 | First Montauk on Iomega - 2/17/99 | ||||||||||||||||
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NEW YORK--(BUSINESS WIRE)--Feb. 17, 1999--First Montauk
Securities Corp. initiating coverage of Iomega Corporation (NYSE: IOM - news)
effective 2/17/99.
Initial Coverage
2/17/99
Rating:
Short term: Buy (2)
Long term: Strong Buy (1)
Risk: Speculative
Shares outstanding 267,234,000
Price as of 2/17/99 $6 3/8
Market Capitalization $1.70 Billion
52-wk range $2 15/16 to $10 3/16
Book Value $1.56
Dividend nil
Yield nil
Earnings Q1 Q2 Q3 Q4 FYE'99
Projected .02 .06 .08 .12 .28
1995 1996 1997 1998 1999E
Sales 0.326B 1.212B 1.740B 1.694B 2.200B
EPS .03 .21 .42 (.20) .28
Projected 5 year CAGR- 35%
Overview
Iomega is a major player in the removable computer data storage market. They have 4 current platforms (Zip, Clik!, Jaz, and Ditto) that provide both businesses and consumers the ability to organize, transport, and store data for the digital age. Zip is their flagship product and it has been adopted as fast as any other product in consumer electronic history. Designed to replace the 1.44 MB floppy drive, Zip is on the verge of achieving that goal. The risk/reward proposition of Zip alone is enough to justify the current price of Iomega's stock. Additionally, Iomega has new products currently rolling out that could substantially enhance the value of the stock as well as increase their dominant position.
The Products-Zip, Jaz, Clik!, Ditto
Zip is a low-end magnetic storage solution that is intended for the floppy replacement market. Zip disks hold 100 MBs of data (70X the existing floppy) on the original, and 250 MBs of data (175X the existing floppy) on the new and improved version. Iomega has shipped over 21 million drives to date and approximately 150 million disks (10 Billion floppy equivalents). They were initially targeted at the hard drive extension market and the heavy power-user market of the graphics industry. Zip is now making a transition into the mainstream, and will be increasingly used more for organization and transport of data, as well as raw storage of data. The company has undergone a transition in 1998 to position it to be able to supply OEM manufacturers with volume delivery at much lower prices. The basic strategic significance of this platform is a razor/razor blade business model that, if successful, could mean an ever-expanding revenue and profit stream in the future.
Jaz is a high-end magnetic storage solution that is intended for the heavy-duty power-user market. Jaz disks hold 1GB and 2GBs of data and are currently the best removable product on the market for professionals. In addition to holding the most capacity, they are almost as fast as a hard drive. This makes them the preferred solution for graphic artists, movie production, large engineering projects etc....Jaz has this market almost entirely to themselves because Syquest, their only true competitor, filed for bankruptcy late last year. (in fact Syquest was recently bought by Iomega) The basic strategic significance of this platform is two-fold. First, it fills the high-end market niche with Iomega's own products, which can be leveraged to protect significant intrusions into the Zip market by competition. And second, to a lessor extent it also has a razor/razor blade model that has the potential to produce significant profitability when not being used to stop aggressive competition (see issues).
Clik! is the smallest magnetic storage solution on the market today. It is Iomega's answer to the expected growth in the miniaturized use of computers. Everything from cameras to MP3 music players to gameboys is going to explode storage needs in the next few years. Iomega developed a low-cost solution to fill this potentially huge market. Clik! has recently started shipping (December 1998) and while it is too early to tell how it will be received, early indications look promising. The basic strategic significance of this platform is also a razor/razor blade business model. Iomega hopes to leverage its success with Zip and Jaz into another platform that has as much (if not more) potential to produce future profit and revenues streams.
Ditto is a tape product aimed at the personal and small business user for primarily backup purposes. Tape use is declining due to the success of Zip and Jaz providing the same functions faster. While Iomega might improve their product and produce some incremental profits, this is largely a non-issue product when evaluating the company and its stock.
