Description

Seagate Technology PLC (Ticker: STX) is a large-cap data storage company that has traded down to a very reasonable 9.8% EBIT/TEV yield, and a P/E under 12x. The stock has had a phenomenal run, more than doubling from the lows of 2016, but over the last few months has pulled back sharply, due to intense price competition in the market.

We think the sky is not falling, the selling pressure on STX is overdone, and today’s price represents a reasonable entry point. STX has become too cheap, when compared with numerous signs that the company is of very quality, and is doing well from a number of perspectives.

STX provides a variety of data storage and technology solutions, designed for enterprise servers and storage systems. STX’s principal business relates to hard disk drives, or HDDs, which are devices that store data on rotating disks with magnetic surfaces. HDDs comprise approximately 92% of STX’s revenues, so the company’s prospects are very closely tied to what happens in the HDD market. The company also produces solid state drives (SSDs), and solid state hybrid drives (SSHDs).

HDDs use an arm with a read/write head to read magnetically coded information on a spinning storage platter. Early incarnations of HDDs were around as early as the 50s and 60s, when IBM offered them commercially. Information stored on an HDD is preserved even if you turn off the system.

SSDs are different from HDDs, in that there are no moving parts to an SSD. SSDs consist of flash memory chips that, as with HDDs, retain information with no system power. They became common in the 2000s, with the advent of smaller notebooks.

SDDs are much faster than HDDs, allowing a PC to boot up in seconds, and they run apps faster than do HDDS. They also don’t use much power. Since they lack moving parts, they are quite durable. Hybrids obviously combine elements of both HDDs and SDDs.

Bear case

Since SSDs are growing in popularity, and offer a better storage technology solution than HDDs, with strong market growth characteristics, competitors have rushed in to supply the SSD market. Leading global players and their market share %, include Samsung (33%), SanDisk/Western Digital (13%), Toshiba (10%), SK Hynix (10%), Micron Technology (9%), Kingston (7%), Intel (7%) and others. These are formidable, well-capitalized competitors.

Due to this intense competition, SSD markets have recently become oversupplied, sending prices tumbling. As SSD prices have fallen, incumbents have lost all pricing power, pressuring top line growth as well as margins for many market participants. Falling NAND (flash memory) prices allow SSDS to eat into existing HDD market share. Makers of HDDs must follow suit and reduce prices to stay competitive. Equity analysts have taken note: Recently, Evercore ISI downgraded STX, which followed a Goldman downgrade in August.

If SSDs are oversupplied, and getting cheaper, woe be to the investor who is long HDDs.

Bull Case

To paraphrase Mark Twain, reports of the demise of HDDs have been greatly exaggerated. Although SSDs are coming down in price, they are still more expensive than HDDs. Additionally, critically, they are arguably not as strong a solution with respect to capacity. If you have longer-term storage needs, or large files, HDDs offer a distinct advantage.   

Thus, while the conventional wisdom is that HDDs will be phased out and replaced by SSDs, the rapidly growing demand for storage effectively means that HDDs will continue to serve many laptop, desktop, enterprise and other markets for many years.

The bull case is based on the idea that even though SSDs offer a competitive alternative, there is still so much near-to-intermediate term growth in storage demand, that HDDs must play a significant role.

Trends

The International Data Corporation (IDC) forecasted that the global datasphere will by 2025 grow to 163 zettabytes, which is ten times the 16.1ZB of data generated in 2016. IDC further estimates that the percentage of data in the datasphere that is processed, stored and delivered via the cloud, will nearly double between 2016 and 2025. There are a number of trends driving this growth.

Data will be increasingly “life-critical.” Consider, for example, that a PC crash that causes us to lose a spreadsheet is irritating, but it is of a different order of magnitude of importance to us if it causes a problem with a self-driving car.

Applications for embedded computing in endpoint devices and the Internet of Things are exploding. Consider such devices as security cameras, smart meters and other building automation, Amazon Echo, and smart automobiles. All these increase people’s interaction with data.

Increasing connectivity is also related to mobile access and real-time responses. By 2025, 75% of the world’s population will be connected, including currently unconnected groups such as children, the elderly and emerging markets.

Artificial Intelligence is also changing the storage landscape associated with cognitive systems. AI-based agents for insurance companies, machine learning for cancer research, facial recognition, and fraud detection at credit card companies are a few of the emerging applications.

The percentage of data requiring security will near 90% by 2025. The proliferation of information requiring security for various reasons (e.g., simple email privacy, compliance-driven (discoverable), custody of account information, financial transactions, medical records, etc.) creates new demands on storage functions.

These are some of big-picture market dynamics that shape the market for HDDs.

