Is STEC's Growth Sustainable?

I'm a believer in growth stocks. As an analyst for our Motley Fool Rule Breakers service, I think you should be a believer, too. But even I have to admit some growth stories are bogus, hence this regular series. We'll be taking a closer look at many of the market's great growth stocks to see which of them show real, numerically relevant signs of sustainability.

Next up in our series is STEC Inc. (Nasdaq: STEC  ) , a maker of solid-state storage devices used in corporate networks. If you're unfamiliar, solid-state storage is different from optical or magnetic storage in that it is based on memory. It's also very fast.

But the breakthroughs come with a cost. At present, solid-state storage is expensive and typically found in higher-end devices such as Apple's iPad and its premium Macs.

Foolish facts

Metric

STEC Inc.

CAPS stars (5 max)

***

Total ratings

780

Percent bulls

92.4%

Percent bears

7.6%

Bullish pitches

115 out of 126

Highest rated peers

Super Micro Computer, Immersion, EMC Corp. (NYSE: EMC  )

Data current as of Sept. 2.

Many Fools don't know what to think about STEC when compared to well-funded competitors, including Intel (Nasdaq: INTC  ) and SanDisk (Nasdaq: SNDK  ) .

"The expectations built into the current stock price are not achievable, unless both 1) the SSD market takes off, and 2) STEC achieves domination in the market, i.e. 40%+ market share. Either one of those may happen but unlikely both will," Foolish investor flashfinancials wrote recently.

Fair enough, yet I'm not convinced STEC is overvalued. Shares of STEC entered the day trading for just over 10 times next year's estimated earnings, and Wall Street has been underestimating the company's earnings power recently.

The elements of growth

Metric

Last 12 Months

2009

2008

Normalized net income growth

82.8%

1,261.9%

(34.8%)

Revenue growth

12.6%

55.7%

20.6%

Gross margin

46.7%

47.7%

31.3%

Receivables growth

(19.5%)

80.1%

26.9%

Shares outstanding

50.8 million

50.3 million

48.4 million

Source: Capital IQ, a division of Standard & Poor's.

Feel cross-eyed looking this table? I don't blame you. Conflicting messages abound:

  • Revenue is up, up again, and then WAY down. What gives? Choppy demand isn't a great sign, though to be fair, the storage business is tied to technology upgrade cycles, and cyclical businesses always produce lumpy results.
  • On the plus side, it's nice to see STEC produce healthy gross margin. The company isn't resorting to steep price cuts to juice sales.
  • The most confusing piece of this puzzle is normalized net income growth. From the numbers, it seems STEC has done an excellent job collecting payments due (i.e., lower receivables) and exerting pricing power (i.e., good, stable margins).

Competitor checkup

Competitor

Normalized Net Income Growth (3 years)

Intel

24%

SanDisk

39.4%

Seagate Technology (NYSE: STX  )

34.2%

STEC

26.5%

Western Digital (NYSE: WDC  )

51.7%

Sources: Capital IQ, a division of Standard & Poor's. Data current as of Sept. 2.

Here, too, it's tough to get a read on STEC. It's certainly not the fastest grower, but I hesitate to give Seagate and Western Digital too much credit in evaluating STEC because they're better known for making PC hard drives.

Grade = sustainable
STEC's story is at times unclear and certainly unfinished, but I like the trends. Gross margin is holding steady and net income is expanding mightily. High revenue growth is going to have to return at some point, but with PC manufacturers and network operators showing a greater appetite for SSD, I believe that day is coming.

Now it's your turn to weigh in. Do you like STEC at these levels? Would you make it one of our 11 o'clock stocks? Let the debate begin in the comments box below, and when you're done, click here to get today's 11 o'clock portfolio pick.

You can also ask Tim to evaluate a favorite growth story by sending him an email or replying to him on Twitter.

For further Foolishness featuring STEC:

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Fool contributor Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team. He had stock and options positions in Apple at the time of publication. Check out Tim's portfolio holdings and Foolish writings, or connect with him on Twitter as @milehighfool. You can also get his insights delivered directly to your RSS reader. The Motley Fool owns shares of and has written puts in Intel. The Fool is also on Twitter as @TheMotleyFool. Its disclosure policy thinks Monty Python is sustainably funny.


