Friday, May 4, 2007

Dot Hill: About to Turn the Corner?

I did pretty well in Dot Hill (HILL) stock once under circumstances quite similar to those existing now. So why am I hesitant to plunge back in?

At this moment's price of $3.81 per share Dot Hill has a market capitalization of $171.6 million. If you had $171.6 million, would you buy the whole company? You might want to look at my summary of yesterday's (May 3) analyst conference before making your decision.

On the one hand HILL had $96 million in cash at the end of Q1, a whopping 56% of market cap. And the guys and gals there aren't sitting on their butts: they had revenues of $53.4 million in the quarter, which is typically seasonally weak in the technology industry, and would make for an annual run rate of $213.6 million.

On the other hand net income for the quarter was negative $6.0 million. That is an annual run rate loss of $24 million a year. That could burn up the cash over time. Also revenues were down 10% sequentially and 9% from Q1 2006. If revenues continue to slide along with cash eventually what we will have is a penny stock.

So it is all about the future, and predicting the future is notoriously risky. Management believes Q2 revenues will range between $56 and $60 million, which is going in the right direction. Their Q1 guidance was lower than their results, so they don't appear to be purposefully deceiving investors.

But Q2 will still show a loss. Can they get to profitability? You need profitability to justify a market capitalization over your cash balance. Can they get to serious profitability, the kind where traders who buy the stock today are going to tell you what analytic geniuses they are a year from now?

If you have a lot of stocks in your portfolio you can just buy it because the risk is relatively low short term (due to the cash and current investor disdain for the company) and the rewards could be pretty good short term (if momentum investors get in), medium term (if Q2 or Q3 results are better than expected) or long term (if they start selling a lot of their product at profitable prices).

Let's look deeper: deeper into what Dot Hill does, and further into the past.

How can you sell over $200 million in widgets in a year and lose money? In Dot Hill's case they are a "leader" in SAN (Storage Area Network) equipment. They have a good reputation for quality: their major customer is Sun (SUNW), which accounted for 76% of Dot Hill revenue in Q1. There, indeed, is the rub. As you know, Sun has not done all that well since 2000. With only one client, itself under pricing pressure, and decreased volumes, HILL had little ability to price its products above cost.

According to management that is changing. A year ago Sun accounted for 88% of revenue. Dot Hill has signed up a number of new clients who are enthusiastic about its 2730 product. But beware. Non-Sun clients bought 12% of $58.7 million in revenues in Q1 2006, or $7 million of stuff. In Q1 2007 they bought 24% of $53.4 million, or $12.8 million. So non-Sun revenues, over an entire year, only increased by $5.8 million.

Management has two answers, and they are worth listening to. They have been building their products in the U.S.A. They are moving production to Asia; they process should be completed in Q3 2007. At that point, barring unexpected problems, decreased costs and firm sales prices should make the company profitable.

And to a certain extent they have been building the 2730 line to spec. In talking to some of their non-Sun OEM customers they are expecting much larger orders going forward, though the timing of that is up to the customers.

Again, why not take the plunge? Let's go deeper into history, to the time I made some money trading Dot Hill stock. It was mid-April in 2005; I bought the stock at an average price of $4.90 per share. Other traders had the same thinking. In February of 2006 I was able to sell for almost $8 per share (just got lucky in my timing), because the stock had gotten way ahead of any actual signs of a turn around.

If I had held my stock I would be well below water today.

So as I write this I don't know. I have very little cash in my portfolio at the moment. The odds are really quite good: it really does look like profitability is a couple of quarters away, just like in 2005, just like in 2006. And even if it is not, other traders might push up the stock price again; I just would have to bail out again at the right time.

If Dendreon (DNDN) hits the jackpot on May 15 I may sell some of it, and with more cash to work with, HILL will certainly be on my short list of stocks to look at.

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