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Seagate Technology: Flooding Profits

February 16, 2012 | About:
The Company

Seagate Technology (STX) is a company involved in the design, manufacture, marketing and selling of Hard Disk Drives (HDD).

They produce HDDs for enterprise applications (e.g. enterprise servers), client compute applications (mainly for notebooks), and non-compute applications (e.g. portable devices).

Seagate reported latest quarterly results (second-quarter fiscal year 2012) on Jan. 31, 2012, posting an impressive (diluted) EPS of $1.28, compared to an EPS of just $0.31 (around one-fourth) for the second-quarter of last fiscal year.

What is the reason behind such an incredible jump? Someone could think to increased volumes, but in the second quarter of last year Seagate shipped 48.9 million hard disk drives, slightly more than the current number (47 million).

Someone is wondering if the management implemented some form of cost cutting, but if we look at the cost of revenue (keeping in mind that shipment volumes are very similar) both quarters show the same number (around $2.2 billions), so this is not the case.

We can go through a long list of complicated reasoning, but the reason is very simple: Seagate increased its gross margin by around 50% (31.6% vs. 19.5%). This was accomplished thanks to the increased average selling price (ASP) of the hard disk drives.

In order to better understand how they managed to do that, we should move to the Far East, and specifically to Thailand.

2011 Thailand floods

Thailand was literally devastated during the monsoon season (beginning at the end of July), involving provinces of Northern, Northeastern and Central Thailand along the Mekong and Chao Phraya river basins.

Before this event, a few people knew that a huge amount of hard disk companies back-end facilities were located over there.

Hard disk drives are not only assembled in Thailand; in fact, most of companies producing HDD components (that is, the hard disk industry supply chain) are located in the land of Thai.

Seagate's first competitor, Western Digital (WDC), was severely affected by the floods.

In their press release on Oct. 17, 2011, Western Digital stated “[..] The company now expects that the flooding of its Thailand facilities, combined with flood damage to the company's supply chain in Thailand, will have significant impact on the company's overall operations and its ability to meet customer demand for its products in the December quarter.”

A few days before, on Oct. 12, 2011, Seagate provided a press release in which they stated: ”Currently, all Seagate factories in Thailand are operational and there are no logistical issues with employees reaching its factories. However, the hard disk drive component supply chain is being disrupted and it is expected that certain components in the supply chain will be constrained.”

Same country, same floods, but very different degree of damage.

Why? Seagate facilities were safely placed on a plateau in the northeastern area, where water could not reach their precious plants.

I don’t really know if Seagate management purposely chose this location in order to avoid such kind of natural disasters or if this was merely a question of luck, but anyway the result is the same: Seagate was not forced to increase HDD prices.

What they did is simply raise prices, aligning them with competitors. They had no damages (if we exclude the supply chain issue), but managed to raise prices like competitors, that had their facilities severely impacted. On the other hand, Western Digital posted lower GAAP earnings (the latest was released on Jan. 23, 2012), due to restructuring charges and expenses related to the flooding, and lower volumes (around ½ of last year corresponding quarter) due to reduced capacity. They were forced to raise prices, in order to avoid going into the red.

If you check, for example, the external HDD prices of any consumer electronics retailer (checking laptop prices is less useful), you’ll see hikes (compared to last year) ranging from 50% to 100% and beyond.

You’ll see slight difference between HDD vendors, and slight difference between retailers: prices are quite high everywhere.

Some questions coming to the mind:

How long will it last?

Are prices set to come back to pre-flooding levels?

Will they remain stable?

Are supply chain issues going to manifest themselves in the future?

Industry Consolidation

A leading role in in HDD prices stabilization is played by industry consolidation.

Seagate Technology announced the acquisition of Samsung’s Hard Disk Drive Business in April 2011, and completed the transaction on Dec. 19, 2011. On the other hand, Western Digital announced the acquisition of Hitachi Global Store Technologies in March 2011 and is still in the process of closing the transaction (the European Commission is worried about possible price fixing).

At this point, we will have only three players (Seagate, Western Digital and Toshiba) in the HDD market (down from five), with the first two covering roughly 90% of the market share.

