STEC Inc. Bringing Out the Big Gun--2H Contract Ups Visibility, Ests, PT, Everything

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1 EQUITY RESEARCH COMPANY UPDATE July 16, 2009 Stock Rating: OUTPERFORM mo. Price Target $45.00 STEC - OTC $ Yr. EPS Gr. Rate 105% 52-Wk Range $28.37-$3.42 Shares Outstanding 48.4M Float 31.7M Market Capitalization $1,336.7M Avg. Daily Trading Volume 1,795,617 Dividend/Div Yield $0.00/0.00% Fiscal Year Ends Dec Book Value $ E ROE 3.6% LT Debt $0.0M Preferred $0.0M Common Equity $185M Convertible Available No EPS Diluted Q1 Q2 Q3 Q4 Year Mult. 2008A NM 2009E 0.08A x Prior (E) x 2010E x Prior (E) x Revenue ($/mil) Q1 Q2 Q3 Q4 Year Mult. 2008A x 2009E 63.5A x Prior (E) x 2010E x Prior (E) x TECHNOLOGY/SEMICONDUCTOR & ELECTRONICS CAPITAL EQUIPMENT STEC Inc. Bringing Out the Big Gun--2H Contract Ups Visibility, Ests, PT, Everything SUMMARY As a follow-up to a recent, 12-month, $28M US military contract, STEC brought out the big gun today (checks suggest EMC), and announced a $120M ZeusIOPS contract for 2H. Relative to our prior model that included ~$60-$70M contribution from EMC, this news raises our model by $50M. Looking ahead to '10, we now expect rev from EMC alone of >$250M, vs. our old model for total ZeusIOPS rev of ~$300M. Thus, we are raising our '09/'10 EPS ests to $1.43/$2.22. Our call for $2/plus in EPS power in '10 now lacks imagination, but with $2/sh-plus at hand in '10 (emphasis on "plus"), we think STEC deserves a better multiple (20x). Reiterate STEC as our one, long-term, secular pick. KEY POINTS In terms of mechanics, the $120M supply contract in 2H:09 (from EMC according to our checks) raises our rev forecast for '09 by $50M, and our earnings model by $0.26/sh--this conservatively assumes 30% drop-through to STEC's operating margin, and 24% taxes. Our understanding of the rationale behind the contract is twofold: 1) The ramp in 2H units from EMC was too large to commit working capital to, without a hard contract. 2) This likely sets a precedent, with EMC and other OEM customers, that to ramp to meaningful volume, a contract is a must. Thus, we not only believe/suspect that a similar supply contract with EMC for all of '10 must be in the works, but we also view similarly contracted agreements may logically be in the works from other OEM customers (e.g., IBM), assuming the initial ramp in Q2/Q3 progresses well. STEC, in our view, is a pre-eminent player in likely the only secular growth story in IT--enterprise SSD--which is levered to Tier 0 storage and virtualization computing. Rhetorically, doesn't this merit a 20x (or more, like Data Domain's) multiple as a base case? We think it does. Thus, raising our PT to $45 from $30. Gary Hsueh, CFA Gary.Hsueh@opco.com Wenge Yang Wenge.Yang@opco.com Stock Price Performance 1 Year Price History for STEC 0 Q2 Q3 Q1 Q Created by BlueMatrix Company Description STEC, Inc. is the leading provider of solid-state drives for high-performance, high-reliability applications in enterprise computing, and has built a strong core competency in customizing controller/firmware design for major OEMs like EMC and IBM. Oppenheimer & Co. Inc. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. See "Important Disclosures and Certifications" section at the end of this report for important disclosures, including potential conflicts of interest. See "Price Target Calculation" and "Key Risks to Price Target" sections at the end of this report, where applicable. Oppenheimer & Co Inc. 300 Madison Avenue 4th Floor New York, NY Tel: Fax:

2 Exhibit 1. Stock Prices of Other Companies Mentioned in this Report (as of 7/16/2009) Data Domain (DDUP-OTC, $33.45, Not Rated) Samsung Electronics ( KSE, 425,000KRW, Not Rated) Source: Oppenheimer & Co. Inc., Bloomberg. 2

