|Shares Out. (in M):||40||P/E||13||9.9|
|Market Cap (in $M):||235||P/FCF||7||5.2|
|Net Debt (in $M):||149||EBIT||43||48|
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Restructured Niche Data Storage Firm Poised for Growth and Margin Expansion Following Share Relisting and Exit of Creditor Equity Position
1) Thesis Description
Quantum Corporation (QMCO) is a provider of data storage and management products/services for the media and entertainment industry. The company is emerging from a period of mismanagement that caused a degradation in financial performance, a SEC investigation into dubious revenue recognition practices, a subsequent NYSE delisting and a refinancing with onerous terms necessary to keep the firm afloat. The newly reconstituted board and management team have completely reorganized Quantum placing it into areas of competitiveness, proactively sorted their accounting/legal issues and anticipate an exchange relisting at the conclusion of the SEC investigation.
The thesis is as follows:
1) At the current price of $5.95/share, the market assumes revenue contracts ~5% per annum. Valuation ranges from $8.50/share to $33.25/share, with scenarios ranging from no growth/margin expansion to ~10% revenue growth per annum and ~200bps of margin expansion per annum.
2) An opportunity is available due to several reasons:
a. Previous management manipulated revenue resulting in an SEC investigation and an exchange delisting, forcing many out of the stock. From ’16 to ’17, Quantum’s management engaged in premature revenue recognition as incentive compensation was geared toward revenue targets. By late ’17, the CEO and other executives left the firm. In early ’18, the company received a subpoena from the SEC regarding accounting practices and promptly halted quarterly calls/financial statement reporting. Then by early ’19, unable to file financial statements, the company was delisted from the NYSE. Notably, the company recently restated previous financials and is up to date with its filings.
b. Despite significant concerns, SEC investigation expected to conclude shortly with minimal payment and subsequent relisting on exchange should improve share liquidity. The conclusion of the SEC investigation is necessary for an exchange relisting. The investigation was prompted by a whistleblower complaint, and a historical analysis of previous investigations shows that self-disclosed issues usually result in no fine, whereas whistleblower-disclosed issues tend to be meted out with a fine. However, given the proactive nature of management to completely revamp internal controls and become current on its filings, the company is likely to have a better standing with the SEC. As such, the SEC fine is expected to be minimal and while the timing is uncertain, with Quantum fully up to date on filings, a conclusion should be short at hand. Interestingly, executive equity compensation of ~3M shares (~7% of outstanding) start to vest once the company is relisted. Following the relisting, share liquidity should improve and a key investment constraint for larger financial participants should be removed.
c. Price-indifferent selling in the short-term as lenders exit significant equity position from exercised warrants. In late ’18, Quantum, under considerable financial pressure, refinanced its debt with a $165M senior secured loan at LIBOR+1000bps, a $45M credit facility along with ~7.1M shares in the form of warrants equating to ~20% of shares outstanding (strike $1.33/share). In late ’19, a subset of QMCO’s lenders with ~3.85M of warrants, exercised ~2.7M and cancelled the remaining warrants. At present, the ~3.25M yet-to-be-exercised warrants equate to ~8% of shares outstanding. Should the other lenders follow suit, we anticipate these non-traditional equity holders are likely to exercise the remaining warrants and sell the ~20% equity position irrespective of price, possibly once the company is relisted as the share liquidity is likely to improve.
d. Almost entirely new management team have stabilized the company after considerable operational mismanagement. Following the ouster of the questionable CEO in late ’17, the company went through multiple CEO’s in a span of six months, each debuting a plan to cut costs. By June ’18, Jamie Lerner, a seasoned executive with a history of turnarounds at Seagate and Cisco, became CEO and signaled a step change in operational efficiency and philosophy. Since then, Quantum’s cost structure of ~$400M per annum was reduced by ~$70M, of which ~70% came from sales and marketing, ~15% from R&D and G&A. Further, misaligned sales incentives were recalibrated to properly drive personnel to generate sales with competitive margins. As a consequence of such actions, Quantum should generate revenue growth of ~6% in FY’20 and EBITDA margins of ~12%, its strongest performance in over 12 years.
