My Favorite Growth Stock Was a Big Mistake
Nikhil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Back in June, I took a look at a seemingly magnificent growth stock opportunity. In my article The Cheapest Growth Stock I had ever seen, I said OCZ Technology Corporation (NASDAQ: OCZ), I said that OCZ Technology Corporation was my favorite growth stock because of 4 major factors. First, it was in a stellar growth industry: solid state memory. Second, the company had a quality management and was making some very smart acquisitions. Third, the company's competitive positioning was improving and the company had quality products on the market. Finally, the company was priced at what I believed to be levels way below what the company was roughly worth.
Today, Ryan Peterson, CEO and Founder of OCZ Technology Corporation has resigned, just a few weeks after the resignation of the CFO, Arthur Knapp, and while I would love to believe that my company is simply having a few temporary problems, these management issues are the latest in a series of warning signs that have simply become too much to ignore. In other words, I will probably be exiting my position in OCZ Technology very soon.
However, while the pain of loss is hard, there is a lot to learn from my mistakes. I'll go down point by point to analyze where I may have gone wrong in each leg of my analysis.
1. It's a Growth Industry
I wasn't wrong on that point. The solid state drive market continues to thrive and grow. Go no further than Fusion-IO (NYSE: FIO), for evidence of that. However, it has become clear to me that I hadn't done nearly enough research here. First of all, healthy companies like Fusion-IO were selling mainly in the enterprise division. Companies like OCZ Technology that sold to consumers had lower margins and more unreliable sales. While this is a growth industry, OCZ was in the worst part of it. Second, as I highlighted in my earlier article, while I focused on the fact that OCZ had much higher market share than any of its competitors, it wasn't using a smart business strategy to take the market. By selling old products at extreme discounts to get inventory off its shelves, OCZ got customers used to buying its products cheap, cutting OCZ's margins.
2. Management's Quality and Acquisition Smarts
I think I was entirely correct that Acquisitions created a lot of value for OCZ. Without the Indilinx Acquisition, I have no doubt that OCZ wouldn't have nearly the competitive position it has today, and if there was one thing that could convince me to retain my position in OCZ, it would be the Indilinx acquisition. As this article points out, the acquisition of Indilinx lowered OCZ's dependence on other companies such as LSI (NASDAQ: LSI) for SSD controllers. OCZ's other acquisition was beginning to show clear signs of helping growth increase for PCIe-based product as well.
In my recent article, however, I show a little snippet of an OCZ conference call from the last earnings announcement, where I believed Ryan Peterson, the CEO, was guiding conservatively to analysts and making it quite obvious that revenue would be higher for the next quarter. It turns out, just a few weeks later, OCZ came out with a story saying that NAND supply issues would force them to lower revenue estimates for the quarter. I'm inclined to believe that the CEO had an inkling of what might have been about to happen and chose not to say, and his sneaky answer to the conference call (see the end of my article) really irks me when I look back at it. After Ryan Peterson (Founder and CEO) and Arthur Knapp (CFO) have both resigned very recently, I can't help but think things are going downhill fast. However, unlike the industry outlook where my research had a big flaw, I don't think I could have foreseen things going wrong with management. I believe this is honestly a situation where management tried their best, and things didn't work out (for the other reasons mentioned here).
3. Quality Products and Competitive Positioning
Like I said with the flawed industry insights, there were flaws with my view of OCZ's competitive position and products. Products were focused on consumers, low margin areas of the industry, and growth was just beginning in the form of new Microsoft contracts in enterprise. While OCZ had quality products in the consumer industry, consumers are fickle and I simply think that product quality doesn't matter as much here as it does in enterprise.
4. It was Cheap
"Fears about OCZ's cash burn rate and lack of profitability (very related problems) are keeping the stock price bogged down."
That was the simple reason for why the stock was down and my reasoning for why the stock price should be higher was simply that the cash burn was for research, the company was becoming more and more profitable quarter by quarter and investments seemed to be paying off. Another plus was that thanks to a recent capital raise, the company seemed to easily have enough cash to handle its basic needs.
Boy was I wrong. The problem here was that I was thinking of OCZ too much as a stock and not enough as a business. The investor's fatal flaw, so to speak. If I had really studied the business itself, I would've realized that with $184 million in working capital, and a lot of cash that needed to go towards R&D (at least $32 million to match last year), OCZ was going to be cutting it very close trying to meet $600 million+ in revenue guidance. Moreover, cash conversion was going to be absolutely key, and OCZ's relationship with both its customers and its suppliers would have to be very strong. As we saw on September 6th, OCZ's relationship with NAND suppliers just wasn't as good as the other competitors for the NAND (Apple has been blamed for buying up a lot of the NAND supply recently as it prepared for its product launch) , and OCZ had to reduce its guidance due to supply issues.
The Bottom Line
Thorough research and understanding is key to any investment. Aside from understanding the company on the surface through ratios and % growth numbers, it's important to dive into the business itself and understand how and why it functions. If you keep that in mind, you'll avoid making my mistakes.
For you OCZ holdouts, I would keep two things in mind: 1) if management has been leaving for perfectly reasonable reasons, you might be able to survive the volatility and find some great gains. I've just had enough. 2) A simple buyout forced a major price run-up a few weeks ago and the same thing might happen again if OCZ is in trouble, just don't expect nearly as high of a price.
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shamapant owns shares of Apple and OCZ Technology Group. The Motley Fool owns shares of Fusion-io. 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.If you have questions about this post or the Fool’s blog network, click here for information.