3 Exhibit 2. STEC Income Statement STEC, Inc. (NASDAQ:STEC) Income Model [in $MM] F2007 1Q08 2Q08 3Q08 4Q08 F2008 1Q09 2Q09E 3Q09E 4Q09E F2009E 1Q10E 2Q10E 3Q10E 4Q10E F2010E FYE: December 31st Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Dec-10 TOTAL REVENUES Q/Q, % -4% 11% 13% -11% 12% 31% 20% 20% -6% 4% 4% 13% Y/Y, % -46% 7% 28% 42% 7% 21% 25% 48% 57% 111% 61% 78% 42% 23% 16% 35% Cost of Goods Sold GROSS MARGIN (GM) GM, % of Sales 30.2% 32.9% 32.3% 32.1% 28.2% 31.3% 36.3% 45.0% 45.5% 46.0% 43.9% 44.5% 44.0% 43.5% 43.0% 43.7% R & D R & D, % of Sales 7.9% 8.5% 8.6% 9.0% 10.9% 9.3% 8.7% 6.6% 5.6% 4.8% 6.1% 5.3% 5.5% 5.7% 5.7% 5.6% Sales & Mktg Sales & Mktg, % of Sales 9.2% 8.8% 8.3% 8.1% 8.4% 8.4% 7.5% 5.8% 5.3% 4.5% 5.5% 5.1% 5.3% 5.5% 5.0% 5.2% General & Admin General & Admin, % of Sales 8.7% 10.5% 10.0% 11.2% 12.8% 11.1% 11.6% 6.4% 5.8% 5.2% 6.7% 4.9% 4.7% 4.6% 4.1% 4.5% Total Operating Exp OPERATING MARGIN (OpM) (2.215) OpM, % of Sales 4.4% 5.1% 5.4% 3.8% -3.9% 2.6% 8.5% 26.2% 28.9% 31.6% 25.6% 29.2% 28.5% 27.8% 28.1% 28.4% Other Income (Exp) (0.081) (0.012) Interest Income Interest Expense (0.081) (0.081) (0.012) (0.012) Other, Net PRETAX INCOME, OPS (2.296) Tax Provision (2.406) Effective Tax Rate 44.8% 44.7% 61.9% 55.1% 104.8% 37.7% 23.7% 24.0% 24.0% 24.0% 24.0% 17.0% 17.0% 17.0% 17.0% 17.0% NET INCOME (NI), OPS NI, % of Sales 3.5% 3.6% 2.4% 1.9% 0.2% 2.0% 6.4% 20.3% 22.4% 24.6% 19.9% 25.1% 24.8% 24.4% 24.7% 24.7% EPS, OPS $0.13 $0.04 $0.03 $0.02 $0.00 $0.09 $0.08 $0.33 $0.44 $0.56 $1.43 $0.53 $0.54 $0.54 $0.61 $2.22 Total Charges, After Tax (3.335) - (0.091) (0.002) NET INCOME (NI), GAAP (0.171) EPS, GAAP $0.19 $0.04 $0.03 $0.02 ($0.00) $0.08 $0.06 $0.33 $0.44 $0.56 $1.41 $0.53 $0.54 $0.54 $0.61 $2.22 Wtd Avg Shares Out, Basic Wtd Avg Shares Out, Diluted Source: Company Reports and Oppenheimer & Co. Estimates 3

4 Exhibit 3. STEC Balance Sheet STEC, Inc. (NASDAQ:STEC) Balance Sheet [in $MM] F2007 1Q08 2Q08 3Q08 4Q08 F2008 1Q09 2Q09E 3Q09E 4Q09E F2009E 1Q10E 2Q10E 3Q10E 4Q10E F2010E FYE: December 31st Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Dec-10 ASSETS Cash and cash equivalents Accounts receivable, net Inventories Deferred income taxes Other current assets Current assets of discontinued ops Total current assets Marketable securities Property, plant & equipment, net Leasehold interest in land Intangible assets (0.074) - - Goodwill Other long-term assets Deferred income taxes TOTAL ASSETS LIABILITIES & STKHLDR EQTY Accounts payable Accrued and other liabilities Liabilities of discontinued ops Total current liabilities Income taxes payable TOTAL LIABILITIES TOTAL STKHLDR EQTY TOTAL LIABILITIES & STKHLDR EQ Source: Company Reports and Oppenheimer & Co. Estimates 4

