STEC Feels Squeeze From Flash Suppliers

I was a little early when I first wrote in September 2008 that Next Inning readers should consider STEC ( STEC - news - people ) as an early mover in the SSD (solid state drive) market.

At the time, STEC ( STEC - news - people ) was trading for about $10 but subsequently fell to a low of $3.42 in December before mounting a spectacular recovery. My timing for Micron Technology ( MU - news - people )and SanDisk ( SNDK - news - people ), which I called as buys much closer to their 52-week lows, was pretty good. What's relevant now, however, is not the timing of these calls, but the common thread for these three stocks--one which is beginning to unravel for STEC.

As is the case for many things in the world of technology, the SSD story is actually fairly complex. SSDs use NAND flash chip--just like the tiny memory cards you use in music players and digital cameras--to replace traditional hard disk drives. The benefits are easy to understand, and include lower power consumption, higher statistical reliability and higher speeds. The obvious downside is higher cost.

In enterprise applications where STEC specializes, however, there are unique trade-offs and higher cost is not always the case; in some applications, using SSD technology can actually lower total system costs. This is where STEC has leveraged its first mover status and the "controller" technology that it developed which enables enterprise class flash-based storage. While its controller and packaging technology have proven to be popular, there are two weak links in STEC's business model that I believe will become more visible as time moves forward.

The rapidly emerging SSD market has been one of several factors that have boosted demand for NAND flash memory and, as a result, boosted NAND flash prices, too. While this trend will likely continue to benefit Micron and SanDisk, it is equally likely to work against STEC in the longer term.

On Aug. 12, Next Inning Technology Research published a brief report regarding the changes in the solid state drive market that I argued would negatively impact STEC's present business model. In that report, I made two key points. First, while STEC was clearly the first mover in the enterprise SSD market, competition was brewing. Second, the upward pricing trend in NAND flash would decrease STEC's leverage in the SSD market and improve the leverage for NAND flash suppliers.

In a research note released on September 17, Wedbush Morgan analyst Betsy Van Hees stated that competition in the SSD market "is intensifying above our previous expectations," and noted, according to her sources, that Toshiba ( TOSBF.PK - news - people ) "is in the final qualification stages" with one of STEC's tier one enterprise customers. This means that Wall Street is catching on to the first part of the changing story in SSD.

As I noted back in my early August report, it would be hard to predict when the mounting competitive pressures and pricing trends in the NAND flash market would begin taking a toll on STEC, and that it wouldn't be surprising at all to see the price of the stock continue moving up in the short-term. However, once Wall Street began to figure out what was going on behind the scenes, the party would end quickly. We saw that in Thursday's trading as the price of STEC dropped nearly 17%.

That leaves me to wonder how the Street will react when it catches on to the second half of the story.

In the fourth quarter of 2008, NAND flash suppliers were selling parts significantly below production costs (at negative gross profit margins). In the first quarter of 2009, we saw prices rebound somewhat, but still not enough to bring gross margins out of the red. Since March, prices have climbed further and gross profit margins for NAND flash memories have rebounded nicely.

The short story here is that it was very easy for STEC to make a ton of money when it was able to buy the key component of a solid state drive for less than its production cost and leverage that with its controller technology. As the price for flash rises, however, the leverage in the bill of material shifts to favor NAND flash manufacturers that are now hotly pursuing the enterprise SSD markets.

I believe that this is what, in time, will put the most serious squeeze on STEC, and that pricing trends will continue to favor NAND flash suppliers like SanDisk and Micron but work against the interests of STEC.