Seagate - 185% Annualized Return In 3 Months, Moving To 'Hold'

Summary

• I wrote an article and initiated a position in Seagate back in October, then having a "bullish" stance on the company due to significant undervaluation.
• My investment paid off in spades in a shorter timeframe than I could have expected.
• I update my thesis on Seagate.
• I do much more than just articles at iREIT on Alpha: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

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Do you remember this article?

Plenty of readers and investors liked it, but I also received some DMs from investors who were dubious of my stance here. While it's impossible to forecast the long term, what I've seen so far should give those that doubt the company some pause.

(Source: Seeking Alpha Article)

Valuation investors such as myself aren't known for chasing capital appreciation or growth. Indeed, my primary investment target is conservative upside over time coupled with excellent yield. I would be lying if I didn't say that capital appreciation in triple digits sometimes comes along with identifying great opportunities, however.

Seagate (NASDAQ:STX) was a great opportunity. The annualized RoR based on my investment in October has been over 180%, or 31.7% total since the article was published. Given the outperformance of 6X to S&P 500, it's beyond question what was the right call - at least up until now.

Let's review the results and thesis.

(Source: Seagate)

How has the company been doing?

What we have is an outstanding 2022, due to the company's fiscal year. The company reports superb revenue increases of 35% YoY that were up sequentially as well. The company continues to boast high gross margins of above 30% on a Non-GAAP basis, and near-sector-leading operating margins of 20.1%, the highest level in an entire decade.

Also, its mass capacity storage has grown to $2B for the first time ever - another milestone for the company.

Financial highlights during the last fiscal were significant.

(Source: Seagate Technologies)

Specifically, the mass-capacity markets saw broad-based growth, excellent spending in enterprise and cloud, and perhaps even more importantly, the decline in legacy is slowly starting to stabilize. The demand for mission-critical hardware is increasing, and this was what saved the overall decline in consumer drives the company saw during late June.

Fundamentally speaking, the company is in a very good position. It doesn't borrow money at the low cost of debt as a European business, but the average weighted interest of 4.3% is still good, with an average maturity of around 6 years. The company has more than $2.7B in liquidity, with almost a billion of that in cash and the rest in a revolver. No money issues here. At an 11x interest coverage ratio, and leverage of 2.2x, this is as safe as IT hardware companies can get.

The company further recently bumped its dividend, really underscoring what's been achieved by the company. The current yield on its price is around 2.47%, a far cry from the 3.45% yield I have on my position and the 3.3% I advertised my latest article with - but this is the price of passivity. I'm not only speaking to those who didn't invest, I speak as someone who should have invested significantly more.

I didn't see many risks in my original article - and I still don't see all that many risks in the company's business. Seagate is one of the largest drive/capacity manufacturers in the world, and while its business can be somewhat cyclical, this to me doesn't impact the fundamental appeal of the business.

What we're currently seeing is a move from consumer towards enterprise consumers, which is a good move, due to somewhat higher margins (typically) here, especially with cloud spending.

Furthermore, a common fear is the impact of inflation and material costs - but the margin indications both on a gross and operating basis give us the indication that STX has been quite successful in passing these along to consumers. The company is returning cash well above a 100% FCF level, and anytime a company such as this showcases these strong sorts of return metrics, things are going well.

The questions now for the long-term concern CapEx spend and discipline, as well as forecasts for the coming cycles - and current visibility beyond 2022-2023 at this time is relatively low. What I have done is adjust my forecast models for STX with the company's 4-6% Capex/Revenue estimates, with 2023 fiscal in the low part of that range.

The core of my thesis, however, remains regarding the valuation, and not paying too much.

What is the valuation?

Valuation remains key, especially following a market outperformance as we've seen from Seagate. It would be unfair to characterize the company as "historically-stable" - it hasn't been.

(Source: F.A.S.T. Graphs)

We can see the company's historical discount being abandoned for the past few years. However, what has changed during the past 3 months is absolutely crucial to the company's thesis. The company's average discount of ~10x on a P/E basis no longer has a forecasted upside - not even with the current EPS growth rates.

(Source: F.A.S.T. Graphs)

This doesn't necessarily mean that the company is no longer investable. I see the company's upside as fundamentally changing its cash flow growth rates - at least for the foreseeable future. I see this confirmed by the margin expansion in the face of the current macro inflation/raw material headwinds. It is no longer incorrect, I believe, to consider an upside of 12-13x P/E.

On the basis of a 13x P/E, the company still has a double-digit upside, outperforming the market with a 10% annualized RoR until 2024. There is no question, however, that the company at this time no longer holds the massive appeal it did only 3 months ago.

Current average analyst targets range from $80 to $135, with an average of $104, indicating an overvaluation of around 9.1%. What we're seeing here are 21 analysts not yet considering a more fundamental upside to the company. Is this correct? That depends on your expectations.

Me, I say that STX is likely to outperform going forward. Growth and sales will continue, and the current rates justify a higher multiple.

However, at the same time, it's also true that STX is at a premium to its public comps, those comps including Western Digital (WDC), Hewlett Packard (HPE), HP (HPQ), Dell (DELL), and others. In terms of revenue, the company is trading at nearly twice the peer average, same with EBITDA, as well as a significantly higher NTM P/E ratio, with most peers below 10x.

Being fundamentally conservative, I'm hesitant to go further here. In fact, at this valuation, I see peers as better-valued. Because of this, I'm moving to a "HOLD" here - but not a sell or profit rotation.

There are better investments with 10% or above upside at more conservative valuations and better yield. This does not mean STX is likely to drop - I just don't believe that we'll see multiple expansions to above 12-13x, and there are better alternatives here.

For that reason, I will move to a "HOLD" here. A price target that I would consider attractive for investment based on my goals would be around $105/share - though every investor of course needs to look at their own targets, goals, and strategies. I would also always consult with a finance professional before making investment decisions such as this.

Thesis

My thesis for STX is:

• A fundamentally appealing tech/hardware company that's vastly outperformed over the last 3 months to the tune of 181% annualized RoR. While it may be early to go "HOLD" here, I want better returns - however, I'm not selling my stake.
• STX is amongst the market-leading companies in its sector, and its continued potential isn't small - but there are higher potentials at cheaper prices available. And I am all about the highest growth at the lowest price, for the most safety.
• For that reason, the time has come to shift my target on STX.

Remember, I'm all about :

1. Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
3. If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.

This process has allowed me to triple my net worth in less than 7 years - and that is all I intend to continue doing (even if I don't expect the same rates of return for the next few years).

If you're interested in significantly higher returns, then I'm probably not for you. If you're interested in 10% yields, I'm not for you either.

If you however want to grow your money conservatively, safely, and harvest well-covered dividends while doing so, and your timeframe is 5-30 years, then I might be for you.

Seagate Technologies is currently a "HOLD".

Thank you for reading.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of STX, HPE, WDC either through stock ownership, options, or other derivatives. 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.

While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment. Short-term trading, options trading/investment, and futures trading are potentially extremely risky investment styles. They generally are not appropriate for someone with limited capital, limited investment experience, or a lack of understanding for the necessary risk tolerance involved. The author's intent is never to give personalized financial advice, and publications are to be viewed as research and company interest pieces. The author owns the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in the articles. The author owns the Canadian tickers of all Canadian stocks written about.