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Are Hard Disk Drive Makers Really That Cheap?
Posted by: Magic Diligence (IP Logged)
Date: January 11, 2013 06:05AM
The two major hard disk drive (HDD) makers, Seagate (STX) and Western Digital (WDC), have been perennial Magic Formula Investing (MFI) stocks for years. Good ones, too. Both are up over 55% over the past 5 years, handily outperforming the S&P 500. The past 12 months have been particularly fruitful, with Seagate more than doubling and Western up 40%, easily exceeding the market's 11% return.
Yet, by most valuation metrics, both stocks continue to look very cheap. At $44, Western Digital's P/E ratio is just 5.8, price to free cash flow is 4 times, price to sales is 0.8, and the MFI earnings yield is a very high 25%. The numbers are similar for Seagate at 4.4, 3.9, 0.86, and 24.7%, respectively. Both companies now pay dividends - Seagate paying a 4.5% yield at 12% of free cash flow, and Western a 2.3% yield at about a 9% payout ratio. To put this in perspective, the S&P 500 has an cumulative P/E ratio of about 14, roughly a 9% MFI earnings yield, and pays a 2% dividend.
The drive makers are even cheap against the group of large-cap stocks in MFI. The average earnings yield of the "top 30 over 3 billion" MFI screen is 15.4%.
Given this, WDC and STX on the surface look like intriguing MFI investments. But we need to do some "magic diligence" to be sure.
The Market has Never Liked Us
The first thing we need to tackle are the valuations. Comparing the P/E and earnings yield against the market isn't a great yardstick. For many years now, concerns over flash-based technology overtaking HDDs and industry volatility has kept valuations in the space low. Over the past 5 years, WDC has carried an average earnings yield multiple of 23.3% and a price-to-sales ratio of 0.76. Seagate's figures are 17% and 0.64, respectively. When you consider this, current valuations don't look nearly as enticing.
Keep in mind too that profitability has always been a roller-coaster ride for HDD makers, given unpredictable supply and demand balance. Over the past 10 years, WDC's gross margin has fluctuated between 15% and 30%. STX has been between 14% and 31%! Look at those ranges and then look at the trailing 12 month figure for each stock: WDC at a 31% gross margin and STX at nearly 33%. Both companies are currently delivering decades-high levels of profitability.
Put simply, the HDD makers are operating at historically unsustainable levels of profitability, but their stock valuations are only slightly below historical averages.
The Changing HDD Landscape
The next question to ask is: has something fundamental changed that would allow these high levels of profitability to continue indefinitely? If so, we can justify expecting a higher valuation for these stocks in the future.
There have indeed been seismic shifts over the past 14 months. In December 2011, Seagate closed its purchase of Samsung's HDD business. Western Digital followed soon after, buying Hitachi Global Storage in March 2012. Together, these two moves consolidated what was a relatively fragmented market. Western and Seagate now operate an effective duopoly, controlling 87% of the global HDD market. Fewer competitors means more rational pricing and better balanced supply/demand, which should ensure better-than-historical profitability for both firms.
How much better remains a question, though. Gross margins really took off for both firms in CYQ3 of 2011, when floods in Thailand literally sank a major production facility for WDC, crippling production capacity and causing unit prices to increase over 20%. While pricing has held up pretty well over a year later, I expect it to moderate going forward, which will mitigate some of the consolidation advantages.
Growth Potential is Limited
Few will argue that the prospects for HDD unit growth are mediocre at best. HDD units are expected to decrease 5% this year, the second straight year of decline, an industry first. PC shipments in 2012 were down over 6% in each of the last 2 quarters. Flash memory-based tablet sales are expected to easily outpace notebooks in 2013 - to say nothing of the plethora of flash-driven ultrabooks coming into the market.
Long story short... the long-awaited replacement of HDDs with flash is finally happening, and rapidly. With consolidation behind them, it will be difficult for Western and Seagate to maintain unit volume, much less grow it substantially. For growth, it will have to be expanding margins and share buybacks. The latter is a Seagate specialty. They have averaged a 5% share count reduction over the past 5 years and are aiming to reduce share count from 400 million to 250 million over the next 2 (!) years. Western Digital has not bought back much stock, historically, but this has been changing recently.
Putting It Together
MagicDiligence believes higher gross margins are here to stay, but expects some pullback due to the flood issues subsiding. I've targeted a 29% figure for WDC and 30% for STX. That implies an average unit price of about $62-64 for both firms - above historical levels but below recent peaks.
My unit growth expectations are quite modest. Near term (next 5 years), I've modeled it at 0%, and even that may be generous. Longer-term, I think it declines 5% annually before plateauing off. I know these companies have some SSD exposure and SSD/HDD hybrid drives, but I see these as just "treading water" products that are unlikely to be growth catalysts.
Shareholder cash returns should be solid going forward. Seagate is liquidating a large portion of their float and Western's share buyback activity has picked up. Dividend raises from both firms are highly likely given low payouts of free cash flow.
Western Digital clearly has the better balance sheet. Cash outpaces debt, $3.5 billion to $2.1 billion, with a 0.26 debt/equity ratio, vs. Seagate's $2.4B to $2.9B (0.82).
Lastly, I've pegged a target pre-tax EBIT/EV earnings yield of 20% for STX and 21% for WDC, a bit better than their historical norms.
This leaves my price target for WDC at $53 and STX at $34, a 20% and 1% upside, respectively. Neither margin of safety really piques my interest, although WDC looks like the better buy, mainly due to its stronger balance sheet.
Stocks Discussed: STX, WDC,
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