Description

I believe STEC (formerly SimpleTech) represents a timely and highly compelling short opportunity.  Over the past few months STEC has been one of the best performing stocks in the world, increasing over four-fold from $5 to $21 per share as momentum investors and research analysts fall over themselves based on a strong quarter and a strong product cycle.  A huge short squeeze has further fueled the party. 

This company is in the relatively unexciting boom/bust business of flash memory and DRAM technologies.  It has been public for about 10 years and has seen its EBITDA cycle between break-even and $30 million several times.  At a current enterprise value of more than $900 million, the stock is trading at 30x peak historical EBITDA, 60x average historical EBITDA and 5.5x book value. 

How can this be?  Other than momentum buying and short covering, I believe a fundamental misunderstanding has taken hold in the market over the past few months.  This view has been fostered by aggressive/promotional talk from management to profiles in Barron's to wildly bullish analyst comments.  The bull case is relatively simple and goes as follows: 

STEC has a flash-based solid state drive (SSD) product for high-end servers called ZeusIOPS.  STEC has a technological lead on the competition and therefore has taken tremendous share and earns high margins. The company should be positioned to continue to take share in this high growth market without any competition.  Based on recent guidance, it is possible this company has $1 per share or more of "Non-GAAP" run-rate earnings power and placing a multiple of 20x on a growing, high-margin technology company with a good product is reasonable.  Ignore the historical results of STEC and all the prior boom/busts with this company and industry because "this time it is different, they have a monopoly".

Currently, the Company has a roughly one year lead on the competition with ZeusIOPS, which will represent over 50% of sales in the coming quarters.  This technological lead has allowed the Company to earn estimated gross margins of around 60% on ZeusIOPS vs. ~25% on its other business.  Historically, the overall business has earned around a 25% gross margin or lower. 

Quite simply, the competition for this market will be fierce and several large companies (Seagate, Samsung, Intel/Hitachi and others) are all looking to bring a competing product to market in the next year.  The flash disk-drive technology is not particularly complex in the grand scheme of things and STEC's market share, pricing and margins will be eroded as has historically always been the case in this industry.  Also the customer base is very concentrated and powerful.  At the EMC World Conference in 2008, EMC (STEC's biggest customer) said "our stated corporate goal is we're trying to drive down [flash SSD costs] as fast as we can".  Furthermore, EMC has stated its intent to use drives from other manufacturers such as Intel and Samsung.

I estimate the Company's EBITDA will fall closer to around $25 million after this product cycle ends in 2010 (which assumes reasonable profits on ZeusIOPS).  At 6x EBITDA, the enterprise value would be around $180 million or $4.50 per share or about 80% below the current price.  I suspect management agrees with this view more than the hype as the CEO began selling significant amounts of stock just a few months ago at $7-8 and several members of management entered into a 10b5-1 pre-arranged stock sale plan (announced on a Friday evening, of course) at prices well below the current price.

Why STEC is a Good Short

Tremendous Competition Entering the Market.  Several large players have plans to bring a competing product to market in the next year which will severely erode STEC's profitability.  Seagate, Samsung, a Hitachi/Intel joint venture and Toshiba are all in the design stage for flash-based enterprise-level SSDs.  Additionally, smaller companies like Silicon Systems and BiTMicro are aggressively entering the space.

Ridiculous Valuation.  As we mentioned above, STEC's valuation is off the charts no matter how you look at it.  The Company has a long history of cyclical margins and profits which indicate the Company is trading at 60x its long-run EBITDA earnings power in an industry where 5-6x EBITDA is often the norm (and justifiably so).  Even using some bullish forecasts of EBITDA in the next 12 months of $80-90 million, the Company is trading at 11-12x that number.  However, valuing the Company off of those numbers makes no sense as that profit level is likely the highest the company will ever see given the certain emergence of competition.

Insider Sales.  Insider sales began after the stock lifted from $5 to $8 per share with some large sales by the CEO.  In a recent Friday evening press release, several members of senior management entered into a pre-arranged stock sale program.

Analyst Bullishness.  From Oppenheimer to Caris to Stifel Nicolaus, everyone agrees STEC is a buy.  It is the only growth story in their coverage universe and it is a must own.  The next couple of quarters look good, so all is clear.  We believe all of these guys are asleep at the switch.

Catalyst

- Significant onslaught of competition

- End of momentum buying and short squeeze