Wednesday, August 19, 2009

Dot Hill Beneath the Surface

Dot Hill makes data storage components, and they have had a rough time the last five years or so. If you just look at the bottom line, it has been a sad story. Dot Hill had (and has) a strong cash balance with no debt, and for years profitability has been just a little over two quarters away.

Yet a lot has changed. If you look under the hood, you can understand why I am not alone in thinking that Dot Hill is likely to start showing profits in Q4 2009 and then really take off in 2010. [Assuming the usual caveat: if the economy does not implode]

At the end of Q2 Dot Hill had $57. 1 million in cash (it has a $0.7 million note payable for a recent acquisition as its only debt). Revenues for the quarter were $54.3 million, barely up from Q1 and down 24% from $71.0 million in Q2 2008.

But expenses have been slashed as well. Part of this expense reduction is a response to the recession, but much of it has to do with Dot Hill's product development cycle. The heavy R&D expenses were in 2007 and 2008. Now much of the R&D expense is devoted to lowering the production costs of the current generation of data storage components.

A few years ago Dot Hill had one major customer for its products: Sun Microsytems. But Sun decided to buy a much larger data storage company, so the writing was on the wall: new products would be developed internally. Dot Hill was relegated to supplying parts for expanding or replacing its old components used by existing Sun customers. And, of course, now Sun has been eaten by Oracle (sound like a Greek myth, doesn't it?).

So Dot Hill used its cash to develop new products for new customers (equipment vendors, as opposed to end customers). Reports are the new products are very good and end customers like them. Dot Hill sells the components to an increasing number of OEMs. Sun represented only 5% of revenues in Q2. A year ago Sun repesented 28% of revenue, and two years ago that was 65%.

HP is now the single largest Dot Hill customers. The new products only became available from HP in March of 2008. In Q2 2009 they represented 51% of revenue. The next largest customer is NetApp, which represented 24% of revenue. All the remaining customers accounted for 20% of revenue.

With sales to Sun unable to drop much further, the ramping HP revenues should cause Hill revenues to ramp in coming quarters.

Dot Hill has hit an economic sweet spot with their new products, which greatly improve storage capacity, efficiency, and power savings at a very attractive price point for end customers.

To a large extent costs of goods sold will ramp along with revenues, as will some operating costs. But right at this moment Dot Hill is running a lean system, so much of the coming revenue increases should increase the bottom line. In Q2 GAAP net income was negative $4.1 million. Non-GAAP net income was negative $3.0 million. But cash flow from operations was positive $3.4 million.

Since cost of goods sold represented 85% of revenues (GAAP), it will take a considerable ramp to get to GAAP profitability. But management believes that as the product lifecyle lengthens cost of goods sold will decrease as a percentage of sales (which is typical for this type of equipment) and there will be savings as production runs scale. Also, Dot Hill (through HP) is starting to sell software to help with storage management, and that has much better gross margins.

As always, things could go wrong with the economy, with clients, or with end-customer demand. But Dot Hill management (and employees) have been through the fire and come out looking pretty good. I believe they are well tempered and able to respond rapidly to changes in technologies and economic conditions.

As always, keep diversified!

More Data:

Dot Hill web site
My summary of the Q2 Dot Hill analyst conference

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