Since I first profiled Seagate (NASDAQ:STX) in August 2012, the stock has climbed nearly 27 percent, outpacing the increase in the S&P 500 by 10 percent. I have read many bearish sell-side pieces on the hard disk drive (HDD) industry in the past year. They couldn't be more wrong in my opinion. The sell-side analysts like to criticize the gross margins of both Seagate and Western Digital (NASDAQ:WDC), arguing that they are unsustainable. Both companies (Seagate - see slide #41 Western Digital - see slide #11) have stated that they expect their gross margin to remain at or above 27 percent for the foreseeable future. The HDD makers have enjoyed record gross margins since the fall of 2011. Here is a look at how Seagate's top line and gross margins have behaved over the past seven quarters.
% chg YoY
GAAP Gross Profit Margin
Source: Quarterly Filings
You can see the big increase in both numbers beginning in the fall and winter of 2011/2012. There are a couple of reasons for this. First, there were devastating floods in Thailand, where many HDDs and related components are made. Many HDD makers did not have enough supply to meet the demand. Seagate was probably the least affected by the floods, so their sales swelled for a few quarters as the OEMs looked to the company to fill supply gaps. Sales have since leveled out as Western Digital returned to full operations. During that same time period, there was industry consolidation. Seagate purchased Samsung's HDD unit and Western Digital purchased Hitachi's. These two companies now produce approximately 90 percent of the world's HDDs, with Toshiba representing the balance.
Most of the sell-side analysts are worried that gross margins will return to the pre-Thai floods, pre-industry consolidation levels, i.e., back to the high teens/low twenties. They couldn't be more wrong in my opinion. What they are failing to realize, is that two companies now control 90 percent of the supply of HDDs; it is essentially a duopoly. A duopoly is a price maker, not a price taker. How easy is it for Seagate and Western Digital to collude without ever actually talking to each other? Extremely easy! If you have ever listened to either company's quarterly earnings calls, you will hear them both talk about a range for gross margins going forward. The bottom number is always 27 percent. Both companies don't want to sell for an average gross margin of less than 27 percent...so why would they ever? Both companies are incentivized to control supply and pricing to make this happen. If they both cooperate, they both win. If one decides to cheat, the cheater will win in the short-term but both will lose in the long-term. This is the classic game theory example of prisoner's dilemma. Anyone that has ever taken an economics course is well aware of this. While I don't see gross margins ticking up much above 27 percent without a real uptick in demand, I don't see either company "cheating" and selling below that level either.
So as long as the two companies continue to "collude" by talking to each other through quarterly earnings calls, I see Seagate maintaining their gross margin at approximately 27 percent, which should allow the company to continue to generate ~$2B in free-cash-flow a year (I'm just extrapolating the past two quarter's results where the gross margin was ~27 percent). About 1/4 of that amount is needed to fund the dividend; the rest can, presumably, be used to buy back stock. The company has stated and reiterated that they intend to have ~250M basic shares outstanding by the end of calendar year 2014. That would be a 28 percent drop from the current level, in just 19 months. If the stock keeps rising at the current rate, that would be a very difficult task to accomplish. But regardless, I still think the share count can get down to at least 300M by that time, which would still be an impressive 14 percent decline in the share count.
Another bear argument I hear is that solid-state drives (SSDs) will eventually replace HDDs. Phooey I say! The HDD bears simply do not understand how HDD technology is progressing and how it is eating into the advantages that SSD enjoys. Both Seagate and Western Digital are building fast and sleek 5mm thick hybrid drives (an HDD paired with some flash to speed up common tasks) for the consumer market that can fit into tablets and boost storage capacity to 500GB or more for a price about 1/5th of what a similar sized SSD would cost. Simply put, I do not believe that SSD will displace HDDs anytime soon. "Big Data" is here and it is real. Digital storage needs are growing at a spectacular rate. If you listen to what the storage companies like EMC (NYSE:EMC), NetApp (NASDAQ:NTAP), and HP (NYSE:HPQ) are saying about their customer's needs, you will see that only a very small percentage of the storage needs to be "hot" or immediately available. That portion is likely stored on flash drives but the remainder will remain on HDDs for many years to come. It is simply uneconomical to store all data on SSDs. It is also impossible from an industry capacity standpoint. It would take hundreds of billions in capital investments before the SSD industry could produce enough flash to meet even 25 percent of the storage demand that exists today.
From a valuation perspective, Seagate is certainly not as cheap as it was last August when I first profiled the stock. I believe that normalized EPS will be in the range of $5.00/share going forward, unless we see a strong uptick in PC sales. That puts the stock at around 8.5x EPS today, which is toward the high-end of the historical range. For a technology hardware company, I would expect the earnings multiple to top out around 12x - any higher and I'd likely be a seller. Of course there is the nice 3.5% dividend yield as well. But if the company buys back even 50M shares by the end of 2014, that multiple will shrink to 7.3x based on the current stock price as EPS would climb to $6/share - assuming they continue to earn the same dollar amount of earnings(~$1.8B). So there is definitely room for further multiple expansion if you are a patient investor.
The risk to this thesis is that I am wrong about the margins remaining north of 27 percent. If they drop to the low 20s, the stock will dive with them. I just don't see that happening as long as both Seagate and Western Digital follow "the rules" as I have laid them out. So why do I like Seagate more than Western Digital? Their market caps and market share are nearly identical. The main reason I like Seagate more is the allocation of shareholder capital. Whereas Western Digital sits on most of their cash, Seagate returns nearly all its excess cash to shareholders. I like to buy shareholder friendly companies. Seagate is one of the best I have seen in that regard.