The Issues
The first issue is the size of the market for removable storage in general. There is no doubt that the need for storage will explode in the future as the world moves from paper to digits. There are currently 6 major ways to store that information: fixed hard drives, CD's or optical, central server storage for networks, mainframes, flash memory, and removable magnetic disks (like Zip). No one single solution will fill every need and several different technologies will co-exist. The basic needs will be 1) raw storage of programs and data, 2) organization of data, 3) portability of data, 4) distribution of data, 5) management of data, 6) back up of data. Zip and zip-like products are very important for organization, portability, and back up of data. While it is difficult to measure the overall growth in dollar terms, it can be estimated that this need will grow with computer growth in general (15%-20%) PLUS growth in applications due to technology improvements (15%+) PLUS growth in the learning curve of users (25%+).
Segments of the storage business are commodity-like in nature. Hard drives and CD-R's in particular are vulnerable to this problem. Many different companies make the products, substitution is prevalent, price/MB is the primary issue, and users rarely pay any premium for brand name or perceived quality. Zip, Jaz, and Clik! are not in that segment. Iomega has carefully sought out the proprietary part of the business that requires compatibility and quality as the primary demand drivers. Price/MB is important and must be somewhat in line with the competitive field, however a premium can be charged for the 'added value' of compatibility and reliability. This is why Zip is very close to exploding into 100% plus growth rates, and why it was so hard for Zip to replace the floppy in the first place.
Zip has sold 21 million drives and should add another 15+ million in 1999. Their installed base of existing customers now buy more disks than new drive purchasers buy. This means they can use the high-margin disk sales as a weapon to fight any new entrants by subsidizing drive costs (a benefit that should not be taken lightly). Eventually a floppy-replacement product will reach a point of inevitability and the competition will either go away or enter specialized niches. Zip is by far the leader and the odds on favorite to be that product. And with the recent introduction of the 250 MB drive (175X current floppy), they are positioned to be technologically superior for many years to come.
Jaz is a volatile, but important part of Iomega. Because it is the fastest and largest capacity drive platform in the market today it is widely used by the 'early adopter' and 'power user' segment. These technically inclined people use Jaz and were initially the first users of Zip. This crowd is very important for Iomega to keep as customers because they 1) use a lot of disks per drive and 2) determine what is 'cool' or 'hot'. Mindshare is hard to measure, but Zip's success depends heavily on stopping these users from defecting to a rival's product. An example of this protection can be seen in the recent bankruptcy of Syquest. Syquest tried to position SparQ 1 GB as a 'Zip-killer' and on a price/MB basis it dramatically beat the Zip. However, when Syquest actually made some inroads into Zip's business, Iomega dropped the price of the Jaz 2 GB drive (took back the price/MB advantage) and kept the power user within the Iomega family. In effect, the Jaz platform is the high-end protection for the cost/MB argument, taking away the issue from any future Zip competition.
Jaz currently has no competition and should actually be quite profitable for the near future. With an installed base of over 2 million drives and a near lock on this niche power-user segment, Jaz will contribute increasing gross margins as the power users continue to buy disks and Iomega won't have to discount the drives and disks as much as they did in 1998. Long-term (2+ years) this product will be replaced by something faster and bigger as technology improves.
Clik! is too early to comment on at length. However it's developments should be monitored closely, because if it gains a foothold, the tie-rates for this product will be very large. The primary uses initially will be cameras and MP3 music players. They have signed up 1 OEM in each area (AGFA for a digital camera, and VaroVision for the MP3 player) and have several bundling deals with Olympus and Compaq. There is no doubt that these areas will ignite consumption of many disks, the issue at this point is what will be the format and media. Currently, flash memory is widely used, but very expensive. Clik! disks are much cheaper, but require an additional drive. Because Clik! is spread across many different platforms, the key issue is whether it can gain enough early acceptance to pull additional inclusion across those different platforms. If so, Clik! could be bigger than Zip, but again it is too early to tell at this point.
