Post of the Day
February 12, 1998

From our AOL
Iomega Board

Subject: SyQuest is worthy of an appearance...
Author: MarkRogo

... aside from a brief comment on the lawsuit (thanks for the nice words Turk) and a question to the incomprehensible Cliff Snyder, I've been gone from these boards for a couple of weeks....

I make an appearance to comment on this quarter's SyQuest release and what it means to Iomega.

Many of you know that I believe the continued presence of lower-priced SyQuest products in the market hurts Iomega sales, mostly of the Jaz drive. The fact that SyQuest is a money-losing outfit doesn't prevent it from making those sales, however.

This first fiscal 1998 quarter, however, does suggest that the new SyQuest is still very far from having developed a sustainable business model. Were it not for the fact there are a lot of warrants outstanding with which SyQuest can raise cash, there would again be a question as to whether the company would survive the next quarter or two (I think there are enough warrants that $120 million can be raised even here if SyQuest can induce the warrantholders to exercise; that may be tricky but they have done it so far when the financial condition was arguably far, far worse).

SyQuest saw revenues rise from $25.9 million in Q4 to $32.1 million in Q1. This increase was somewhere near 24%, which is a healthy rise. Already, it has been noted this rise is not as healthy as Iomega's quarter-over-quarter revenue growth, which I believe was 27%. This lack of better-than-Iomega growth rates is certainly disappointing for SyQuest, especially because Iomega appears to have retarded its own growth due to failure to ship products.

Much more disappointing, however, is the tremendously negative gross margin percentage of -25%. Q1 of FY98 was marked by some signifcant events at SyQuest. It appears that limited production capacity has caused the company to essentially discontinue its older 44/88/200 line, which despite miniscule sales was almost certainly contributing much to margins (I say this with affirmativeness only in hindsight). For reasons beyond comprehension, the company still appears to have been building the EZFlyer (filling backorders they could've unilaterally canceled?) which is now doubtless a money loser due to price cuts without cost savings.

But the scary thing is that in total, the gross margin percentage fell from a miniscue positive in Q4 to a huge negative. This despite what the company calls "a successful product launch of our exciting new SparQ drive, as well as strengthened sales of the SyJet."

Revenue for the compay has been split lately, about 50-50 with drives and cartridges. All totaled, the company probably shipped fewer than 100,000 drives (if the average wholesale price was $160, this would be 100K drives at 50% of revenues... I suspect the mix toward SyJet makes the average wholesale higher), a total that is probably well below total Jaz shipments for the quarter -- a bad quarter for Jaz, to be sure. It is dwarfed, obviously, by the 3 million Zips shipped in the quarter, but that's somewhat immaterial. Those drives, if it was 100K total, cost well over $200 each to build, but sold for about $160. Remember, we know they make money on the cartridges, so the drives gross margins are so negative they are wiping out all the gains from cartridge sales!

Now, some might say this is just the ramp up and volumes will bail out SyQuest. But the evidence is shaky on that. You do not, as the old saw goes, lose money on every sale but make up for it in volume. You do not sell more cartridges than people need just because they are relatively cheap. In other words, SparQ owners aren't gonna buy 10 gigs worth of carts if they only need 2, despite the low price. I would guess that if revenue doubled in Q2 for SyQuest, margins would still be negative based on this performance. It appears, for example, that SparQ costs more to make than they sell it for. In the SparQ-free Q4, gross margins were positive. SparQ, ironically, didn't need to be sold so cheaply to make its presence felt, in my opinion. Jaz externals are twice the price of SparQ externals; surely there was room for a price gap of less than 50%?

Furthermore, to generate the revenue growth over Q4, SG&A soared by $9.7 million. Like Iomega, I think we can say that much of the increment went to advertising... If that's true, each $1 of advertising appears to have resulted in less than $1 in incremental sales! Again, there is a ramp here, but let's get serious. [Also, SyQuest's legal bills must be a major burden with lawsuits against Iomega and Castlewood.]

The net loss of $39 million would wipe out all cash and all receivables if duplicated in Q2, but the company's release suggests they don't fear an immediate bankruptcy. That must mean sales and margins are rapidly improving -- maybe but how much? -- or they are going to get more cash from their investors or lenders. Still, short-term borrowings are already at the level of receivables and payables are almost the total of cash and receivables. This is a company once again on the brink without additional finacncing.

The one calculation that is totally meaningless is earnings per share. Another poster on this board notes that the loss has "narrowed" from $.86 to $.57 per share. Well, what magic? The number of shares is up five-fold!!! If the company had made money, earnings per share would have hardly grown at all due to this newfound shareholder base. This is ugly.

With such a constrained financial condition, the one thing that seems most unlikely is that production capacity will grow much if at all. I think an optimistic target might be 200,000 drives total this quarter, a doubling, and I'd not put much faith in that. Inventories are high, and we don't know how much of that is parts, WIP or finished goods. If it's parts, then they could possibly hit the goal. If it's finished goods, that means even more trouble for SyQuest (finished goods would be SyJet and carts, not SparQ, which did sell out whatever production they could muster -- maybe 30k?).

The reason Iomega is not lowering Jaz prices much to meet the SyQuest threat, I feel, is that SyQuest can satisfy such a small portion of market demand that Iomega doesn't want to get dragged into a price war. Remember, the war hurts the small fry, with his lower volumes, less than the big fry in absolute dollars. [Note, I believe Jaz1 wholesale pricing was lowered by Iomega in January, although I don't yet know how much.]

Certainly, Iomega sees no threat to Zip, which could be produced in quantities of 5 million this quarter, vs. an all-SparQ-SyQuest's 200K drives. Of course, SyQuest isn't all SparQ. I still believe, however, that due to volumes SyQuest is targeting Jaz, not Zip, and that Iomega is going to foreclose the Zip-sized market once prices unambiguously fall to $99... Sony claims they'll say HiFD for the same price as Zip, but that seems really unlikely given their track record (look at MD, for example).

I am far less impressed by SyQuest's results than even my most negative interpretations would've been. I believe that buyers don't largely care a whit about this, nor do computer journalists, nor do retail-store employees. They see interesting SyQuest products at low prices and like them. But the lack of volumes and the possibility of another company-threatening fiscal crisis make the SyQuest threat seem kinda paltry. Unless the company is taken over this quarter and/or gets an additional $20 million in financings, it again will face delisting by next quarter. Without $60-80 million, it appears unlikely to survive the year and especially unlikely to expand production capacity.

Iomega has many big problems right now. It still faces SyQuest as a Jaz competitor. But the two companys remain headed in very different directions... One is growing earnings rapidly and growing gross margins as well. The other is facing more and more red ink, and is letting margins slip to levels not seen since the desparate intro of the EZ135. If history is repeating itself for SyQuest, and it feels that way, then trouble is afoot.

Neither long nor short either stock.


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