Anyone remember this letter I sent to Quantum's CFO in June 1997?
Mr. Rick Clemmer, Chief Financial Officer
Via: E-mail
Subject: Draft Letter to Quantum's Management Regarding Spin-off of DLT Shares
Following is a draft of a letter on a subject I believe to be of great importance to both Quantum Corporation and its shareholders. Quantum represents a long term and very important investment for us, which is the reason for my concern. I am sending a draft for your review in case you have any comments, suggestions, or are aware of any factors which make such a proposal technically infeasible.
Congratulations on a remarkable turnaround and thanks for your attention.
Sincerely,
DRAFT DRAFT DRAFT DRAFT DRAFT DRAFT
Mr. Stephen M. Berkley, Chairman
Mr. Michael Brown, President and Chief Executive Officer
Mr. Rick Clemmer, Chief Financial Officer
Quantum Corporation
500 McCarthy Boulevard
Milpitas, California 95035
Dear Sirs,
As a long term Quantum shareholder, I am writing to express my views on a matter which I believe to be of great importance to both shareholders and management. I am also concerned with the possibility for issuance of equity related securities under the shelf registration announced June 19th. Implementation of the following suggestion would either materially change or eliminate the need for securities issuance pursuant to this registration.
The concern stems from the fact that that Quantum's present share price is far below Quantum's true value, which is the sum of the valuations which the market would separately place on the disk drive business and on the tape business. Working with information the company has made public, it can be reasonably estimated that Quantum's present share price is roughly half of this true valuation. (Rationale for this estimate will be discussed). While valuation estimates may be subject to differences of opinion, I believe there is no supportable estimate which would alter the conclusions which follow.
At Quantum's deeply discounted present valuation, the issuance of either additional shares or convertible debt would result in a dilution of existing shareholder interests without adequate compensation having been received in return. While I appreciate that the press release does not specify acquisitions as a possible reason for issuance of these securities, it is worth noting that due to a low share valuation, acquisitions are effectively precluded. It would seem extraordinarily unlikely that any acquisition the company might desire to make through issuance of equity or convertible securities would be worth its true cost. It would also be unlikely that Quantum could find, let alone buy at the requisite premium, any entity that would be priced as reasonably as Quantum/DLT. (In other words, there is little possibility that an acquisition could be found which would be superior to the repurchase of Quantum stock). In summary, Quantum stock must presently be viewed as a currency so "weak" that the company would be overpaying (by a factor of roughly two) for any acquisition. Issuance to raise cash would raise only one half the security's true value. In fact, such a move would seem so ill advised that announcement of any equity based offering would be likely to further depress share price making the economics still less attractive.
.
Proposal
On the positive side, I believe that there is a simple solution that would have an immediate and dramatic impact on Quantum's market valuation. It is also one, which I believe should be undertaken regardless of Quantum's intent with respect to the issuance of additional shares. The solution is to have some shares of DLT trade publicly so that DLT has a stand-alone fair market valuation. Given an objective valuation for DLT, it is almost inconceivable that DLT would not add substantially more to Quantum's share price than the $5 per share or less that one might reasonably conclude that DLT presently contributes.
There are two logical ways for Quantum to issue publicly tradable shares of DLT. One possibility would be to create 160 million shares of stock in the DLT division (the same number as exist for Quantum post split and fully diluted). Quantum Corporation would retain 90 percent of the shares while the other 10 percent would be spun off to existing shareholders at the rate of one share of DLT for each ten shares of Quantum stock owned. (A 90/10 split was chosen arbitrarily for purposes of illustration).
Alternatively, if Quantum's goal were to raise cash immediately, nearly the same end result would be attained through a public offering of 10 percent of DLT. Because Quantum's low share price would mandate that these shares of DLT be sold at a discount (it would be too much to ask of the pre-IPO road shows to raise Quantum shares to a price at which DLT stock could be issued for its full value), shareholders would end up marginally worse off than under the proposed alternative, but far better off than under a "Do nothing" scenario. Both alternatives produce the desired result of dramatically higher market capitalization. The differences are that under the spin off scenario, Quantum shareholders have not effectively sold a small part of the business at an undervalued price while under the public offering scenario, Quantum's balance sheet is strengthened considerably, presumably eliminating need for the securities contemplated in the shelf registration.