e. Inflection point reached in sustainable growth and operating leverage as development redirected from lagging hardware sales to emergent data storage software trends and niche market segments. Throughout the past decade, growth in data centers and public cloud computing have resulted in companies outsourcing their on-premise data storage, reducing Quantum’s addressable market. Compounding this issue, data centers evolved with new hyper-convergence infrastructure designs that emphasized workload efficiency to minimize the number of physical devices used to manage storage. The company’s previous leadership maintained a hardware-centric approach, even with competitive software offerings entirely tied to a physical box. Despite enterprise data storage pressures and self-induced problems, Quantum maintains a best-in-class video data storage/streaming capability and competitive standing in the media and entertainment industry, where data storage is expected in increase ~5x by ’23. With new management, Quantum has refocused to develop storage software-as-a-service, decoupling it from hardware, and direct sales efforts to the video-specific markets. Further, the debut of NVMe flash hardware and specialized storage devices for video surveillance and autonomous vehicle markets has positioned the company to address the latest storage requirements in adjacent end markets with long-term growth. Going forward, Quantum’s financial performance in both revenue growth and operating margins should outperform its historical execution as its position in growing end markets becomes evident and recurring software sales gain revenue share.
3) The largest micro risk in the name is sales execution, pace of consumer adoption for storage software and new leading edge hardware offerings and supply chain execution issues. The largest macro risks are lower data storage spending due to efficiencies and technical obsolesce due to new technology.
2) Business Analysis
A Brief History
Quantum Corporation was founded in 1980 predominantly selling scale-out tape data storage systems for long-term archive and data protection. Since then the company has adapted its end-to-end tiered storage products and services for new technologies. However, over time Quantum’s main product, tape systems, were in a declining market as HDD and SSD drives dominated storage, and their new offerings were not as competitive. Further, data centers increasingly took market share as on-premise providers outsourced their IT infrastructure. Notably, the company has a royalty revenue stream as they are in a LTO tape consortium with Sony, Fujitsu and Maxell.
Quantum has four business segments: Primary, Secondary Storage, Device/Media and Services.
Revenue comprises of 30%-35% services, ~30% tape storage systems, ~15% high performance storage systems, 10%-15% Device/Media and ~5% royalty revenue.
StorNext: Data storage software, StorNext, is a processing system for high performance data streaming and access. The software can run on standard servers and is currently sold with storage arrays. Notably, Quantum is simplifying the user interface and adapting the software to be sold separately as a service, while being able to run on cloud/third party servers. The company believes this should expand the software’s use cases to other large scale video data industries.
F-Series: Debuted in mid-’18, the F-Series is an NVMe SSD flash storage array. NVMe is a storage protocol that enables 5x the bandwidth of legacy SATA SSDs. Notably, customers have seen a 5x-10x increase in data writing performance with one to two NVMe arrays.
QXS-Series: Quantum’s legacy line of hybrid storage arrays of HDDs and SSDs.
VS-Series: Debuted in mid-’18, the VS-Series is a product line of hyperconverged storage arrays for surveillance applications. This offering is coupled with Quantum’s Cloud Storage Platform.
R-Series: Debuted in mid-’18, the R-Series is a product line of ruggedized removable storage especially for in-vehicle data capture, mobile surveillance and military application.
Scalar Tape Storage: The Scalar tape system is a low cost, long-term data storage medium. Tape systems can scale to Exabytes levels of storage and provide off-line storage in the event of cyber-attacks. Secondary storage footprint can be 2x-3x that of primary copies.
DXi Backup Systems: The DXi system is a backup and disaster recovery system. The system duplicates data and stores is in multiple locations while minimizing data center footprint.
Device and Media
LTO Disk Drives: Quantum offers a line of LTO disk drives, tape drives and media.
