Fusion-io Tries To Hit Reset, But The Street Will Carry A Grudge

By Stephen D. Simpson, CFA | August 12, 2013 AAA

By no means is it unheard of for tech companies, including storage companies, to stumble in their early years. With Fusion-io's (NYSE:FIO) fiscal fourth quarter and guidance, management can certainly check that box. The trouble now is the question of how to weigh out the balance of the company's interesting enterprise flash storage technology (and the growing marketing opportunity) with the likelihood that the company can and will execute on that opportunity.

Fusion-io deserves the time it's going to spend in the doghouse. Earlier management was brash and bold, and the Street doesn't necessarily have a problem with that, but the failure to deliver is now an issue. I don't particularly like this company, but even I have to say that the valuation is now at a point where the stock is possibly interesting again if the company doesn't have to reset guidance to a lower level once again.

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Miss-And-Lower Instead Of Beat And Raise
Neither EMC (NYSE:EMC) nor LSI (NYSE:LSI) gave investors any reason to believe that Fusion-io was going to have a blow-out quarter, but the company's reported earnings and guidance were considerably worse than competitive read-outs would have suggested.

Revenue did jump 21% from the prior quarter, but fell 1% year-on-year and came in a bit shy of the average sell-side estimate. Unexpectedly strong sales to Facebook (NYSE:FB) helped the quarter (more than one-third of total revenue), but revenue from Apple (Nasdaq:AAPL) continues to be soft.

Fusion-io's margin performance is arguably secondary to the story right now. Gross margin declined less than a point sequentially, but the reported result was about a point better than many analysts expected. Operating expenses were basically in line with expectations, with sales and marketing expenses up more than 50% from the year-ago level.

Guidance Cuts Out The Stock's Legs
The true bad news in the quarter came with the company's guidance for the next quarter. Against an average revenue target of $124 million, management guided to a midpoint of $85 million. That's a pretty shocking shortfall for a market that is supposed to still be seeing rapid adoption growth, and well ahead of the guidance revision seen at LSI.

There are at least two ways to look at this revision. First, Fusion-io has a new CEO in place now, and it's not at all uncommon for new CEOs to “clear the decks” and reset expectations to more easily achievable levels – more often than not, the revision is blamed on the old management team's mistakes, and the new management gets to take the credit if actual results exceed the lowered bar.

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But it's also certainly possible that Fusion-io's much bragged-about product/system advantages aren't what they sold them to be. To that end, EMC, LSI, and IBM (NYSE:IBM) appear to be gaining traction in Fusion-io's targeted markets, and EMC will soon be rolling out a new all-flash enterprise storage platform. With that, there are worries that Fusion-io's software doesn't stand out as differentiated as investors once hoped.

A Hiccup, Or True Gastric Distress?
Bulls will note that Fusion-io would not be the first storage tech company to see a hiccup or bobble before resuming an attractive growth trajectory. Compellent, Isilon, and Netezza all experienced such a wobble, and all three ultimately secured pretty appealing buyout multiples (from Dell (Nasdaq:DELL), EMC, and IBM, respectively).

Along those lines, the fact that Facebook and Apple continue to buy Fusion-io products suggests to me that there's more than a little legitimacy to them. Moreover, so long as the company can maintain the relative quality of its technology, the execution issues won't necessarily preclude a buyout. While I think EMC or IBM are probably low-probability acquirers, there's a long list of potential buyers who could pay 4x to 6x sales in an M&A deal.

The Bottom Line
Long-term revenue growth of 13% works out to a fair value of about $15 today, and 13% growth would have been deemed a ridiculously low estimate until very recently. The next few quarters are going to be interesting, particularly with respect to what EMC and LSI accomplish in enterprise flash relative to Fusion-io.

I've long thought that management was over-selling the Fusion-io story, but now there's a new management team in place. These shares are only suitable for the most risk-tolerant investors today, but if management can re-establish the company's legitimacy as a growth play on flash storage, it's not hard to imagine the shares recovering quite a lot of the lost ground.

Disclosure –At the time of writing, the author owned shares of EMC.

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