News Analysis date published New: 
Friday, October 12, 2012 - 10:00
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Friday, October 12, 2012 - 10:00
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Friday, October 12, 2012 - 10:00

Bankruptcy Watch: This Struggling Tech Stock Can't Afford Any More Losses

Friday, October 12, 2012 - 10:00am

At first glance, it seems as if data-storage companies are all growing at a torrid pace. Fusion-IO (NYSE: FIO), for example, which I discussed this past spring, is on track to boost sales roughly 50% in fiscal (June) 2013, while many other industry players look set for double-digit sales gains as well.

But looks are deceiving. The broader industry isn't growing quite that fast, and for every industry winner that can only grow quickly through market share gains, there are also big-time losers.

OCZ Technologies (NYSE: OCZ), for example, is surely a loser. As I noted a month ago, "OCZ continues to generate negative free cash flow (a cumulative $125 million over the prior two fiscal years). And with further free cash flow losses in the current fiscal year, the company's balance sheet could soon start to feel the strain."

Well, the news is even worse than I thought, as this technology laggard may soon see its stock lose some or all of its value.

Funny numbers
OCZ Technology is hardly at the technological vanguard of the data-storage industry. The company simply builds storage equipment using components and technologies developed by other firms, making it more of a high-end assembly shop. This explains why OCZ had gross margins of just 13% in fiscal (February) 2009, 2010 and 2011, and negative operating margins of roughly 8%. The company appeared to find ways to boost margins in fiscal 2012, as gross margins surged past 20% and operating losses shrank sharply.

But as it turns out, that may have been just fiction. The company just announced that it had "material weakness" in its accounting. On Monday, Oct. 15, the company is set to provide more clarity on this matter, when its files its 10-Q. The company might need to restate fiscal 2012 results, though that's not the real concern here.

Instead, it's an alarming cash burn rate. Note that OCZ had generated negative $28 million in free cash flow in 2011, which expanded to a $96 million free cash flow drain in fiscal 2012. To keep cash in the bank, the company had to sell 22 million shares in fiscal 2011, raising the share count to 51 million.

But here's where things get scary: OCZ now says fiscal second-quarter sales plans will be well below the $120 million consensus estimate, leading to a hefty operating loss. The fact that OCZ likely had negative gross margins in the most recent quarter is truly scary. As of the end of the fiscal first quarter (ended May), OCZ still had $43 million in cash left, thanks to that 2012 capital raise from the share count increase. But the company just tapped a credit line, which is a worrisome sign.

How much of that cash was left as of the end of August? And if losses continue, then how much will be left after the quarter ends this November?

OCZ will find it much tougher to raise cash by selling stock this time around. Investors who bought into the previous capital raise have been badly burned, so they probably won't return the bankers' calls this time. In short, OCZ has a very short window to stop the bleeding.

Watching for bankruptcy
Last week, I kicked off a new series of articles that look at companies in deep financial distress.

All three companies mentioned in that article need to play their hands with a deft touch or they will start to pop up on short sellers' list of "terminal shorts." In short, these companies might make a beeline for bankruptcy with a few bad breaks, although I'm removing Clearwire (Nasdaq: CLWR) from the Bankruptcy Watch for now.

New reports have circulated that wireless services firm Clearwire may end up getting acquired as part of a multi-tiered acquisition strategy by Japan's Softbank. There are a lot of questions around these rumors -- Softbank's ability to pay for multiple firms, for example, yet the mere specter of these rumors are likely to provide support to shares.That's why I'm removing this stock from the bankruptcy watch list, though I may look to put the company back on this list if Softbank fails to move forward with its rumored plans.

In the case of OCZ, its bankruptcy score of six tells me "bankruptcy is possible within the next 12 months."

Risks to Consider: Upside risks? It's hard to see them, at least in the near-term. New management will try to enact a turnaround but that will take time, and in all likelihood, things will get worse before they can get better.

Action to Take --> It's unclear whether prior results will need to be restated. The real issue is the fundamental nature of this business model. Is it capable of generating positive cash flow? Or will cash simply dry up? With questions such as these, this could soon emerge as a serious candidate for a bankruptcy filing as management seeks court protection while fixing the business.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.