Distributed Cloud Services: Debuted in mid-’18, Cloud Services are offered to complement traditional implementation and maintenance services with a Storage-as-a-Service business model. The company also offers analytics and global services with several subscriptions levels based on baseline capacity.
LTO Royalty Revenue
Quantum is a member of a consortium that develops, patents and licenses Linear Tape-Open (LTO) technology. The company receives royalty payments for LTO sold under licensing agreements. LTO-8 tape (30TB) is the current tape generation, though has been unable to sell due to a lawsuit between Sony and Fujitsu. The consortium has a roadmap up to LTO-12 with ~480 TB capacity.
In June ’18, Jamie Lerner, joined Quantum as CEO from Pivot3, an IT infrastructure firm, where he was COO since ’16. Prior to that, he was President of Cloud Systems at Seagate and SVP of Cloud Systems at Cisco, where he led turnarounds. Mr. Lerner’s compensation comprises of a ~$475K base salary and an annual performance cash bonus of 100% of salary. His long-term equity compensation includes ~1M shares (~2.6% ownership) portions of which are contingent on share relisting and share price targets out to ’22 ($8-$13/share targets based on previous compensation agreements).
In May ’18, Michael Dodson, joined Quantum as CFO from Greenwave Systems, a software company, where he was CFO since ’17. Prior to that, he was CFO at Mattson Technology a semiconductor processing equipment company, which sold to a Chinese PE company for a 55% premium. Additionally, Mr. Dodson was CFO at DDi from ’09 to ’11 and eTelecare from ’06-’09, each with a history of being turned around. Mr. Dodson’s compensation comprises of a ~$400K base salary and an annual performance cash bonus of 50% of salary. His long-term equity compensation includes ~0.265M shares (~0.7% ownership) portions of which are contingent on share relisting and share price targets out to ’22 ($8-$13/share targets).
Since ’18, the company has hired 10 new executives, with key positions externally sourced. The executive team should own ~10% of QMCO should they execute the share relisting and reach share price targets by ’22.
Quantum’s history is replete with activist shareholders, seeing value in the company and attempting to extract it through restructuring and other actions. In ’13, Starboard Value aided in reconstituting the Board and improved operations, though with the dubious CEO, who engaged in accounting chicanery, still in charge. The investment firm continually sold its position from ’15 through ’18.
In early ’17, VIEX Management, an investment fund acquired ~10% ownership, added Eric Singer to the board in late ’17 to aid in the turnaround. Notably, they brought in a consulting firm to find additional cost savings and market opportunities. With the turnaround complete, Mr. Singer has retired from the board to focus on other investments requiring more attention. Additionally, by ’18, B. Riley Financial acquired ~15% ownership and brought John Fichthorn, Head of Investments, onto the board in ’19.
The board now comprises of four shareholder-friendly directors with VIEX and B. Riley owning ~25% of Quantum.
The company sells its products to media and entertainment firms as well as storage OEMs, distributors, VARs and DMRs. Revenue from the top five customers amounted to ~33% of sales in FY’19, with none above ~10%.
Quantum media customers range from TV and Hollywood movie studios to ad agencies and news publishers. For Hollywood in particular, the company has customer relationships dating over 20 years. These customers have a need to keep data on-premise due to confidentiality concerns and the fact that large video data sets are not well suited for cloud storage. The high demands from video workflow necessitate best-in-class data storage systems, such NMVe flash and fast writing software. Additionally, the long shelf life for movies and TV shows make tape a low cost choice for data storage periods over 30 years or more.
Notably, Quantum is expanding into adjacent markets with customer dynamics similar to the media industry such as video surveillance (industrial, military and commercial), autonomous vehicles, geospatial, life science and energy data storage industries. At present, the company is selling video surveillance products directly to building contractors, who have sales and build cycles of several years for large buildings. For smaller projects, sales cycles are generally faster at 3-6 months.
