This Fallen Tech Star is Poised for a 45% Rally

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For the past 20 years, you've been working on computers that store information on hard disk drives. These turntable-like devices, made by companies such as Western Digital (WDC) and Seagate Technology (STX), have benefited from tremendous improvements, enabling these drives to hold ever-larger amounts of data.

But the disk drive era may soon be coming to an end. Flash drives, which have no moving parts, consume less power and can be made in small form factors, are a much better choice for today's electronic devices. They are in your smartphones, tablet computers, and increasingly, traditional desktop and laptop computers.

The disk drive makers see the writing on the wall -- and they're breaking out their checkbooks. Western Digital, for example, has acquired three companies over the past four months that possess flash drive expertise: Virident, sTec and VeloBit. Indeed, it was the $685 million purchase of Virident in September that caused investors to take notice of the fact that few standalone flash memory firms remain available, now that this niche is rapidly consolidating.

If Seagate (or any other technology firm) wants to establish a meaningful presence in flash memory technology, it needs to move quickly. And that has led to speculation that flash storage provider Fusion-io (FIO) is next to be acquired.

Judging by recent transaction prices, FIO could get a bid in the low $20s, or about 50% above the current price. In my view, shares are worth almost that much even if no such buyout emerges.

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FIO Stock Chart

FIO has not built the strongest reputation on Wall Street. Shares traded as high as $40 in 2011, thanks to lucrative relationships with Facebook (FB) and Apple (AAPL). But in recent quarters, the company has been slow to add new marquee customers.

As a result, a company that boosted sales from $10 million in fiscal 2009 (ended in June) to $360 million by fiscal 2012, a compound annual growth rate of 230%, saw sales growth slow to just 20% in fiscal 2013. Few analysts now expect the company to exceed 20% annual sales growth in the years ahead.

Yet these forecasts incorporate a fairly myopic view of industry trends. Engineers at many leading tech firms are still tinkering with flash storage solutions, and this technology is not quite in the mainstream. FIO is suffering from the traditional growing pains of an immature market, but its technology leadership is still unquestioned.

One of the knocks against this company was a seemingly limited product line that required customers to configure other suppliers' tech components around FIO's flash devices. That was a strategy that worked for huge clients like Facebook and Apple that buy so much hardware that they have the expertise to configure and optimize their hardware components in house. Smaller companies lack that ability.

In response, FIO recently unveiled a much broader set of products that are much more easily configured.

"Fusion has built out its product line to include six flash card products (ioMemory), two virtualization accelerators (VDI and server VMs), and two shared flash accelerators (ION and ioControl). This portfolio approach is taking a page out of EMC's go-to-market book," noted UBS (UBS) analyst Steven Milunovich, who has a "buy" rating and an $18 price target on the stock.

Milunovich thinks the enhanced product line, coupled with the recent industry consolidation, set the stage for a buyout. "We think the likelihood of acquisition has increased. Flash is the hottest technology in enterprise computing, but Fusion needs to improve execution before competitors catch up," he said.

So what kind of offer might FIO receive in a buyout? Well, Western Digital paid roughly six times sales for Virident. FIO currently trades for around three times trailing sales. An apples-to-apples purchase would yield a $27 a share buyout. That's likely too high, as it would entail a $2.7 billion price tag, which would be pretty stiff for Seagate or others. Instead, a purchase price in the $20 to $22 range seems a lot more realistic.

In the context of UBS' $18 a share fundamental valuation for FIO, and the slightly higher price the company might receive in a buyout offer, a $20 six-month target seems reasonable, which is about 45% above recent prices.
 
Recommended Trade Setup:

--Buy FIO up to $15.50
-- Set stop-loss at $11
-- Set initial price target at $20 for a potential 29% gain in six months

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