Seagate Technologies: Follow The Money

Apr.19.12 | About: Seagate Technology (STX)

Seagate Technologies (STX), one of three surviving competitors in the disk drive market, reported blow out earnings for the first quarter Tuesday and closed Wednesday at $28.96. Seagate earned more than 1 billion dollars in the first quarter and is now trading at about 12 times quarterly earnings (yes, you read that correctly). Of course, everyone knows that the disk drive business isn't really profitable and is about to come to an abrupt end (I have been hearing that for about 10 years now), but somehow these guys keep minting money.

The industry has gone through a massive consolidation and is down to three players: Seagate, Western Digital (WDC), and Toshiba (OTCPK:TOSBF). Given antitrust sensibilities, it is unlikely that there will be further consolidation. This is important because it may allow us to predict what will happen to the enormous amount of cash that Seagate has been throwing off.

I use the sequential balance sheet method of evaluation in which I review the past quarter's balance sheet and compare it with the previous quarter's balance sheet to see where the cash lands at the end of the 90 days. When I performed this exercise with Seagate, at first I was baffled. Comparing March 30, 2012, numbers with Dec. 30, 2011, numbers it appeared that after a quarter in which Seagate earned over a billion dollars, debt stayed about the same, and balance sheet cash was actually down a little. There was a big buildup in Accounts Receivable, but that was matched by a big buildup in Accounts Payable. I put on my green eyeshade and dug deeper, hoping that I had stumbled upon the next Enron -- or at least maybe a Worldcom -- and I would go down in history as a forensic accounting sleuth. Where in the world did all the cash go?

Part of the answer is that Seagate paid out over $100 million in dividends, but that is only about 10% of the cash the company generated (a low payout ratio, by the way, a topic we will revisit). But almost all the cash went for stock repurchases; $1.1 billion was spent purchasing some 43.1 million shares -- that's roughly 10% of the total issued shares in one quarter. Seagate also repurchased an additional 9.4 million shares after the end of the quarter in early April (through April 16). When you look at year-over-year share count (which I always try to examine to determine the net effect of repurchases and stock options), that number is actually slightly up. So, once again, I was momentarily baffled.

The explanation is that Seagate made a large acquisition in late December 2011 (paying Samsung some 45.2 million shares), which increased share count prior to the repurchases. In essence, Seagate bought a big operation that expanded its business in late December and had completely paid for it out of earnings some 90 days later (by buying back the shares issued as the purchase price). A shareholder on April 1 owned essentially the same percentage of a much bigger company than the company he or she owned part of back on Dec. 1.

So the question before the house is what will happen to the cash now that Seagate has reduced share count back to the pre-Samsung acquisition level. Most analysts predict cash flow of roughly $1 billion a quarter for the next five quarters. A buyback program at current share price levels and at the pace of the last quarter would reduce share count in half. But with the kind of buyback program under way it is unlikely that share price levels will remain this low. Dividends could certainly be increased. In addition, Seagate still has nearly $3 billion of debt, but net debt (debt minus balance sheet cash) is less than quarterly cash flow.

I think that we will see more buybacks and a dividend increase. We will probably not see a major acquisition in the disk drive space because consolidation has pretty much run its course. Of course, the current stock price bakes in an expectation that the good times will not last forever and that current levels of earnings and cash flow are not sustainable. But between now and the "day of reckoning," a great deal of financial engineering can be done to enhance per share value. We will be watching the cash each quarter to see how this plays out. With Seagate now paying a dividend north of 3%, it has moved up high on my list of attractive undervalued stocks.

Disclosure: I am long STX.