Private investors have the benefit of deciding the duration of their investment horizons. It should be noted, however, that shorter-term investments in unpredictable businesses are concave in nature. In terms of investments, concavity reflects a scenario where although the expected odds of realized downside are relatively low, the upside is capped, while the full downside potential is comparatively large. An investment in Seagate Technology (STX) is concave in nature, but appears to have very limited downside, given its present valuation and the underlying business dynamics.
Let's start with some context on the future of Seagate's product offerings:
HDDs: Not Dead Yet
To invest in the harddrive space, an understanding of the technologies is vital. HDDs, or hard disk drives, are used in a variety of complex devices. Examples include workstations, supercomputers, enterprise servers, PCs, laptops, medical imaging devices, and home entertainment products. In the past few years, consumers with certain data needs have increasingly trended towards SSDs, or solid state drives.
HDDs are, in computer terms, a very old technology. As a result, they are far cheaper, specifically on a price to GB (gigabyte) ratio. For HDDs, the ratio is about $.10 per GB, compared to $.90 per GB for a comparable amount of space provided by a SSD. While the investment community appears to believe that the death of HDDs is imminent, there is a much less exciting dynamic at play. Simply, the cost differential results in very different end-uses.
HDDs are still the drive of choice for the following types of users:
- "Heavy downloaders" - Supercomputers, video collectors, and other collectors of massive quantities of data require large capacities at a reasonable price per GB. Keep in mind that all information on the "cloud" is stored on huge central databases.
- Cost-conscious consumers - While Macbooks and iPads use the expensive, high-quality SSDs produced by Samsung and Toshiba, most other mobile PC suppliers are trying to appeal to consumers on a budget. Mobile PCs aside from Apple's products make up about 73% of the market, leaving a huge market for Seagate and Western Digital (WDC) to compete over. Producers like Dell (DELL) and Hewlett-Packard (HPQ) are trying to appeal to consumers by selling laptops under $800; they can't do that with the high relative cost of SSDs.
- The everyday consumer - With the exception of the premium-hardware buying Apple customer, one has to question whether it's necessary that a device like a mobile computer even have a SSD given the current cost structure. For sure, SSDs have their advantages; significantly faster start-up speeds, they are essentially silent, and are less likely to lose their data. However, with nearly two-thirds of the PC market dominated by lower-cost producers, it's clear that the majority of consumers aren't willing to pay up for the benefits just yet.
The Mobile Growth Question
HDDs have no place in handheld devices, so the natural inclination is to conclude that companies Seagate will lose out on the growth of the cloud. While Seagate won't directly benefit from the trend towards greater usage of mobile devices that use SSDs, the growth story here is a derivative play off of that.
Demand for HDD capacity storage is expected to triple over the next ten years. As a leader in client solutions for cloud storage, this growth will have a transformative effect on STX's bottom line.
Most importantly, Seagate is developing a precense in the SSD market. Its partnership with DensBits is a move to develop products for everyday users. Additionally, STX's Momentus XT drive was exceptionally well received.
The Outlook For Seagate's Bottom Line Is Exceptionally Bright
Given the above factors, what we're left with is an industry that the investment community is misunderstanding. The following is true:
- PC demand is weak, and will likely remain so in a relatively stagnant global economy.
- On a capacity and price basis, HDDs are still the clear leaders
- SSDs are likely to remain a niche market for quite some time, given the shortage of NAND flash that plagues SSD manufactures. This is likely to persist for the next several years.
- STX will indirectly benefit from the migration to SSD-using mobile PCs and handheld devices, thanks to its cloud offerings.
On a micro basis, STX's management is executing some very interesting plans.
STX plans to reduce the number of shares outstanding to 250 million by 2014. With nearly 400 million shares outstanding today and $2.86 billion of net income, diluted EPS will rise to $11.44 - up from the TTM figure $6.49 - assuming profits stagnate.
Some within the investment community may believe that this aggressive share buyback indicates that management is either: (1) trying to inflate earnings, or (2) can't find better places to allocate capital.
Neither of these accusations hold much water. I find it highly unlikely that management has been operating a buyback program this large just to meet specific earnings targets or estimates. Additionally, this program has been carried over the past few years, reflecting management's belief that the company is substantially undervalued. A private equity firm tried to take STX private in 2010.
As for capital allocation, the company has been investing in its SSD business, improving its HDD offerings, and acquiring talented management like Gary Gentry (former GM of Micron's SSD unit). Furthermore, the company has grown net income by 75% since fiscal 2010 despite stagnant capital expenditures.
While the HDD business is fairly commoditized, pricing pressures are offset by the duopolistic nature of the industry. Similarly, the recent move towards greater utilization of SSDs is unlikely to be much of a medium-term threat for two reasons. Firstly, Seagate benefits from the general trend of accelerated data creation, since it has an impressive cloud storage/solutions presence. Second, the cost of SSDs and shortage NAND flash (the main component in the chips that SSDs utilize) limit the intermediate-term market potential for SSD manufacturers.
This is a company trading at less than 5 times earnings, despite a gigantic catalyst in share buybacks at ultra-cheap values, a strong competitive position, and a 4% dividend.
Share repurchases aside, I expect STX's organic earnings to grow at a mid-high, single-digits rate. This reflects the accretive effect from the Samsung HDD purchase, an improved global economy, growth opportunities in cloud solutions and server storage, and new SSD offerings. With only 250 million shares outstanding in 2014, the company should be earning at least $12 per share. Even with zero multiple expansion, STX would be valued at about $60 per share.
Admittedly, low valuations have plagued both STX and WDC for quite some time, and this may persist for the next few years. Given the nature of the business (unstable and unpredictable cash flows), I wouldn't value the company at more than ten times earnings, but five is simply far too low, given the internal cash flow generation.
By 2014, I expect the market to continue valuing STX with skepticism, but earnings growth and increased distributions will force the stock higher towards the $60-$75 range.
I particularly like the asymmetric return profile and margin of safety on this prospective investment. The current valuation implies little or no growth prospects, weak shareholder return, and a dying business. Given economic reality, this is misguided. Short of a collapse in earnings, the stock has exceptionally limited downside, and potential returns that greatly outstrip said downside. Even if my projected 2014 earnings are 30% short and come in closer to $8 per share, shareholders would have received at least 4% annually in dividends, and the stock would still be trading at a dirt cheap multiple.