Do You Know How To Forecast Seagate's Future?

| About: Seagate Technology (STX)

After recent soft guidance from both Seagate (NASDAQ:STX) and Western Digital (NYSE:WDC), shares of Seagate have fallen from just over $60 per share to about $50. But what does the recent soft outlook really mean for investors? As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. We think having an understanding of the fundamentals of a firm 3, 5, 8 years into the future makes much more sense than evaluating how it did in any given quarter relative to consensus expectations, which are almost always wrong (ever hear of earnings misses or beats?).

But first, a little background to help with the understanding of this article about Seagate's valuation. We've received quite a few questions regarding how we derive our revenue and earnings estimates for Seagate (and any company for that matter), and we'd like to point you to this piece (click here) before you dig in to the current article. Please do take a read of the article before advancing forward on this piece. We're looking at so many things that it's just impossible to include them in one article for every firm in our coverage. And we don't want you to feel that we're not doing our homework. With that said, let's dig into the process we use to estimate Seagate's intrinsic value. A focus on intrinsic value, discounted cash-flow analysis, margin of safety and range of probable outcomes remain core at Valuentum.

Investment Considerations

Investment Highlights

• Seagate earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 87% during the past three years.

• Seagate is a leading provider of electronic data storage products. Its principal products are hard disk drives, commonly referred to as disk drives, hard drives or HDDs.

• Seagate has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 16.2% in coming years. Total debt-to-EBITDA was 0.9 last year, while debt-to-book capitalization stood at 44.3%.

• The markets Seagate competes in are intensely competitive. The firm not only bumps heads with rivals for a limited number of major disk drive customers but also competes with other companies in the electronic data storage industry that provide flash memory and SSDs.

• The firm sports a very nice dividend yield of 3.1%. We expect the firm to pay out about 32% of next year's earnings to shareholders as dividends.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital - ROIC - with its weighted average cost of capital - WACC. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Seagate's 3-year historical return on invested capital (without goodwill) is 87%, which is above the estimate of its cost of capital of 10.3%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Seagate's free cash flow margin has averaged about 18.8% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Seagate, cash flow from operations increased about 141% from levels registered two years ago, while capital expenditures fell about 7% over the same time period.

Valuation Analysis

The estimated fair value of $64 per share represents a price-to-earnings (P/E) ratio of about 13.3 times last year's earnings and an implied EV/EBITDA multiple of about 8.4 times last year's EBITDA. We see pricing upside on the basis of our fair value estimate of Seagate. Our model reflects a compound annual revenue growth rate of -0.8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 8%. Our model reflects a 5-year projected average operating margin of 17.9%, which is above Seagate's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 0% for the next 15 years and 3% in perpetuity. For Seagate, we use a 10.3% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $64 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Seagate. We think the firm is attractive below $48 per share (the green line), but quite expensive above $80 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Seagate's fair value at this point in time to be about $64 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Seagate's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $80 per share in Year 3 represents our existing fair value per share of $64 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.