TPS Trade Alert – July 20, 2016

Recommendation:

Buy Netlist, Inc. (NASD: NLST) up to $1.65 per share.

 

The Opportunity:

The language of technology can get complicated in a hurry.  Terms like “memory interface” and “cache-based memory subsystems” aren’t exactly part of our everyday conversation.

But wander the hallways of Netlist, a small Orange County, California tech company, and this is what you’ll hear.  Netlist does business in a specialized niche of the tech world… it designs, manufactures, and sells logic-based memory subsystems for the datacenter, storage, and high-performance computing markets.

What does a logic-based memory subsystem do?

The simple explanation is that it helps manage and secure data storage.  Wherever there are massive amounts of data being stored, either on the cloud or in an on-site data center, you’ll find integrated circuits, circuit boards, and other components that create the subsystem that makes safe and efficient storage possible.

That’s the business Netlist is in.  It is a huge business that’s going through massive changes and growing at a remarkable rate.

The firm markets what it calls, “Next generation persistent memory solutions that enable businesses to transact quicker, gain insight faster, and reduce datacenter costs.”  The company holds a portfolio of patents for hybrid memory, rank multiplication, and load-reduction.

According to research from Computer Weekly, “The demand for storage has grown more than 50% annually in recent years, a rate faster than the rapidly decreasing unit cost of storage.”

Look at just about any company’s IT budget, and chances are you’ll find that data storage is the line item in the budget that is increasing the most.

It’s not difficult to understand why data storage is in the midst of an unprecedented boom.  Start by looking at your own personal computer and how many files you’re saving compared to just a few years ago.

Your photos, your audio, and video files… thumb drives, external drives for backup, and whatever cloud services you might be using… they’re all small examples of what’s happening on a larger scale in the enterprise IT world.

An extreme example is Netflix.  At last report, Netflix used 3.14 Petabytes of cloud storage space for its master catalog.

A petabyte equals 1,000 Terabytes or one million Gigabytes.   You can pack 20 million 4-door filing cabinets full of text into one Petabyte.

So the thirst for storage is massive, growing, and involves so much data the numbers are difficult for us to get our arms around.

How much money is spent on the enterprise storage market where Netlist does business?

Just for the cloud, where data is stored and applications are run, we’re looking at a $37 billion market according to IDC.

Netlist has a microscopic sliver of this pie.  Revenues in 2015 were only $8 million.

The firm was launched in 2000.  It has 87 employees, corporate headquarters in Irvine, CA, a design center in San Jose, CA, and manufacturing facilities in Suzhou, China.

But while the data storage is booming, Netlist is struggling.

 

Financials:

For 2015 fiscal year, Netlist revenues were $805 million, down from $19.2 in 2014 and $23.0 million in 2013.

But each of the past three years, the company has lost money.  In 2015, there was negative net income of $20.5 million.

On the balance sheet, long-term debt is growing.  It is now $13.7 million, up substantially from the $3.5 million reported at the end of 2014.

 

Trade Rationale:

This is clearly a struggling company.  The combination of long-term debt and the inability to turn a profit is typically a recipe for disaster.

But on closer inspection, here’s what we see in Netlist.  The ability to innovate and successfully compete in a booming market, and significant improvements in revenue.

Q1 2016 revenue of $4.6 million was up 118% from Q1 2015.  The net loss narrowed considerably to $1.4 million from $6.5 million.  Operating margins are now at an admirable 75%.

One of the reasons for this growth is a strategic partnership with Samsung.

According to CEO C.K. Hong, “We remain focused on capturing license opportunities as well as leveraging our intellectual property assets to drive the adoption of our breakthrough products in the marketplace.”

Netlist is on schedule to introduce what could be an important new product, a first generation NVDIMM-P storage class memory solution.  And the firm has scored legal victories on the patent protection front.

We are not alone in our belief that Netlist can stage a turnaround.  Major institutional holders of the stock include Vanguard, Goldman Sachs, and CALPERS.

Earlier this year, NLST traded at $0.74.  The stock showed signs of life after these results were released in May and reached $1.40.  It has given back some its gains and has been trading recently in the range of $1.02 – $1.52.

The stock was added to NASDAQ in late 2006.

Life has never been easy for Netlist.  It was battered by plunging memory chip prices in 2007 and 2008, which reduced the value of its inventory and cut into profits.

The stock nose-dived in early 2009 before rebounding later that year when the company diversified products to expand from a core offering of memory modules.

 

Investment Risks:

We have already illuminated our concerns with the balance sheet.  If there is not progress made on paying down debt, the potential of this stock will be held back.

As with any tech company, competition is fierce.  A competitor’s innovation could negatively impact Netlist’s product advantages.  The strategic alliance with Samsung could become unhinged and the expected introduction of the new NVDIMM-P storage class memory solution could be met with a yawn in the marketplace.

 

Potential Return: 

The Netlist stock price flirted with $11 in 2007.  It has never come close since, but we see an opportunity for a 20% short-term gain.  When Q2 results are reported, the Q1 loss could easily be transformed into a small profit.

It is not unrealistic to expect Netlist to trade in the $1.75 – $2.25 range later this year.  The stock could double in the next 18 months, and from there, build on its success and solidify addition gains.

 

Key Facts:

Company:                                   Netlist

Ticker:                                          $NLST

Recent Price:                              $1.51

Buy up to Price:                          $1.65

Market Cap:                                $77.14 million

Avg. Daily Volume (3 month):        157,644

 

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Category: TPS Trade Alert