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Is Seagate Buyout a Steal for Private Equity?

|Includes:MU, Seagate Technology (STX), WDC

Seagate is cheap. It's a cyclical stock, one that is still mired in uncertainty due to the commodity nature of its business, the struggles with a fast growth competitor in Western Digital, a new CEO, the cyclicality of storage/hardware business, and now valuation since the whispers of a buyout offer. Nevertheless, it does mean that Seagate is worth only $16/share. And especially not to a consortium of private equity firms that can raise money at rates of 6% to buy the company out. If the new CEO (Luczo) is looking for a quick payout, I'd be extremely surprised that an ex-Sr Managing Director of Bear Stearns Technology Group and a tenured history at Seagate since 1993, will make him devoid of the true valuation of a company like Seagate.

First off, normalized earnings for a Seagate is about $1 billion. I've accounted for the fact that 2010 was stronger than usual and that they currently are not paying any taxes. Some #'s for my valuation:

D&A = $800mil
Capex = $625mil
OCF = $1.8 billion (my definition is NI + D&A)
FCF = $1.175 billion
Invested Capital = $3.05billion
Cash Flow ROIC = 39%

Cash = $2.5billion
Debt = $2.5billion

Market cap at $16 is $8billion. Since net debt is 0, the enterprise value for Seagate is also $8billion. FCF yield on a valuation of $8billion is 14.7%. That is nuts when you can borrow to buyout a firm at 6% interest rates! In my opinion, this yield should be about 10%, or a valuation of $11billion and $22/share. I also highlighted the ROIC #, mostly because its just insane for a hardware company. The thing is about hard drives, is that its now an oligopoly business run by a few dominant firms (Seagate, Western Digital the runaway leaders). This allows for lower capex investments - which is awesome for any LBO-er by the way - and creates this high ROIC #. If you want a comparison, take a look at semiconductor companies where there are a much larger # of firms competing. Routinely, their ROIC #'s come in at around 20-40% lower and they are probably more cyclical, yet have valuation multiples that are generally higher (Micron Technology would be an example of a lower ROIC operation with a similar valuation). It really makes no sense, and is why I bought into Seagate at prices of around $13/share.

Now the argument may be that the offer price for Seagate is fair because it matches the multiples of Western Digital. That's all fine and mighty - except Western Digital is cheap too. The buyout consortium has simply made them both equally attractive at Seagate's current price of $15/share.

My advice: hold firm for an offer above $20. At this price, buyout firms will still be able to make a 20-25% annualized return by my estimates.

Current price: $15
Conservative fair value: $22, 50% higher from current price
Strategy: Sell November puts at strike $14 for $.55, a yield of almost 4% in one month, or even buy shares outright for this one!


Disclosure: Long STX
Stocks: STX, WDC, MU