Read/Post Comments (11) | Recommend This Article (6)

Comments from our Foolish Readers

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  • Report this Comment On September 03, 2010, at 6:51 PM, flashfinancials wrote:

    Good discussion, thanks for quoting me!

    The table on revenue here doesn't tell the whole story...take a look at the full year 2010 (actual+estimated) financials...the revenue and earnings growth will both be NEGATIVE. If anyone defends the growth story, please address why we should ignore 2010.

    A PE of 10 would be pretty good, but we're being very optimistic in our assumptions behind that. The forward-looking P/E shown above is very forward looking...they haven't finished 2010 yet, and the analysts consensus is for earnings of 0.46/share (heavily back-weighted...so that number may be optimistic). At a current price of ~$12, there 2010 earnings consensus equates to a PE of 26. That give them a PEG of ~1.5 if you use a 5 year est growth of 16% (Yahoo's estimate).

    So are they a growth story? Only if we believe they will abrubtly arrest their current negative trajectory and turn it around. Hard for me to believe this will happen in 2010 or 2011. The analogy of catching a falling knife here seems appropriate. If you believe in their long term prospects, let the knife hit the floor first then pick it up. Probably will be a slow bleed on the stock price for the next 6-12 months. Keep an eye on these guys and buy them in a few quarters, after the market adjusts to their negative growth.

    On a macro level, they need flash memory pricing to come down (a LOT!) to make their product even close to price competitive with the mainstream HDD solution. I don't see flash prices weakening much in the next 1-2 years, right now it is a supply-limited market. So I am bullish on Sandisk and Micron, who manufacture flash memory, and thus bearish on STEC. STEC management is doing their best to cope with this tough BOM cost environment by going after the enterprise market, but I don't see that providing the revenues in the next couple years to justify their valuation. From a competitive view, if STEC doesn't get big revenues in 2010 and 2011, they will be unable to invest the right amount in R&D and will lose the long term race against better-funded competitors.

  • Report this Comment On September 03, 2010, at 7:33 PM, jrmart wrote:

    STEC received $120 million from EMC in 2009 for ZEUS enterprise solid state storage devices. That order allowed STEC to post 1,261.9% gains in 2009. Unfortunately, EMC at that time was STEC's largest enterprise solid state storage device customer. Other large enterprise storage companies like IBM, 3PAR, Concurrent Systems, etc. had only ordered small quantities of STEC's ZEUS solid state drives for evaluation. In the meantime, it took EMC 9 months to sell off all that ZEUS inventory.

    Today things are rapidly changing for STEC.

    "SSD demand is on the upswing and Stec is still the only provider of SSDs in the enterprise storage market right now," ThinkEquity analyst Rajesh Ghai said.

    Stec's competitor, Hitachi Global Storage Technologies may take up to the middle of next year before it comes out with an SSD that it can sell, Ghai said.

    "Even after competitors come, these guys (STEC) are wading fast enough to stay ahead of competition," he said.

    For the third-quarter, Stec forecast adjusted earnings of 18 cents to 20 cents, per share, above analysts' average expectation of earnings of 13 cents per share, according to Thomson Reuters.

    It sees revenue of $78 million to $80 million. Wall Street is looking for revenue of $68.8 million for the period. Revenue from sale of STEC's flagship ZEUS solid state drives was $34.7 million, up from $10.4 million in the first quarter, and made up more than half of total quarterly sales.

    During the quarter, the company had three customers who accounted for more than 10 percent of total quarterly revenue, it said on a conference call with analysts.

    STEC has now sold over 175 million dollars of ZEUS solid state drives to several large customers. Since it takes a minimum of 12 to 18 months for any new enterprise solid state product to be accepted for enterprise storage, STEC has a commanding lead in this multi billion dollar enterprise storage arena.

  • Report this Comment On September 06, 2010, at 2:40 PM, jsIRA wrote:

    We are very bullish on the long term growth on STEC's business.

