An In Depth Valuation of OCZ Technology Corporation
OCZ Technology(NASDAQ: OCZ) is worth around 400M to 500M in an acquisition, really depending on the value of it’s Indilinx subsidiary. On its own, however, it’s worth a heck of a lot less.
Our Valuation Methods: Taken from the book Value Investing: From Graham to Buffett and Beyond by Bruce Greenwald.
Asset Reproduction Value: Attempting to value the company based on what a competitor would have to pay to replicate its business (assets, competitive position, customer relationships, intellectual property,etc). In a perfect world, if a company has adequate management and industry and competitive conditions allow it to fully leverage its assets, normalized no-growth earnings power should be greater than or equal to asset reproduction value.
Earnings Power Value: Attempting to value the company based on normalized current (no-growth) earnings power. Ideally this should be equal to Asset Reproduction Value, however, if the company is unable to fully leverage its assets(usually due to bad management or industry conditions) it can be far below Asset Reproduction Value.
Asset Reproduction Value
The reasoning for any adjustments is below.
|Balance Sheet(Reason for Adjustment)||Book Value||Asset Reproduction Value|
|Prepaid Expenses/Other CA||12.9M||12.9M|
|Property and Equipment||5.9M||5.9M|
|Hidden Asset: R&D(4)||0M||41.3M|
|Hidden Asset: Marketing (5)||0M||46.9M|
|Value of Equity||250M||503M|
(1)-Inventory: A risk for OCZ is that in order to steal market share and turnover older product inventory,OCZ has sold older products at clearance prices to get them off the shelves. In the recent quarter, for example, OCZ discounted their inventory by 3% to recognize this impairment. I believe that with the dramatic change in the industry and the shift in focus to higher margin products, the inventory could be replaced at lower prices, so I discounted the inventory value to reflect this.
(2)-Intangibles: Most of the intangibles came through the Indilinx acquisition, and I’ll be accounting for the value of Indilinx in Goodwill. I will also be accounting for the value of customer relationships in Marketing. Moreover, assets like “trademarks” aren’t worth almost anything because the industry is so cut throat.
(3)-Goodwill: 36.4 million of goodwill on the books is related to the Indilinx acquisition. While the maintenance of the goodwill from the other acquisition is questionable, OCZ has seen a clear value in its Indilinx acquisition through the controller’s it has produced. Using LSI’s (NYSE: LSI) Sandforce as a comparison (Sandforce is used in a variety of SSD companies and was sold to LSI for $370 million), we can assume that Indilinx is worth at least 2/3 of this value, so the Indilinx acquisition was given a reproduction value of 246.6 million. I didn’t give any value to the other acquisitions, and they would only serve as potential upside.
(4)-R&D: In order to compete with OCZ, you’d have to replicate the R&D expenditures OCZ has been putting into developing its business. I’ll say that R&D depreciates by 20% per year in this industry (meaning that research has a 5 year useful lifespan). This is simply an assumption. Remember at 20% annual depreciation, R&D that is more than 5 years old is considered worthless. Considering the industry’s change, I don’t think that research’s lifespan is any longer than 5 years or any shorter than 3 years (I think you need the intellectual property of at least three years to compete), so depreciation of 33% to 20% is merited. I think if OCZ has one strength it has been the value of their R&D (as seen in the performance of their products and the fast creation of new products), so I’m depreciating at 20%. Using the last 3 years of R&D (OCZ has only been in the SSD business since 2009), R&D’s reproduction value is 41.3 million.
(5)-Marketing: Generally I’d look at a historical cost ratio and assume a number of years necessary to create OCZ’s customer relationships, but since they’re so new, I can simply add back depreciated advertising and customer relationship building expenses at depreciated values. OCZ breaks the information down fairly well in the annual report, separating sales and marketing expenses from general and administrative expenses. Sales and Marketing value is $46.9 million.
Earnings Power Value: Starting with Gross Profit, I’ll adjust all expenses for normalized, non-growth income to get a value for OCZ’s earnings.
*using information from 10-K, 1 quarter delayed.
**Note that interestingly enough, with this method OCZ appears to be a profitable company that can be fundamentally valued without too much speculation.
+82.4M Gross Profit-Not enough information to adjust for cyclicality and the industry is still in a growth stage anyway.
-1.1 M Special Charges- They had 5.7M in acquisition/inventory charges. Assume this occurs once every 5 years.
-27.9M General, Administrative, Operations-This is the unadjusted expense on the income statement.
