A Loser
Adaptec Inc.
62.2% Decline
(Nasdaq: ADPT)
www.adaptec.com
12/30/97 Price: 37 7/8
6/30/98 Price: 14 5/16

The Company's Biz. Trying to get a quote on Adaptec? Don't type in SCSI, you might not like what you see. Adaptec used to be one of the dominant players in the computer input/output (I/O) arena, thanks largely to a standard for high-speed connections to peripherals called Small Computer Systems Interface (SCSI), pronounced "scuzzy." Continuing the "Computer Verbiage as a Second Language (CVSL)" course, input/output, pronounced "eye-oh," describes any operation, program, or device that transfers data to or from a computer. Typical I/O devices are printers, hard disks, keyboards, and mouses. However, some devices are fundamentally input-only, like keyboards and mouses, or primarily output-only, like printers; while others incorporate both elements, like hard disks, diskettes, and writable CD-ROMs. Adaptec makes products that interconnect these myriad devices with the heart of the PC.

Adaptec's products increase the data transfer rates between PCs, servers, peripherals and networks, and consist primarily of host adapters, network products, CD recordable software solutions, application specific integrated circuit controllers for hard disk and CD-ROM drives, and storage system solutions that incorporate RAID and Fibre Channel technologies.

The Story. A slowdown in the disk drive sector in the waning months of 1997 precipitated a decline in Adaptec shares in early December over concerns that the 20% of revenues that the company derived from sales of disk drive controllers was in jeopardy. Indeed, that gloomy scenario came to pass, and much of those declines were built into the company's stock price at the beginning of the year.

However, on the 9th of January the company was rocked, losing $14 7/16 to $21 1/2 after announcing that it expected to report Q3 EPS between $0.35 and $0.40 excluding charges, which was significantly shy of the First Call mean estimate of $0.56 per share -- the actual figure came in at at $0.38 a share. Despite the company's positive outlook on its conference call, where it stated that it had shipped 6% more host adapter units than it had in the prior quarter ($25-$30 million in revenue was not recognized in the quarter due to a year-end build-up in channel inventory primarily in North America), Adaptec's fortunes took a turn for the worse when it missed its year-end quarter estimates of $0.29 a share by a full $0.09. The inventory build-ups were beginning to be understood as a decline in end-user demand.

Here are some handy definitions required to understand the rest of the story, as well as the future:

oSCSI: Small Computer System Interface. A standard for high-speed connections to peripherals.

o1394: The Institute of Electrical and Electronics Engineers (IEEE) designation for an interface developed for easy connection to consumer devices, such as video and computer peripherals.

oFireWire: The Apple trademark for the IEEE 1394 interface.

oi.Link: The Sony trademark for the IEEE 1394 interface.

oEIDE: Enhanced Integrated Drive Electronics: a cheap interface for hard drives and CD-Roms.

oUSB: Universal Serial Bus: an easily expandable interface for keyboards and modems.

oFibre Channel: A high-end storage interface for fast data transfer in storage networks or data centers.

oHost Adapter Card: A card placed inside your computer to add a connector port.

oBus: The total wires in a communication path.

oRAID: Redundant array of inexpensive disks. The term coined in 1987 by researchers at the University of California at Berkeley to describe a series of redundant architectures used in fault-tolerant disk arrays (RAID levels 1 through 5).

How Could You Have Seen This Coming? Had you been on the frontline in the technology trenches you might have seen the battle firsthand as Enhanced Integrated Drive Electronics made its way into the majority of sub-$1000 PC boxes. As with all rapidly evolving technologies, standards shift, and despite the best efforts of the premiere operators wedded to the "old" standards, the blood loss can oftentimes not be staunched.

The Future. Adaptec did not mince words in its growth projections going forward, as evidenced by its most recent 10-K, which states in the Management's Discussion and Analysis (MD&A): "The company presently expects that its sales growth is unlikely to resume before the third quarter of fiscal 1999 at the earliest." So why would investors even consider buying now? The bearish case goes something like this: SCSI is certainly not dead, but unit volumes will probably not increase very substantially over the next year considering the omnipresent threats on both the high end and the low end. On the low end, the introduction of Universal Serial Bus (USB) support in Windows 98 will allow all manner of devices, including tape drives, scanners, and the rest to move to cheap USB. And for a lot of high performance disk applications multiple EIDE drives and controllers can increasingly offer the same performance at a lower price -- users can almost put in twice the EIDE infrastructure for the price of SCSI with no performance loss.

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.

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.

-Alex Schay (TMF Nexus6)

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