Weak Results Pummel Seagate. Seagate (NASDAQ:STX), one of the household names for disk drives, has had a rough year so far. In April, the company reported that revenues had dropped by 22% in the 3rd Quarter of Fiscal 2016 and that earnings had swung from a profit of $291 million to a loss of $21 million. At the same time, Seagate's Gross Margin declined from nearly 29% in the 3rd quarter of 2015 to under 23% in 2016. Not surprisingly, its stock has fallen by close to 35% in the year to date.
The decline in Seagate's performance was largely expected: its core product, Hard Disk Drives (HDD), faces considerable headwinds as a result of the decline in personal computer sales, which dipped to an 8-year low in 2015 - and continued to slide by another 11.5% in the first quarter.
Dividend Impact. Despite its gloomy fortunes, Seagate maintained its dividend of 63-cents per share and management stated that it believed its dividend to be 'manageable' and 'very defendable against what [Seagate will be] able to generate moving forward.' Its CFO, Dave Morton, also stated that there had been no change to the company's dividend policy and that 'defending the dividend' was the 'first thing it would do [with Seagate's cash flow].'
Seagate is currently trading with a dividend yield of around 11%. That puts it head and shoulders above the rest of its peer group and means that any investor who purchases 100 shares of Seagate for $2,272 can expect passive income of around $252 a year.
This begs the question: if the dividend is manageable is now the time to buy the stock?
Maybe not. For one thing, even Seagate's executives acknowledged that its dividend is at a payout ratio (126%) that is well-above the 30% to 50% payout ratio that it had indicated to investors previously. Seagate's executives hedged that it believed that the payout ration was something company could '[grow] into.'
However, drive makers face an even greater conundrum ahead: HDD shipments actually fell at an even faster rate (17%) than PC sales (8%) in 2015. Even worse, by the estimation of both Seagate and Western Digital (NYSE:WDC), which happen to be the two largest makers of HDD in the world, the Total Available Market for hard drive-based storage is actually contracting at a significant rate.
In that sense, even Seagate's own forecast appears to be at odds with management's statement of being able to grow into its dividend payout ratio. Indeed, Seagate's revenues have actually declined by an average of 2.8% over the past 3 years - a faster rate of revenue slippage than the 1.8% rate of its industry.
To be sure, Seagate does have a decent working capital ratio of around 1.6-to-1.00 based on its most recent SEC filings. However, this is a third lower than its working capital ratio of nearly 2.4-to-1.00 from just nine months ago. It's easy to see how this happened: it drew-down nearly $1.4 Billion from its cash over the last 4 quarters - and half of that went to paying dividends. In that sense, unless there is a radical change in the trajectory of its core business, it's difficult to see how it can continue to pay around $188 million in dividends indefinitely.
In particular, there is the matter of its debt to resolve. With over $4 Billion in long-term debt and just $1.7 Billion in equity, the company's Gearing is very high at 2.45. In fact, Seagate is considerably more leveraged than its peer group which, on average, has just 40 cents of debt for every dollar of equity.
It's also important to note that Seagate's equity declines with each dividend payout it makes when it loses money - or when its dividend payout ratio exceeds 100% - so its Gearing can get worse before it gets better. As any investor knows, debt claims are senior to equity claims so at some point (depending on Seagate's fortunes) the company may have no choice but to cut its dividend or risk falling behind on its debt servicing.
Outlook. Looking ahead, Seagate's revenues are expected to fall by 6% a year over the next five years - compared to revenue growth of close to 17% for its industry peers. This divergence could be the result of the shift in the industry: Enterprise shipments are expected to take up 45% of industry petabyte demand by 2018. Seagate already derives 59% of its revenues from Enterprise Cloud/New Storage Applications so there is less headroom for it to grow.
Considering the foregoing, we believe that Seagate will be under intense pressure to reduce its dividend before long. The current consensus estimate is for Seagate to earn $1.96/share in Fiscal 2017 - 48% lower than the $3.75/share estimate from just 90 days ago.
If we assume that this forward EPS estimate is accurate and that Seagate goes back to a 50% payout ratio, then its quarterly dividend could slide from 63-cents per share to just 24.5-cents per share - a 4.3% dividend yield at the current stock price.
Of course, this assumes no change in the stock price - one analyst has come forward and set a $15 target price on the stock - a 34% drop from its current level that would eliminate any cash gains from Seagate's high dividend yield.
Interestingly, under these two scenarios we've mentioned, the combination of a lower stock price and reduced annual dividend would reduce Seagate's yield to just 6% -- still below its current level - and not all that attractive to investors.
As such, we would caution dividend-seeking investors from being tempted by Seagate's seemingly high dividend yield. The balance of risks suggests that this is unsustainable and that investors should expect a reduced dividend from the company in the year ahead.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Company financial data is taken from the company’s latest SEC filings unless attributed elsewhere. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.