The Bear Case for Fusion-io: Part 1

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Are you looking for a stock to short? I will develop a bear case for Fusion-io (NYSE: FIO) in two parts, where I will analyze the fundamentals, business, and recent acquisitions of this IT company. It seems that more chest pain for shareholders could be on the way. That is, if they still hold their long positions after a disastrous yearly performance: stock price is down almost 28%, and I do not see any signals of improvement in the near future.

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The first time I heard about this company was after reading a special report by Victor Bonilla on SumZero. The reasons he provided were so convincing that, despite having high expectations from Fusion-io's business, I decided to research about this particular firm.

These two articles summarize my findings. In the first article, I start by providing an overview of Fusion-io's businesses and develop one bear case. In the second article, I will provide two more bear cases and one variant view. Stay tuned!

Understanding Fusion-io

Founded in 2005, Fusion-io is all about increasing the computing power of servers for data storage processes by using solid-state drives (SSDs) that plug into the PCIe slot. One Fusion-io device can perform I/O as fast as several hundred of the fastest traditional hard drives. This translates into less operating and maintenance expenses in the long run. For example, the company mentions an interesting study case: how they helped Japanese Internet giant Rakuten achieve efficiency:

Japanese Internet service provider, Rakuten, used ioMemory to eliminate over 50 percent of its Microsoft FAST environment's existing rack space, replacing a few hundred 2U servers with five percent fewer 1U servers. ioMemory also provided significant performance headroom to defer future scaling needs. Overall, the ioMemory implementation beat Rakuten's closest competitive bid by over $4 million.

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What kind of clients does the company target?

Basically, anybody who has big data. According to the firm's website: from e-commerce retailers to the world's social media leaders and Fortune Global 500 companies, our customers are improving the performance and efficiency of their data centers with Fusion-io technology to accelerate the critical applications of the information economy.

In practice, Fusion-io has two big customers, Apple and FacebookThe firm's revenue is so dependent on them that when the two companies delayed their orders in early January, the stock price fell 12%. More recently, on the latest earnings call, Co-Founder and CEO David Flynn (who renounced some weeks ago) confirmed the importance of these two clients:

Our relationship with Facebook and Apple is strong. Their orders this quarter were in line with our expectations. They are a key -we are a key part of their infrastructure and expect to grow as they grow.

It doesn't surprise me then that Fusion-io's stock is performing so terribly this year. But the story does not end here.

Introducing three bear cases

1. Decreasing revenue growth rates will make it hard to beat the Street consensus next quarter

The company has achieved profitability only once so far, in 2011. That should not be very worrying if we assume that the company is still in "an early stage." If so, the growth rate of revenue should be typical of a company in its "early stage." That is not the case here. According to data from Morning Star, the growth rate of revenue is decreasing.

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This trend is not improving. In the latest earnings call on April 24, the company announced the acquisition of NextGen Storage, perhaps to drive attention away from the following fact (not surprisingly, the acquisition of NextGen for $100 million was one of the first things mentioned in the earnings call):

"Turn now to revenue. Our revenue was $87.7 million in the quarter and it represented 7% decline in year-over-year growth. Core revenue, which excludes contribution from Facebook and Apple, stood at $68 million, growing 61% year-over-year. Of our 10% customers in the quarter, Facebook represented 16%, HP represented 19%, Dell represented 17% and IBM represented 11%. Our key industry vertical this quarter were web services, public sector and once again, telecommunications. In the coming quarters, we will provide additional color on verticals as we continue to outgrow customer concentration. We will still provide visibility into customers that represent 10% or more of revenue." (Dennis Wolf, CFO)

What is more worrying is that the company's guidance is way too high:

So for the fiscal fourth quarter of 2013, we expect revenue of approximately $110 million. Gross margin is expected to be at the high end of our target range of 56% to 58% given anticipated customer mix. We expect a loss in the quarter of approximately $5 million, and we expect diluted shares outstanding to be approximately 98 million shares.

For the full fiscal year 2013, we expect revenue of approximately $435 million. We expect gross margin to be in the range of 59% to 60%. Operating margin is expected to be in the range of 7% to 8%, and we expect diluted shares outstanding to be approximately 109 million shares.

They are promising a 26% q/q increase in revenue. However, the prior quarters have seen much more conservative rates in sales growth. On an annual basis, the revenue growth of Fusion-io also shows a decreasing trend: 256.81% (2010-12), 445%, and 82%. Between 2011 and 2012, the growth rate of revenue decreased almost 80%. In this context, the 45%-50% guided for this year might prove to be a tall task.

The most recent figures clearly show that sales acceleration is not happening. Furthermore, as I will explain in detail in the next case, this is an industry with low barriers to entry, and competition is increasingly fierce. On top of that, the company only has two main customers: Apple and Facebook. The necessity for diversifying the customer base is urgent. 

The unexpected high guidance caused the Street consensus estimate to increase. In the words of Brent Bracelin, from Pacific Crest Securities:

And then obviously on the guidance, $110 million, clearly above kind of where we're at and where the Street was at, do you expect growth to come from the core customers?

According to Yahoo! Finance, the current average forecast for the next quarter revenue is very close to the official number given in the latest call: $110.21 million. Therefore, if Fusion-io fails to deliver this number in the next quarter (and unless they close some really big sales, most likely they will, even after taking into consideration that by acquiring NextGen they could obtain an additional $5 million -$10 million of sales), we could see a massive decrease in stock price.

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At this point, you might be wondering what is causing the decrease in revenue growth. There is fierce competition!

This could be hard to believe. After all, at first glance, the business of Fusion-io looks unique and they were first-movers, once upon a time. The situation is completely different now. More and more competitors are joining the game.

One example is EMC (NYSE: EMC). Historically, EMC has occupied a leading position in the network storage industry. However, by leveraging its existing assets, the firm is also active in launching new products and entering into different market segments. An example is EMC's PCIe flash card, VFCache, which can be deployed in the server to "dramatically improve application performance by reducing latency and accelerating throughput."

According to EMC, its new VFCache may be faster than Fusion-io alternatives, because VFCache handles flash management and wear leveling, while Fusion-io cards offload this to the server CPU. Fusion-io has refuted these claims, but only time will tell which option will prevail. However, having a big corporation like EMC as a competitor could damage Fusion-io's margins by limiting its pricing power. 

Another example is LSI (NASDAQ: LSI). Since 2010, the company has been aggressively marketing its flash storage products, making some impressive sales in the process. Furthermore, LSI acquired SandForce in January 2012 to further strengthen its storage PCIe flash adapter product portfolio. Now, LSI offers both custom and standard flash storage processors for ultrabook, notebook, enterprise SSD, and flash solutions.

It seems that LSI has no plans to give up its position in this market, and a new generation of SandForce products could give LSI the leading position going forward. Furthermore, LSI goes beyond PCIe accelerator solutions: it can provide integrated solutions to companies that involve both networking and storage alternatives.

Coming soon

The Bear Case For Fusion-Io (Part 2): 2 bear cases and 1 variant view.

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Adrian Campos has no position in any stocks mentioned. The Motley Fool owns shares of EMC. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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