The Risks/ The Competition
The biggest risk to Iomega is that someone develops a product that is technologically superior to theirs and can justify a premium. In order to overcome Zip's huge installed base, this product would have to be significantly better in terms of speed and size. Price won't work as a primary factor because: 1) The Zip drive is essentially a $50 product to the OEMs (and going lower), and very few of the 21 million+ Zip owners would switch platforms to save $5 or $10. 2) Iomega can subsidize new drives with profits from sales of high-margin disks to the existing customer base that competitors wouldn't have. However, several factors could be combined to invent a negative scenario. For instance, if a marginally better product in terms of speed and size were combined with a deep-pocketed competitor willing to lose $100 million+ to gain instant entry, then Zip would have a formidable fight.
The next biggest risk to Iomega is their own performance. Slow product delivery, defective products, poor customer service, general corporate arrogance, etc....would be items that could provide a window for competition to climb through. While Iomega has made very important appointments in top management in the last 12 months, it is by no means a certainty that they won't have to go through more shakeups.
Capitalization is a somewhat relevant risk when weighed against future growth and competition. Iomega is a $1.7 Billion company but is attempting to grow to $10 Billion. If successful, they would strain existing resources. Inventory management is very important and the company hired Scott Flaig to implement the 'Build-to-order' operational management system that he pioneered at Dell. Any loss of key personnel in this area could dramatically hinder Iomega's ability to capture the opportunity before them.
Return to profitability is also very important and the failure to do so could seriously impair Iomega's ability to fend off rivals. Overall R&D spending is still low compared to the large cap technology stocks and should be increased over time to strengthen future product offerings. Advertising spending has been cut back dramatically and will need to be increased in the future. Any setbacks on the profitability side could hinder brand building that is crucial to Iomega in the long run.
Current competition is actually fading fast, but 3 identifiable competitors in the magnetic area can be discussed. The only one of them with a current competing product is Imation. Imation makes the LS-120 or Superdisk, which competes, in the Zip market. It is a 120 MB magnetic disk which also is backward compatible to the 1.44 MB floppy. They have been on the market almost as long as Zip and have had lukewarm reception. They have an installed base of a reported 4 million drives, and have announced 'intentions' to double that installed base by the end of 1999. They have gained a few recent wins in the OEM market (Compaq and NEC), however they have to 'seed' these drives by subsidization in hopes to gain a foothold by 2nd half of 1999. They recently sold a large division to Kodak, so they are flush with cash, but they appear to be carving out a niche for themselves rather than going after Zip directly.
The larger and possibly tougher competition could be Sony. Sony has announced, shipped, recalled, and now is reportedly going to re-ship the HiFD 200 MB magnetic disk drive. This drive would also be able to read the 1.44 MB floppy disk, and on paper is the closest competition for Zip. It is much faster than the LS-120, higher capacity, and would have a brand-name recognition with the consumer that Imation doesn't have. If it does ship, expect one of the two products (LS-120 or HiFD) to drop out within a year. Sony stated they are going to re-release the product this quarter, but the product was originally due in Spring of 1998. Iomega answered the introduction of Sony's product with their higher capacity Zip 250 MB that is also very competitive on speed.
Castlewood's ORB, is the last identifiable direct competitor in the removable magnetic field. The former founder of Syquest runs the company and they are reported to be producing a 2.2 MB Jaz-like product that would compete mainly on price. Similar to Sony's announced but not yet shipped product, the ORB is late. It was due mid 1998 and still hasn't been seen in distribution channels.
Other competition is always appearing and disappearing because of possible advances in technology, however at this point it is unlikely that any product other than those announced could be developed, produced, and scaled in time to affect the current Zip penetration path. The Jaz market will likely face new threats in 2 or more years, but Iomega is likely to be developing their own increased capacity products. Clik!'s market is so broadly defined that talking about competition at this point could include just about any storage product and method of transferring data. The most direct competitor they currently face is flash memory which is more durable and available, but is almost 10X more expensive.
