The Company
Seagate Technology (STX, Financial) 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, Financial), 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