For enterprise and backup storage, the company is in a testing phase with three hyperscalers. Historically, Quantum has not sold to this customer base (Microsoft, Google, Apple, etc..), which represents a new opportunity. These customers’ sales cycles are 12-18 months and their purchases are typically exabyte sized. Notably, given growing storage capacity demand, hyperscalers are increasingly utilizing tape for long-term storage as rapid access is not a high priority and costs can be 1/3 to 1/6 of HHD storage.
Customers using Quantum’s products and services have experienced a ~25% decrease in total storage costs compared to previous system architectures.
Quantum’s supplier dynamics have changed substantively over the last year. First, manufacturing has moved to lower cost regions, such as Mexico. Hardware has been redesigned to use less expensive components and simplification of software has reduced CPU and storage needs. Further, hyperconverging the physical products and increasing software-only sales has further reduced the reliance on suppliers for hardware. All of these actions have reduced build costs and power of suppliers.
Lastly, for LTO tape, the product is sole sourced from Japan. With the legal issues between Sony and Fujitsu over, LTO-8 should start to enter the market.
The data storage market is highly competitive and Quantum’s competitors are usually much larger and well established. For every new generation of storage products, costs drop and capacities increase. Additionally, new storage technologies enter the market every 5-10 years, which ramp in capabilities and then adoption, ultimately displace obsolete tech.
For high-performance shared storage systems in media and entertainment, the company competes against EMC (part of Dell), IBM and NetApp. In this particular market, Quantum is noted as being very competitive with best in class offerings and service, though difficult to use given its complexity. In the past, the company’s core issues had to do with sales execution not with any concerns as to the product quality.
In data protection and secondary storage, Quantum competes against firms like Commvault.
For Scalar tape systems, the company competes with IBM, Oracle, SpectraLogic and HPE. Sale of tape comes from Sony, Fujitsu, Quantum and Maxell.
Data storage hardware market has gone through several waves of new technology entry, mass adoption, maturation then decline. Decline in technology usage is twofold, lower physical sales due to efficiency gains and overall decline in sales as older formats are phased out. Following introduction, new data storage technology has an almost hyperbolic rate of change in increased storage density and writing speed.
Tape and hard disk drive were the dominant technologies in the mid to late 20th century. In the ‘90s, solid state drives (SSD), with greatly increased storage density and speed, began entering the storage stack. By the late ‘90s, NAND flash memory entered the fold, with similar storage density as highly developed HDD systems, despite being in the early stage of development. In the early ‘10s, NVMe flash was developed and is able to have ~65K commands per queue compared to previous host controller interface technology of 32 commands per queue.
Given the large increase in speed, NVMe is expected to create a step change in functionality for data storage users with product growth of over 25% per annum through ’27. Notably, most hyperscaler systems today connect the cluster nodes over Ethernet, which creates a data locality issue as firms try to grow their data environments. Meaning that data storage infrastructure latency increases almost linearly as nodes are added to the network. The adoption of NVMe-based data storage systems can greatly reduce this latency issue, making it a high cost though high value-add hardware component.
New technologies, while more costly than previous generations, decline substantively over time. NAND flash costs decreased from ~$10K/TB in ’06 to ~$350/TB in ’18, while tape costs declined from ~$5K/TB in ’06 to ~$215/TB in ’18. Cloud storage is expected to cost ~$100/TB. Notably, digital archive shelf life for a disk is ~10 years, whereas tape is ~30 years.
Media and entertainment data storage, in exabytes, is expected to grow over 30% per annum to over 90EB by ’24. While the M&E market is expected to grow ~12.5% per annum to ~$16B by ’24, according to Coughlin Associates. The variance in growth between storage capacity and overall market revenue opportunity is attributable to expected decreases in cost per EB.
The video surveillance generates ~550 PB every day, and is anticipated to grow to ~3.5EB per day due to the proliferation of cameras (traffic, security, and police bodycams), according to IHS. In addition to the greater video usage, shelf life of the data is expected to increase.
