’s closest peer, Isilon, was purchased in November of 2010 by EMC for 12.2x revenue.  Based on conversations with industry participants, we believe Stornext is in a hot space and likely would garner substantial interest from strategics.  Of all the businesses in the portfolio, Stornext is the one that could legitimately get sold for a “silly” price.  Isilon has a larger market opportunity than Stornext, had a larger revenue base, and is more strategic, but still provides some sense of what this kind of asset could be worth.  We assume 3x revs in our base case, which we believe is conservative. 5x+ is not out of the question, though we aren’t betting on that.

Other Pockets of value

There are a few other assets of value that we don’t currently ascribe meaningful value to in any of our scenarios, but that may have substantial value.   There are also several other creative structures (other than outright split and sale of the assets) that may generate more value than what we have given credit for in our sum of parts analysis.

Patents

QTM has over 400 patents , the majority of which are not covered by their royalty stream.  Although many of the tape patents are either worthless or close to expiry, we do believe the company has several patents in this portfolio that may have substantial value.  QTM in particular holds one patent for “variable length data de-duplication” which is a core patent and technology used by almost all the data de-dup providers.  We also believe this technology is used by other companies like Google, Apple, and others.  The company licensed the technology for one-time payments from EMC and Riverbed, but could likely monetize this from other industry players.  We would also note that Starboard in particular has an excellent track record of recognizing and monetizing patent value (see AOL, MIPS).  There is good reason to think there could be significant value here, though we have not tried specifically to quantify it and view it as a free call option.

NOLs:

The company has over 350M in federal NOLs.  Because our sum of parts analysis assumes a split and sale of the company (with no associated taxes), we are generally making the simplifying assumption that Dxi & Stornext, which we believe have a pretty low cost basis, utilize most of the NOLs in the event of a sale.  That said, it is unclear how much of the NOL would be utilized in a sale and there still may be some residual value here.

Alternate Structures:

One possibility here is that the company sells Dxi & Stornext and keeps the tape business & royalty as a high dividend paying company focused solely on maximizing free cash flow.  It is possible that yield starved investors would be willing to pay more for the tape business than selling the business off to private equity.  While we recognize this would be a feat of financial engineering more than anything, it is worth contemplating.  In this scenario, we believe we are creating Dxi & Stornext for free (and potentially a negative value):

Activist Involvement and likely plan:

Starboard should have a relatively easy time taking control of the board.  Much of the shareholder base here are hedge funds or traditional asset managers that are fed up with management and that would likely support Starboard were they to run a slate.  The board here is elected annually and the voting is “cumulative”.  Under cumulative voting, each share gets a number of votes equal to the number of board members (in this case, 8).  You can choose to pledge all your shares to vote for one member, or split your vote evenly.  Given Starboards current position, they are guaranteed to elect at least one shareholder to the board if they run someone.  We also believe that two of the board members are friendly (including one board member who also serves on another Starboard board) and that the CEO here is actually well respected, smart, and open to doing what’s right by shareholders.  We either expect Starboard to run a slate and take control, or to guide the company through the process of what they want them to do.  Recent articles suggest this perspective has started to become the presumption:

http://www.channelregister.co.uk/2013/04/15/quantum_loses_50

Catalyst