More competition in the growing market for corporate flash memory drives appears to be eating into profits and changing Wall Street’s outlook on Santa Ana-based STEC Inc.
Analysts have zeroed in on signs of eroding earnings at the company—which, until this year, had been the unchallenged leader in solid state drives.
The drives have no moving parts and are seen replacing traditional spinning disk drives in corporate storage networks.
In the past few years, STEC saw gross margins of about 55% on its flagship product, ZeusIOPS.
Competitors have been creeping into the market as their products get qualified with big makers of servers for corporate networks.
The new entries include big players such as Irvine’s Western Digital Corp. and Scotts Valley-based Seagate Technology LLC, among others.
The competition appeared to take its toll last week, when STEC reported gross margins of 45% in the fourth quarter, down from 51% for the prior period.
“Margins are shrinking in a long-term kind of way,” said Anders Bylund in a report on stock website Motleyfool.com
Chief Executive Manuoch Moshayedi told analysts in a post-earnings call that lowering prices over time is a common practice in the storage industry—and something that customers expect.
The lower margins hit STEC’s bottom line in the fourth quarter, sending adjusted profits down to $18 million, a decline of 30% from a year ago. Sales fell to $94 million, an 11% dip.
The results beat analysts’ expectations. But Wall Street seemed to get hung up on STEC’s shrinking margins amid signs that the new competition is pushing prices for solid state drives down.
“The one main disappointment in the quarter was the gross margin,” said Gary Mobley, an analyst at Benchmark Capital Co., in a research note.
He said he was adjusting his gross margin estimate “due to more competition and falling solid state drive prices” after STEC came in below the 46.5% gross margin he expected in the fourth quarter.
“Guidance commentary would indicate that the gross margin is again expected to decline” in 2011, Mobley said. “With more competition being qualified at customers such as EMC, ZeusIOPS margins should continue to trend down toward 45%.”
STEC didn’t give a gross margin outlook for the current quarter.
Some analysts are glad to see STEC adding customers to its roster, which at one point was dominated by storage kingpin EMC Corp.
EMC made up about 40% of STEC’s $94 million in fourth quarter sales.
Newcomers include IBM Corp, Hitachi Global Storage Technologies Ltd., Oracle Corp.’s Sun Microsys-tems Inc. and a dozen others.
Although STEC once was the exclusive provider of drives to EMC, “second sourcing” is now the norm.
“According to our sources, EMC has now qualified Hitachi and Samsung as second- and third-source suppliers of solid state drives,” Mobley said.
STEC said it believes overall market growth can offset narrowing profit margins.
“We are right now in a period where we feel that we already have legitimate competitors in the market,” Chief Executive Moshayedi said. “Even with that, as you can see, Q1 is much higher than we had anticipated previously and we are having our best Q1 ever … I think the market growth is overcoming the fact that competition is arriving in these markets.”
Analyst’s Take
Analyst Richard Kugele of Needham & Co. signaled agreement.
“The company continues to build upon good execution and has a strong pipeline of products with potential for very significant ramps in 2012,” he said in a research note. “With customer diversification worries being lessened with each passing quarter… the outlook is promising for STEC. Margins were the only negative on the call.”
Kugele has a “buy” rating on the stock and recently boosted his price target to $29 per share, up from a previous target of $21 per share.
STEC’s shares, which were trading at about $22 late last week, are up 20% since the start of the year. It had a recent market value of $1.1 billion.