Why We're Passing On Seagate

May. 5.14 | About: Seagate Technology (STX)

Summary

The markets Seagate competes in are intensely competitive.

Seagate has cut its dividend in the past, and investors should be aware of its controversial track record.

We generally prefer more stable firms that operate in a better industry environment and that have Valuentum Buying Index ratings of a 9 or 10.

We divide our expansive coverage universe into over 100 industry groups, and the computer and peripherals industry, where Seagate (NASDAQ:STX) operates, is one of the worst from a structural standpoint. However, the company hasn't performed terribly since the depths of the Great Recession, but that's no reason to jump in head-first. Let's take a look at a calculation of the firm's intrinsic value and evaluate how Seagate stacks up in the context of the Valuentum style.

But first, a little background to help with the understanding of some of the terminology in this piece. At our research firm, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.

Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money-manager's focus, the Valuentum process covers the bases.

We liken stock-selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money-managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking "common sense."

With that said, let's dig into Seagate's report.

Seagate's Investment Considerations

Investment Highlights

  • 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 15.5% 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.
  • Seagate has cut its dividend in the past, but the firm's dividend coverage ratios today are on much firmer ground. The company also boasts an above-average yield. We're keeping the company on our watch list, but investors should be cognizant of its controversial past. History never repeats, but it rhymes.
  • If a company is undervalued both on a discounted cash-flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Seagate posts a Valuentum Buying Index score of 6, reflecting our 'fairly valued' DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals. We generally prefer more stable firms that operate in a better industry environment and that have Valuentum Buying Index ratings of a 9 or 10 on the index.

Industry Structure

Firms in Seagate's industry primarily make storage solutions, but others may offer custom-designed computer/mobile interface solutions or other ancillary computer/mobile products. The industry is characterized by rapid technological change, which has not only increased the adoption of technologies for use in a variety of devices but also has put significant pricing/gross-margin pressure on industry constituents. Competition is fierce, threats of over-supply are continuous, and the prospects for generating long- term competitive advantages are negligible. We don't like the structure of the group at all. Even though recent performance at Seagate has been acceptable, the industry's fortunes can change on a dime.

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 with its weighted average cost of capital. 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 86.5%, which is above the estimate of its cost of capital of 10.2%. 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 20.3% 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 72% from levels registered two years ago, while capital expenditures fell about 7% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Seagate's shares are worth between $51-$77 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. We use such a wide range mainly due to the industry's pricing dynamics which are unpredictable at times. Shares are trading just north of $51 each -- at the low end of the fair value range. We'd grow much more fond of Seagate if it were trading below the low end of our fair value range and also exhibiting positive technical and momentum indicators. Under this scenario, Seagate would register a much higher rating on the Valuentum Buying Index.

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. Our model reflects a compound annual revenue growth rate of -0.4% 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 19.3%, which is above Seagate's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 0.5% for the next 15 years and 3% in perpetuity. For Seagate, we use a 10.2% weighted average cost of capital to discount future free cash flows.

Our discounted cash-flow process allows us to arrive at an absolute view of the firm's intrinsic value. However, we also understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money-managers--those that drive stock prices--pay attention to a company's price-to-earnings ratio and price-earning-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash-flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth (NYSE:PEG) ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For relative valuation purposes, we compare Seagate to peers EMC Corp (EMC), NetApp (NASDAQ:NTAP), and SanDisk (SNDK).

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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 $51 per share (the green line), but quite expensive above $77 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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In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in theBest Ideas portfolio. Past results are not a guarantee of future performance.

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.