Data Storage Paupers: Tomorrow's Princes?

T. M. is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Earlier, we looked at the kings of data storage, and ended with a note on the bargain bin of the industry. As with many technologies, there are a wealth of competitors in this sector, many of them priced affordably, among them Datalink Corp (NASDAQ: DTLK), which designs and manages server and storage infrastructure; OCZ Technology Group Inc. (NASDAQ: OCZ), which designs, manufactures, and distributes solid-state drives; and STEC Inc. (NASDAQ: STEC), which is in much the same racket as OCZ. All are trading at low prices. But are they fair prices, or are these businesses positioned to gain on their larger competitors in the months and years to come? Once again, we’ll take a brief look at a few of their financial fundamentals, with special attention paid towards research and development.

The Shape of Things to Come

As with most businesses working with young technologies, R&D is an important measure of where this company is going, and how it regards itself. Larger competitors have far more cash on hand to invest in developing cheaper, more effective products, and it’s left to their lesser to invest smartly if they want to stay in the game:

<table> <tbody> <tr><th> <p><strong>Company & Market Cap</strong></p> </th><th> <p><strong>Average Quarterly Growth in R&D </strong></p> <p><strong>(T4Q)</strong></p> </th><th> <p><strong>R&D to Gross Operating Income </strong></p> <p><strong>(Latest Quarterly Filing)</strong></p> </th><th> <p><strong>R&D </strong></p> <p><strong>(Latest Quarterly Filing)</strong></p> </th></tr> <tr> <td> <p>Datalink:</p> <p>$152.6M</p> </td> <td> <p>11.8%</p> </td> <td> <p>65.5%</p> </td> <td> <p>$5.16M</p> </td> </tr> <tr> <td> <p>OCZ Technology:</p> <p>$280.8M</p> </td> <td> <p>45%</p> </td> <td> <p>18%</p> </td> <td> <p>$19.28M</p> </td> </tr> <tr> <td> <p>STEC:</p> <p>$332.2M</p> </td> <td> <p>6.37%</p> </td> <td> <p>94%</p> </td> <td> <p>$17.47M</p> </td> </tr> </tbody> </table>


Here we see an interesting diversity among how these companies have been approaching R&D. STEC clearly impresses: being the larger of the three, its minor quarterly growth in R&D means that its massive investment of income into that aspect of its business model has been sustained for some time now; STEC’s commitment to its future, and developing products that can beat out its competitors, is obvious here. OCZ, despite its smaller commitment to R&D, has actually managed to spend more in that department than STEC. Meanwhile, Datalink has posted modest investment in R&D, though it is also by far the smallest of the three.

What’s the significance? STEC is clearly the more driven of the three small-caps when it comes to researching and developing new products in a young field. OCZ is matching STEC’s expenditures, but we want to see where the rest of that operating income is going if it isn’t being reinvested into the company’s future. Datalink’s numbers bear noting, but tell us little beyond that the majority of Datalink’s income goes towards a relatively paltry R&D department.

Welcome to the New Economy, Same as the Old Economy

R&D alone doesn’t guarantee the future of an investment, of course; OCZ’s founder and CEO Ryan Petersen resigned recently, leading to speculation that the company is bound for a takeover, perhaps by LSI Corporation (NASDAQ: LSI). With no long term debt to speak of and plenty of equity (though unable to make any returns on it, with return on equity at -8%), it’s likely that stockholders will see a pay-off on this cheap stock should it see the takeover that analysts are predicting.

Datalink, on the other hand, is less a bargain than a growth-hunter would like. Its PEG has risen to 0.7, above my comfortable margin of undervaluation. Price-to-book is at 1.7 and current ratio is 1.3, making it overvalued enough that any volatility in the business’ fortunes would leave shareholders with a loss; when a small company with this level of liabilities experiences a downturn, it could very easily go under.

However, the stock is trading with a P/E of 13 – on the cheap, in other words, considering its increasing revenues due to sales and its solid return on equity of 13%. In other words, Datalink is a healthy company that seems to be relatively well-priced, but could very easily move up on news like its recent partnership with LSI Corporation.

Finally, we come to the R&D-heavy STEC. The data storage company is currently delivering a -19% return on equity to shareholders, gross profit has been in decline (-19% from last quarter), and their profit margin has taken a nose dive in March, down to -121%. Their PEG ratio, meanwhile, has dropped into the negatives at -0.47. This is a company that is essentially unprofitable, while its not expected to grow -- indeed, its expected to shrink.

The company has no debt, while cash and equivalents total 60% of their market capitalization and, stars and garters, current ratio is over 4. In other words, STEC, while experiencing trials and travails in its profitability, has the assets and cash to fund its continued research and development in a field where innovation will determine who captures the lion’s share of an infrastructure that is still in flux. Their relatively poor performance in recent quarters certainly contributed to driving the PEG down so low, though no doubt the shake-ups in management haven’t inspired much confidence either. You’ll have to decide for yourself if you’re willing to risk STEC’s current poor performance and bet on their investment in themselves.

Risk If You Do, Risk If You Don't

Strangely, OCZ ends up coming out ahead in this evaluation; the looming specter of takeover for what is actually a relatively healthy company could mean a quick profit for investors. Datalink is a relatively safe, stable investment, while STEC presents a rather schizophrenic front: insider trading charges from the SEC, massive amounts of funding for R&D, and strong fundamentals outside of, uh, profits.

Either way, investing in bargain stocks is always a matter of measuring the fundamental value of a company against the vicissitudes of the market -- and against your own instincts towards greed and fear. If the risks presented here don't tickle your fancy, you may be more interested in similar companies with larger capitalization; or perhaps you'll spend more sleepless nights like me, trawling, searching for the perfect undervalued stock...

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