Buy, Sell, or Hold STEC?

Solid state drives (SSD) are the future of data storage. Compared to traditional hard disks, drives built on flash memory chips work faster, run cooler, use less power, and are impervious to physical jostling. They're also many times more expensive per gigabyte, which is why you don't see SSD technology in every computer on the market -- yet.

STEC (Nasdaq: STEC  ) , formerly known as SimpleTech, has refocused on SSDs in recent years, discarding most of its consumer-oriented memory products in favor of enterprise-class SSD wares. That refocus placed STEC right in the middle of a red-hot industry: 2009 sales increased 56% over 2008, which in turn was 21% higher than 2007. Recession? What recession?

But does STEC have what it takes to separate itself from the SSD pack? Let's take a look at the things working for and against STEC as an investment today.

Buy! Buy! Buy!
Business-class drives have proven more profitable than the sprawling catalog of mostly consumer-level gadgets that Simpletech used to sell. Have a comparative look:

Metric

2006

2009

Revenue

$216 million

$354 million

Diluted EPS

$0.44

$1.41

Gross Margin

31.7%

47.7%

Net Margin

10.1%

20.5%

Free Cash Flow Margin

Negative

26.0%

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

Something is clearly working here. Every sort of profit margin has expanded since STEC made the end-market switch in 2007. When you stack better margins on top of stronger sales, you get a potent cash-generation brew.

STEC has plenty of cash and no debt. The stock trades at 12.6 times trailing earnings. It's an exciting growth company standing on a rock-steady balance sheet, and you can buy it for a very reasonable earnings multiple today -- even after a 255% gain over the last 18 months.

What's not to love?

Sell! Sell! Sell!
Well, the same things that make STEC look attractive actually run rampant in the storage industry:

Company

LTM Revenue Growth
(2009 over 2008)

Trailing P/E Ratio

STEC

37%

12.6

Seagate (NYSE: STX  )

16%

4.2

Western Digital (NYSE: WDC  )

32%

5.0

Hitachi (NYSE: HIT  )

-10%

N/A

SMART Modular Technologies (Nasdaq: SMOD  )

16%

11.1

SanDisk (Nasdaq: SNDK  )

45%

9.6

Source: Capital IQ, a division of Standard & Poor's. LTM = Last 12 Months.

Hitachi tags out because the massive electronics conglomerate is dragged down by weakness in many other product lines. Fun fact: After a series of transactions in 2007 and 2008, Hitachi now owns the SimpleTech brand and many of STEC's former product lines.

But the valuations of storage rivals Seagate and Western Digital are enough to make any self-respecting value investor drool. Even SMART Modular is cheaper than STEC; that company has about half the market cap of STEC, but nearly twice the sales. Most of the competition is larger and better-capitalized than STEC, and their balance sheets look even stronger. It's very easy to find alternatives to STEC as a storage-minded investor.

Besides that downside, STEC is also subject to a unique risk: The overwhelming majority of STEC's business comes from storage titan EMC (NYSE: EMC  ) , with profound effects on this small cap. When EMC loaded up on STEC drives late last year, business was booming. However, when news broke that EMC had built up too much inventory, and would cut that down before ordering more, first-quarter revenue fell off a cliff.

Risk-averse investors beware: Here be dragons.

Hold!
When you put it all together, you see a company with plenty of upside, but also lots of risk. If you own the stock today, you've probably seen your holdings soar to incredible heights, only to get cut down to size again. It's a volatile stock, because SSD is an uncertain entity right now. Flash prices could drop, spurring industrywide adoption of the goods STEC and others offer. Alternately, pricing may stay high and stable until the magnetic-platter dudes figure out a way to stay in the game. Uncertainty drives volatility.

Final call
All told, I'm in the "hold" camp on STEC. My "outperform" call in CAPS is doing well, and I'm willing to sit out a bumpy sleigh ride until the whole storage market figures out where it's headed. Would I buy this stock with real money today? Nope. I'd much rather own something like Seagate, where you get a lot of the same upsides as STEC's stock, but at a far greater discount.

How are you playing the data storage market? Leave a comment in the box below.

Fool contributor Anders Bylund holds no position in any of the companies discussed here. You can check out Anders' holdings and a concise bio if you like, and The Motley Fool is investors writing for investors.


Read/Post Comments (5) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 28, 2010, at 6:15 AM, CaptChamp wrote:

    A very well written article that is understandable by people like me with limited knowledge of the market. I allowed emotion to tag me and sold WDC at 27.60 for a loss. The worst mistake I have made since trading. Now I am looking to get it back at that price, or close to it, and hold it. My understanding of the financial stability of WDC and the cost of SSD’s coupled with market share; WDC has almost predictable upside potential. I see 33.00 – 35.00 is the near future. Again a great article I appreciate your effort with this. I would be really interested in others opinions of both the up and down side for WDC.

  • Report this Comment On August 04, 2010, at 4:49 PM, EnglishLP wrote:

    OCZ is another SSD play worth considering. Price is currently $2.20 compared with analyst fair valuation of around $7. Their products regularly receive excellent reviews and their customer service is known to be outstanding. Current valuation is very low compared with sales projections. A newcomer to NASDAQ, OCZ are still under the general investment community's radar.

  • Report this Comment On August 06, 2010, at 10:00 AM, Floridainvest wrote:

    The article here makes references to Hitachi that are quite myopic, which makes me doubt the rest of the facts and opinion. The "storage" portion of Hitachi is approx. 8 % of their business, some of which is quite profitable. BTW- since this article, HIT has made a big move up. It suffered mainly as the entire market did, and the issues with automotive. (disclaimer - I do own the stock, but am not trying to push it - I hold a under $ 5k long). To me, businesses like this have strong demand in that they make many components for other companies which feed the world market. This historically trades at 60-70 dollars. You make the call.

  • Report this Comment On December 07, 2010, at 1:14 AM, Floridainvest wrote:

    Looking back on my article of August 6 of this year - hmmmmmm. Hitachi has risen to 50 plus, from the low 30's.

  • Report this Comment On February 03, 2011, at 2:53 PM, Floridainvest wrote:

    Wow - Hitachi almost 60 as of today. Looks like the call for this to be a 60-70 dollar stock was right on the money, almost a 100 % jump. Got to leave the stock picking to the pros, I guess. Advice is cheap. If they were that good, they wouldnt be writing blogs, they'd be on a yacht with Jennifer Aniston AND Jessica Biel !

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