Dot Hill Scrambles for Profits

Dot Hill (symbol: HILL) disappointed me with their Q1, 2010 results, but the analyst conference on May 6, 2010 reminded me that the data storage manufacturing company is about investing for future profits. So it still fits with my core strategy.

It was not that horrible of a quarter, it is just that, unlike my chip companies MCHP and AMD, revenues did not show a big sequential ramp. They were down 4% from Q4, which is still better than the usual seasonal downturn.

Revenues were $60.0 million, down 4% sequentially from $62.6, but up 11% from $53.9 million in Q1 2009.

GAAP net income was negative $6.4 million, a sequential drop from negative $5.0 million, and also worse than negative $3.3 million year-earlier. GAAP EPS was negative $0.12, down sequentially from negative $0.11, and down from negative $0.07 year-earlier.

The question investors, current and potential, have is: how is Dot Hill going to make a profit?

To understand how that might happen, you need to understand why HILL is not making a profit now. It makes data storage systems for businesses. These are typically standalone arrays of hard disks that attach to a network. This is a low margin business; it is fairly well-understood, there is plenty of competition, and it is hard to differentiate your products without raising your costs and cutting into your already slim margins. HILL acts as a supplier to OEMs, the main ones being HP and NetApp. It used to supply Sun, but even before Sun was absorbed by Oracle (the Blob of technology companies), Sun bought its own storage supply company and discontinued HILL.

If gross margins [revenues less the actual costs of making the goods] are low, a company can become profitable by keeping its operating (administrative and R&D) costs low while ramping up the volume of sales.

The other strategy is to increase gross margins by changing the nature of your product. Dot Hill management is determined to do both. Cost cutting is well-understood, so I will focus on how they plan to increase margins.

Data storage systems need to be managed, and while some management capabilities need to be built into the hardware, the management software can be sold separately. Software has much higher gross margins than hardware (but beware that software development costs go into the operating costs).

Since Dot Hill is already selling hardware, if it can get the end customers to buy its software packages as well, its hardware prices remain competitive, but it generates some high-margin revenues. In addition to its internal development efforts, HILL bought Cloverleaf Communications in January. The software is now for sale. It even works with non-Dot Hill products.

So when the report on the June quarter, the most important indicator will be attach rates. How much software revenue have they been able to attach to the hardware revenue? Of course it takes time to get this sort of program going, but management should be able to give an indicator of the trend for the June quarter.

Dot Hill is also introducing its 3000 series, which they say brings many features that in the past were only available on much more expensive storage systems. Customers have the choise of implementing the features or not; they pay to implement them. Hopefully the HP and NetApp salespeople will be pushing the customers to choose to pay to implement a full feature set.

HILL is working hard to be less dependent on HP and NetApp. By the end of Q1 they had doubled the number of small resellers they work with to 118. In Q4 the total HP + NetApp share of revenues was 84%, but in Q1 it declined to 80%. Because of the nature of the business, profit margins are better when HILL sells through smaller resellers. That is an encouraging trend.

Other major OEMs are negotiating with Dot Hill to become resellers of the 3000 system. This is a mixed blessing. It should be good in the long run if a third major OEM joins the team. But in the short run it means another ramp in R&D spending to ensure compatibility and the specific feature set the OEM will mandate. Which would mean more delays in getting to profitability.

Dot Hill is a risky stock because demand could soften, or OEMs could drop out or demand even lower margins. That would be ugly for a company that is already bleeding money.

On the other hand the up side potential is pretty good, and the stock is dirt cheap (it closed Friday at $1.38, giving it a market capitalization of $75 million). Dot Hill has a relatively clean balance sheet with about $50 million in cash on hand.

I own Dot Hill stock. For more detailed Q1 data see my Dot Hill Q1 2010 analyst conference summary.

See also Dot Hill www.dothill.com

And Keep Diversified!