Tape sales amounted to ~0.1 exabytes in ’17, up 13% y/y and represent a ~$6B market, according to Persistent Market Research. Normalized growth is expected to average 1%-1.5% per annum as newly introduced LTO versions have higher sales, while simultaneously cannibalizing older versions. Growth in the tape market from ’17 to ’19 has been anemic as legal fights have held up the introduction of LTO-8 for several years. Going forward, LTO-8 purchases are likely to equate to ~8% per annum growth in ’20 due to a pent up demand.
Software defined storage (SDS) is the use of software to efficiently manage data storage regardless of the underlying hardware, also known as hyperconverging. By pooling storage/computing assets through software, hardware has essentially become commoditized. The SDS market is expect to grow ~20% per annum from ~$2.7B in ’19 to ~$6.5B in ’24, according to IDC.
3) Why now?
Quantum was a historically poorly managed entity and the latest activist shareholders have succeeded in turning around the business. The new shareholder-friendly board and management team have streamlined the cost structure, realigned sales initiatives and are developing solutions to address the data storage industry’s largest problems. We advocate entering into a position as the company relists on the stock exchange following the conclusion of a SEC investigation and lenders exit their equity position.
A few key points below illustrate the company’s value potential at this point in time:
1) SEC Investigation Conclusion and Subsequent Relisting, Motivated Non-Traditional Shareholders Likely to Sell: Quantum currently trades OTC and the lower liquidity by being OTC inhibits large holders from selling their shares or new investors from entering the name. The SEC investigation is expected to conclude with a small fine, de-risking the name while likely not detrimentally impacting QMCO’s financial standing. The company cannot relist until the investigation is complete. Offsetting the positive impact of relisting, lenders who have or are expected to exercise their warrants (~20% shares outstanding) should be able to exit their position more rapidly, as they traditionally do not hold equity investments. This anticipated motivated selling should dislocate the share price from intrinsic value in the near-term, creating an advantageous situation to acquire a position.
2) Successfully Restructured Organization and New Strategic Priorities Creates Two Tiered Growth Profile: After a period of management turmoil, the current CEO has hired an entirely new leadership team and restructured the company financially and operationally. The company’s cost structure of ~$400M per annum was reduced by ~$70M, of which ~70% came from sales and marketing, ~15% from R&D and G&A. Misaligned sales incentives were recalibrated to properly drive personnel to generate sales with competitive margins. The newly invigorated sales effort should create a strong self-help dynamic, driving growth in the near-term regardless of end market dynamics. In the long-term, QMCO’s new products, both hardware and software, target large, growing markets within the data storage industry as opposed to the company’s historical declining scale-out hardware market.
3) Optimized Hardware Manufacturing and Move to Recurring Software Sales Model Should Further Increase Operating Margins: Following the restructuring, Quantum should generate EBITDA margins of ~12% this year, FY’20. However, the company is in the midst of shifting its supply chain which should modestly improve gross margins and capital intensity. Importantly, Quantum is adjusting their revenue strategy to include cloud services and a recurring storage software subscription model. Additionally, their custom-built hardware strategy is being revamped to be more modern and cost effective. The introduction of a high margin product with a recurring nature should create revenue stability and operational leverage in the business. As such we anticipate the company should increase EBITDA margins to ~20% by FY’24, ~150 bps of margin expansion per annum.
4) Pent Up Demand for LTO-8 Should Drive Growth in Royalty Revenues, Tape Supports New Strategies: Quantum’s LTO royalties allows the company to profit from industry-wide tape sales activity at 100% margin. In ’17, Sony and Fujitsu initiated a legal battle over licensing of LTO-8, the soon to be released generation. During this dispute, LTO-7 was the only available tape on the market, and sales growth dissipated as large customers waited for a conclusion to the legal fight. In late ’19, the companies finalized an agreement and LTO-8 is expected to sell in earnest next year. In FY’17, Quantum generated ~$35M in royalties and should generate ~$25M in FY’20. Going forward, we anticipate royalty revenue growth of over 7.5% per annum through FY’22 due to pent up demand for LTO-8. Further, the company’s tape systems (~30% of revenue) should exhibit growth as hyperscalers shift long-term data storage from disk to tape. Quantum is in testing with three hyperscalers and contract sizes range from $10M-$30M depending on the capacity. A large tape-based hyperscaler contract win would materially benefit the company allowing reinvestment into newer technologies/products.