Valuation-Traditional
Traditional methods of valuation would assign a Price/Earnings or Price/Sales ratio. These multiples in addition to Price/Book are the most common methods used. However, severe adjustments and liberties must be taken to 'estimate' what Multiple to place on the stock. Further, once successful and profitably moving forward, the earnings of a company with a dominant position in a proprietary market actually accelerate. And still further, with this success, the predictability of the earnings improve and 'analysts' are more comfortable looking farther out in time. This leads to a phenomenon that causes the Multiple to rise in addition to the actual earnings rising. This can cause very explosive upside moves, and a recent example of this is AOL (AOL has moved from $9 to $160 in less than 2 years).
With this in mind it is important to realize that the current multiple assigned to IOM is subject to change based on three very identifiable factors.
1) Expected Growth Rate- This can be measured in units or in Dollars. In units we expect Zip to grow at 50%, and in dollars 30-35%. Dollar sales will continue to grow at a lesser pace than total units as IOM finishes their transition into OEM units on the drive side. On the disk side, Iomega will use the price/elasticity curve to realize very significant volume increases on very small price drops. Profit growth is meaningless against last years loss, but at this point we believe a 35% 5yr CAGR is achievable from my 1999 baseline target of $0.28. Jaz should be up 15% in units and in dollars as pricing pressures should subside dramatically and increasing disk sales compensate for what pricing actions are taken. Clik! and Ditto will be a net overall positive in revenue growth, but overall growth rate will be determined in 1999 by Zip and Jaz.
2) Future Earnings Baseline- Until management at IOM can demonstrate successful profitable growth, 1999 will be the baseline of earnings with which to measure and evaluate the price. The current price of $6.50 is trading at roughly 24X our 1999 estimate of $0.28 in EPS. On a Price/Sales basis IOM is trading at 0.78X our 1999 estimate of $2.2 Billion in Revenues.
3) Predictability of Earnings- Confidence in management's ability to deliver on earnings is a very significant factor when deciding on an appropriate P/E or P/S level. While management has delivered as promised in the last 2 Q's, the overall lack of profits in 1998 has seriously impaired the streets perception of this company. Every quarter is significant towards restoring their credibility. Look for this part of the multiple equation to increase or decrease directly based on each quarters performance with respect to consensus. Weighing all three factors, we believe a IOM is very good speculative buy at 24X 1999 earnings and <1X 1999 sales. Based on current market position, installed base, 50% unit growth rate in Zip, increasing margins, and management improvements, We are initiating a Long-Term Strong Buy Rating (1) and a Short-Term Buy Rating (2). I believe that IOM at this time will trade between 20X current year earnings on the low side and 40X on the high side. (On a P/S basis 1X-low side to 2X-high side) However, if the Company performs up to expectations these multiples could move rapidly.
Alternative Valuation Method
The traditional method waits for successful implementation of a business model, and then predicts more success in the future with that same model. This works really well with 'momentum' investors and is the primary reason why it is so highly adopted in the investment community. However, when proprietary market wars are fought, the actual results should be measured in ways that are not necessarily directly related to current earnings and sales growth. Barrier to entry is very important, in fact issues such as strategic alliances, marketing channels, installed base, product virtues, etc.... are far more valuable in the long run.
The alternative valuation model looks at the value of the prize, if successful, and then backs into current value by determining the likelihood of success. Put another way, it is the handicapping of a market participant's ability to achieve near-monopoly status.
As it relates to Zip:
A) What would the value of IOM be if Zip WERE the replacement for the floppy? What would be the cash flow per year from disk sales (similar to MSFT model)? What would the leadership position in the industry allow them to 'control' as it pertains to new products and upgrades of existing products (similar to INTC model)?
Several assumptions must be made when valuing the floppy replacement market winner. Probably the most important is the idea that there will be only 1 format commonly used to transfer, organize, and backup data between computers, set-top boxes, printers, scanners, etc.... Another significant assumption is that there will be little profit in the hardware manufacturing (except for the short upgrade cycles), and most of the profit will be achieved through disk sales.
