Seagate Blames a "Bubble" In Rare Earth Prices for Causing a Margin Squeeze

| About: Seagate Technology (STX)

For some time now, rare earth supply, demand, and prices have been hot topics of discussion and debate. While these elements are critical components in many high-tech products, they usually represent a very small part of overall product costs. While the Japanese have clearly been scrambling to reduce their dependence on Chinese exports and to otherwise secure greater supplies, I have never heard a company complain that soaring rare earth prices were materially hurting profit margins, until now.

Seagate Technology (NASDAQ:STX), a manufacturer of hard drives and provider of storage solutions, warned during its earnings report on July 20 that rare earth prices are starting to squeeze its profit margins. In particular, soaring prices over the last two months or so have hit the company hard.

From the Seeking Alpha transcript of the earnings conference call:

The costs of many upstream materials, especially rare earth elements…have increased significantly. These costs are expected to adversely impact gross margins by at least 200 basis points.

Two hundred basis points is significant and material given gross margins of 19.3% last quarter.

Historically, Seagate has absorbed increases in the costs of materials, presumably due to the on-going efficiencies in hard drive technology and production processes. Times have changed now with commodity prices, not just rare earths, in a strong, bullish trend:

In regards to the increasing cost of upstream materials, Seagate has historically been able to absorb these cost increases and insulate our customers. However, the recent dramatic increase in the cost of rare earth elements, combined with a pre-existing upward trend for a broad base of other commodities, far exceeds our ability to find offsetting cost reductions.

The situation has clearly become critical for Seagate because the company is now trying to figure out how to reduce its consumption of some rare earths in its manufacturing processes as well as how to pass along the increasing costs to its customers through temporary rare earth surcharges. Management admitted that they remain uncertain about their ability to execute price increases. Regardless, the company calls the potential surcharges temporary because of expectations of an imminent resolution to current supply shortages:

It’s important to note that for the relevant rare earth materials, there does not appear to be a significant supply constraint. And while we have a short-term concern over margin impact, we do not currently have a long-term concern.

Interestingly, management seems to believe that U.S. mines alone (Molycorp (MCP)?) will soon solve the problem:

it doesn’t appear that there’s a true supply constraint here. There’s a lot of dynamics around owners of rare earth materials and processors of rare earth materials and who is controlling inventories at what level, as opposed to there’s fundamentally some shortage…So I think our point is that right now, since it doesn’t feel like there’s a fundamental supply issue, that it probably works itself out. And by the way, if these prices stay high, guess what, there’s a bunch of U.S.-based mines that are going to come online again, and it will solve itself. It’s not like the stuff doesn’t exist. It’s just that a lot of mines were closed down when the prices fell below $75, whatever the magic price is, and we’re well above that right now. So I don’t think it’s a long-term issue.

Management went so far as to say “…this feels a little bit like a bubble.” Management compared the price run in rare earths to a 6-month run the company experienced in ruthenium prices in 2006. I will need to research more closely what happened at the time to understand the specific similarities to today’s rare earth market. I will post my findings in a future post.

Seagate did not call out Dysprosium by name, but this rare earth element must be one of the culprits impacting Seagate’s cost structure. According to management, rare earths are about 2% of the cost of a hard drive because of a magnet and the motor. Dysprosium and its compounds are highly susceptible to magnetization and are employed in various data storage applications, such as in hard disks. One quick scan of the related headlines on Asian Metal (registration required) provides confirmation that Dysprosium has experienced a severe squeeze in supply, surge in demand, and strong lift in prices all year. The latest headline from July 21 announces “Dysprosium oxide offer skyrockets in the west” (scroll down for the Dysprosium headlines for the year). Stories like these confirm the strength of the current upward price trends.

If Seagate is specifically relying on Molycorp to eventually relieve the supply crunch in the near future, they may be disappointed. On July 11, BBC News quoted Jim Sims from Molycorp claiming that, “as China’s exports are being restricted, we are looking at outright shortages of rare earths, probably this year and next”.

Moreover, I have cited other references in a previous post challenging claims that rare earths will be plentiful as early as 2013, titled “Chinese Academic’s Rare Earth Forecasts at Odds With Industry Experts“. In other words, the “bubble” in rare earth prices will likely last a lot longer than consumers like Seagate expect (or at least hope!).

Seagate's stock ended the day after earnings down 17%, returning the stock to negative territory on the year. Molycorp MCP soared 7% on the day with most of the gains coming in the final minutes of trading. MCP is up 18% for the year.

Be careful out there!

Disclosure: I am long MCP.