5) Debt Refinancing Should Free Up Capital Structure, Enabling Greater Reinvestment: Quantum, in late ’18, refinanced its debt with a $165M senior secured loan at LIBOR+1000bps, a $45M credit facility along with ~7.1M shares in the form of warrants equating to ~20% of shares outstanding (strike $1.33/share). At present, the company has leverage of ~3x net debt to EBITDA, which should decrease to ~2x by FY’21. Even as leverage declines, an interest rate of ~12% should consume ~50% of the company’s operating cash in FY’20. Due to the current credit agreements, the company anticipates a refinancing should occur in FY’21. With improving fundamentals, Quantum should be in a better position to refinance its debt to a more reasonable ~6% per annum, freeing up cash flow while de-risking the capital structure.
6) Newly Constituted Board and Management Should Own Almost 35% of Quantum, Incentivized to Create Shareholder Value: The company’s largest institutional holders, VIEX Management and B. Riley Financial cumulatively own ~25% and have board representation. At present, the remaining board directors and several C suite executives have ~6% ownership and should receive an additional ~4% ownership contingent on long-term company performance. In sum, the board and management should hold ~35% of Quantum. With substantial ownership, the company’s leadership is highly aligned with shareholders.
4) Concerns/Thesis Pressure Points
New Product Risk
Quantum has produced an entirely new subset of products that are intended for end markets adjacent to its historical areas of expertise. Further, the company is now bifurcating its products between software and hardware, a shift that customers may push back on. Slow consumer adoption and longer sales cycles would put the company’s growth at risk and lead to uneconomic returns.
Technical Obsolesce Risk
Data storage technology has historically exhibited rapid development rates and new formats/architectures come about every 5-10 years. The company’s legacy technologies are likely to become obsolete after several years, decreasing revenue and necessitating development of new products, which are subject to the risks listed above.
The company currently sits in markets dominated by larger competitors, though have managed to maintain competitiveness in a few niches. Should competitors engage in aggressive price responses in hardware or software, a smaller operator such as Quantum would be disproportionately affected.
Capital Structure Risk
Quantum’s capital structure is currently leveraged ~3x net debt to EBITDA, with interest payments of ~12%. While financial leverage is expected to decline with operational performance, the capital structure introduces increased risks until the company can refinance at a lower interest rate.
Market Cycle Risk
The company’s end markets for hardware are typically cyclical, with a span of 2-3 years. Should a market downturn occur, enterprises would likely defer IT related spending. However, a software subscription revenue source would help damp out hardware cycles.
Large Shareholder Risk
Two investors, VIEX and B. Riley, own ~25% of QMCO. Should they sell their positions the stock would be disproportionately affected as this would signal a lack of insider conviction.
5) Business Valuation
Quantum should exhibit upper single digit growth over a number of years as the company executes its new sales operation and provides new innovative solutions to niche markets. The company generates revenue through services, hardware sales, royalties and has an emerging software component.
A summary of the Base Case assumptions for the company is below:
1) Short-Term Guidance FY’20: Revenue: $424M-$430M, EBITDA: $51M-$55M, Capex: $7M.
2) Long-Term Guidance: Revenue Growth: 10% per annum, Gross Margins: >50%.
3) Total revenue should grow ~8% to ~$435M in FY’20, then grow ~7.5% per annum to ~$625M by FY’25.
4) EBITDA margin of ~12% in FY’20 should improve to ~20% by FY’24, a ~150bps expansion per annum.
5) Capex: ~$7M in FY’20. Going forward, capex should average ~2% of revenue.
