Always drawn by value, I recently established a long position in Seagate Technology (STX). I didn't do as thorough a research job as I like to think is typical for me, and have since developed some reservations: I like hard disk makers but note that flash is potentially a superior technology, especially in laptops and net-books. Also, STX seems less attractive than Western Digital (WDC) based on a side to side comparison on a number of metrics:
At the time this table was prepared, TTM P/Es were very comparable. However, comparing the other metrics demonstrates an advantage for WDC – greater efficiency and management effectiveness.
Margins - a look at recent margins shows some trends:
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As the table above shows, STX has suffered a more rapid erosion of margins than WDC. Questions on WDC's last conference call suggested that STX had backed off after being very aggressive on pricing for several quarters, consistent with STX CEO Bill Watkin's statements that at some point they stopped trying to “make the quarter” and started to push for rational pricing. When presenting at Barclay's Global Technology Conference on 12/10, Watkins stated that he could manage to a profit at revenues of as low as 2 billion but could not do so until he had clarity as to what demand was going to be. Any manufacturing operation has a high proportion of fixed costs, so making money at lower revenues will involve impairments, which are coming, as announced.
Capex - ROA metrics in the first table above suggest WDC is outperforming STX. Here is a history of Capex for the two firms:
What I see, comparing Capex histories and P/B, is that WDC expends their money more effectively, creating more value. STX's coming impairments provide evidence along these lines.
Inventory, A/R and A/P to Revenue – a comparison of the ratios suggests STX is not running on a steady and stable basis:
The point to note here is STX shows more inventory as a percentage of Revenue, and inventory is not being brought back in line with revenue. Also, payables as a percentage of revenue is higher for STX and not developing favorably. All of this is consistent with rumors that STX had been cutting prices to move inventory during their as yet unreported Q2 2009. STX's increased payables ratio, when combined with their recent draw on their credit line, does not present an impression of controlled cash flow.
Debt Load – WDC has nominal debt, while STX has approximately 2.5 billion outstanding. STX's debt is trading to yield 17-19%, although it is doing better in the past week or so. On 12/17 Fitch cut their debt to BB+, no longer investment grade; ie., junk. On 12/10, STX drew down 350 million on its 500 million credit line, stating the reason as follows: “The borrowing under the Revolving Credit Facility is intended to enhance Seagate’s liquidity and cash position as it takes steps to rationalize its production capacity and improve its overall cost structure.”
To provide a little flavor on the need to draw down the credit line, in an interview covered by Eric Savitz in an October 22, 2008 article on Seeking Alpha, the following is noteworthy:
Meanwhile, Watkins says the company continues to buy back shares, while still keeping a close eye on its cash position. He notes that if the credit markets were more favorable, he would consider borrowing enough capital to buy back $1 billion worth of stock, which would be more than a quarter of the market cap.
This is not promising – Fitch has downgraded the company, the debt is trading at 17-19% yield, and three months ago Watkins felt the company's stock price problems could be addressed by buying back shares with borrowed money. After outspending WDC on capex for years there is the need to rationalize production capacity and improve overall cost structure. Meanwhile Fujitsu wants to exit the HDD market and lately has confirmed WDC is a potential buyer of its operations. I had been hoping WDC would acquire Hutchinson Technology (HTCH), like they did Komag: that would help me more than their buying out Fujitsu's disk operation.
Speaking of debt load and repurchasing shares, here is an excerpt from STX's 2008 10-K:
During fiscal year 2008, we repurchased approximately 65 million common shares through open market repurchases at an average price of $22.89 for a total of approximately $1.5 billion. Of this amount, we repurchased approximately $974 million under the $2.5 billion August 2006 stock repurchase plan and approximately $500 million under a new plan announced on February 4, 2008, to repurchase up to an additional $2.5 billion of our outstanding common shares over 24 months.
Shareholders will be less than pleased if STX is forced to raise equity capital at share prices under 6.00, under a storm of short-selling, after buying the shares for 22.89 on average, as outlined above. That 1.5 billion they spent to buy shares looks mighty attractive, if only they could get it back and reduce debt. If only, if only.
HDD vs SDD – Robert Castellano submitted a thought provoking article here on Seeking Alpha, to the effect that SSD (flash) will displace HDD as the storage medium of choice. Reading his article and the comments it received, and looking at earnings transcripts, interviews and press releases, my impression is that SSD is potentially a superior technology and players such as Hitachi (HIT) and Intel (INTC) are making investments in bringing it up to its full potential and reducing the cost per gigabyte of storage to compete with HDD. For now, HDD has gained a lot of traction in net-books which are the coming thing. My guess is that HDD will go the way of the record made of wax, but not anytime soon.
2009 Growth - Intel's guidance and STX's negative pre-announcement are disheartening. My take on storage is that the proliferation of digital content will steadily increase demand, and HDD is the most cost-effective method to date. Thinking along those lines, I expect the disk makers to perform well after capacity is rationalized. Apparently, Fujitsu and Seagate are the ones who will bear the brunt of the rationalization.
Disclosure: I am long STX and bit player Hutchinson Technology (HTCH). I am actively considering reducing or eliminating those positions in favor of WDC.
