In 2009, we posted a short idea on a company called STEC on the view that an excessively bullish management team had convinced the market to overlook how competitive its core solid state drive business (SSD) was about to become. The stock settled out sharply lower a few months later following several investor disappointments. In 2010, we posted a short idea in a company called Motricity on our belief that an overly promotional management team had obscured the doomed nature of their core products by issuing a series of bullish press releases. Several months later, the stock is down over 60%.
Enter, OCZ Technology Group. Founded in 2002, OCZ's historical business model was primarily selling low margin memory modules to computing enthusiasts. In 2006, the company went public on the AIM stock exchange in London (an exchange littered with companies looking to escape the onerous disclosure requirements of more widely-recognized stock exchanges). After a series of earnings misses, the company's stock price declined over 90% from its highs and was eventually delisted. The company relisted its stock in early 2010 on the OTC bulletin board in the U.S., and shortly thereafter, it moved to the NASDAQ. After a sharp fall immediately following its U.S. listing, the stock has been a darling of late, rising almost five-fold from its lows in recent months.
Despite non-existent profits, OCZ boasts a $500 million market capitalization largely based on strong revenue growth and ambitious long-term margin targets provided by management. Much like STEC, OCZ has redirected its focus to the SSD industry over the past couple of years and has attempted to reinvent itself as a pure-play SSD company. SSDs are effectively the next generation of memory storage drives that have been gradually replacing hard disk drives (manufactured by companies like Seagate and Western Digital). Management claims its forecasted surge in profitability will be achieved through selling enterprise-level SSDs which are high value, high margin products used in storage systems (with OEM customers like EMC, Dell, HP, etc.). We are highly skeptical that this forecast will come to fruition for OCZ.
OCZ has built up its SSD revenues over the past several quarters selling mainly lower-end SSDs to individual consumers (such as computer gaming enthusiasts with high memory requirements) and small businesses. Our discussions with industry players paint a grim picture for OCZ's enterprise SSD prospects. One competitor declared that "the Tier-1 OEMs would not touch OCZ with a ten-foot pole." Companies like STEC do not even mention OCZ as a competitor in their public filings. Enterprise customers demand significant R&D and engineering capabilities, which we believe OCZ lacks. In its most recent fiscal year, OCZ spent only $4 million on R&D compared to $44 million at STEC. Furthermore, OCZ's property and equipment on its balance sheet is a mere $3 million compared to $33 million at STEC.
We also believe that enterprise SSD margins will be coming down significantly in the coming years as the industry is infiltrated by several new, large competitors. The largest input cost for SSDs is NAND flash memory, a market which is dominated by Intel/Micron, Samsung and Toshiba. All of these companies are investing heavily in R&D to offer their own SSDs. As OCZ does not produce any NAND flash on its own, its relative cost disadvantage will be material.
As a valuation sanity check, consider that STEC, which is the current leader in enterprise SSDs, has an enterprise value only $200 million to $300 million greater than OCZ. As I mentioned above, STEC has ten times more R&D spend and property and equipment, and STEC does not merely have aspirations to provide enterprise SSDs - it is actually doing it now. STEC generates around $70 million of EBITDA, significantly more than we believe OCZ would generate even if it managed to get significant enterprise customer design wins. We are not bullish on STEC, as we believe new competition poses a real threat to its current profit levels, but I do believe this comparison highlights the extremity of OCZ's valuation.
Finally, we would suggest to an OCZ shareholder that if you are going to purchase a stock based on trust in a forecast for which there is scant supporting evidence, then you ought to at least have a lot of trust in those providing that forecast. If the company's complete failure on the AIM and other historical disclosure inconsistencies are not enough to raise investor doubts, consider this recent addition to CEO Ryan Petersen's bio:
"Just as OCZ's corporate evolution from cottage memory overclocking to enterprise class solid state drives has been atypical, Mr. Petersen's path from an aspiring musician and youthful indiscretions to a storage technology pioneer has been similarly unique."
We are not accustomed to coming across mentions of "youthful indiscretions" in SEC filings, particularly when describing the CEO of the company. It sounds harmless enough, but we do not believe this is a playful reference to innocent childhood hijinks as one would be excused for assuming. Instead, we find it concerning that this is seemingly OCZ's only attempt to subtly address the CEO's extensive criminal history, which includes convictions for grand theft, forgery and drug possession (a simple background check yields several pages of offenses).
While we are sympathetic to the fact that certain people with troubled pasts could turn their lives around, we are not willing to give OCZ or its CEO the benefit of the doubt here given the company's dodgy disclosure on the matter and track record of over-promotion.
Even when the topic came up on a recent conference call, here was the CEO's response:
"The information about my past is public information, it's available to anybody. It's of course more than a decade ago. It's previously been disclosed in OCZ documents, filings, though there is no legal obligation to do so. So as an example, during our public offering we had met with a number of investors who actually wanted to know a little bit more about it, and we proactively discussed it with them. To whatever extent they wanted to, I'm always open to discuss that with the large institutional investors."
So I suppose if you are a large institutional investor, you might get some color, but otherwise you are left to ponder his "youthful indiscretions".
DISCLAIMER: We currently hold a short position in this security. We may change our position at any time without posting an update. The views expressed here are merely the opinion of the author. Please do your own research.
Reversal of momentum, lack of meaningful profitability / falling short of targets, increased competition