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Monday, January 4, 1999

An Investment Opinion
by Alex Schay

Adaptec Adapts

In the investment world, there is rarely consensus when a company hits rock bottom. While the factors that caused the sinking are usually identifiable, the waters that swallow up the unfortunate investment are always murky -- and often very deep. Restructuring -- accompanied by expectation for a turnaround -- presents an interesting scenario for investors. An admission has been made by the company that capital has been misallocated, and the investor then gets to make an assessment about the firm's "new" or "re-newed" focus.

To continue with the ship metaphor, a firm that announces a restructuring has hit an underwater shelf and is poised to be successfully "found" and raised to the surface, or sent to the bottom of the sea by the strong tides of business change. Mercifully, we'll end the metaphor here and talk about Adaptec (Nasdaq: ADPT). The data transfer rate booster was up $1 to $18 9/16 today on some product news -- a ship with a new crew charting a bold new course (sorry). At midyear 1998, Adaptec was already taking on water -- OK, I'll stop -- finishing the month of June down over 60% on the year, and en route to a price well below $10 by early October. Here's what we had to say at midyear:

"So, inside the machine, for cost conscious end users and manufacturers some flavor of integrated drive electronics (IDE) will prevail. Indeed, the technology has become standard fare in most PCs because it is cheaper than SCSI and is suitable for most single-tasking desktop environments. Outside the box, and where cost is an issue, SCSI will continue to be employed because of its ability to support longer cable runs. However, the bears argue that even in this case the now higher cost fibre will still ultimately displace SCSI and become the connection medium of choice for "inter-box" link-ups. Therefore, the combination of EIDE (or some derivative) dominating the intra-box connections, fibre dominating inter-box connections, workstation vendors dropping SCSI as the standard expansion interface, and the scuttled Symbios merger axing Adaptec's plans for a quick entry into the high-end UNIX based server market make the future look pretty grim."
At this time, investors didn't really have the opportunity to make a clear investment choice. A metaphysical leap of faith was required. However, online, in the arena of emerging technology, Ben Graham's adage that investment is best when it's most business-like takes on an entirely new dimension. Here's how we completed Adaptec's outlook at midyear last year:
"The bulls don't quite think all is lost, however. After all, Adaptec has been at it for more than 16 years and is certainly not blind to the competitive issues outlined above. The company sees enormous opportunity ahead in storage and RAID sub-systems in NT/Intel environments, as well as in high-performance servers that will use the most advanced forms of SCSI available. The bottom line is that Adaptec has roughly $700 million in cash and marketable securities at its disposal to invest in whatever technologies it feels will make the firm competitive again. The firm has gone from a $6.2 billion company to a $1.4 billion firm in less than a year, and the bulls feel it has hit rock bottom, trading at 9 times forward estimates and less than 2 times book value. This valuation level not only makes the firm attractive to acquirers, but to itself as well -- assuming Adaptec looks in the mirror and likes what it sees, it may utilize some of its substantial free cash flow to buy back shares."
Where else but online can cheap, virtually instantaneous, feedback on computer-related products be received from key decision makers and consultants (either directly or through message board posts)? Getting the opportunity to make an investment, where almost all of the risk is encapsulated in how receptive end users are to a particular IT product, is inherently transformed by the online medium -- and Philip Fisher's "scuttlebutt" techniques are transformed as well. Staying on the soapbox just to close out this paragraph: if you are currently involved in an online discussion about the prospects for a particular company, try and steer the discussion away from chart technicals and toward product specs. Get as many people as possible into the discussion who actually use the technology that is being discussed.

Although Adaptec's announcement today was foreshadowed by its November 12th agreement with Dell (Nasdaq: DELL) to develop 64 bit PCI RAID controller technology, the fact that it will be able to ship the AAC-364 RAID controller in January is giving the company a boost. Peripherals Solutions -- the segment that constitutes 18% of the firm's revenue -- had Q2 sales (ended September 30) of $26 million, down 63% year-over-year and 25% quarter-over-quarter. Any decent news on this front is likely to lift the gloom.

In the second quarter, fresh from the divestiture of three "non-core" businesses (external storage and Fibre Channel, satellite technology, and high-end peripherals semiconductor technology) and in the throes of a cost-cutting program, Adaptec reported revenue of $144 million -- which was down 48% year-over-year and down 20% quarter-over-quarter. Host bus adapter sales (the balance, or 82% of total revenues) came in at $118 million -- falling 43% year-over-year and 19% quarter-over-quarter. Was there an audible thud at the time?

The firm began its cost slashing in the quarter, and low and behold, operating
expenses dropped to $86 million, or 59% of revenue, down 10% quarter-over-quarter. Adaptec has set its sights on an aggressive target of dropping its operating expenditures to 35% of revenues. The company's cash position, as noted last year, has continued to remain relatively strong even during the worst of times -- down $68 million but still at $614 million, or $5.43 per share (net cash is at $3.40.)

With Ultra2 SCSI (10% of revenue) set to ramp up over the next quarter and Ultra3 SCSI to be released by midyear (and will run at 160 MB per second), it might be a good idea to take a closer look at Adaptec's products. The potential for Fibre Channel, as interconnect or inside, needs to be looked at further as well. Let's go investors, we have a chance to debate the merits of some technology adoption, let's get to it -- Adaptec reports its third quarter on January 21st.

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