In a few words, prices will be completely under the control of these two companies, penalizing consumers and (probably) benefiting shareholders.

Conclusion and Investment Thesis

In the last months, Seagate managed to raise prices (and consequently revenues, margins and earnings) taking advantage of Thailand floods, that damaged some competitors' facilities and supply chain companies. The price hike has more than offset restricted capacity (at least for now) and other related issues.

If prices are destined to remain high and stable (and industry consolidation goes in this direction), company earnings (and consequently, the stock price) will be strong again, leading to higher valuations.

I wouldn’t be surprised if, during this year, STX's stock price (even if the recent stock rally has clearly reduced the margin of safety) would range between $35 and $45.

Disclosure: I am long on STX

About the author:

Nicolas73
I'm both a Value Investor and a Computer Engineer, so I love searching for value (especially in the tech area) for my investments and write articles in order to share my investment thoughts

Visit Nicolas73's Website


Rating: 4.0/5 (31 votes)

Comments

cimminop
Cimminop - 2 years ago


very useful article...
Nicolas73
Nicolas73 premium member - 2 years ago
Thank you,

this was my very first article.

I hope I will always have something useful to write!

Nicolas
Matt Blecker
Matt Blecker - 2 years ago
Nicolas73,

Nice article. I recently exited Seagate at approximately $26 per share. I bought this past summer starting at $14 all the way down to roughly $10.50.

I exited early based on my fair value for the company, as I still feel the company is slightly undervalued, and decided to reinvest the proceeds in holdings which I feel are more undervalued than Seagate at its current price.

I value the company in the mid 30s, using a normalized gross margin of 23%, 5% revenue growth for hard drives the next five years, and 5% declines in hard drive prices annually. In addition, I assume Seagate has approximately 40% market share, and use the firm's guidance for its share repurchase program.

The 5% revenue growth forecast is roughly in line with the estimates from research firms Gartner and IDC.

In the fall the company was being priced for permanently low recessionary margins of 15% and falling hard drive demand and prices. Just as I felt the street was too negative last summer, I feel the street is a bit too positive today. As you probably know, the high price of rare earth minerals was also a contributor to lower margins earlier last year, but the price was bound to come down, as many sources thought rare earth minerals were not that rare. How ironic lol.

Although Seagate is generating higher margins in the high 20s/low 30s due to higher hard drive prices because of shortages as a result of the flooding in Thailand and may also lock up some long-term contracts while Western Digital's production is lower than usual, over the long-term prices should come down and Western Digital should maintain share once they resume normal production and supply again meets demand. Prices should revert back into the mid 50s and Seagate's margin should fall back to the low to mid 20s.

You could justify a slightly higher fair value than $35-36 if you assume Seagate takes some share from Western Digital by locking up longer-term contracts until Western Digital resumes full production, but I feel at this price the risks are equal to the reward and you are better off investing in more undervalued securities such as Dell or higher quality businesses such as Google.

Nicolas73
Nicolas73 premium member - 2 years ago


Hi Matt,


Thank you for your comment. I think you raised some interesting questions.


I don’t know if rare earth minerals price will raise again (speculation is always alive), or if Seagate market share will increase due to temporary Western Digital issues. I don’t even know if this possible increment will be a short or long-term advantage.


What I do know is that when you have an industry consolidation like the one they’re having right now, usually the “survivors” have a better price control, and have no reasons to lower them if they don’t feel so much pressure from their competitors. Why struggling for a wider market share if you can earn a lot of money just keeping your slice and your prices stable?


Moreover, I think hard disk market size will still grow (especially for enterprise market), because 1) storage demand is strongly growing and 2) different technologies (like Flash memories) didn’t outstrip some of HDD main advantages (in particular: cost per bit and reliability).


Referring to your statement: “over the long-term prices should come down and Western Digital should maintain share once they resume normal production and supply again meets demand”.


If possible, could you give a little explanation of the reasons that led you to this beliefs? I'm really open to considerations I wasn't able to take out from my experience.


