Wednesday, March 10, 2010

Dot Hill Potential and Pitfalls

Dot Hill, which makes data storage equipment sold by HP, NetApp, and other OEMs, is a very interesting story these days. If you were to just look at the numbers, you would think the stock price is too low. If you know its history of of always seeming to find its way to losses out of the jaws of profits, you can understant the lack of investor enthusiasm.

I think management has been making the right moves, but we probably won't see the proof (or disproof) of it until 2011.

Dot Hill makes hard disk arrays for business class data storage. This is not a high margin business. In the latest quarter ending Dec. 31, 2009 revenues were $62.6 million, but cost of goods sold was $53.6 million, leaving a gross profit of $9.0 million, or a gross margin of just 14.4% of revenue. Even though the the company is run efficiently, spending only $3.1 million on marketing, $6.8 million on research and development, and $2.6 million on general and administrative, this led to an overall GAAP loss of $5.0 million in the quarter. Take out a $1.5 restructuring charge and some non-cash costs and the non-GAAP loss was still $3 million.

As I said, this kind of near-miss has been going on at HILL for as long as I can remember. So why do I own the stock? Partly because I have been buying on dips, but there is also a long-term method to my investment.

First, Sun used to be the only major client, but Sun bought its own storage company and is now being absorbed in Oracle. Despite revenues from sales to Sun being less than 1% of revenue, this change did not lead to Hill's demise. Hill designed storage arrays that NetApp and HP are very happy with. If not for the recession, Dot Hill might have been profitable in 2009. I believe revenues will ramp in 2010, partly from more OEMs coming on board. Even if gross margins don't improve, it should become easier to cover operating costs out of gross profit.

At least as important is Dot Hill's determination to raise its gross margins. The main way this will be done is by selling software to manage the hardware along with the hardware. They have already begun doing this, but they are also acquiring Cloverleaf, which has the right software for this job.

Of course acquiring Cloverleaf will take some cash, and operating expenses will go up as well. More sales expense and more R&D expense will preceed the bulk of the software revenue. The next two quarters probably won't look that great. But hopefully by Q3 or Q4 of 2010 we will see software revenues ramping appreciably. Software revenues should have gross margins above 60%, maybe well above that by 2011.

If the scenario works out, that would change the picture entirely. Dot Hill would still have roughly $50 million in cash with no debt. It should hit a revenue run rate of over $300 million per year by the end of 2010. And with improved gross margins, it should start generating a profit. I see no reason why a 4% operating profit on revenue can't be achieved in 2011.

So what would that make the company worth? A lot more than the $81.6 million in market capitalization (at $1.51 per share) that Dot Hill ended today with.

But this scenario has its risks. Will the end users accept the software? Could HP or NetApp drop Dot Hill for a different supplier? Will more OEMs sign up? Will the economy hold up?

If you are going to invest in risky stocks, no matter how golden the upside looks, remember to:

Keep Diversified!

More data:
My Dot Hill main page
Q4 2009 Dot Hill analyst conference summary

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