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Investors Wary of STEC’s Competition, Drop in Business

The tide has turned against STEC Inc.

The Santa Ana-based maker of flash memory drives for powerful servers used by big corporations once was a Wall Street darling that’s now been left to languish by many investors.

Investors are skittish because STEC’s competitors are threatening to close in on the market share lead it has enjoyed for years . At the same time its top customer is said to be looking for a second source for drives.

“When you have 100% market share and one big customer, the market share has no where to go but down,” said Gary Mobley, senior equity analyst at Benchmark Co. in St. Louis. “When you have competition closing in on the lead that STEC had, it strikes fear into investor hearts.”

The company’s stock price slowly has been circling the drain for some time as investors look to dump shares on increasingly dimmer prospects.

Shares are off nearly 30% since the start of the year on a recent market value of roughly $600 million.

“It’s like a game of musical chairs,” Mobley said. “No one wants to be left holding STEC’s shares when the revenue becomes volatile.”

Key Customer

The company, whose soaring shares crashed late last year amid a drop in orders from a key customer, makes solid state drives used by banks, retailers and other large corporations.

Solid state drives have no moving parts, are more durable and are faster at some tasks than traditional spinning disk drives. They’re also pricier than the old disk standbys, but are seen as taking off for corporate storage.

STEC’s been joined at the hip with Hopkinton, Mass.-based EMC Corp., one of the top makers of data storage computers. EMC accounts for more than 60% of STEC’s yearly sales, which are projected at about $268 million this year.

There are a lot of players trying their hand at solid state drives, including disk drive makers Western Digital Corp. of Lake Forest and Scotts Valley’s Seagate Technology LLC.

Fountain Valley’s Kingston Technology Co. also makes solid state drives, as does South Korea’s Samsung Group.

“There are more than 100 different companies out there that are competing with STEC,” analyst Mobley said.

In a conference call with analysts, STEC’s executives said that Hitachi Global Storage Technologies Ltd., a unit of Japan’s Hitachi Ltd. that makes solid state drives, was said to be testing its products with EMC.

Qualifying trials can take many months at EMC, which is known for being tough to break into.

Competition Timing

Chief Executive Manouch Moshayedi said that he didn’t see a real competitive threat to STEC coming until next year.

“We introduced our product more than three years ago,” he said. “It’s going to be about two years before they will have an ASIC out and another year for qualifications, so they will be more than six years behind us.”

But worries abound.

Earlier this month, Seagate announced it inked a development and licensing agreement with Samsung to make the controller technology that allows solid state drives to run in large servers used by corporations.

The controller chips often are the most finicky part of a drive.

“We view this as a very significant announcement,” said Richard Kugele, an analyst at Needham & Co. in Boston. “As investors know from STEC, enterprise solid state drive controller technology is challenging.”

The move takes down two big stumbling blocks for Seagate, according to Kugele.

“We believe that for Seagate to have a long-term position it needs to own its own controller technology and have a strong supply relationship with a flash memory supplier,” he said. “This agreement solves both issues.”

Seagate last year struck a similar deal with LSI Corp. to develop controller chips for higher-performance solid state drives.

“They have taken a tiered approach with respect to trying to catch up to STEC with the different segments of the market they play in,” Benchmark’s Mobley said.

But STEC still thinks it has the advantage.

“There is a huge learning curve involved in building these products,” Moshayedi said. “Intel and Hitachi and Samsung and Seagate are having to partner up to match a technology that we have had for years. That’s a big compliment to our engineering team.”

The market is still very much a proving ground until the second half of 2011 and the first half of 2012, analysts say.

“We suspect that Seagate will not (pose) a serious challenge to existing solid state drive players, such as STEC, until the 2012 launch,” Kugele said.

In the meantime, STEC is looking to diversify its customer base with other top-tier server makers, including Dell Inc., Hewlett-Packard Co., IBM Corp. and others, as well as make a cheaper product.

“We are one of the first companies to come out with our own technology that dramatically brings down the cost per gigabyte, which has been one of the stumbling blocks for full adoption,” Moshayedi said.

However this emerging market shakes out, STEC “will continue to be a viable player,” according to Mobley.

“But it wont have 100% share in the highflier of enterprise class storage,” he said. “Their share will go down and their gross margins will go down.”

STEC’s unlikely to regain the high-flyer status it saw last year.

“The dilemma for STEC’s share price is that the stock will always trade with a low valuation multiple because no one wants to get into a company that is bound to lose market share,” Mobley said. “Everyone will always question the forward earnings potential.”

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