Description
Seagate is the leading player in an industry that has seen significant structural improvement over the past five years. Due to cyclical concerns, the stock has traded below 7x trough earnings (and <5x mid-cycle earnings). As the industry adjusts production to match demand, pricing / margins will stabilize and structural improvements to the business will become apparent. Seagate should have mid-cycle earnings power of >$2.50/share, which at a 10x multiple would give us a $25 stock, up >115% from today.
Business
Seagate builds hard disk drives. Making drives requires assembly of media (aluminum or glass disks), heads that read/write to the disks, pre-amps, motors, and read channel / controllers. Each generation must be developed, tested, and qualified with key customers in a 12-24 month cycle.
While this is a relatively straightforward business, it is by no means easy and requires continuous R&D to keep up with the pace of technology and improving the density of storage. Seagate's revenue is 30% Enterprise, 40% Desktop, 22% Notebook, and 8% Consumer Electronics. Seagate has ~30% market share, tied with Western Digital at ~30%, and ahead of Hitachi Global Storage Technologies (formerly IBM) at 18%.
Consensus View
- HDD industry is cyclical, ruthlessly competitive, and generally a bad business
- HDDs are in freefall now due to weak PC trends, growth of tablet computers led by the iPad and heightened competition
- Solid State Drives will replace need for HDDs, especially in notebooks / tablets
Alternative View
- This is a much better business than investors understand; 5-year ROIC ~20%
- HDD makers remain very flexible-STX was FCF+ in all but one qtr of recession - and that was due to self-inflicted wounds made by previous management
- Industry consolidation has led to much faster responses to weakness; trough should be shorter/shallower than in past cycles
- SSD is not a viable threat to HDDs given sustained cost disadvantage - particularly in the enterprise where flash drives will create increased need for HDD's to store the additional data output enabled by faster cloud and other online computing
- Tablets (ex iPad) will soon have 7mm hard drives to store consumers' videos, music, pictures, etc. As well, HD video will drive increased data storage needs.
- STX management is focused on generating FCF and buying back stock
Catalysts
- Stabilization of pricing / margins in Sep and Dec qtrs as production adjusts to demand
- Sustained share repurchases
Risks
- Weak PC trends persist, leading to reduced demand and oversupply of HDDs
- Continued production growth from Hitachi hurts pricing / margins
The HDD Industry Is Much Better Than Investors Appreciate
Returns on capital for the HDD industry are quite good, and significantly better than investors appreciate. Seagate's ROIC has been volatile, however trailing 5-yr ROIC has been in the mid-teens, and returns on tangible capital ~20%.
FYE June 30, 2006 2007 2008 2009 2010E
Return on Invested Capital 13% 11% 20% 0% 33%
Return on Tangible Invested Capital 22% 16% 30% 0% 37%
Last 5 yrs ROIC 18% 15% 15% 13% 16%
Last 5 yrs Return on Tangible Inv Capital 22% 20% 22% 17% 21%
In addition to good returns through the cycle, financial performance in downside situations was much better in this last recession. Despite being seen as a highly cyclical business, Seagate only lost money in the December '08 and March '09 quarters. In the March '09 quarter, STX actually generated $185m of cash due to destocking. In the FYE June '09, revenues declined 23% but Seagate generated +$107m of FCF. Again, previous management created the weak quarters through poor strategic decisions. Western Digital did not lose money nor bleed cash.
The HDD Industry Is In Final Stages of Consolidation
Over the past decade, the HDD supply chain has consolidated both vertically and horizontally. Seagate and Western Digital now control ~30% mkt share each, and both internally source the majority of their heads and media. Hitachi also is mostly vertically integrated, but has only ~20% drive share and ~12% head/media share. The remaining two producers, Toshiba and Samsung, rely completely on merchant heads and media.
The upstream supply chain has consolidated as well. TDK is the only merchant head manufacturer. LSI and Texas Instruments are the only preamp makers, while the read channel/controller segment is consolidating on just LSI and Marvell.
Industry consolidation makes it significantly easier for HDD makers and their supply chain to manage inventory. Also, the supply of key upstream components (especially heads) regulates potential capacity additions by weaker players. If TDK doesn't increase capacity, Toshiba and Samsung cannot grow production.
As shown by the pricing environment in the last quarter, the HDD market is clearly not totally consolidated and there will continue to be inventory adjustments, however they should be shorter and less severe than in the past. In May, all the HDD vendors cut build plans to adjust to weakening end demand, however excess supply still needed to be worked through the chain and pricing was down sharply for certain key products. Since then, several datapoints (most recently MRVL) have suggested that the HDD inventory adjustment has ended. While in the past, and inventory correction took ~2 quarters and had a severe negative impact on margins, this correction should be only ~1 quarter and only take the HDD makers to the bottom of their targeted gross margin range.
Solid State Drives Are Not a Significant Threat
Solid state drives are very useful for a sub-segment of the market, but are years away from becoming mainstream. Currently, a 160GB SSD costs $400, vs $40 for a 160GB HDD. Seagate estimates that this market will take ~5 years to develop, and even then will only address a fraction of units shipped. Other research supports this thesis
The numbers behind a transition to flash also show the challenges behind widespread transition to SSD. Analysts estimate that it would cost ~$100-140b to build capacity to replace all the HDD storage to flash. Using typical capex/sales ratios, this would require the SSD market to be >$500b vs ~$30-40b HDD market. And when building for the masses (and consider the growing middle class around the world - NOT just the US) as well as enterprise storage that has front-end flash drives for performance, zippy and light flash drives are not neccesary and much too expensive.
Seagate just released hybrid SSD/HDDs. These devices use ~$10 of flash, deliver most of the performance advantages of flash, and have the storage capabilities of a hard disk.
Seagate is Aggressively Repurchasing Stock
Seagate has been very aggressive in repurchasing stock, including 32m shares YTD. Given current valuation, the Company is able to significantly reduce the share count with these repurchases. Also note that unlike Western Digital, Seagate's tax structure allows the company to use its cash to do buybacks/dividends without running into onshore/offshore cash issues.
Seagate's CEO has been very good at trading the stock. He ended up with a sizable stake when he took STX through an LBO in 2000, then sold >$40m in 2006-2007 in the mid-$20's. In 2009, he bought 1m shares between $3.50-4.50, and another 100k at $12.38. He owns 5.9m shares and has 3.5m in-the-money options, or $90m in equity at $11.
Catalyst
1. Margins troughing in the 20-22% range will show sustainable profitability
2. Growth of PC/notebooks - despite further tablet growth
3. Use of 7mm hard drives in tablets might change investor psychology (and thus the multiple)
4. Increased growth of hard drives into the enterprise - represents a disproportionate amount of STX's profitability
5. LBO - recent rumors of a LBO at $14 - a price that seems materially below what the CEO thought the company was worth only a few months back. But it would be a great deal for management.