The Implications of OCZ Technology's Market Price
Nikhil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
OCZ Technology(NASDAQ: OCZ) is worth around 400 million to 500 million 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.
For an investor, valuation is all-important. The price you buy is the permanent determining factor in your future investment returns, so it's important to make sure you're getting a deal. It's the same with buying much of anything. If you overpay for your car now, it's likely you'll have a much bigger hole in your pocket the next time you need cash. So what do you do? You look for a deal. You check car prices around several dealerships and you negotiate. While you can't quite negotiate with the market, the market is sometimes a much better alternative because sometimes it doesn't realize how great a deal it's giving you.
For a company like OCZ Technology, a company that isn't profitable and is a small company in a cut-throat competitive yet growing industry, valuation is both absolutely essential and appears to be extremely difficult. Instead of trying to do a rough estimate using analyst earnings projections and P/E ratios, methods that are unreliable and can mislead us, I'll try to actually walk through a serious and down to earth valuation of OCZ based on the information I know right now, without using too many projections into the future.
A Strategic Valuation
The first method in finding out how much a company is worth is to look at its value from a strategic standpoint. A company can have all the tractors or farmland in the world, but if its earnings come from the technology sector, a competitor wouldn't need to buy the tractors or farmland in order to compete. A potential competitor would have to reproduce the value of the company's product designs, its relationships with customers, and on a more literal level it would have to reproduce the equipment that the company actually uses to create its products (maybe computers or a production factory it owns).
In OCZ Technology's case, most of the value that a competitor would have to reproduce is in goodwill, Research and Development, and Marketing, which makes up $330 million of OCZ's value. I arrived at the value of the goodwill by looking at the sale of Sandforce (similar to Indilinx on OCZ's books) to LSI Corporation (NASDAQ: LSI). I assumed that a growing Indilinx division would have a value at least 2/3 of the price Sandforce had upon acquisition. Therefore, the total value I believe that OCZ has strategically is anywhere from $500 million to $400 million, depending on the value of the Indinlinx division. If you're interested in how I got the specific numbers, please go to my more detailed posting here, although I'd recommend finishing this post first.
A dive back into reality: Earnings Value
That strategic valuation of OCZ Technology implies that OCZ is worth around $7.5 per share. However, that's the amount of money it would take for a competitor to replicate what OCZ Technology currently has. Real value doesn't come from the assets you have, but from the earnings you can produce from them. How is that determined? It comes down to the company's management, it's place within its industry, and a lot of other minute factors. OCZ Technology, specifically, is extremely unable to leverage its assets to their full value because they're in a bad part of the industry. Unlike competitors Fusion-IO (NYSE: FIO) and LSI, which are in the enterprise segment of the SSD market and have 57% and 47% gross margins respectively, OCZ has an extreme disadvantage in its 22% gross margins. That means that OCZ's assets in the hands of LSI or Fusion-IO, catering to enterprise customers, would be worth a whole lot more. It also means that OCZ Technology's value right now, assuming management doesn't successfully move OCZ towards the enterprise market or OCZ Technology doesn't get acquired, is a lot less than its strategic valuation would imply.
To get the value of OCZ's earnings as it stands, we use a process called Earnings Power Value. OCZ currently isn't a profitable business because it's investing so much money into research, but if OCZ wasn't looking to improve its prospects and just wanted to maintain its current earnings, OCZ would likely be profitable. Therefore, we can look at OCZ Technology as a no-growth firm and see what its value looks like there. In order to do this, I adjusted R&D and Sales expenses to assume that OCZ did just enough R&D to compete and just enough marketing to keep its old customers. According to this, OCZ produces $12.1 million in normalized maintainable earnings, and assuming it doesn't invest in growth OCZ should be worth roughly $121 million. Notice how almost $300 million to $400 million of OCZ's strategic value is lost when we look at OCZ's actual market value. In fact, this goes a long ways in explaining why I believe OCZ's strategic value is $400 million to $500 million, when OCZ's current market price is $225 million.
The Sad Truth About Growth
If OCZ's market price is $225 million, 2x it's earnings right now, does that extra $100 million come from expectations of future growth? Sadly, no. OCZ's $12.5 million in earnings came from $190 million in invested capital. Essentially, for every $1 invested in creating OCZ's earnings, it only produced 6 cents. With the risk implied by OCZ's cut-throat market, I believe that OCZ's cost of capital is at least 10%. In other words, due to the risks of OCZ's business and industry, OCZ shareholders would benefit more from simply receiving 10% of the earnings annually (so they can reinvest that money in businesses that make more than 6 cents for every dollar invested) than if OCZ reinvests all of its earnings in assets that produce only 6 cents on the dollar. To put it even more simply, for OCZ Technology, while growth has been hyped as the biggest savior, growth doesn't increase value. In fact, it might even destroy value. This is an idea that's a bit tough to grasp quickly, and if you're still interested, I recommend 2 books: Valuation by Mckinsey and Co. and Value Investing by Greenwald.
In any case, if you'll just believe me for a second when I say that growth doesn't create value for OCZ Technology right now, you'll be asking the obvious question: Why is OCZ Technology worth double its maintainable earnings? There are two possibilities: First, management's goal, even before the CEO and CFO changes and especially after, has been to improve OCZ's margins. Management believed that 30% gross margins were well within OCZ's sights. If margins were to improve to 30%, OCZ's earnings would suddenly be worth $300 million. When you consider that most investments in growth before margins improve to 30% are destroying value, valuing OCZ at around $230 million seems to make sense. Of course, if margins improve to 30%+, the situation changes completely. Suddenly, growth creates value as the company produces 15 cents on every dollar invested, making it worthwhile for the company to keep its money and invest in itself.
With OCZ worth $400 million to $500 million in acquisition or $300 million and above if margins can improve to 30% or higher, you might have started to think OCZ is a screaming value. It's not. Investors have to face the facts here. Without improving its margins, OCZ is only worth $120 million. Moreover, OCZ's management continues to invest in growth, even if it destroys value, in the hope that OCZ can keep up with the big boys in the industry. As OCZ spends huge numbers on R&D expenses, cash burn becomes a problem that OCZ investors need to worry about. Finally, the SSD industry is cut-throat, and improving margins by 10% is no easy feat. Essentially, OCZ is racing time in that it needs to improve its margins so that growth becomes value-creating before it runs out of cash. If it does, and it has to stop investing in growth, OCZ will be worth only $120 million or less, and buying now would be paying twice the true value.
To conclude, you may be asking, why would management choose to invest in growth when it destroys value? Surely they understand business growth better than this ignorant writer! I think the fact that they continue investing in growth shows just how competitive the industry is. There is no more room for companies that aren't aggressive. Either you're growing, or you're quickly losing market share, so while OCZ destroys value by investing in growth now,it can't stop or it risks being kicked out of the game. Investing in growth, while value destroying, is survival for OCZ. So OCZ is in a race to improve its margins before it hits the obvious problem...what happens when the value is gone?
As always, do your own research before making any investment. 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.
For a more detailed understanding of my valuation, see this post. For a more detailed understanding of my valuation model, see the book Value Investing: From Graham to Buffett and Beyond by Bruce Greenwald. Prior to valuing OCZ, I read the book twice all the way through and I've gone back and read certain parts far more. I think it's better than The Intelligent Investor, a true game changer.
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