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Author: DeliLama Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35  
Subject: Needham notes Date: 1/11/2002 12:15 AM
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Recommendations: 2
Participants:
Bill Gervais, CEO
Matt Natalizio, CFO [who seems a bit unpolished to me]


Bill Gervais started out

(Safe Harbor statement, remember owning a stock has risk)

Qualstar went public about 1.5 years ago with the help of Needham. They came out with an offering price of $7.

About 12.5 million shares outstanding [12,643,000 diluted shares at last count]. About half is float. Insider own about 47%. Institutions own about 23%.

They've been in business for 17 years. The focus has been on high reliability robotics. Reliability is a key factor as these things typically run overnight automated. They've been profitable for 16 consecutive years. 6 Consecutive years of revenue growth. The growth was funded by cash flows up until they went public. 110% compound annual growth rate of tape libraries revenue.

Tape libraries are used where cost/megabyte matters. Tape libraries have 1/10 the cost of disk RAID systems. Libraries are used where you don't think you'll need access to the data, but if you do, you don't mind waiting a while.

Qualstar builds both tabletop and rack mount. They just introduced two new models of rack mount libraries. They believe they are the leader in the small to midrange system libraries in the tabletop and freestanding area. The rack mount products will start shipping in the next quarter.

[I was surprised to hear the claim that they are the leader in this area. ADIC is huge and has the AIT100, LTO 200D, DS900, and Tape Array 5. Exabyte has a lot of midrange standalones. 18% of their 2000 sales were to a single OEM and were mostly small library products. In overall sales, QBAK is very small compared to ADIC, EXBT, and others. In Qualstar's own 10-K SEC statement, they said, "Based on revenues, we believe Advanced Digital Information Corporation has a dominant share of this market segment, followed by Exabyte and Overland Data."]

They maintain compatability with every major operating system. Also compatability with virtually all of the storage management software packages on the market.

[Let me explain how these guys operate. They buy tape drives, robotic stuff, enclosures, power supplies, interface equipment, etc. and assemble them as a type library system that ends up controlled by independent software running typically on a PC. This is a surprisingly common style of business model in the high tech area. Lots of companies contribute to a system for the end user. If we step back, we see that there are lots of tape drive companies competing against each other. There are tape companies competing against each other. There are over 30 software management producers competing. And there are tape library companies like QBAK, ADIC, EXBT, and many other competing against each other. The important thing is who can hold onto their margins and/or who has the lowest costs.]

The business is being fueled by the explosive growth in data. Some estimates of data growth is around 100% per year. Some percentage of it needs to be backed up. Recent events have shown the importance of backing up data offsite and video surveilence (both utilize Qualstar's products).

Qualstar has a long history of revenue growth and profitability and is well capitalized to pursue any activities that they decide to pursue.

A lot of the growth in data is video, photographs, and other high information content items.

Qualstar estimates that the tape library market they participate in is about $3 billion. The market is segmented into mainframe class libraries (IBM, Storage Technology, ATL Products) and the rest of the library market which is small to midrange, which is growing. Overall, the market is growing 10% to 12% per year based on revenue.

Qualstar has benefitted from improvement in tape drive and tape media quality/reliability/cost. The cost has been dropping for both tape and tape drives. Lots of suppliers compete, driving down prices. The cost to the end user is coming down over time. With each reduction in cost, new applications emerge for the use of tape libraries. Video surveilence is a new one. Qualstar is in many Target stores, airports, gambling casinos, etc. The use of digitized video is just starting to replace VCRs to record activities.

Qualstar offers products with Fibre Channel interfaces (which fit well into storage area networks, SANs). They believe they're one of the quickest library companies to adopt new tape technologies and new technologies in general as they come along. [In Sept. 2000, they began shipping LTO based libraries. It looks like ADIC was shipping LTO based libraries in 1999.]

They buy tape drives from Sony, Erix(?), and Exabyte. They buy DLT tape drives from not just Quantum but also Benchmark. [The suppliers list is important because when they have a sole source, they can get put on allocation and have limited quanities to purchase. Sony did this for a year during 1999 with AIT tape drives]. They buy LTO drives from HP and IBM.

Customers: Boeing uses Qualstar tape drives to record data during shuttle engine tests (http://www.qualstar.com/boeing.pdf ). Microsoft Hotmail is one of their largest installed sites with nearly 200 libraries onsite.

They work with all the relevant major software vendors: Legato, Veritas, Computer Associates, etc. It's a major effort to keep everything compatable as new products and revs of software come out. http://www.qualstar.com/swmatrix.pdf

They use two marketing channels [technically sales channels... go ahead, ask me the difference between sales and marketing]: The VAR [value added reseller] channel and the OEM [original equipment manufacturer] channel. The VARs give them a very effective sales presence and a geographic presence. Some VARs are StoreNet (http://www.storenet.co.jp/product/index.html I can't tell if Qualstar is the BullFrog, TreeFrog, or Gator), Cambridge, and others. They've been expanding the VAR channels by opening VARs outside the USA, so export sales should be increasing over the next few quarters as the result of investments of about a year ago.

The OEM channels allow them to reach customers they otherwise couldn't reach, targeting specific vertical applications [probably like gambling casinos].

The primary OEMs are Converse Data [can't find it] who owns Loronix [which I did find http://www.loronix.com/ ]. Roarke Data [can't find it] is using Qualstar libraries in a medical digitizing application. Rather than storing MRIs and X-rays on film, they're storing them digitally on tape. The Government apparently is requiring storing the data for the life of the patient. Also Nice Systems (http://www.nice.com/cem/products/storage_center.html ).