Referring to STX valuation, I mostly agree with you. We’ve bought STX at at roughly the same price. I also agree with you on the fact that the company doesn’t offer a big margin of safety anymore.


Buying an undervalued company as Dell (I’ve seen you’ve just posted an article on it, I look forward to read it) will probably pay better, but I don’t completely agree on Google. I’m not so confortable with companies carrying higher multiples, also if I consider it an outstanding business with very high (and multiple) growth chances.

Matt Blecker
Matt Blecker - 2 years ago
It was just released that Seagate's HDD share was 38% last quarter. Combined with Samsung's 9% share, that gives Seagate 47% of the market. Western Digital will surely look to undercut them to gain share back once they resume full production.

While consolidation does often lead to pricing power, in this case it should only lead to more price stability. Seagate's average price per HDD last quarter was $68 up from $55 in the third quarter. I believe the third quarter is more reflective of the long-term trend. Once Western Digital resumes full production, which should happen sometime within the next year or so, prices should decline because of increased supply. The consolidation should certainly slow price declines, but the increase in prices during Q4 was not due to consolidation, only to shortages. Longer-term the industry also must deal with the threat of SSDs. While SSDs are much more expensive currently, surely over time they will become more economical and pose a greater threat to hard drives.

To justify a value in the mid 40s for Seagate, everything would have to go right, i.e. high prices, high margins, and ample demand.

I definitely recommend Dell at this price. Would love to hear your thoughts on my analysis.

Regarding Google, the company is cheaper than you think given their incredible competitive advantage in a growing industry, strong balance sheet, and rapidly growing earnings power. I estimate the company will earn approximately $36 per share this year. Adjusted for the Motorola deal, Google still has $115 in net cash per share. At its current price of approximately $623, adjusted for net cash, Google is only trading for 14x my earnings estimate for this year. To buy a company like Google for slightly lower than a market multiple adjusted for net cash is not such a bad deal. I bought this summer around $500, a price I thought was cheap. If I were constructing a portfolio today, I would still buy Google, but would make it a smaller % of assets than I did when it was $500 per share. I would use any significant correction in the stock to increase my position.

I would classify companies like Google and MasterCard as Buffett-type value stocks. High return on capital, competitive advantages, ability to increase intrinsic value, etc...Sorry to mention Buffett as I have seen enough articles analyzing Buffett's thoughts in Berkshire's Annual Report, but I think the example fits.

I would classify stocks like Seagate at $12 or Dell currently at $17 as classic value stocks with a significant margin of safety.

Nicolas73
Nicolas73 premium member - 2 years ago
Matt,

Thank you again for sharing your point of view.

I've just one comment.

I remember (something like 5-6 years ago) people saying that SSDs (based on non-volatile Flash memories) would soon replace HDDs, but it didn't happen.

SSD main advantages are: consumption, shock and vibration resistance (they don't have any mechanical part to be moved in order to access data), better temperature ranges, etc, so they could be a good candidate for that, but when a company like Google wants to build one of its huge server farms, they just think to 2 factors: cost/bit and endurance (the average time a device takes to wear out).

Recently a lot of companies showed up trying to produce smart software for SSD (racks), in order to increase their data safety (through redundancy-like techniques) and endurance, but, at the moment, this result comes only increasing costs (added value devices carry higher prices), so I think we still have at minimum 3-4 years before HDD replacement with SSD devices will be really convenient for enterprise purposes and will begin to seriously impact companies like STX and WD.

Referring to Google, what you've just written convinced me to take a closer look to it, thank you!
Matt Blecker
Matt Blecker - 2 years ago


Nicolas,

I agree with you in terms of time frame (3-4 years), which is not that far out when considering a long-term investment.

When I ran sensitivity analysis using different inputs for revenue growth, market share, margins, share count, hard drive prices, etc...my fair value ranged from the low 20s to the mid 40s. I sold at $26 because I felt it was close enough to my midpoint estimate of fair value and because the different scenarios I used resulted in such a large fair value range. I felt really comfortable owning Seagate in the low teens, but much less comfortable at this price than I do owning securities such as Dell, Intel, and Microsoft.

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