Fusion-iO (FIO), one of the more controversial companies in our coverage universe, posted fiscal second quarter results last Tuesday. As we pointed out to investors in this note, the firm could be a revolutionary company with a very bright future. However, due to a weaker gross margin outlook as well as share dilution from the December secondary offering, we have lowered our fair value estimate on Fusion-iO to $15 per share, significantly lower than its mid-$20s price tag currently.
Our biggest concern about the firm is deteriorating levels of profitability. For one, Fusion iO’s gross margin in its fiscal second quarter came in very light, at around 51%, while consensus expectations were at least 400 basis points higher. This number was also down 770 basis points from the same quarter last year, mostly as a result of a product shift.
Second, we also have an issue with the firm’s customer concentration risk. Fusion-iO is overly reliant on Facebook and Apple (AAPL), which generated the vast majority of its sales. Though fiscal second-quarter sales did grow an impressive 169%, to $84.1 million, from last year’s quarter, the net loss in the period nearly doubled to $5.4 million, from $2.7 million. Earnings-per-share wasn’t as negative, but that was entirely due to a significant increase in the number of shares outstanding, not as a result of improved profitability.
That said, there were some positive takeaways in the quarter. The company signed a reseller agreement with Digital China, which will allow Fusion-iO to enter a rapidly growing Chinese IT infrastructure market. Additionally, the company generated $13.5 million in cash from operations in the second quarter, leaving it with net operating cash flow (before capital expenditures) in the first half of its fiscal 2012 of $16.6 million. Generally speaking, our biggest issue with high-multiple companies is the lack of cash-flow conversion, but that isn’t much of an issue at Fusion iO. The firm has been free cash flow positive thus far in its fiscal year, while still making over $10 million in capital investments through the first six months of fiscal 2012.
We also believe the company is making strides in producing better and faster technology. With the high latency from legacy servers, we think the addressable market for Fusion iO’s product remains enormous. Still, we’d like to see a broader customer base, better traction with respect to profitability, and a more attractive valuation before considering Fusion-iO in the portfolio of our Best Ideas Newsletter. However, we continue to keep a close eye on the firm.