Revenues

Over recent history, the company’s products seem to be growing reasonably, although not spectacularly. For fiscal 2018, Revenues for STX were up 3.8% YoY, with the last three quarters exhibiting quarterly YoY growth. Again, HDD sales make up ~92% of total Revenues, and HDDs were up 4.5%. Will the trends discussed above help support this growth in HDDs? We think they will.

Franchise Value

A franchise possesses some sustainable competitive advantage. If a business earns sustainably high returns on capital over a long period of time, it may indicate the business is a franchise.

One metric we like to use to assess franchise characteristics is long-term (8 year) geometric ROA, since we believe this represents the persistence of a company’s ability to earn high return on assets over a business cycle.

STX’s 8-year geometric ROA (net income / assets) is 13.7%. That’s impressive and strong enough to place it in the top 10% of all tradeable stocks in our universe.

We also focus on long-term (8-year) Return on Capital, which we define as: EBIT (1-tax Rate)/(Debt + BV Equity – Cash). Again, we use a geometric average of ROC, which in STX’s case is a robust 20.0%. As with our long-term ROA metric, 8-yr ROC places STX in the top 10% of all tradeable stocks.

Perhaps a firm has a complicated capital structure, or other reason that creates inconsistent returns along one of those metrics. But if a firm succeeds over a longer term as measured using both metrics, we think that demonstrates consistency in returns and increases the odds that the firm is in fact a franchise. STX appears to have performed exceptionally well along both long-run return metrics. That’s unusual.

Another indicator of the persistence of strong returns is free cash flow generated over an 8-year cycle. We think such a longer time frame can reflect a company’s ability to generate cash on its investments. We scale this metric by total assets, which sheds light on the company’s efficiency in generating cash, as compared with its asset base.

Over trailing 8-year period, STXs Free Cash Flow was $15.5 billion, compared with Total Assets of $9.4 billion, for a remarkable 144% of total Assets, which places in the 99^th percentile of all tradeable stocks on this metric. That’s remarkable.

Consider some other companies, with comparable metrics, that are also in the 99^th percentile: Mastercard, 189%, Intuit, 131%, Verisign, 172%, Domino’s Pizza, 172%. All these companies are cash cows, but trade at EBITDA/EV yields that are less than half of that for STX. We think that’s compelling from a valuation perspective.

Gross Margins

The company has grown its gross margins substantially over recent history. 8 years ago, the firm’s gross margin was under 20%, but over the past 12 months its gross margin exceeded 30%.

Current Operating Trends

STX’s 2018 ROA (net income / total assets) was 12.6%, an increase over the prior year. On our FCF/Assets ratio, STX over LTM returned 18.6%, also an increase over the prior year. The company increased its gross margin in fiscal 2018 versus 2017.

We also like to examine the asset turnover ratio (sales/beginning of the year assets), as a means of assessing the company’s efficiency in using its assets to general revenues. STX’s turnover increased in fiscal 2018, as compared with fiscal 2017. These are all positive trends.

The company is also paying down debt. During fiscal 2018, STX repurchased $214 million of outstanding debt. The company is also a net repurchase of shares, repurchasing 10 million shares for $361 million during fiscal 2018. STX also paid cash dividends of $726 million during the year. We think that’s pretty shareholder friendly and may demonstrate the discipline of the managers.

In short, STX is doing a lot of things right, and it appears to have significant operating momentum.

Patents

STX has approximately 6,000 US patents, with 1,00 pending, and 1,400 patents outside of the US, with 600 pending. This patent portfolio, representing STX’s core intellectual property, offers numerous benefits, including the potential to protect market share, develop new revenue streams, and discourage infringement. We like this intangible aspect of the business.

Summary

STX represents an opportunity to pick up a very good business at a price that has been driven down too far, due to an overreaction to deteriorating product pricing fundamentals. Its 9.8% EBIT/TEV yield is higher than that for 90% of stocks in the market. That’s cheap.

Meanwhile, there are strong storage demand trends in place, including emerging requirements for self-driving cars, IoT, mobile, AI and Security, that support a case for the continued use of cheap, high-capacity HDDs. STX appears to have a franchise, as it demonstrates extremely high long-run returns on capital and assets. It has been a prodigious cash generator over time. It has grown its gross margin significantly over time. The company seems to be doing many things right: multiple key metrics are improving, it has paid down debt, bought back stock, and paid out a lot of dividends. It’s got a nice patent portfolio.

We think that over time the company’s long-term metrics will continue to assert themselves. This is a good business you can buy at a reasonable price today.

Catalyst

- Strong demand trends in storage

- Long-run ROA and ROC

-Cheap