6) ~10x normalized EV/EBITDA multiple for Quantum. Reasoning behind the multiple is in the Peer Analysis section below.
7) Discount rate at ~17.5% (micro-cap).
Five-Year Operating Model
A simple five-year operating model is utilized to determine value.
Base Case assumes the company grows ~7.5% per annum and expands operating margins ~150bps per annum.
- Base Case Valuation: $19/share.
Upside Case assumes the company grows ~10% per annum and expands operating margins ~200bps per annum.
- Upside Case Valuation: $33.25/share.
Downside Case assumes the company does not grow or expand operating margins.
- Downside Case Valuation: $8.50/share.
Peer Analysis – Trading Comps
Quantum has few direct public comparables, the closest being Commvault and NetApp. The remainder of the comparables consider firms which exhibit similar characteristics as to products, competitive positioning/strategy and the degree to which they are embedded in client operations. Analysis below utilizes a normalized EV/EBITDA metric to account for the margin implications of business model shifts.
Public Comparables – EV/EBITDA
1) Avid Technology (AVID) – ~8.5x normalized EV/EBITDA; currently at ~9.25x FTM.
2) Commvault (CVLT) – ~18x normalized EV/EBITDA; currently at ~16.5x FTM.
3) NetApp (NTAP) – ~9.75x normalized EV/EBITDA; currently at ~9x FTM
4) Pure Storage (PSTG) – ~22.5x normalized EV/EBITDA; currently at ~23x FTM.
Avid Technology is a provider of applications and services to the media and entertainment industry for content creation and distribution. While not a competitor to Quantum, AVID does address a similar customer base. The company is in the midst of transitioning to a subscription software model, which currently comprises <20% of revenue. Growth is expected to average ~2% per annum over the next five years.
Commvault is a provider of data protection software applications/services, partly competing with Quantum’s secondary storage products. The firm is working on expanding its subscription revenue model, which comprises >20% of revenue. Growth is expected to average ~5% per annum over the next five years.
NetApp is a hybrid cloud service provider, supplying enterprises with both hardware and software solutions. Quantum competes with NetApp in scale-out products. Growth is expected to average ~0% per annum over the next five years.
Pure Storage is an all flash data storage hardware provider for medium enterprises both on-premises and in the cloud. The company is focused on expanding its subscription revenue services for both hardware and software. Growth is expected to average ~17.5% per annum over the next five years.
The group’s normalized EBITDA multiple equates to ~13.25x and has ranged between 7x-20x from ’14 to ’19 and currently trades at ~15x FTM assuming ~6% per annum revenue growth. Quantum currently trades at ~7.25x EBITDA and does not have useful historical trading multiple data given the large changes in the business.
Peer Analysis – EBITDA Margins
1) Avid Technology (AVID) – ~14.75% normalized EBITDA margin; currently at ~14% FTM.
2) Commvault (CVLT) – ~18% normalized EBITDA margin; currently at ~15% FTM.
3) NetApp (NTAP) – ~23.25% normalized EBITDA margin; currently at ~24% FTM
4) Pure Storage (PSTG) – ~9% normalized EBITDA margin; currently at ~9% FTM.
Avid’s operating margins have increased ~200 bps per annum since ’17 and are expected to expand similarly for the next five years as R&D and SG&A scale. Capital expenditures have averaged ~2% of revenue.
Commvault’s operating margins have increased ~140 bps per annum since ’15 and are expected to stabilize for the next five years due to increases R&D. Capital expenditures have averaged ~1% of revenue.
NetApp’s operating margins have increased ~190 bps per annum since ’15 and are expected to expand less than 50 bps per annum of the next five years. Capital expenditures have averaged ~2.75% of revenue.
Pure Storage’s operating margins have increased from below zero to ~9% in ’19 and are expected to expand ~170 bps per annum for the next five years as R&A and SG&A scale. Capital expenditures have averaged ~6% of revenue.
