Description

Hutchinson Technology (HTCH - $17.10; FY Sept.), the world’s leading producer of suspension assemblies (SA) for hard disk drives (HDD), is remarkably undervalued at 72% of a virtually all tangible BV, a TEV of less than four times this year’s EBITDA ( and 7.5 times EBITDA – maint cap ex) and about seven times this year’s estimated FCF. I expect significant price appreciation in 2008 and beyond based on three catalytic developments:

 

Strong earnings improvement driven by higher volume from recovery of market share that was lost last year to a competitor that priced itself to the brink of insolvency.

 

With the recent completion of a major capital program that positions HTCH to be the only suspension maker that is vertically integrated for the “next step” in trace (the electrical leads that carry data between the spinning disk and the rest of the drive) technology, D&A of about $120MM will exceed maintenance capex by nearly $60MM. The Board recently authorized a $130MM share buy-back.

 

The Inspectra medical device, ten years in development and recently costing the company about $5MM/Q ($0.13/share), is being adopted in leading trauma centers and pulled into other parts of hospitals at a faster than expected rate. This division will likely show a greatly reduced operating loss in FY 09, be approximately breakeven in FY 10 and experience viral growth in capturing a significant portion of a market potential estimated to exceed $5B.

 

A little bit about Suspension Assemblies   At the heart of disk storage is a spinning disk that holds the data and a “head” that writes and reads data to and from the disk. A suspension assembly positions the head as it literally flies over the disk, and contains the electrical circuitry over which data passes between the disk and the rest of the computer. The company Website (www.htch.com) provides ample detail as to why this is such an engineering challenge, so I will limit my discussion to a few key points. Demand for SA is ultimately determined by the demand growth for data storage offset by improvements in areal density (the amount of data that can be stored in a given amount of space) With the recent step change to PMR (perpendicular magnetic recording) from LMR, areal density is improving at a close to 40% rate, but with the recent growth in user generated content, demand for storage is growing even faster. (At its March 5 Investor Day, Intel described it as 50%+.) The disparity between these trends is the reason the most recent demand forecast for HDD raised the growth rate from 10% to 12%. Unit growth for SA should approximate this. It is reasonable to expect that pricing will be relatively stable and less of an issue than volume.

 

The most important thing to understand about SA is that as impressive as the product engineering might be, it is the ability to put the processes in place that matters most. HTCH has capacity to produce on the order of 20MM/week, which on a 24/7 basis is roughly 120K/hour. This is a trick to do. It is about having all the right disciplines, as well as tools and instruments that are so proprietary that it is better to not let anyone see them than to patent them, and to be able to undertake collaborative design work and timely re-tooling for product life cycles that are counted in months. These challenges, coupled with the volatile demand patterns of a technology in its adolescence, are why an industry segment that once had dozens of competitors is now down to three.

 

An easy knock on HTCH would be to look at its history and see that while it has had some good CF generating years, it has had to put it all back into capital to stay in the game. For example, in 1997-99, HTCH spent heavily to install the ability to produce TSA, a “make a laminate and then etch it” process to incorporate the traces into the suspension and so do away with wires that needed costly and error-prone manual attachment. This is but one example of having to step up to meet the challenge of incorporating ever more functionality into less and less space, with millions of parts produced every week to the most exacting specifications. The latest “step change” has been to supplant TSA with an “additive” process. This is necessary because suspensions have gotten smaller and the number of leads going to the head is growing from two to six or more, and this cannot be accommodated with a “subtractive” process like TSA. In FY 05 to 07, HTCH spent close to $300MM above maintenance levels on capacity, in part because rapid growth in demand caught the HDD industry a little short, but also to install capacity for the “additive” process. This capacity is now up and under going qualification for customer programs that will likely commence in volume toward the end of FY 08. Capex is expected to about $75MM this FY, slightly above maintenance levels, and based on current industry growth projections, should remain there for 2-3 years at least. It is also likely that based on the outlook for areal density growth (based on PMR and beyond), head size shrink, and other factors, that whatever step changes, if any, HTCH needs to spend for will be modest in nature.

 

If you look at the history, you will see that HTCH has been in a difficult business that destroyed most of its competitors. The SA industry is now down to HTCH, NHK and TDK. NHK is a Japanese maker of precision springs and according to HTCH has been a rational competitor for over twenty years. TDK entered the business in late 2007 when it purchased Magnecomp. Only a couple of years ago, Magnecomp, a subsidiary of a Bangkok listed Magnetech, purchased the assets of KR Precision. This attempt at industry consolidation got off to a promising start but then started to struggle with manufacturing and customer qualification issues. In an effort to stay in the game, they cut prices on 3.5” ATA product to a point that HTCH walked away from some market share. By late 2007, TDK stepped in and bought the assets. TDK is a formidable company whose core competency is understanding ferrites, the basis for their leadership in read/write head technology. Like NHK, its balance sheet and recent earnings strongly suggest that they are smart business people. Most likely, the reason they bought it was to protect this franchise. It remains to be seen how long it will take them to fix the production assets of Magnecomp (it will require significant additional investment), but what I think we can count on is that going forward, the SA industry is likely to be dominated by three strong and rational players.