5 Exhibit 4. STEC Cash Flow Statement STEC, Inc. (NASDAQ:STEC) Cash Flow [in $MM] F2007 1Q08 2Q08 3Q08 4Q08E F2008E 1Q09 2Q09E 3Q09E 4Q09E F2009E 1Q10E 2Q10E 3Q10E 4Q10E F2010E FYE: December 31st Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Dec-10 CASH FLOW FROM OPERATIONS Net income (0.171) Depreciation & amortization Reversal of non-cash/non-operatio (0.184) Stock based compensation, non-ca Deferred income taxes (0.325) (1.396) (0.661) (0.890) (0.357) (0.357) Changes in operating assets/liabilitie (2.918) (19.208) (34.052) (50.841) (15.904) (16.876) (6.541) (6.146) (1.252) (17.811) (16.088) Accounts receivable (0.644) (17.222) (10.014) (14.859) (8.614) (10.959) (29.134) (4.307) (1.721) (11.474) (13.282) Inventory (7.716) (39.643) (1.333) (36.256) (11.486) (6.101) (9.714) (8.015) (5.622) (2.737) (12.724) (16.883) Leasehold interest in land (2.376) Other assets (1.501) (1.925) (3.318) (4.164) Accounts payable (5.433) (17.358) (9.322) (3.890) (2.867) (1.200) Accrued and other liabilities (0.166) (0.246) Cash provided (used) by discontinue (0.224) (0.052) (0.145) Cash provided (used) by operations (16.919) (30.014) (31.404) CASH FLOW FROM INVESTING Capital expenditures (27.622) (3.742) (8.554) (3.700) (3.181) (19.177) (0.668) (3.320) (2.500) (2.400) (8.888) (1.695) (2.360) (2.153) (2.093) (8.300) Proceeds from sale of Consumer Div Sales/maturities of investments Purchases of investments ( ) (47.711) (0.059) - - (47.770) (5.200) (5.200) Cash provided (used) by discontinue Cash (used) for investing activities (10.231) (1.754) (3.700) (3.179) (18.864) (5.868) (3.320) (2.500) (2.400) (14.088) (1.695) (2.360) (2.153) (2.093) (8.300) CASH FLOW FROM FINANCING Net proceeds from IPO Proceeds, tax benefit from ESOs (0.049) Stock buyback (2.513) (13.003) - - (6.484) (19.487) Cash provided (used) by financing (12.223) (6.533) (10.679) Effect of FX changes on cash Net increase (decrease) in cash (20.657) (10.822) (33.488) (60.947) Cash/cash equivalents - beginning Cash/cash equivalents - end Source: Company Reports and Oppenheimer & Co. Estimates 5

