Seagate (STX) is the largest player in the global hard disk drive industry, which has been characterized by cycles of peaks and troughs. There is little differentiation in the hard drive industry, which means that customers buy mainly based on price per storage unit. However, Seagate stock has surged by more than 100% over the last couple of years, as the industry has consolidated around two players. A spate of M&A has made Seagate and Western Digital (WDC) the two dominant players in the industry. The earnings for both companies have spiked due to improving margins and revenue. Seagate has rapidly increased both dividends and buybacks as it has returned the windfall gains to investors. Though both the earnings and stock price have gone up, the valuation multiples have not meaningfully expanded, due to investor fears about this being a temporary peak in the HDD cycle and the threat from NAND Flash memory. This means that the stock is still quite cheap despite the stock price outperformance.
Why you should buy Seagate
- Industry Consolidation - The hard drive industry has consolidated, with Seagate buying Samsung's hard drive unit for $1.4 billion in stock and WDC buying the 3rd biggest player Hitachi's HDD unit. This has left STX and WDC with a lion's share of the market, with Toshiba a distant third. Pricing pressures have reduced leading to improving margins and profits. We do not think there is any immediate threat of greater competitive intensity, as the companies do not want to enter a mature sector.
- Cheap Valuation - Seagate valuation is cheap, despite the stock price surge as the company's revenue and profits have increased dramatically. Seagate trades at a forward P/E of 5.5x and a P/S ratio of 1x. This is quite cheap compared with the rest of the technology sector. The dividend yield at 3.4% is also quite good given that the company is buying stock. The payout ratio at ~13% remains quite low and provides a big cushion in cases of earnings decline.
- Huge Buybacks - Seagate has reduced its share count considerably, using most of its cash flows to buy back its own stock. This has been a great strategy as STX shares have touched new all-time highs. The company spent almost 70% of its Operating Cash Flows [OCF] to buy back shares in FY12 and expects to spend 55% of its OCF to buy back shares in FY13.
- Margin Improvement - In 2011, Seagate has reported the best gross margin in the last decade due to the better industry environment. The company had a gross margin of 31.4% in 2011, compared with the 14% to 28% range in the last decade. Operating Margins have also increased dramatically to ~21%, as the company has managed to reap the benefits of higher pricing power.
- Digital Content is being created faster than ever - Digital content is being created at an ever increasing rate (50% annually), with the proliferation of digital devices like tablets and smartphones. While NAND memory represents an alternative to HDDs, the cost of a HDD is almost ~20 times lower than SSDs currently. This means that HDD will continue to remain the cheapest and most convenient way to store digital content at least in the medium term.
- New Digital Storage Products to offset traditional PC HDD growth decline - Seagate is coming out with newer products, to offset the decline in the traditional HDD used in PCs. The company has come out with a network home storage solution and wireless storage products. With Smart TVs, tablets and smartphones not having big HDDs like PCs, the data being created or consumed will have to be stored somewhere. Seagate has also introduced solid state drives (SSDs) and hybrid drives, consisting of a mix of NAND and magnetic disk drives to diversify from its traditional HDD business. The company announced a partnership with Virident Systems, a startup that sells devices that plug into servers and store data on flash memory chips. STX will also invest $40 million in Virident as a part of the deal.
- PC Decline - The traditional desktop and laptop industry is witnessing a unit shipment decline because of cannibalization by tablet and smartphone growth. The big players of the PC ecosystem like HPQ (HP), Microsoft (MSFT), Intel (INTC) etc. have seen sharp price declines because of this reason. STX has not been affected till now, as consolidation in the HDD industry has more than made up for the PC unit declines. However, STX faces secular headwinds to its main bread and butter PC HDD segment. Industry shipments declined 3% sequentially in the current quarter (Q412) driven by the notebook market, as all other segments demonstrated quarter-over-quarter growth.
- Cloud Computing Growth improving Storage efficiency - Cloud Computing is decreasing the need for storing data at the consumer level. With data and applications residing in the cloud, there is less need for data to be stored in multiple places in an enterprise. The increase in storage efficiency is a headwind for digital storage suppliers like Seagate. However, we think this threat is limited because it is not possible for users to store the gigabytes of their personal content on the cloud. There will always be the need for cheap long-term storage to store the increasing amount of personal digital content like photos, music and movies.
- Stock Price Performance - Seagate is trading near its all-time peak stock price of $37, due to the dramatic increase in revenue and profits. The stock shows high volatility due the cyclical nature of the HDD industry. This has meant that the wise way to trade, is to buy during cyclical lows and sell during a cyclical peak. The industry is currently at a cyclical peak, with the two dominant players showing the best margins in a long time. This makes the investment case less compelling. The stock has outperformed the technology sector as well as S&P 500 by a wide margin showing a positive return of ~80% in the last year.
The biggest risk with Seagate is whether the margin and revenue improvement marks a cyclical peak. We don't think STX faces the threat of new entrants into the HDD industry. The biggest risk is substitution of HDDs by solid state drives (SSDs) and lower HDD sales due to PC unit declines. However the low valuation means that the stock is already discounting at least some of these risks. Given the earnings yield of ~20%, investors can recover their entire investment in just five years, even without the company not growing at all. Seagate remains a good investment in our view despite the stock price increase, as the company will continue to benefit from changed industry dynamics. The stock has corrected slightly after announcing a weak demand environment in the current quarter. We would be looking to buy Seagate on dips, given that the stock price is touching new all-time highs. We think another good memory investment might be Micron Technology (MU) because of the ongoing consolidation in the DRAM and NAND industry. MU potentially represents Seagate of a year ago when the stock rose by ~80%.