    STEC is clearly the leader on SSD technology.

    The stock has been in $10 - $15 base since November 2009 and will fly once the base is break-out.

    Buying on dip shoul be be a good investment strategy.

  • Report this Comment On September 07, 2010, at 12:08 AM, flashfinancials wrote:

    The stock seems priced a little rich for a growth "story", rather than growth actuals.

    Can anyone address why they are on a negative growth path (revenue & earnings) for 2010?

    Does anyone disagree with my estimate of 2010 PE of 26?

  • Report this Comment On September 07, 2010, at 12:25 PM, flashfinancials wrote:

    The comment "STEC to post 1,261.9% gains in 2009" is a bit out of context given their current 2010 financials. They went from barely breaking even in 2008 - 4M profit on 227M revenue, to 73M on 354M in sales in 2009. Analyst consensus put them at something like 23M profit on 270M sales in 2010 (note, however, that they are showing a loss so far for the first two quarters). That is a -68% earnings growth rate, and is more meaningful than 2008-09 trend.

    We could go back and look at any company from a low point where they were just breaking even and show a massive % change in profits, but it is not very meaningful (infiinte % change if they were losing money!).

    Good business, bad business...good questions to explore...yes, they have a story, and they are not likely to go bankrupt anytime soon...but I see danger signs on this stock in there 2010 financials, and the "story" behind the stock does not address those danger signals. The expectations are much higher than STEC is likely to deliver in the next several quarters. The market will say "show me the revenue, show me the earnings".

    JRMart, can you address (in your own words, or please cite the source and date if you are cut-and-pasting from a dearly bought report from 6 months ago) the 2010 revenue and earnings? Is it due to a dependence on EMC? If so, why is such high dependence on a single customer not a concern going forward?

    jsIRA, your quote is out of context. Who is "we"? If that is a quote from an analyst, could you please cite a reference and timeframe that it was made?

  • Report this Comment On September 08, 2010, at 2:26 PM, jrmart wrote:

    Flashfinancials, you are a great Super Bowl qualified Monday morning quarterback when it comes to past stock financials. On the other hand, I like to look at ALL THE FACTS, including key future changing events. In the case of NETFLIX, that occurred after APPLE announced APPLE ITV on September 1, 2010. The APPLE ITV will stream NETFLIX movies right to your HDTV. I immediately ordered one from Apple and also bought NETFLIX stock. Since then, in just 5 trading days, NETFLIX posted a 20 point gain.

    When it comes to STEC, the key changing event occurred last quarter. Revenue from sale of STEC's flagship ZEUS solid state drives was $34.7 million, up from $10.4 million in the first quarter, and made up more than half of total quarterly sales. When your flagship product just tripled sales from the previous quarter and now makes up over half of your revenues, that is a future key changing event, especially in the multi-billion dollar solid state enterprise storage arena where your the leader.

  • Report this Comment On September 09, 2010, at 11:12 AM, flashfinancials wrote:

    jrmart, I congratulate you on your investment in netflix and hope it continues to do well. However, equating a deal with a kingmaker like Apple to a new drive selling to EMC is a bit off. If you've got any news about STEC striking up something with Apple, then I would put that in the "key future changing events" category. Until then, we've got financials and projections based on the information out there. And 30M in Q2 product sales for a company with 354M in 2009 sales is a part of a bigger story. Total Q2 sales in 2009 were ~90M. Total Q2 sales in 2010 were ~60M. Yes, half of that is the zeus drive. Where did the rest of the sales go? Are all their other products falling off their roadmap, or in a drastically declining state? That is what is implied by the financials when you back out the zeus drive numbers.

    Let's go with your thesis there, and just look at the zeus drive as the key valuation metric. 3x Q-on-Q growth is great, that will certainly drop off to a lower growth level. What sort of longer term growth do you see on the Zeus drive going forward? Will the rest of their products continue to decline?

    Financial data tells a story. "key changing events" can add or subtract from that story, but they don't warrant ignoring historical data. Many a good quarterback spends their Monday's looking at film of their past performance, those who look forward and ignore the past do so at their own peril.

