NOTE TO READER: This report contains substantially new material. Subsequent reports will have changes highlight
Reason for Report: 2Q05 earnings update.
Overview
Colorado based Storage Technology Corporation (STK or the Company) engages in the design, manufacture, sale, and maintenance of data storage hardware and software, as well as the provision of supporting services worldwide. The Company operates in two segments: Storage Products and Storage Services. The Storage Products segment offers tape, disk, network, and other storage products for the mainframe and open-systems markets. Tape storage products include automated tape libraries, tape drives, and a virtual tape product. The Storage Services segment offers maintenance and support services, as well as professional services, which include data center operations, business assessments, data migration, continuity and recovery, product implementation, and product testing and packaging, as well as storage consulting, implementation, and storage management services. STK offers products and services to the financial services, retail sales, healthcare, broadcasting, telecommunications, transportation, and manufacturing markets. It markets products and services through direct sales organizations and indirect channel partners, including original equipment manufacturers (OEM’s), value added distributors and resellers, and other distributors. The Company also resells fibre channel switches, directors, and multiprotocol storage routers for storage area network solutions. STK was founded in 1969 and is headquartered in Louisville, Colorado
Investment Positives / Investment Risks· New opportunities: New business opportunities within Storage Information Lifecycle Management could provide incremental revenue.
· Favorable regulations: New regulations, such as Sarbanes-Oxley, could benefit the storage industry in terms of data needed to be stored.
· Steady stream of cash flow: The Company has the ability to generate and sustain substantial free cash flow.
· Liquidity: Strong balance sheet. / · Competitive threats: Increasing competition from IBM in the tape business.
· Acquisition Disruption: Any uncertainty in the agreement between SUNWW and STK will lead to a subsequent decline in the share price of STK.
· Technological disadvantage: Disk technology is evolving rapidly and tape technology needs to keep pace to maintain its 10x-100x cost advantage.
Further information on the Company can be found at www.storagetek.com
STK’s fiscal year ends on December 31. All calendar references coincide with the fiscal year end.
Recent News
On 2nd June, Sun MicroSystems (SUNW) announced that it intends to acquire STK for $4.1B in cash ($37/share). The deal is expected to close in late summer/early fall. Under the terms of the agreement approved by the boards of directors, STK stockholders will receive $37 per share in cash for each STK share (total $4.1 billion), including the assumption of employee stock options.
Sales
STK reported Q2 revenue of $549.3 million, down 6.3% Y/Y, and 10.0% sequentially. Revenue in storage products included revenue from tape business, Disk Business, and network business.
Storage Products
Tape Business: STK generated tape revenue of $242.5 million, up 13.0% YoY and 14.0% sequentially. According to analysts, the increase reflects (1) STK’s favorable mid range/high-end product cycle - SL500 and SL8500solutions (analysts believe the Company's ability to now provide Pass-Through Port (PTP) functionality on its SL8500 is also a driver), and (2.) a push ahead of SUNW's pending acquisition of STK. This represents the strongest YoY tape growth STK has posted since late 2003.
Disk: Disk revenue was $35.8 million, down 22.0% YoY and up 10.0% sequentially. The results reflect typical seasonality according to analysts. However, the Company has faced some end user hesitation in its disk business ahead of the SUNW acquisition expecting SUNW to likely retain its own disk solutions rather than StorageTek's.
Networking: Networking revenue was $17.3 million and accounted for 6.0% of total revenue. Revenues declined 7% YoY, but grew approximately 35.0% sequentially.
Services: Services revenue came in at $43.4 million and accounted for approximately 44.0% of total revenues. Revenues grew 7.0% YoY and 4.0% on a sequential basis. The services business has been seen as a catalyst for SUNW's pending acquisition. Professional services continue to represent approximately 12.0% of total services revenue.
