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:

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:

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.