Pre-Flood verse Post-Flood Seagate
From the standpoint of Seagate's (STX) year old 10-K, the company is not too impressive. Before the floods in Thailand gave Seagate a new position in the disc drive world, their industry was at the low point of the product cycle, profit margins were slim and cash flow was weak year-over-year. But with the record results released Monday night, Thailand's flooding has allowed Seagate to achieve a new operating level; the value of which, it appears, has not been taken into account by the markets. First, let's look at the challenges facing the disc drive industry generally.
The hard disc drive business is notoriously hard. In fact, in the classic, "The Innovators Dilemma," Clay Christensen studies the evolution of industries by studying the early disc drive industry specifically. He chose the disc drive industry because of its rapid transformation, evidenced by the rise and fall of companies from the late 70's through the 90's. Studying the rapid rise and fall of companies was, to Professor Christensen, like the geneticists studying fruit flies for their rapid birth and death.
One problem facing the disc drive industry is price erosion. Their products "commodify" shortly after each new product release. That is, their gross margins on new products decline after their introduction (over 2 or 3 quarters according to Seagate CEO Steve Luczo). The key sign of a "commodified" product is increasing unit volumes with decreasing price per unit. Case and point, Seagate's (Pre-Flood) 2011 10-K, p. 54:
Seagate Operating Statistics
July 1, 2011
July 2, 2010
July 3, 2009
Total Units Shipped (millions)
Average Selling Price (per unit)
While Seagate's products face tough economics, the market for disc drives grew 4% from July 2010 to July 2011 and would have grown further in July 2011 to July 2012 if it wasn't for the flooding in Thailand. From 2010 to 2011, storage demand by gigabytes increased 34%. (No numbers were available for this past fiscal year, but chances are the pattern was similar.)
For investment, it is unappealing that Seagate's products face persistent price erosion. But, having said that, this is not a negative analysis.
Post Thai Flood: 29% to 42% Market Share
While the Thailand flooding last year put some headwinds on hard disc manufactures, PC OEMs, and other manufactures in need of hard disc drives, Seagate made it out good.
Seagate, according to iSuppli, went from having a 29% market share in Q3 2011 to a 38% market share immediately following the flood in Q4. Having shipped 50 million hard discs in Q3 2011 before the flooding, it shipped a record 66 million in the most recent quarter (Q1 2012), for a market share of approximately 42%.
Seagate has closed the gap with market leader Wester Digital (WDC), who has market share of 44%. Seagate gained substantial windfall from the disaster and posted a 40% increase in revenue as of July 2012. But with Seagate's earnings release two nights ago, we witness the folly of the financial markets. After achieving record revenue, record net income and record operating cash flow, the shares were down 8% in aftermarket trading and further the following day.
Seagate's Results and Share Buy Backs
Seagate, as noted above, increased revenue by 40% year-over-year and had net income of $2.9 billion, representing a ROE of 117%. If it were not for share buybacks, book value would have more than doubled. Their share buy backs were substantial as management made clear in the conference call (transcript):
"For the fiscal year, Seagate generated over $3.2 billion in operating cash flow, of which we returned over 85% to shareholders through dividends and share redemptions."
And in their press release:
"Through the first half of the 2012 calendar year, Seagate has redeemed approximately 88 million ordinary shares, representing approximately 19% of the company's market capitalization."
These share repurchases were partially to offset the shares issued during their acquisition of Samsung's disc drive division at the end of last year, so saying that the shares they purchased represents 19% of the companies market capitalization is a little misleading. Nevertheless, they had a diluted share count of 467 million last July and now have a diluted share count of 427 million, or a reduction of 9%. But more interestingly, they further said in the conference call:
"We are on plan to reduce our share count to 350 million ordinary shares outstanding by calendar year-end 2012. Assuming market and macroeconomic conditions and the company's performance and valuation metrics are similar to what they are today, we plan to reduce our share count to 250 million ordinary shares by calendar year-end 2014."