Geographically: North America accounted for 48.0% of revenue, and was up 3.0% YoY. Europe accounted for 37.0% of revenue and was up 2.0% YoY. Asia was up 13.0% YoY and Latin America was up 32.0% YoY.
in $ millions / 2004A / 1Q05A / 2Q05A / 3Q05E / 4Q05E / 2005E / 2006ENet Sales / $2,224.0 / $499.3 / $549.3 / $551.8 / $682.6 / $2,280.5 / $2,325.0
Digest High / $2,224.0 / $499.3 / $549.3 / $560.5 / $707.0 / $2,305.6 / $2,371.6
Digest low / $2,224.0 / $499.3 / $549.3 / $542.4 / $645.0 / $2,254.1 / $2,215.0
Digest Average / $2,224.0 / $499.3 / $549.3 / $551.8 / $682.6 / $2,280.5 / $2,325.0
Margins
Storage products gross profit margin increased during 2Q05 and FY05 as compared to the same period in 2004, primarily due to a shift in product mix toward tape automation products, which typically sell at higher margins than the Company’s disk and network products. Storage services gross profit margin remained largely unchanged in 2Q05 and FY05 as compared to 2Q04. The analysts believe the mix of service revenue will continue to shift to more professional services. If professional services becomes a greater portion of service revenue, the resulting change in services mix could adversely impact storage services gross profit margin, as professional services typically carry lower margins than traditional maintenance offerings.
Overall gross margin came in at 46.6%, down 0.4% quarter over quarter but up 0.6% year over year. Operating margins were lower than expected at 6.1%, primarily due to additional marketing expenditure related to the launch of the Flexline 600 and the IntelliStore disk to tape archive solution. Additional SG&A expenditure of $5.2 million related to merger expenses (attorney, accounting and M&A advisory fees) was also incurred, but not reflected in pro forma earnings.
Consensus Margins2004A / 2005E / 2006E
Gross Margin / 47.4% / 47.1% / 46.8%
Operating Margin / 10.0% / 8.8% / 9.2%
Net Margin / 8.6% / 6.0% / 6.2%
Earnings per Share
STK reported pro forma EPS of $0.32 that fell short of consensus expectations of $0.34 despite revenue that was 3% higher than consensus, due to higher operating expense and pending merger.
FY ends December / 2004A / 1Q05A / 2Q05A / 3Q05E / 4Q05E / 2005E / 2006EZacks Consensus / $1.72 / $0.22 / $0.32 / $0.41 / $1.84 / $1.91
Digest High / $1.72 / $0.22 / $0.32 / $0.42 / $0.97 / $1.88 / $2.08
Digest Low / $1.72 / $0.22 / $0.32 / $0.32 / $0.66 / $1.56 / $1.51
Digest Avg. / $1.72 / $0.22 / $0.32 / $0.37 / $0.84 / $1.74 / $1.85
EPS estimates for 2005 range from $1.56 (SIG) to $1.88 (Goldman) and for 2006 range from $1.51 (SIG) to $2.08 (Goldman). The analyst at the low end for 2005 and 2006 (SIG) is Neutral on the stock. The analyst (Goldman) on the high end for both years believes that new products, combined with slight improvement in the overall spending environment, should contribute to strong performance.
Target Price/Valuation
Target prices for STK range from $31.00 (Punk Ziegel) to $37.00 (Friedman, Billings, R W. Baird and RBC Cap.) with an average of $34.80. Most of the analysts have used a P/E multiple to value STK. The P/E for STK represents a discount to the storage universe, which the analysts believe is deserved given the lack of growth compared to competitors such as EMC, Network Appliance and others. Some analysts use a DCF valuation to account for the economic value generated from earnings.
Rating DistributionPositive / 0.0%
Neutral / 67.0%
Negative / 0.0%
Not rated / 33.0%
Avg. Target Price / $34.80
Metrics detailing current Management Effectiveness are as follows:
Metric (TTM) / ValueReturn on Assets (ROA) / 8.07%
Return on Equity (ROE) / 12.97%
Return on Invested Capital (ROIC) / 12.88%
Cash Flow and Capital Structure
STK’s cash position remains solid according to analysts. At the end of 2Q05, the cash and investment balance stood at $1.16 billion (vs. $1.15 billion at the end of the prior quarter). Excluding long-term debt of only $9.2 million, net-cash balance now stands at $1.15 billion or $10.70/share (up from $10.50/share at the end of the prior quarter). DSOs for 2Q05 declined to 76 days (vs. 79 days in the prior quarter), while inventory turns improved to 9.2x (up from 7.9x in the prior quarter; 5x turns using STK’s average inventory calculation). Inventory declined 5% sequentially to roughly $127 million during 2Q05. The Company generated roughly $47 million in CFO, or $31.2 million ($0.29/share) in free cash flow during 2Q05. The Company spent $38.5 million on share repurchases during 2Q05; however, shares repurchase activities ceased after the announcement of the Company’s pending merger with SUNW (announced in early June).
