To say that Seagate (STX) has had a good run this year would be an understatement. Its stock is up by 19.7% in 2013, besting the return on the S&P 500 by 8.7% in the same span. It has also risen by 52% since the middle of 2012, more than trebling the gains of the S&P500 in the same period.
More pertinently, Seagate leads most of its direct competitors in the same period:
Table: Select Storage Stock Measures
Source: Bloomberg, WSJ
As may be seen from the table above, Seagate has posted incredible stock performance despite having negative forward earnings growth. Indeed, while Seagate delivered fiscal third-quarter earnings of $1.26 per share against analysts earnings estimate of $1.15 per share, it is less than half of the $2.64 per share it earned in the same period a year earlier.
For its fiscal year ending in June 2013, Seagate is expected to register earnings of $5.21 per share - 23% lower than the $6.75 it earned a year earlier. It doesn't get much better over the next five years, with the company forecasting to see its earnings contract by 7% on an annual basis over that span.
By most conventional measures, Seagate shouldn't be performing as well as it has - but there's the rub: the story of Seagate is the story of a market that is being transformed by changes in the way that businesses and consumers are utilizing storage and storage devices. In that sense, the key to understanding the stock is context.
Indeed, looking at Seagate using a non-conventional five-year forward P/E, it turns out that it would be the second-cheapest stock among itself and its major competitors, even accounting for its putative earnings growth contraction.
Moreover, as is typical with forecasts, later years' numbers are more likely to be inaccurate as there is simply no way to correctly anticipate changes in consumer demand or technological innovation over that span. In fact, most analysts revise their forecasts four times a year to coincide with the typical earnings reporting cycle. Regardless, Seagate is anticipated to see its earnings rise by 5.2% in fiscal 2014 (half of which will be recognized in calendar 2013) so near-term earnings growth is generally expected to be positive.
Seagate: The Post-PC Era
Seagate is well-known as a maker of storage devices for computers. One merely has to visit Best Buy (BBY) or any other popular electronics chain to see boxes and boxes of Seagate hard drives of various capacities and speeds on sale. As a consequence, the conventional analysis of Seagate will focus on typical storage solutions and sales growth of those units in relation to the number of PCs sold.
However, as Apple (AAPL) co-founder Steve Jobs was famous for popularizing, we now live in the Post-PC era and the data has been confirming his assertion. However, even as personal computer shipments registered their sharpest fall ever, smartphones continue to go from strength-to-strength, with shipments rising by 36% in the first quarter.
Meanwhile, the fastest-growing segment of the mobile device space, tablets, is expected to exceed PC sales for the first time in 2013. In that sense, any company still focused entirely on leveraging itself in the old desktop PC paradigm is likely to suffer.
Seagate is not such a company: indeed, the story of Seagate is a combination of its shift into the mobility space of its storage devices and providing high-speed data access to enterprise.
The new paradigm is different in that mobile devices require smaller form factors and, because user-experience is important in retaining customers, device manufacturers such as Apple, HTC, Samsung (OTC:SSNLF), and one of our favorites Nokia (NOK), are focusing more keenly on performance - even for their cheaper offerings.
Seagate has adapted to this new paradigm by offering smaller and faster form factor devices such as its Momentus XT line of hybrid-SSD drives that combine the storage capacity of a mechanical drive with a smaller array of solid-state memory chips that enable faster performance through dynamic caching technology. This allows Seagate drives to be shipped with much thinner devices such as Ultrabooks or Tablet Hybrids, which is important since such devices are expected to be the saving grace of a flailing market.
However, where Seagate is really expected to shine is in the enterprise space.
The post-PC era is already seeing a subtle shift in the way devices are used: with the broad availability of faster data connections such as LTE, mobile devices are being used less as portable media libraries and more as portals to cloud services. After all, why should consumers limit themselves to the capacity of their smartphones - typical only 5% that of the average PC hard drive - when they can access more of their data online through the cloud?
Moreover, as businesses deploy more mobile devices to employees and provide mobile access to enterprise-level applications such ERP systems via smart devices, the demand for high-performance server storage will increase.
This, in turn, shifts the onus of providing fast data access from device manufacturers onto the providers of cloud services, which have seen high levels of adoption in the past year, based on app utilization. In short, while the ultimate end user of all that fast data access is retail, the customers are the enterprise market that provide the backbone for these services.
Indeed, Enterprise SSD demand is predicted to rise by more than 10-fold in the five years ending in 2016 - for a 59% CAGR. However, the rise in SSD demand for enterprise, while remarkable, is anticipated to grow at a slower pace than the abandonment rate of mechanical HDD, hence a more muted earnings growth curve for Seagate and its competitor, WD, which has been witnessing strong growth in this space.
In effect, a bet on Seagate isn't so much a bet on near-term earnings prospects but a bet on the evolution of the storage market, which is in the early stages of evolving as a result of a paradigm shift in usage scenarios. In our view, the earnings contraction being witnessed this year is simply a result of Seagate adapting to the new environment - something that its peers will also have to do sooner or later.
Seagate: Solid Fundamentals
We would not be comfortable recommending Seagate if we did not think it could sustain itself in an evolving market environment. The good news? It is.
As we've already mentioned, the stock is cheap relative to its peers even with tepid growth rates as it evolves its product offerings. As we've asserted, other companies in this space, such as EMC and SanDisk (SNDK), are likely to transition themselves in order to adapt to the new paradigm - meaning that their forward earnings are also likely to come under pressure and fall in line with those of Seagate and Western Digital (WD). Consequently, we believe that the valuation gap will widen - Seagate will become cheaper, especially if, as we believe, its earnings beat expectations down the line.
Seagate is also cheap on important metrics such as price-to-free cash flow - at just 4x FCF, it is trading at one-fourth the valuation of its industry peers. Together with strong cash fundamentals (both its quick and current ratios are better than the industry and/or the S&P 500), we are confident that Seagate can continue to finance its transition years. This is confirmed by the fact that while its margins are lower than industry average at 37% to its industry's 50%, its returns on investment and assets at 56% and 37%, respectively, are far higher than its industry's 9% and 8.2%. Seagate management is simply more adept at extracting value than its competitors.
Finally, Seagate also has a generous dividend yield of 4.4% -- nearly quintuple its industry's 0.9% and more than double the S&P 500's 2.1%.
Seagate is worth every penny of its 4.7x multiple and while it's just $1.54 off of its 52-week high, it could add another 10 to 15% in the next three months, especially after exceeding earnings estimates.
Disclaimer: Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.