Seagate: Short-Term Bearish, Long-Term Bullish

Summary

• Seagate shares were very volatile over the last 6 years.
• The reason for high volatility was the decline in revenue and operating margin.
• The decline will likely persist in the near future and therefore short-term outlook is weak.
• On the other hand, there is a positive long-term outlook favoring the demand for storage.
• When the company stabilizes the business, it will be a buy, in the meantime, it is just a hold.

Seagate (NASDAQ:STX) is likely to face negative pressure in the short term due to further revenue and operating margin decline. On the other hand, the opportunity for the long term is imminent stemming from favoring trends in the industry. Internet of Things, which means digitalization, data collection and the general movement to cloud, is going to create yet further demand for the data storage where HDD products are to benefit. And so, Seagate is well positioned to outperform in the long term. However, the company needs to demonstrate the ability to profit from the positive industry trends and stabilize the deteriorating business fundamentals. Steve Luczo, the CEO of the company, highlighted cautious optimism for business model stabilization, but I would wait for 2018 outlook to confirm his words.

High volatility

Seagate has been very volatile during the last six years. The shares advanced from low of $7.7 in 2011 to the peak of $69.4 in 2014. After that, it reversed the bullish momentum and declined to a bottom of $17 in 2016. Consequently, the shares reached a high of $50 in April this year.

Source: www.finance.yahoo.com

And so, the investors could see the shares increase nine-fold, decrease 75 percent, increase three-fold and decrease 25 percent to current levels in a matter of six years. These huge swings have been caused by huge volatility in underlying profitability.

Profitability swings

The revenue reached a peak of $14.9B in 2012. Since then, sales declined every year. And they are projected to decline further next year.

Source: Seagate 10k's, Analyst Projections

Source: www.finance.yahoo.com

The decline in sales had a direct impact on the decline in operating margin. Operating expenses as a percentage of revenue increased from 10.5% in 2012 to 20.2% projected for 2017.

Source: Seagate 10-K's

There is an exact inverse relationship between revenue and operating expenses. Therefore, further weakness in sales will put yet another pressure on the margin. On the other hand, the gross margin has been fluctuating from low 20’s to high 20’s and is projected to reach 30% in 2017. This is historically above average, and therefore, I expect there is a high probability of gross margin mean reversion in 2018. My assumption is that the gross margin profitability fluctuation is the result of cyclicality in the business. And therefore, as the gross margin expanded last year, it may contract next year. This is supported by the recent concerns that sent the stock to the downside with respect to HDD sales.

Source: Seekingalpha.com

If the management confirms investors’ concern with respect to the weakness in HDD sales, the shares will continue decline. Therefore, I would like to wait for more clarity with respect to operating margin stabilization. Bulls have been favoring Seagate by low P/E ratio, high dividend yield, high cash flow generation, but even that has deteriorated recently.

Cash flow generation

Despite the weakness in operating margin, the company has been able to cover its dividend payments with the cash flow generated from the business. However, as the dividend increased and the operating margin decreased, the ability to cover the dividend decreased substantially. For instance, Seagate was generating enough cash to cover seven times higher dividend in 2012. However, last year, it was only one and half times. In 2017, the gross margin expanded and the ability increased slightly. But this excludes one dividend payment that Seagate skipped. Otherwise, it would be two times.

Source: Seagate 10-K's

As revenue is projected to decline further, it will put pressure on operating margin yet again. The gross margin is already above historical levels, and so it is unlikely it can expand meaningfully higher. Therefore, lower ability to cover dividend payments, further revenue decline and operating margin squeeze, as well as a potential reversal in gross margin, will potentially put pressure on equity in the short term. Therefore, I suspect another weakness in the shares following the outlook for 2018. Particularly, I would watch the $35 and $31 levels given they worked as a resistance on the way up. Despite the short-term weakness, the management highlights the strong industry fundamentals from the digitalization.

Data age 2025

Seagate management highlights that the society will create 163 zeta bytes of data till 2025. There is a strong movement towards data collection with respect to car industry automation, the rise of the artificial intelligence, further digitalization and the movement to cloud. More devices and artificial intelligence data learning will result in higher demand for enterprise data storage which will result in higher HDD storage needs.

Source: Seagate 3Q Supplemental Information

The company has been transforming and shifting its focus away from PC and flash business storage towards enterprise, and so the opportunity for Seagate is imminent. But the company needs to deliver stronger results to demonstrate it can profit from the positive industry trends. The reason is that the data collection, the movement to the cloud, digitalization has been already happening over the past 4 years. And yet, the revenue declined and the operating margin got squeezed. Therefore, the outlook for 2018 will be crucial to set the further trajectory in shares as it may confirm the business stabilization or further weakness.

Takeaway

The key takeaway is that shares have been very volatile in recent years. The reason for the volatility was the fluctuation in profitability and partially the decline in revenue. The last year showed a sign of stabilization in operating margin. However, this was done through gross margin expansion that is now above historical average. If that will revert towards historical average, then the company may decline in the short term. On the other hand, there is a huge opportunity for the company long term from favoring industry trends. However, the company needs to deliver stronger results to demonstrate it can profit from those trends.

Analyst’s 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.