Long-Term Growth
The long-term growth ranges from 1.0% (RBC Cap.) to 11.0 %( Lehman), with an average of 6.0%.
Analysts believe that following the SUNW/STK combination, OEMs will review their respective strategies with regard to tape libraries, and consider options to ensure a continuous source of supply to provide customers with a full storage related solution portfolio. STK was not a major OEM supplier as it sold about 90% of its tape products directly or through VAR partners. SUNW was STK’s largest OEM customer and HP was beginning to ramp a highly modified version of STK’s SL500. STK’s merger with SUNW calls into question the strength or longevity of STK’s reincarnation of an HP relationship and in effect could open possible opportunities for other tape library vendors including ADIC, OVRL, DSS.
Near term, analysts expect HP to continue with its SL500 based offering. However, they believe that the STK/SUNW deal raises the possibility of other library vendors being acquired by ADIC. Given that STK was not a major OEM supplier and a number of vendors remain independent including ADIC, DSS, OVRL, QBAK and Spectra logic, OEMs should not be compelled to take any immediate steps. Once STK is acquired by SUNW, ADIC is expected to become the most prominent independent vendor of libraries and most likely to receive M&A attention in the analysts’ view. ADIC’s primary OEM relationships are with Dell and IBM (accounting for 50% of sales). Regarding OVRL, the SUNW/STK deal is neutral to slight positive as it reduces the prospect of STK making substantial inroads at HP. It also eliminates STK as a competitor for OEM deals with SUNW’s competitors (Dell, IBM, HP, and Fujitsu).
Individual Analyst Opinion:
POSITIVE RATINGS
None
NEUTRAL RATINGS
AG Edwards – Stock is rated Hold – July 26, 2005. The analysts have retained a Hold rating on the stock and feel its cash position remains extremely solid.
Adams Harkness – Stock is rated Market perform. – April 26, 2005. The analysts believe STK maintains a dominant position in the tape library market and is doing a good job of expanding into disk subsystems. The 47% contribution from service revenue helps provide stability and visibility to the business model and with the stock buyback in place, there is potential for earnings improvements. However, there is a lack of visibility on the Company’s return to growth.
SIG – Stock is rated Neutral – July 26, 2005. The analysts have maintained a Neutral rating on the stock .They believe there is risk in the merger with SUNW and STK.
Friedman, Billings – Stock is rated Market perform with a price target of $37 – July 26, 2005. The analysts have reiterated a Market perform rating and have raised the target price to $37.00. They believe that midrange tape systems generally have fewer requirements for services as it has less complexity than high-end system.
RBC Cap. – Stock is rated Sector perform with a price target of $37 – July 27, 2005. The analysts have reiterated a Sector perform rating on the stock and the target price of $37.00. They believe that primary risks to the target price are future growth rates of IT spending, competitive pricing trends, and the timely approval and closure of the impending acquisition by SUNW.
R W. Baird – Stock is rated Neutral with a $37 price target – July 26, 2005. The analysts have maintained a Neutral rating and the target price of $37.00. Due to the pending merger they have left their estimates unchanged, except increasing operating expenditures and other income projections.
Lehman – Stock is rated Equal weight with a price target of $32 – July 26, 2005. The analysts have maintained an Equal weight rating and a target price of $32.00. They believe that completion of merger has been priced into the stock.
NOT EXPLICITELY RATED: FAVORABLE
Merrill – June 2, 2005. The analysts have not provided any rating as the stock will no longer trade on fundamentals. The analyst, however, believes that STK clearly benefits from a much larger sales force organization. Furthermore, the acquisition will give STK opportunities to sell tape libraries at the point of a server sale.
Morgan Keegan – July 26, 2005. The analysts believe 2Q05 has been solid quarter for STK. They see no impediments in the pending merger with SUNW.
NOT RATED
Goldman – July 26, 2005. The analysts have not rated the stock as they are the financial advisor of SUNW, with which STK is merging.
Needham – Stock is rated Hold – July 27, 2005. The analysts have not provided any rating due to its pending merger with SUNW.
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