Imagine this. On Monday, you invest in a hot tech company with all the right buzzwords: cloud computing, Web 2.0, virtualization, etc. This company, STEC Inc. (STEC) builds solid-state, flash-based hard drives for enterprise users.
Sure, the company is trading at a pricey 19.5x trailing earnings, but who cares about trailing earnings? Only future earnings drive investment returns, right? On a forward basis, the company is closer to 12x, which is a comparative steal compared to other new tech companies (though, still expensive compared to the *yawn* old tech companies of yester-millenium). Factor in the company’s debt-free balance sheet and $191 million in cash (around 20% of its market cap), and the company is even cheaper!
Hey, maybe you are a value investor!
You go to sleep Monday night with a sense of comfort, knowing that you won’t be missing out on the next tablet/app/social bubble. Not like last time, when you missed out and watched your friends get rich (and then poor).
Tuesday is sort of a bad day. The company’s shares fell about 6% after the company disclosed before open the following 8-K:
As first disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009, the United States Securities and Exchange Commission (“SEC”) is conducting a formal investigation involving trading in the Company’s securities. The Company and certain of the Company’s officers and employees, including its CEO and President, have received subpoenas in connection with the SEC’s investigation. The Company is fully cooperating with the SEC in regards to this matter. On July 19, 2011, the Staff of the SEC notified the Company, its CEO and President that they are considering recommending that the SEC initiate a civil injunction action against the Company, its CEO and President, charging them with violations of the antifraud and reporting provisions of the federal securities laws. Under a process established by the SEC, the Company, its CEO and President have the opportunity to submit to the Staff any reasons of law, policy or fact why they believe that the civil action should not be brought (a “Wells Submission”) before the Staff makes its formal recommendation to the SEC regarding what action, if any, should be brought. The Company, its CEO and President intend to continue to cooperate with the SEC to attempt to resolve the Staff’s concerns, but there can be no assurance that the SEC will decide not to bring an action against them.Wait a second. So some jerk at the SEC decided, after 18 months of fuddling about, that now is the time to recommend a civil injunction and now your investment is down 6%? Don’t they realize that this company is revolutionizing the world? This is insanity.
Later, while consoling yourself over a glass of Laphroaig it hits you — this is why you bought STEC “cheap” rather than jumping in with your friends into those new high-flyers like Zillow (Z) or LinkedIn (LNKD). You bought a company that actually produces something tangible, and you got it at a steal, right? You tell yourself that yes indeed, you are right. Besides, the company’s earnings are coming out on Thursday after the close, and if Seagate (STX) and Western Digital’s (WDC) earnings were an indication, it seems the SSD manufacturers are eating their lunch, so STEC should recover nicely.
Wednesday is a boring day. The stock is down another 1%, but that’s probably because of Washington’s dawdling over the debt ceiling. When will they get on with it? Only one more day until earnings!
Thursday started out as a good day. The stock recovered well throughout the day. Maybe this is the result of information leakage, signalling an after-hours jump? Then the earnings came out and WHAM! OMGHOWISTHISHAPPENINGTOME? Oh no oh no oh no oh no. The shares are TANKING. Down, down down. Finally halted, but they’ve lost 35.7% of their value in the after hours. But it only missed by a penny! (Don’t forget about the negative forecast.)
You invested around $18 on Monday, and by Thursday evening, your investment was worth $10.75, for a 40.3% decline, or 12% per day!
Ok, let’s do a post mortem. When you invested, you ignored some important things.
First, the company’s revenues are highly concentrated. Almost comically concentrated. One customer, EMC Corp. (EMC) accounts for around 40% of the company’s sales in any given year, while the top 10 account for nearly 90%. This puts the company in a precarious position whereby a problem with just one customer would have a large effect on STEC’s operations, and it is dealing with customers who can exert significant pressure given the company’s reliance. If, for example, one of these customers decided to takes their products in a different direction, utilizing a different technology in order to compete in a different customer space, this could have a big effect on the company’s sales. Turns out, this is exactly what the company is forecasting. From its 8-K announcing its earnings:
[W]e believe lower-cost SSD solutions have been qualified at some of our customers. These alternative solutions usually involve coupling lower-cost, lower performance SATA-based drives with a connectivity bridge to a SAS or FC interface. We believe that some of our OEM customers are selling their systems incorporating these alternative products to end-users at prices lower than the OEMs are currently able to offer the same systems that incorporate our ZeusIOPS® SSD solutions. Despite the performance and latency advantages of ZeusIOPS, our OEM customers may be using the alternative solutions to reduce the overall cost of end-user SSD implementations in order to stimulate overall demand. Second, we believe that competitive SAS SSDs may have been qualified at some of our major customers, which has led to fewer orders for our SAS SSD solutions for the third quarter.Second, the company has had a horrible track record as steward of shareholder capital. Its returns have been in double digits just twice in the last decade, hardly justifying your purchase at a whopping 3x book value (just how liberal were the assumptions in your residual earnings valuation?).
Third, the only thing worse than the company’s returns was the company’s history of generated free cash flows. Over the last decade, the company has generated just $15 million of net free cash flow. Operating cash flows have been likewise poor at just $103 million over the decade. At the same time, the company increased shares outstanding by 34%.
Fourth, did you not read "Financial Shenanigans" (or at least, my in-depth review here)? If you had read it, you would certainly have looked at the components of the company’s cash conversion cycle and realized that the company’s Days of Inventory is currently twice what it was in 2006 (at a whopping 141 days!).
Sorry you’ve had a rough week, but maybe now is a good time to take a look at your investment process. Pick up this book as a good, highly readable starting point.
Have a different view of STEC? Let me know in the comments below!
(Note: I wrote this before market open on Friday.)
Author Disclosure: No position