It was a busy week in Seagate (STX) land. The stock rose on Monday through Wednesday thanks to the bullish commentary on its Q1 earnings call. That momentum was disrupted on Thursday when Jim Chanos made a short case at the now-famous Ira Sohn Conference. In short, Chanos believes that the demise of the PC market will kill the HDD market.
The last time I checked in on Jim Chanos, he was calling GameStop (GME) a value trap at $25 a share. That was back in 2011. It has since rallied to nearly $40. It's certainly possible that GME could go out of business in the future, but being long has been the right move for the past 18-months. In other words, be careful who you listen to.
Chanos is correct in his belief that HDD demand is suffering alongside the PC market. What he obviously doesn't realize is that storage has been moving to the cloud at a faster pace than it has been moving away from PCs. The reason is not widely known - storage on most PCs doesn't get backed up. In stark contrast, Cloud storage providers have to ensure disaster recovery, failover, around-the-world availability and performance. This requires them to replicate their storage at least three times.
This dynamic is just starting to positively impact the market because 1) PC demand has been falling fast and 2) Cloud storage providers buy storage as they need it, whereas consumers buy a lot of storage capacity up front. With the shift from consumer purchasing to Cloud purchasing, the market experienced the equivalent of an inventory digestion period…which is now coming to a close, as exemplified by STX's stellar earnings report.
In fact, worldwide demand for storage (as measured in bytes, not drives) has increased by about 40% per year since the dawn of the industry. Last year, that number dipped to just over 10% (because of the aforementioned digestion period), but is now rebounding sharply. If history is any guide, growth will exceed 40% for the next year or two before settling back into the standard 40% range. In other words, HDD-based storage will experience robust demand for several years to come (yes, flash will grow rapidly as well, but could be 10 years away from being big enough to make a meaningful impact on HDD sales).
Finally, Chanos expressed his concern about margin pressure in the HDD market. That was a valid concern until STX and WDC acquired the next two largest vendors (Samsung (OTC:SSNLF) and Hitachi (OTC:HICTF)), who also happened to be the most price-aggressive vendors in the marketplace. Those acquisitions effectively turned the HDD market into a benevolent oligopoly, which may experience anti-competitive investigations before they bow to pricing pressure.
Augmenting our argument is the fact that Cloud HDDs carry higher margins than PC HDDs. Also, the industry will run out of manufacturing capacity by year-end. Most means of adding capacity are not particularly cost effective (especially upgrading to new technologies like HAMR), so we can expect supply to tighten and pricing to remain as stable as it has been in some time.
Conclusions: HDDs are still king in the storage market…and storage is red hot. Worldwide proliferation of mobile devices and multimedia content (photos, music, movies/videos, etc) will keep this dynamic rolling for the foreseeable future. This explains why STX's CEO reiterated his commitment to the company's massive buyback program last week. These are the top things to remember the next time a bearish pundit growls about PC demand, flash memory, etc.
Remember, there is always a flood of data points available in the market - but in almost every case, only two or three really matter. In this case, insatiable storage demand and an oligopolistic competitive environment are reasons why Seagate retains its place in our Stocks To Triple portfolio.