DLT Valuation
Based on management guidance, it would seem that DLT earned about $.26 per share of Quantum stock (post split and fully diluted) in the March quarter. Given today's very high market valuation levels, a two year history of DLT growth in excess of 100 percent, a current growth rate of roughly 100 percent, an end market growth rate of over 40 percent and DLT's strong franchise, 30 times earnings would seem conservative and would result in a value for DLT alone of over $30 per share of Quantum stock.
Given the difficulty of valuing high growth companies and the prevalence of momentum investing, the market today could well value DLT at fifty times earnings or $50 per share. Assuming that DLT profitability grows 20 percent in the June quarter these valuation estimates rise to $36 and $60 respectively. The beauty of 100 percent annual growth is that these numbers will rise and compound by 20 percent every quarter that the DLT outlook remains intact. A minimum multiple of 30 should hold as long as growth continues to exceed 30 percent annually which would seem likely for quite some time given end market growth in excess of 40 percent. The largest wild card in valuing DLT is the fact that any one hundred percent growth business in today's market has the potential to become a very hot stock, subject to extremes of irrational exuberance and short squeezes, which may result in still higher market valuations.
Evaluation of DLT's market capitalization/sales ratio serves as a double check of these valuation estimates. Interestingly, dividing Quantum's entire market capitalization by annualized March quarter DLT revenue results in a ratio of only 3.2, well below the multiples typically associated with high growth businesses. Valuations of DLT at $30 and $50 per share result in multiples of 5 and 8 times revenue respectively, still within reasonable limits. And each quarter of continued growth substantially reduces these multiples.
Conclusion
The market has reflected only a small portion of the most conservative valuation of DLT despite having had more than ample time to do so. It is likely to be blinded to DLT's value for the foreseeable future as DLT revenues continue to be overshadowed by disk drive revenues. Quantum's experience supports Wall Street wisdom that combined businesses will trade at the multiple accorded the least desirable of the businesses. There is no reason to believe that DLT undervaluation will not persist until the company takes positive action to address the situation.
The need for DLT shares became even more evident with Montgomery Securities June 25th downgrade of Western Digital. This rationale provided for this downgrade would seem to mark a turning point in Montgomery's previously bullish sentiment on the industry, effectively torpedoing any near to intermediate term hope of higher price/earnings ratios for the disk drive companies. If Montgomery's premise of increased competition in the desktop business by market share oriented companies is correct, there is increased need for Quantum to distance DLT from disk drives. If they are mistaken, this is just another reminder of the perpetual negativity that surrounds the disk drive industry and the fact that small trading oriented firms dominate the coverage of the business inducing fear and excess volatility.
A spin off (or partial public sale followed by a spin off) of all of DLT is the one certain means of insuring that shareholders realize full market valuation for the combined businesses. Realizing that there may be valid strategic reasons for not taking this action, a spin off or public offering of a small part of DLT holds the greatest promise for increasing market capitalization without compromising strategic considerations.
It is significant that undertaking this action will have far-reaching favorable consequences. With shares of both Quantum and DLT trading at fair market value, it would then be possible to issue stock or convertible securities in either entity without producing an immediate loss in shareholder value. In other words, the value received for the shares will equal that which was given up.
It is also worth noting the risk of inaction. By virtue of having grown into a billion-dollar business in just several years, DLT has already achieved a level of success which very few companies have ever been fortunate enough to experience. Both computer technology and the financial markets are inherently subject to rapid and unpredictable change. There is no guarantee that passage of time will not close the window of opportunity which exists today for the recognition and financial benefits which come with such extraordinary success. It would be a shame for Quantum, its shareholders and its management if this remarkable achievement were to pass away virtually unnoticed and scarcely rewarded.
While this discussion has focussed on shareholder interests, the implications for Quantum's management of a doubling of market value are much more dramatic given the leverage provided by stock options. (I believe it goes without saying that management options should be adjusted to include a pro rata share of DLT). With DLT's standalone market value presently far in excess of that reflected by the market and growing by about $5 per share every quarter, neither management or shareholder's can afford to have DLT continue to be reflected in Quantum's share price at a discount of at least 80 percent.
I hope you will give this matter serious consideration.
Sincerely,
|