End users range from Target Corporation (the retailer) to Catepillar (the earth moving equipment maker).

The management team is very stable and has been around a long time. Bill Gervais has been in the company since the founding in 1984. Matt has only been in the company 2 years.

They're currently expanding the product "horizon" on the low end and high end. A year ago, Bill Gervais alluded to shipping a 600 tape library and now they've shipped around 70 of them. The large libraries have higher margins that the smaller ones and they've been focused on expanding toward the high end and they're also working on the low end.

They believe they have over an 80% market share of the digital surveillence market. They've focused on those types of customers and they've tailored the designs of the libraries for the needs of those customers.


Next Matt Natalizio, CFO

Qualstar has a long history of growth with the exception of the last year, with 4% growth in a very tough market. Q1 (which included Sept 11) was an extremely tough quarter. It was like business stopped for almost 3 weeks. But they were still profitable and cash flow positive.

In 2001, they wrote off about a $1.1 million investment "in a company we had made, otherwise it would be almost flat that year" [Chaparral Network Storage, Inc*]. Otherwise it was $1.2 million profit on $8.8 million in sales for the quarter. $43 million working capital, $27 million is cash and short term securities. Securities are all investment grade and short term. Some paper goes out 5 years to pick up "a little extra yield". Of course I suppose we shouldn't be concerned that having long term notes in current assets opens the company up to interest rate risk. [Note: even when a security matures in more than one year, it is still considered a "current investment" if it is an investment that is by its nature readily realizable and is intended to be held for not more than one year from the date on which such investment is made. Therefore, since all of QBAK's investments are under current assets, they plan to sell those 5 year notes before maturity, i.e. interest rate risk.]

The product designs are such that there are a lot of commonality between products which lowers the risk of inventory going stale.

Gross margin targets are 32% to 34%. In the past they've done 36% and even in Q1 they did 38%, but margins will decline slightly with the sale of rack mount products. Sales and marketing are around 6% to 7%. General and Admin is around 4% to 5%. Qualstar's G&A are mostly fixed costs and thus there's a certain amount of operating leverage [as in most companies]. R&D is in the 4% to 6% range [they tend to be lower than say ADIC or especially EXBT]. People say that it seems low based on revenues, but [and I'm quoting this directly] "we only produce half of what we sell, so it's more like 8% to 12%." [I understand what he means, but I'm just wondering if that could have been worded better. :-) The thing is that other companies develop both the tape drives and the libraries while QBAK only produces the libraries. There's nothing particularly wrong with that whatsoever. It's the business they choose to do, and given their numbers, perhaps it's a good choice.]

17% to 20% operating income. DSOs [Days sales outstanding, a measure of inventory turnover] are around 45 to 50 days, 51 at the end of fiscal 2001, 56 at the end of Q1 02 (which was the slowdown period). It has come down "back to normal". Inventory turns were 2.5 times for 2001, the target is 3. Because the sales model is through VARs, they have to compete almost with the distribution. They need to keep a lot of inventory on hand to compete with the 24-48 hours of distribution (commonality in design helps).


QUESTIONS AND ANSWERS

1) Can they elaborate on medical imaging?

[Bill answered] They have 2 customers in the medical imaging business. Both are supplying similar types of systems. These account for about 8% to 10% of sales and is increasing. They found that it's economically feasable now that the costs of storage in digital format have come down, it's less expensive to store an MRI or X-ray [digitally] than it is to store that image in film. It costs about 7 cents a year to store an image in film format. It costs about 6.5 cents a year to store that same image in a large library, so it's very compelling even though the systems are very expensive to digitize the images, store, and catagorize them. [That really doesn't seem very compelling to me, a 7% savings requiring a big capital expense when you don't know whether even more compelling things will come along next year.]

2) [Garbled, but based on the response it sounds like wondering what they're going to do with the excess cash.]

[Bill answered] They've looked at 4 opportunities. They're continuing to look at opportunities. They haven't found anything yet that they felt compelled to do. But it's there and they continue to look for what to do with it. [Ok, this sounded better the second time I listened to it. My opinion is they should keep looking and if they find nothing that would return higher than the riskfree interest rate, either pay out dividends or better yet, buy back stock.]

They've considered buying back stock, but the trading volume isn't really heavy enough to buy back say a million shares at the present time. [I'm not sure of all the legalities, but I wouldn't have a problem driving the price up to around $12. Buying anything above that is probably not a good use of capital.]

They would like to get the trading volume up to have that option. [Buffett has made the argument that a low trading volume is a good thing. It shows people acting like owners and not like traders.]

They sound like they're going to be putting it to use within the next couple of quarters.

3) [Another garbled question]

[Bill answered]
They have plenty of opportunity to grow their market share since they only have 8%. For the short term, they will work on enhancements to libraries, new library models, new features on existing libraries. But the current path is to stay in the library area. [Excellent idea.] There are very good margins in the tape library business as investors might notice.

THE END


* http://www.chaparralnet.com/news.cfm?action=archive&archivemonth=all

From Qualstar's latest 10-K:
"Impairment of investment. During the fourth quarter of fiscal 2001, we determined that the carrying value of our investment in Chaparral Network Storage, Inc. exceeded its net realizable value as a result of rapid changes in technology and the availability of capital for further development of its family of products. Accordingly, we recognized an allowance in the amount of $1,050,000 to reduce the carrying value of the investment in Chaparral to zero."

[Don't you hate when that happens?]

DeliLama
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