Share Buy Backs and Future Earnings
Since we all know that:
- P/E = Price per share / Net Income Per Share
- Net Income Per Share = Net Income / Shares outstanding*
(*It's a bit more complicated than this because of dilutive securities, but that doesn't matter here.)
Let us hypothesize that next years earnings will equal this past years record earnings, to better understand the potential effects of these share buy backs. On that assumption, we see that Seagate's net income, with 350 million shares outstanding will be about $8.28 a share.
|For the Year Ended July 2012||For the hypothetical year ended July 2013|
|Net Income||$2,900 million||$2,900 million|
|Share Outstanding||427 million||350 million|
|Net income Per share||$6.79**||$8.28|
(**This won't match the numbers released on Monday because of the way "average diluted shares" is calculated. Fortunately, this is just an exercise.)
Therefore, with a present P/E of 4.65, and no change in either net income or share price, their P/E next fiscal year would be 3.65:
|Net Income per share||$6.49**||$8.28|
(**Diluted, as released)
In this case, no change in share price would make the shares appear even cheaper because of the buy backs.
Or, differently, if they retained their P/E of 4.46 over the period of share reduction, mathematically speaking, their price would increase to $38.50, or about a 27% return from today's prices.
|Net Income per share||$6.49**||$8.28|
(**Diluted, as released)
Notice that is assuming either (i) no change in share price, or (ii) no change in P/E valuation. Both of which are incredibly unlikely and we will probably see a higher valuation--a higher share price--in the future, barring any unforeseen cataclysm. And that is what we are looking for.
Of course, the problem is whether they will maintain their earning power--a problem with the industry as a whole, mentioned at the start.
Market Leader and Customers
With Seagate's new market leader position and technology leadership, status quo bias suggests they can maintain their new position. In addition, 69% of 2011 revenue was from large OEM's like Dell (DELL) (13%) and HP (HPQ) (15%) whose business is steadier (I argue) than that of the consumer business which makes up 9% to 31% of revenue.
Also, because they are also leading in the introduction of new products, they are likely to have higher gross margins in the near term. Of course, those margins will erode overtime as supply catches up with demand (see p. 50 - 51 of 2011 10-K on the effects of industry supply and demand imbalances).
Seagate's position, then, will not look as strong a year from now simply due to their product cycles and their competitors reestablishing themselves. In fact, one can see the wave of the two-year disc drive product cycles below in the cash from operations line:
STX Revenue TTM data by YCharts
All this implies that we are likely on a peak of earnings which will probably last through the Window's 8 release. This should cause us to use caution when accepting the valuations based on present earnings above. But today, the future is different than the past. They captured more market share after the flood. Therefore, the troughs in TTM operating cash flow will likely be shallower in the future.
Seagate is undervalued and the market's reaction on Monday and Tuesday was arbitrary.
To conclude, I leave you with a notable quote from Monday's conference call about Seagate's new hybrid drives.
Richard Kugele - Needham & Company, LLC, Research Division
Just 2 quick ones, one on technology. In terms of the enterprise hybrid hard drives, do you see others in the industry supplying that as well? Or looking at it another way, do you think the OEMs will acquire multiple sources for that? Or do you think you can go for a while as a single vendor?
Stephen J. Luczo
Well, I don't think -- again, Rich, if -- the type of hybrid drive we're talking about no, we don't think that there's anything competitively in the marketplace just because of the amount of time that we've spent developing the technology around our hybrid drives. It's been going on for 4 or 5 years really. And in terms of the OEMs, since we've had OEMs that have asked us for exclusivity, I would say that it would be really obnoxious for them to ask for exclusivity but require redundancy. So I think we'll probably get over that heartache. The performance on these drives and certain attributes that certain segments require is pretty impressive given the dollar investment relative to pure SSD. So it's a pretty exciting opportunity, and I think people will feel quite comfortable. Probably half of our portfolio, we're the only company that provides right now. So it's not like we're not sole sourced through a lot of our customers in the enterprise. Most of the small form factor SAS products we're really the only supplier of right now. So that's something that they're pretty comfortable with.
(Please post disagreements or counter-facts in the comments section below -- that way I can either address them or learn something new.)