 

Earnings Outlook HTCH is presently under earning its potential for a couple of reasons that will dissipate over the next few quarters. It boils down to capacity utilization, which is presently at about 75% (based on the processes involved and seasonality, “capacity” should be treated as an approximation rather than an absolute.) This was partly due to additions made at the behest of customers following tight conditions in 2005, partly due to the installation of the “additive” process, and partly due to HTCH having walked away from some market share in its largest (normally 60%+ of volume) product segment, 3.5” ATA used in desktop computers and consumer products like DVRs. The good news is that drive programs are supplanted with a next generation program every nine months or so, and HTCH is on the next generation programs. Management has indicated that based on this, if the Dec Q was not the market share bottom, March will be. The volume improvement trend might be obscured by the fact that June is the slowest Q of the year for HDD production, but certainly by September, HTCH will see improved volume. This will translate into improved capacity utilization and so a higher gross margin. (Gross margin has also been helped by a cost reduction program implemented in late FY 07 that reduced operating expense by about $35MM/year.) Coupled with the growth that should come from HDD industry growth on the order of 12%, capacity utilization is likely to trend significantly higher over the next several quarters.  Based on this, I am estimating that HDD revenue will trend from about $700MM in FY 08 (not much changed from 07) to about $850MM in FY 09 and $960MM in FY 10. SA gross margin, which exceeded 27% as recently as FY 05, is estimated to improve from 19% to 21.5% to 26% in FY 09. I presently estimate this will translate into an EPS progression from about $0.44 this year to $1.54 next year to better than $3.00 in FY 10, although some of this improvement will be driven by the other two catalysts.

 

Cash Piling Up As of December 31, 2007, HTCH had $320MM in cash and securities and $378MM in debt. This debt consists mainly of two issues: $150MM 2.25% Notes due March 2010, convertible at $29.84 and callable as of March 20, 2008, and $225MM 3.25% Notes, convertible at $36.43, callable as of January 2011, and due 2021. Having seen countless competitors and customers fall by the wayside over its 40+ year history, HTCH has made it a point to keep enough cash on hand to get through a season of adversity. Now, for the first time in its history, the need for this “cash cushion” is at least debatable (based on the apparent maturing of the technology and the consolidation of the supply chain), and appears more likely than not to decline in the years just ahead. With ample capacity in place, D&A is expected to be about $120MM this year, capital spending will be about $75MM. Management not only expects net income to improve as a function of increased volume from drive programs that HTCH is presently qualifying for and otherwise helping to design, but they expect capital spending to remain close to the maintenance level for a few years at least and see no reason why it should ever be significantly (i.e., to the degree it was in FY 06) above the maintenance level again (because whatever technological step changes remain for HDD will be incremental in nature).   This means that even without the income improvement that appears likely to occur, HTCH would enjoy an extended season of FCF.

 

On February 4, the company announced a $130MM share repurchase authorization. Not only will they be able to under spend D&A for the next few years, but the stock price is at a discount to book value (which has almost no intangibles) that is a great as it has ever been, except in 2000 when the entire tech segment faced a far bleaker near term future than it does today. I get the distinct sense that management views this as an opportunity, so I deem it much more likely than not that share repurchase will have a positive effect on both book value and future EPS. Even at the depressed level of earnings I estimate for FY 08, FCF should be about $58MM, which coincidentally is the company’s “net debt” as of 12/31/07. I think it would be reasonable to expect the basic share count to be reduced by a few if not several million over the next year or two. If, as I expect, earnings recovery lifts the share price to the neighborhood of $30 in the next year or two, HTCH will be able to retire the 2.25% Notes and bring the fully diluted share count closer to the basic count. This will be all to the good when the earnings estimates for FY 10 and beyond start to appear and figure into the Market valuation, and it will be in this timeframe that the third, and potentially largest, catalyst starts to work its way not only into EPS but into the P/E multiple as well.

 

Avoid Shock, Save Money At least ten years ago, HTCH started looking for ways to leverage its considerable expertise. They developed Inspectra, a near infrared based sensor that non-invasively measures oxygenation in body tissue. The technology and the clinical evaluations are all well covered on the company Website. What the investor needs to know is that developing and now marketing this product has been a drain on earnings that will not last forever. When I first got involved with HTCH, the thinking was that they could always get a pop in earnings by “pulling the plug” if it didn’t work out. The product has been on the market for about a year, and as expected the adoption cycle for a new product like this runs the better part of a year, but there have been definite signs that this is on its way to success.

 

InSpectra is important because the drop in tissue oxygenation it detects has been shown to be an excellent indicator that a trauma patient is going into shock. (The sensor goes on the base of your thumb, and your body knows to shut down your extremities and favor your core vital organs when something really bad happens.) Outcomes are improved, and since trauma centers generally lose money when a patient goes into shock (they tend to get a flat rate per patient), the indication that InSpectra provides enables the doctor to take actions that stabilize the patient before they go into shock and so more than pay for making InSpectra part of a standard of care. The product consists of a monitor that goes for about $16K and, importantly, a single-use sensor that sells for about $150. The gross profit margin on the sensor, which HTCH can assemble on-site with very little capital outlay, is on the order of 75%. For the first two years (the product was launched at the end of CY 06) this hardly makes a dent in the considerable expense of the sales professionals that HTCH has hired to cover leading trauma centers in the US and Europe and the studies they are sponsoring, but this should start to change in a meaningful way in FY 09.