-19M R&D -This is one of the toughest adjustments to make. In 2009, 2010, and 2011, R&D was 2.8%, 4% and 8.7% of revenue, so the relationship between R&D and revenue for OCZ has been far from consistent. Clearly they were ramping up R&D as a percent of sales to grow earnings, but I’m willing to bet that R&D had to be increased as a % of sales due to the increasing competition in the consumer SSD market as well. Therefore, I can’t simply go to the prior years’ R&D levels as the R&D hike may have been partly a preservation measure. Competitors Fusion-IO(NYSE: FIO) and LSI have 15% to 30% of sales consistently going towards R&D expenses. However, this is due to a structural advantage as Fusion-IO and LSI have 56% and 47% gross margins respectively, compared to OCZ’s 22% gross margin. OCZ has continued to compete despite lower gross margins and lower R&D investments because it competes in a slightly different market, the consumer market rather than the enterprise market. As OCZ shifts to the enterprise markets, expect gross margins to increase and R&D to increase as a % of sales as well. In any case, if we assume that their three year average R&D(rather than simply the previous year itself) is necessary to maintain, not grow, revenue, R&D should make up 5.2% of revenue. A $19M R&D expenditure.
-15.4M Sales and Marketing Expenses -Sales and Marketing have remained a consistent 7.5% of sales for the last three years making it easy to differentiate between Sales and Marketing related to growth and related to maintaining revenue. Revenue increased by 175M yoy, so growth related Sales/Marketing expenses were 7.5% of 175M, or 13.1M. The remaining 15.4M in Sales and Marketing expenses must have been necessary to maintain sales.
= 19M*.65(35% standard tax rate)=12.4M
+1.7M Depreciation and Amortization
-2M in Maintenance Capex(I calculated this with the same method I used for calculating no-growth Sales amd Marketing Expenses)
=12.1M in Normalized Maintainable Earnings.
OCZ has no debt on its books, so its cost of equity equals its cost of capital. With interest rates so low, even while OCZ is in such a competitive industry, I believe the Cost of Equity will approximate 10%. This would make the EPV $121M. After adding 90M in excess cash, Total EPV was 211M. Of course, while I can’t use more current earning data because of the extreme difficulty of extrapolating results, I can use the more current balance sheet. In the most recent quarter, OCZ had only 47M in excess cash, so Total EPV would be 168M. As OCZ continues to burn cash, however, it is most appropriate to look at 121M as the EPV for OCZ, and to watch out as continued cash burn or the taking on of debt could reduce this figure even further.
Why Growth Doesn’t Matter
The 12.1M earnings for OCZ came from 190M in invested capital, resulting in a ROIC of 6.3%. Unless ROIC is higher than the cost of capital, investing in further growth destroys value for the company where it could simply distribute earnings to shareholders who could reinvest at rates of the cost of capital or higher. Why then might OCZ’s management continue to invest in growth? If OCZ can bridge the gap between the potential of its assets and its current earnings, it could create a lot of value. Competitors in the enterprise business have significantly higher ROIC. LSI Corporation has 23% ROIC using unadjusted income figures, and ROIC with maintenance earnings would be much higher. In fact, if OCZ’s Asset Reproduction Value of 500M is to be believed, if its assets are properly leveraged, OCZ should be able to produce a 26% ROIC right now. Of course, OCZ is in the hardest part of its market(the consumer side) and is a small player with no real leverage over suppliers, so fully leveraging its assets is easier said than done.
Why Is This Important?
With OCZ trading at 234M, the only reason to buy right now is if you believe it is very likely that OCZ will be acquired (Seagate(NASDAQ: STX) has been confirmed to not be interested), or if you believe that management can successfully bridge the gap between the potential of OCZ’s assets in the hands of a well-funded competitor and OCZ’s current earnings situation. This means that OCZ will have to quickly figure out it’s NAND memory supply issues and continue to break into the higher margin enterprise business as it has recently as it secured contracts from Microsoft(NASDAQ: MSFT). If margins today were at the 30% level that OCZ strives for, for example, EPV without adding cash would be 297M.
Even so, at today’s prices, OCZ is clearly no bargain unless an acquisition occurs. The industry is extremely cut-throat competitive and it is unlikely that new management will have a much better time than old management at improving the business. However, if OCZ crashes after a terrible quarter as many expect, make sure to watch in case OCZ is available at attractive levels. Not only is there upside in the event of an acquisition, but if management successfully increases margins to 30%(26% in the recent quarter), OCZ might be worth checking out even as a standalone company.
As always, do your own research before buying. I’ve been wrong about OCZ before, and I sincerely wish I had valued OCZ like this before I bought shares in the first place. I implore you to learn from my mistakes.