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Seagate (STX) - There Can be only Two

March 11, 2011 | About:

Seagate is the market leader in the enterprise HDD market with 60+% of revenues and units sold. Revenues have grown at double-digit rates for all of the last eight years except 2009. It has consistently generated returns on invested capital over above its cost of capital averaging 20+% during the same eight year period and has an average un-levered free cash flow to total enterprise value yield of 5.25% over the past 7 years.

Total estimated digital data storage has been growing exponentially and is projected to grow exponentially for at least the next 5 years. Industry consolidation including Western Digital's recent announcement of a possible acquisition of Hitachi and economies of scale should allow Seagate and Western Digital/Hitachi to capture that growth by investing in R&D to increase areal density while maintaining attractive margins in HDD units versus the other 4 major manufacturers, who collectively have less then 15% of the market.

The recent introduction of Solid State Disk (SSD) devices has been seen as a disrupter in the storage industry and is why, along with the secular nature of HDD sales, HDD manufacturers are trading at historically low valuations. SSD has power consumption and service time advantages over HDD, but are 10 times more expensive per GB as HDD. Similar to tape vs. HDD, that gap should be maintained as areal density increases. SSD is capturing market share in mobile computing devices such as cell phones and tablets. However, capacity constraints on SSD are shifting data storage down the storage hierarchy to the cloud/enterprise where Seagate enjoys dominance and has its highest margins.

Further, Tape technology, the primary medium until HDD was introduced in the early 1960s while decling in revenues still exists. It is anticipated that tape storage will continue to decline at 9.1% annually and HDD technology will replace backup and disaster recovery requirements increasing demand in the enterprise space and for removable disk products. The fact that tape is still used after 40+ years of a technology disruptor is testament to the potential staying power of HDD over the next 20 to 40 years.

Modeling Seagate we factored in downside risks including possible disruptive technologies such as SSD and a potential price war with Western Digital. Upside potential included increase in consumption of enterprise HDD for backup and disaster recovery systems and consumer adoption of lower capacity SSD technology that shifts data lower in storage hierarchy to the cloud (enterprise HDD). Key value drivers were determined to be gross margins and market share. Based on our valuation range we recommend acquiring STX equity at current price levels at a 30-50% margin of safety.

Rating: 3.3/5 (15 votes)


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