 

As of December 31, InSpectra had been installed in about a dozen hospitals, and about seventy additional evaluations were underway. One of the most encouraging developments is that interest from other parts of hospitals, such as the ER and some surgical applications, is driving additional trials. Management expected this to occur eventually, but not as quickly as it has turned out. Anesthesiologists have joined the ranks of a small but growing corps of Inspectra “champions”, which is helping to broaden the market beyond the ER and into the OR. Having been in the market for a year and gotten a better handle on the value proposition (better outcomes and significant avoided costs from monitoring for this new vital sign), HTCH has increased its estimate of the market potential. Recent public presentation data puts the market opportunity at $5.3B, and includes scenarios, based on moderate market penetration, for $2B+ in revenues and operating income in excess of $500MM.

 

As optimistic as I have become about Inspectra, its prospects are more relevant to the future decision of when to take some money off the table than it is in deciding whether HTCH is undervalued today and likely to appreciate in the year ahead. If you do buy the stock, you should follow InSpectra closely, but HTCH does not need success here for the stock to find its way back above book value over the next year or so. However, there is one more aspect of this that is worthy of comment. One thing that would make the SA business much better in the future than in the past would be if all three producers (HTCH, NHK and TDK) are financially flexible and, in dealing with the customers (Seagate, Western Digital, Hitachi, Toshiba, Fujitsu and Samsung) can “say no and mean it”. NHK can do so because of their position in the world of precision springs. TDK is similarly situated in head technology and other applications of its ferrite technology. HTCH is the clear leader in SA (the share loss in 3.5” notwithstanding, they utterly dominate the enterprise segment and lead in mobile as well) and with the “additive” process in place are about to become more so, but having another source of income from Inspectra would solidify their ability to “say no to a customer and mean it”.

 

What can go wrong? The biggest concern I would expect an investor at the margin to have is that being a HDD component maker has been a difficult and ultimately unprofitable business since the beginning. I believe that this is one of those industries that takes forever doing it but eventually consolidates down to where a few rational survivors can do well for an extended period of time (e.g., the carpet industry in the US). It is possible but not probable that NHK or TDK will choose to be irrational as opposed to profit minded. The other concern that I hear is that the HDD will be supplanted by flash memory. I would argue that at present, flash is actually boosting HDD demand by facilitating all that user generated content that needs to be stored, archived and shared in ever increasing exabytes. No one is arguing that flash is going to be making meaningful inroads against HDD in the applications that matter any time soon. (Both Seagate and Intel will tell you that the high performance slice of the enterprise market is, at present, the most compelling segment for flash in-roads, but this is application would seem to be where the read/write limitations of NAND, which get tougher with every node shrink, would matter most.) We can expect hybrid drives incorporating a bit of flash into an HDD, but for the foreseeable future, reference Apple’s latest notebook. It is available with either an HDD or an SSD. An extra $1000 gets you the same weight and profile, much less storage capacity and five more minutes of battery life.

 

Bottom line, if you are paying a single digit multiple of FCF for a company that has an arguably “too strong” balance sheet and is one of a very few companies that can make a product that is essential to how we live and not going away any time soon, the future can be an awful lot worse than I expect and you should still make money. Even if earnings were to remain closer to their present depressed level than to my expectations for the next few years, and even if flash memory were to some how get to a value proposition that HDD demand stops growing a few years from now, a TEV of less than $500MM and EBITDA well in excess of $100MM means that things have to go awfully bad awfully fast for the owners to not get their cash back in just a handful of years.

 

My Expectation: While the Street will probably take a “wait & see” until they see signs that the seasonally slow June Q is not a disaster for the tech sector, I expect that clear signs of market share recovery will translate into a much higher share price during 2008. Simply regressing to a traditional 1.2 times BV would put the stock closer to $30 than to $25. If, when the “these guys aren’t going out of business after all” sign appears, the short interest is still at its recent 3.7MM shares, much of this appreciation is likely to take place over a couple of days. Longer term, my biggest concern is that a large medical instrument company takes InSpectra from us before its potential is more publicly evident. If HTCH can remain independent and InSpectra realizes a meaningful fraction of its potential, I would think of the long term appreciation potential in terms of a premium multiple on $5.00+ in EPS. Of course, given the FCF and their flexibility and motivation to use it, it is not worth putting too fine a point on future results on a per share basis. Suffice it to say that at less than 75% of BV and about seven times FCF, the appreciation potential is more than enough to justify the risk to the downside.

Catalyst

Three noted include an earnings recovery based on a volume recovery that is essentially programmed in, recent completion of capex program has allowed company to authorize big buy back; a new product, 10+ years in development and a drain on earnings, is showing promising signs of being a big winner.