Seagate: Looking For The Bottom

Summary

• Seagate’s revenue results were in line, but EPS beat consensus estimates.
• The EPS beat was driven by higher-than-expected gross margins, lower operating expenses, and lower interest and other expenses.
• However, the shift from HDDs to SSDs poses a threat to Seagate, which generates over 90% of its revenues from the sales of HDDs.
• But the stock has already de-rated and now trades cheaply at ~8x P/E, while offering a dividend yield of 6%.
• We think the market is excessively bearish on the stock, and any surprises to the upside could lead to a short squeeze.

While Seagate Technologies (NASDAQ:STX) did post a better-than-expected quarter this time around, challenges remain. The company has been a clear beneficiary of accelerating data storage growth as enterprises adopt new technologies such as AI, IoT, and Automation, but margin recovery remains a key challenge. We see plenty of headwinds near term, e.g., cloud slowdown, Intel CPU shortages, and macro uncertainty - all of which should weigh on the top line going forward.

We see the company reaching the lower end of its 29-33% gross margins target range, but a sooner-than-expected cloud demand recovery could bring GMs to the mid-point of the range. We think the key to the Seagate story in 2019 will be how management navigates margins, as tight discipline will be required to keep operating costs within the 13-15% OpEx target range.

But there is a silver lining in the Seagate story - valuation. At current levels, Seagate is priced at ~8x trailing P/E, ~6x EV/ EBITDA, with a dividend yield of ~6% to boot. Thus, we think the stock might be worth a look for income investors, as HDD revenue has turned out a lot more stable than many had initially anticipated. Plus, with sentiment already very bearish on the stock (short interest is at ~11% of float), the bar is low, and we think Seagate might be ripe for a squeeze.

Results

Seagate reported revenues of $2,715 million, which were down 9% qoq and in line with consensus estimates. HDD revenues were $2,490 million, which were below estimates of $2,547 million. HDD unit shipments were 36-37 million and below consensus estimates of 37.9 million. Enterprise units sold of 8.1 million were above consensus estimates of 7.9 million. Flash and Enterprise Systems revenue was $225 million, above estimates of $190 million. Seagate shipped 87.4 exabytes this quarter in terms of storage capacity, which is down 12% qoq and flat yoy. Average capacity per drive was down from 2.5 TB in 1QFY19 to 2.4 TB. Non-GAAP gross margin was 29.7%, which was above estimates of 29.3%.

The company's operating EPS was $1.41, above estimates of $1.27. Despite in-line revenue results, this beat on EPS was primarily driven by higher gross margins, lower operating expenses, and lower interest and other costs.

In terms of Seagate’s cash flow, cash decreased by $585 million to $1,357 million. OCF was $288 million, but CapEx was $127 million, share repurchases were $136 million, dividend payments were $180 million, and repayment of long-term debt was $499 million.

The company’s guidance for 3QFY19 was below consensus estimates: revenue guidance was $2,300 million at the midpoint versus estimates of $2,500 million, and EPS guidance was $0.70 at the midpoint versus estimates of $1.04. Seagate also expects a lower gross margin for the next quarter as well as exabyte shipments to decline 10-15% qoq.

Tailwinds

As a data storage supplier, Seagate benefits from the accelerating growth in the data storage industry as a result of new technological advancements in AI, IoT, and automation. These advancements require large amounts of data, and businesses and individuals turn to data storage suppliers such as Seagate to handle them. Cloud is another area that has seen rapid growth in demand, which can also benefit the company’s business.

One of the main threats to Seagate’s business is the shift away from HDD to SDD. This is a material threat to the company because it generates over 90% of its revenue from HDD. However, it can take several quarters for OEMs and Seagate’s other customers to shift purchasing decisions. Furthermore, in the face of this threat, Seagate still repurchased $136 million of its stock this quarter and paid out an additional $180 million in dividends, and management reiterated its dividend payments for the future, which currently provides a yield of 5-6%.

Headwinds

One of the main threats to Seagate is the shift from HDD to SDD. The company generates over 90% of its revenue from its sales of HDD, and this decrease in demand for HDD could be very disruptive for its business. Seagate has reduced production of its HDD to control inventory levels, but this only addresses the issue in the short term, and the underlying long-term threat of lower HDD demand remains. Furthermore, NAND prices have also dropped, which is another catalyst for the shift from HDDs to SSDs.

Conclusion

Seagate reported revenues that were in line with estimates and EPS that beat estimates. This was driven mainly by higher gross margins, lower operating expenses, and lower interest and other expenses. The company shipped 87.4 exabytes this quarter in terms of storage capacity, which was down 12% qoq. In addition, the average capacity per drive was down 0.1 TB qoq.

As a data storage supplier, Seagate benefits from the growth of the data storage industry, spurred on by the growth of AI, IoT, automation, cloud, and other technological advancements. However, the industry has also seen a shift away from HDDs in favor of SSDs. This poses a significant threat to Seagate given that the company’s business is very concentrated, as it generates over 90% of its revenue from sales of HDDs. Seagate has reduced production of its HDDs, but this is only a temporary solution and does not address the longer-term threat that it faces.

Management’s guidance for the next quarter was below consensus estimates for both the top and bottom lines, but they also reiterated their dividend guidance for the future, which currently produces a 5-6% yield. The company paid out $180 million in dividends last quarter and also bought back $136 million of its shares.

Overall, we think Seagate might be worth a look for income investors - valuations are cheap at ~8x trailing P/E, and there's a nice ~6% dividend yield to boot. With the market bearish on the stock and a sky-high short interest at ~11% of the float, the bar is low, and we think Seagate might be ripe for a squeeze.

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.