6 Price Target Calculation We set our price target on STEC at $45, up from a prior $30. With increasing visibility on STEC's growth with its ZeusIOPS enterprise solid state drive (SSD), sustaining technology leadership, and lower manufacturing cost after moving all products to its Malaysia facility (netting a mid-teens effective tax rate in '10), we expect the company to post solid earnings over the next two years, and confidently believe the company can achieve $1.43 EPS in '09, and $2.22 EPS in '10. We apply a more generous P/E multiple of 20x to our '10 EPS estimate of $2.22 to arrive at our new price target of $45. Key Risks to Price Target The biggest risk to our estimates in '09/'10 and our $45 price target is a steeper/deeper macroeconomic downturn, catalyzed by the crisis in the financial markets, and rapidly decelerating worldwide GDP (impacting STEC's SSD and monolithic DRAM products). In addition, given that STEC sources NAND flash predominantly from Samsung, we believe any supply dynamics from Samsung potentially in '09 could negatively impact STEC's margins on its OEM flash drives. Specifically, checks recently suggest that Samsung may be mulling over a 30% cut in NAND flash production in '09, and coupled with product cuts elsewhere (including incremental NAND flash production cuts out of Hynix in '09), could contribute to a temporary rise in NAND flash pricing per bit. This would have negative consequences for STEC's margins on its OEM SSD products. We note that based on book value, with STEC displaying high-growth potential over the next month on the back of its enterprise SSD products, normalized price to book multiple is a better yardstick to assess STEC's downside risk compared to the trough multiples we used in the past. Adopting a new normalized multiple of 3.0x on book value, we view STEC's downside based on book to be at ~$14/share (rounding up after applying 3.0x to our estimated CY09-end book value of $4.50). To summarize, the risks to our $45 price target are as follows: 1. An extended downturn in '09, affecting STEC's top line for both SSD and monolithic DRAM products; 2. Near term, a steeper/deeper downturn could drive more significant inventory write-downs; 3. Potential NAND flash production cuts by Samsung/Hynix in '09 could result in a temporary recovery in NAND chip pricing, increasing STEC's component cost in SSD and negatively impacting margins (chip costs comprise ~80% of COGS in STEC's SSD products); and 4. Potential competition from flash memory maker INTC, Samsung and SNDK, which has better access to the NAND core, and hence has the possibility to come up with more competitive SSD products. Important Disclosures and Certifications Analyst Certification - The author certifies that this research report accurately states his/her personal views about the subject securities, which are reflected in the ratings as well as in the substance of this report.the author certifies that no part of his/her compensation was, is, or will be directly or indirectly related to the specific recommendations or views contained in this research report. Potential Conflicts of Interest: Equity research analysts employed by Oppenheimer & Co. Inc. are compensated from revenues generated by the firm including the Oppenheimer & Co. Inc. Investment Banking Department. Research analysts do not receive compensation based upon revenues from specific investment banking transactions. Oppenheimer & Co. Inc. generally prohibits any research analyst and any member of his or her household from executing trades in the securities of a company that such research analyst covers. Additionally, Oppenheimer & Co. Inc. generally prohibits any research analyst from serving as an officer, director or advisory board member of a company that such analyst covers. In addition to 1% ownership positions in covered companies that are required to be specifically disclosed in this report, Oppenheimer & Co. Inc. may have a long position of less than 1% or a short position or deal as principal in the securities discussed herein, related securities or in options, futures or other derivative instruments based thereon. Recipients of this report are advised that any or all of the 6

7 foregoing arrangements, as well as more specific disclosures set forth below, may at times give rise to potential conflicts of interest. Important Disclosure Footnotes for Companies Mentioned in this Report that Are Covered by Oppenheimer & Co. Inc: Stock Prices as of July 16, 2009 SanDisk Corp. (SNDK - Nasdaq, 16.20, PERFORM) Intel Corp. (INTC - Nasdaq, 18.05, PERFORM) Rating and Price Target History for: SanDisk Corp. (SNDK) as of /25/06 B:$60 10/17/06 B:$66 10/20/06 N:NA 03/12/07 B:$50 03/28/07 B:$52 04/02/07 B:$53 07/17/07 B:$60 07/20/07 B:$70 10/11/07 N:NA 01/22/08 P:NA 09/23/08 P:$ /21/08 P:$15 02/02/09 P:$11 04/21/09 P:$20 Research coverage transferred to Daniel Morris on 3/7/08. Created by BlueMatrix Rating and Price Target History for: Intel Corp. (INTC) as of /14/08 I:P:NA Created by BlueMatrix 7