Zip penetrated (at the OEM level) 7.5% of all PC's sold worldwide in Q4 1998. The floppy replacement winner should attain roughly 70% of the PC market. Total removable drive sales double from PC-only sales in the future as new non-PC devices such as scanners, printers, and set-top boxes add removable storage.
Prices of the disks will fall and units sold will explode. Initial success of the high capacity removable was driven by a cost/MB need. Future disk consumption will be driven by the relatively low cost/unit of organizing and transporting data. As the world becomes increasingly more digital, removable storage disks will replace filing cabinets and photo albums for organization. In addition, sharing and transport of data between different devices, family members, and home-to-office will all be accomplished in a common format.
Zip disks alone accounted for at least $400 million in total high-capacity removable disk sales in 1998. When competition is added, $500 million would be a realistic number. It is not hard to envision 10X that number or $5 Billion as a future yearly requirement. Assuming operating margins drop to a conservatively low 30% on these disk sales, the cash generated by this monopoly (on disk sales alone) would be $1.5 Billion per year.
In addition, the leadership role that the winner in the 'floppy war' will have will also be quite valuable. Similar to Intel in the chip market, the leverage that could be applied over future formats could build another dynasty. (Digital film is one example) While the hardware manufactured will be low margin, each upgrade of capacity and compatibility would be higher margin. In addition, licensing revenues from other drive manufacturers could also become significant.
The actual value of the winner is very volatile and subject to individual interpretation. Our assessment is that the company that attains this status would be worth at least $30 Billion. For comparison of other near-monopoly or proprietary computer companies:
MSFT $375 Billion, INTC $210 Billion, AOL $72 Billion, AMZN $16 Billion.
B) What are the chances of success?
Zip has 21 million units installed. They shipped 9.5 million units in 1998. Estimated current market share is 80%. All major OEM's include Zip in either build-to-order or standard fashion. OEM inclusion rate is 7.5% as of Q4 1998 (vs. roughly 4% in Q4 1997). Next closest competitor (Imation) has 4 million units installed. Zip has locked up the 'early adopters' and 'power users'. Zip 250MB is currently shipping, which gives Iomega the 'best' product on the market regarding price/size/speed.
To win 'the floppy war' Iomega will need more money. While they returned to profitability in Q4, they will need to maintain that profitability or raise additional money through either another equity offering or a strategic investment by a partner.
There are many other issues that Iomega must overcome before Zip is clearly the winner in the floppy replacement race. However, at $6.375 per share ($1.70 Billion market cap) the market is either a) misjudging the value of the ultimately victorious company, or b) grossly under-estimating Iomega's chances. In handicapper's terms, IOM at the moment is given about a 16 to 1 shot to replace the floppy. Our assessment is that Zip has roughly a 5 to 1 shot in the current environment.
Our conclusion based on the alternative valuation model is that the market value for the final 'floppy replacement product' should be $30 Billion, and Iomega's chance of Zip becoming that product is 5 to 1. Therefore, a long-term holder looking at a fair risk/reward ratio would be willing to pay up to $5 Billion (or $18 per share) for IOM right now. At $6.375 per share, the stock is a very compelling opportunity.
This communication reflects our opinion as to the securities mentioned herein, but is neither an offer to sell them nor a solicitation of an offer to buy or sell them. Any recommendation contained in this report may not be suitable for all investors. Moreover, although the information contained herein has been obtained from sources believed to be reliable, its accuracy and completeness cannot be guaranteed. First Montauk Securities Corp. may make markets or have positions in the securities mentioned herein (or options with respect thereto) and may have performed investment banking services for the issuers of such securities. In addition, employees of First Montauk Securities Corp. may have positions and effect transactions in the securities or options of the issuers mentioned herein and may serve as directors of such issuers. Copyright 1999. All rights reserved by First Montauk Securities Corp. Member NASD/SIPC.
First Montauk Securities Corp.
Dave McCoy, 800-876-3672
Email: info@firstmontauk.com
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