Quantum’s comparable group generates ~17.50% normalized EBITDA margins, underpinned by operating margin expansion of ~100 bps per annum. Quantum is expected to expand EBITDA margins ~150 bps per annum from ~12% to ~20% by FY’25, in between Commvault and NetApp’s normalized margin profile.
Strategic Acquirer Analysis
1) EMC (data storage) – 2.5x EV/Revenue, ~11.5x EV/EBITDA (’15 to Dell)
2) Hedvig (software defined storage) - ~15x EV/Revenue, (~$15M revenue) (’19 to CVLT)
3) Isilon (software defined storage) - ~18x EV/Revenue (~$125M revenue) (’10 to EMC)
Precedent transactions for a large data storage firm show that valuations ~10x EBITDA appear reasonable. However, for software defined storage companies, EV/Revenue multiples above 10x show the value of the software subscription business model
On the whole, a 10x EV/EBITDA acquisition multiple appears to be applicable for Quantum in its present hardware dominant form. However, over time should QMCO’s software defined storage revenue stream gain substantive traction, it’s clear that strategic acquirers and investors would value the company at a higher multiple.
Peer Analysis – Conclusion
For Quantum, a ~10x EV/EBITDA normalized valuation appears reasonable based on a ~25% discount to the group due to the uncertainty around the emergent nature of its business models. Further, the valuation multiple aligns with precedent transactions of data storage firms. Lastly, should Quantum grow its software subscriptions and cloud services, the market would likely apply an EV/Revenue multiple above 5x at a minimum to said business segments, elevating the company’s valuation above the current 1x EV/Revenue.
6) Market Expectations/Perceptions
Quantum’s is covered by 3 analysts with an average price target of ~$8/share. All the analysts have a Buy rating. Investor commentary acknowledges the new management’s success so far and the uncertainty around the potential customer adoption of new products. With a share relisting, QMCO would likely generate increased investor interest and is more likely to be covered by more analysts.
Further, most investors seem concerned over leverage and SEC investigation settlement payments. The SEC settlement should be minimal and a refinancing is should be conducted in a year or two. Lastly, most do not realize the potential for non-economic selling from the creditors, who have ~20% in equity via warrants.
Consensus forecasts ~5% revenue growth through ’22, and EBITDA expansion of 200 bps per annum to ~16% in FY’22. The company does not break out software sales yet given the early stages of the product, and further disclosure around that revenue stream would be welcomed by investors.
7) Downside Protection – Where’s the Margin of Safety?
At $5.95/share, the market assumes revenue declines ~5% per annum and operating margins remain at ~12%.
The company’s downside is well protected as Quantum has not lost one customer since the new CEO started the turnaround in ’18. Additionally, with LTO-8 entering the market, both consortium royalties and tape system revenue should start to exhibit growth. Further, revenue growth in tape systems could accelerate as the company receives contract wins following its operations testing with three hyperscalers.
Interestingly, if Quantum can generate ~$100M in revenue from storage defined software services, equivalent to its current run-rate on system hardware sales, at a modest ~5x EV/Revenue the software segment alone would make the firm worth ~$8.50/share.
Quantum is an improving business with short-term and long-term tailwinds thanks to its revamped organization and new strategy. The emergent nature of its new, innovative products (hardware/software) and almost entirely new board/management team should drive the company to perform beyond its historical operational relationships. Additionally, a growing software sales revenue stream could create substantive multiple expansion.
The SEC investigation conclusion and share relisting provide hard catalysts that should drive investor interest, while potential non-economic selling from creditors should temporarily disconnect shares prices from intrinsic value. Lastly, improving operations should allow QMCO to refinance, providing another catalyst.
As of December 10, 2019, the name is trading at $5.95/share. With a Base Case valuation of $19/share, we believe there is ~220% upside, equating to ~26% annualized IRR.
· SEC investigation settlement
· Share relisting
· Non-economic equity selling from lenders
· Hyperscaler contract wins
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