8 Rating and Price Target History for: STEC Inc. (STEC) as of /23/06 I:OP:$6.5 10/19/06 OP:$10 11/09/06 OP:$12 05/15/07 SP:NA 07/16/07 OP:$9 11/28/07 OP:$10 01/14/08 I:O:$10 01/31/08 O:$9 03/06/08 O:$8.5 05/06/08 O:$13 08/04/08 O:$ /22/08 O:$9 11/11/08 O:$7 12/15/08 O:$6 03/13/09 O:$9 05/12/09 O:$17 06/09/09 O:$30 Created by BlueMatrix All price targets displayed in the chart above are for a 12- to- 18-month period. Prior to March 30, 2004, Oppenheimer & Co. Inc. used 6-, 12-, 12- to 18-, and 12- to 24-month price targets and ranges. For more information about target price histories, please write to Oppenheimer & Co. Inc., 300 Madison Avenue, New York, NY 10017, Attention: Equity Research Department, Business Manager. Oppenheimer & Co. Inc. Rating System as of January 14th, 2008: Outperform(O) - Stock expected to outperform the S&P 500 within the next months. Perform (P) - Stock expected to perform in line with the S&P 500 within the next months. Underperform (U) - Stock expected to underperform the S&P 500 within the next months. Not Rated (NR) - Oppenheimer & Co. Inc. does not maintain coverage of the stock or is restricted from doing so due to a potential conflict of interest. Oppenheimer & Co. Inc. Rating System prior to January 14th, 2008: Buy - anticipates appreciation of 10% or more within the next 12 months, and/or a total return of 10% including dividend payments, and/or the ability of the shares to perform better than the leading stock market averages or stocks within its particular industry sector. Neutral - anticipates that the shares will trade at or near their current price and generally in line with the leading market averages due to a perceived absence of strong dynamics that would cause volatility either to the upside or downside, and/or will perform less well than higher rated companies within its peer group. Our readers should be aware that when a rating change occurs to Neutral from Buy, aggressive trading accounts might decide to liquidate their positions to employ the funds elsewhere. Sell - anticipates that the shares will depreciate 10% or more in price within the next 12 months, due to fundamental weakness perceived in the company or for valuation reasons, or are expected to perform significantly worse than equities within the peer group. 8

9 Distribution of Ratings/IB Services Firmwide IB Serv/Past 12 Mos. Rating Count Percent Count Percent OUTPERFORM [O] PERFORM [P] UNDERPERFORM [U] Although the investment recommendations within the three-tiered, relative stock rating system utilized by Oppenheimer & Co. Inc. do not correlate to buy, hold and sell recommendations, for the purposes of complying with FINRA rules, Oppenheimer & Co. Inc. has assigned buy ratings to securities rated Outperform, hold ratings to securities rated Perform, and sell ratings to securities rated Underperform. Company Specific Disclosures Oppenheimer & Co. Inc. makes a market in the securities of STEC, SNDK, INTC, and DDUP. Additional Information Available Please log on to or write to Oppenheimer & Co. Inc., 300 Madison Avenue, New York, NY 10017, Attention: Equity Research Department, Business Manager. Other Disclosures This report is issued and approved for distribution by Oppenheimer & Co. Inc., a member of all Principal Exchanges and SIPC. This report is provided, for informational purposes only, to institutional and retail investor clients of Oppenheimer & Co. Inc. and does not constitute an offer or solicitation to buy or sell any securities discussed herein in any jurisdiction where such offer or solicitation would be prohibited. The securities mentioned in this report may not be suitable for all types of investors. This report does not take into account the investment objectives, financial situation or specific needs of any particular client of Oppenheimer & Co. Inc. Recipients should consider this report as only a single factor in making an investment decision and should not rely solely on investment recommendations contained herein, if any, as a substitution for the exercise of independent judgment of the merits and risks of investments. The analyst writing the report is not a person or company with actual, implied or apparent authority to act on behalf of any issuer mentioned in the report. Before making an investment decision with respect to any security recommended in this report, the recipient should consider whether such recommendation is appropriate given the recipient's particular investment needs, objectives and financial circumstances. We recommend that investors independently evaluate particular investments and strategies, and encourage investors to seek the advice of a financial advisor.oppenheimer & Co. Inc. will not treat non-client recipients as its clients solely by virtue of their receiving this report.past performance is not a guarantee of future results, and no representation or warranty, express or implied, is made regarding future performance of any security mentioned in this report. The price of the securities mentioned in this report and the income they produce may fluctuate and/or be adversely affected by exchange rates, and investors may realize losses on investments in such securities, including the loss of investment principal. Oppenheimer & Co. Inc. accepts no liability for any loss arising from the use of information contained in this report, except to the extent that liability may arise under specific statutes or regulations applicable to Oppenheimer & Co. Inc.All information, opinions and statistical data contained in this report were obtained or derived from public sources believed to be reliable, but Oppenheimer & Co. Inc. does not represent that any such information, opinion or statistical data is accurate or complete (with the exception of information contained in the Important Disclosures section of this report provided by Oppenheimer & Co. Inc. or individual research analysts), and they should not be relied upon as such. All estimates, opinions and 9

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