  • Report this Comment On September 09, 2010, at 12:34 PM, jrmart wrote:

    Unfortunately, many of the manufactured negatives that the shorts provide, and the media gloms on to, are not true. STEC has sold over 175 million of ZEUS solid state enterprise storage devices in a marketplace that can potentially be worth over 10 billion by 2014. Granted, others like Hitachi, Seagate, etc. will enter this very lucrative marketplace, but if you use the analysis that STEC has a 18 month lead on them, and already has major ZEUS customers like IBM, EMC, 3PAR, etc., STEC could easily capture a substantial part of this multi-billion dollar enterprise storage market. Also, cloud computing is growing by leaps and bounds and will require lots of enterprise solid state storage devices because of their response speed. Apple's MobileMe automatically keeps mail, contacts, and calendar information in the cloud and uses push technology to keep everything in sync across your iPhone, iPad, Mac, PC, and the web automatically. So no matter where you go, or which device you use, all your information is up to date — NO DOCKING REQUIRED. Could Apple be using enterprise solid state devices in their MobileMe cloud? PLEASE WAKE UP, the old spinning drive world is rapidly going away, and STEC is in the best position to increase ZEUS sales in this MULT-BILLION cloud/enterprise storage marketplace. These are REAL KEY CHANGING EVENTS.

  • Report this Comment On September 09, 2010, at 1:48 PM, flashfinancials wrote:

    Good points, I don't disagree that STEC has a strong lead in a potentially lucrative market. The biggest question marks I see are 1) will the market grow quickly, especially given the NAND pricing environment, and 2) will STEC be able to sustain its lead over bigger and better funded competitors. Presumably Hitachi, Seagate, and WD are very cognizant of the magnetic vs. solid state drive market trends, and will not idly sit by. If the transition is slow and gradual, they will have time to adapt.

    Not likely that the spinning drive is going to go away anytime soon, just like solar isn't going to replace fossil fuels in the next couple of years. The economics aren't there. Maybe they will be in 10 years. Right now, the SSD cost vs HDD cost for consumer applications is ~30x differential. For enterprise, the differential is smaller, something like 10x. Those are both pretty big numbers, and the trend has been in the wrong direction for SSD recently...HDD is dropping cost per GB at a faster rate than SSD. For most applications, SSD provides a performance advantage. For most applications, this does not outweigh the cost advantage.

    Apple's Mobileme, as far as storage is concerned, is an enterprise application that likely will drive incremental adds of low price commercial-level enterprise storage. I haven't heard of Apple looking at STEC drives for a high volume consumer hardware product.

    If overly generous use of capital letters in website postings is found to somehow drive higher enterprise SSD usage, then I am going from bear to bull.

  • Report this Comment On September 09, 2010, at 11:37 PM, jrmart wrote:

    In the late 80's two small telecom companies had great leading edge T1/T3 products, I know that because I worked for one of them. It took these 2 small telecom companies several years to become accepted, but they soon replaced all the giant competitor's old technology that had been installed in the big banks, the large insurance companies and giant Wall Street firms. Very small orders quickly became multi-million dollar orders. After the first couple of successful installations, these two companies became the new standard. These two small companies were eventually bought out by larger competitors. Just hold on to your hat, buy some STEC stock and get ready for the same great ride again. That telecom marketplace was worth 3 billion, STEC has a substantial lead on all their competitors, and the marketplace potential is now potentially 4 BILLION per year.

  • Report this Comment On September 17, 2010, at 10:38 PM, HKJoe wrote:

    SSD technology itself is definitely a fast growing in both development and application; but share price is whole different game, we have no clue on how existing and would-be investors price a stock. Stec is definitely a buy for long term investors.

    SSD almost the magic bullets for speeding up today's computers, we have a lot and excessive CPU power but do not have fast enough information retrieving from the storage for CPU to process.

    SSD does give high cost and benefit ratio to overall system instead of storage alone. Plus, prices of other computer components and peripherals falling fast, a expensive price does not stop the trend.

    I think every investor who thinks of investing SSD stock should try one in his computer.

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