Seagate Technology: Why The Likely End Game Is A LBO

| About: Seagate Technology (STX)
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Seagate Technology (NASDAQ:STX) has strung together several solid quarters in a row now. The flooding in Thailand during the 2011 monsoon season, which temporarily and significantly affected global hard disk drive (HDD) supply, has actually led to the highest gross margins in recent years, if not ever, for this industry. Seagate came out of the floods positioned extremely well. Some of their suppliers experienced stoppages in production, but Seagate was still able to post record results in the March and June 2012 quarters as pricing rebounded and they took market share from competitors (they also purchased Samsung's HDD business in December 2011, which added to results).

(in millions)

June 30, 2011

Sept. 30, 2011

Dec. 31, 2011

March 31, 2012

June 30, 2012







Diluted EPS












While the FCF growth is impressive, gross margins have almost certainly peaked. Still, they should remain well above the previous normal range of 18 - 20 percent due to tighter supply, growing demand, and industry consolidation. Management has said they expect gross margins to be at least 30 percent for the remainder of the calendar year 2012. With their focus on selling higher margin products, Seagate should meet their margin goals for the next few quarters.

So what has Seagate been doing with all that cash it generates? In a word (or two): a lot. They have been buying back stock (a ton of it), paying down debt (current net debt is only $1.1B, which is less than last quarter's FCF), paying dividends and making acquisitions (they purchased Samsung's HDD business, for which they paid half the purchase price in cash, the remainder in stock).

And yet the stock still trades at a trailing P/E ratio of 5.4x and even lower on a forward basis. This after a 50%+ run-up in the stock price since early June. Of course technology hardware companies like Seagate historically trade at high single digit multiples, but a Company executing as well as Seagate should trade at the upper-end of that historical range in my opinion, especially when it has a 3.7% dividend, which is only an 10-12% FCF payout ratio.

So what is the Board doing to help get the stock to a respectable P/E multiple? First, they raised the dividend for the second time in a year last month, to an annualized $1.28/share (3.7% yield based on the current stock price). Second, they will continue to repurchase shares, boosting EPS significantly. Over the past two quarters alone, the Company has repurchased $2.2B of shares. At June 30, that was nearly 20 percent of the Company! In six months!

Management has stated their intention to end calendar year 2012 with a basic share count of 350M shares (basic weighted average share count at June 30 was 411M). They also recently introduced their intention to get the basic share count down to 250M shares by calendar year-end 2014. That would be a massive reduction in share count and would serve to maintain or expand diluted EPS even if margins deteriorate more than anticipated.

Additionally, management recently stated that they are indeed looking for acquisitions in the solid state drive (SSD) space, particularly in the enterprise space. OCZ Technology was rumored in late July to have sold itself to Seagate, however that rumor has so far turned out to be false. And just this morning IBM agreed to purchase Texas Memory Systems, an enterprise storage technology provider. IBM's purchase might just be the one that sets off a wave of consolidation in the SSD space. While Seagate already builds and sells HDDs and SSDs (as well as hybrid drives), they can certainly benefit from aggregating additional capacity under their umbrella. Synergies amongst two companies combining forces (particularly with one having the size and scope of Seagate) will help offset the lower margins that the pure play SSD makers have.

So where does this leave Seagate shareholders? By most reasonable valuation metrics, Seagate is undervalued. It generates a ton of free cash flow. If a private equity shop believes that Seagate can continue to generate $3-$4B in FCF a year, it is a no brainer leverage buyout at these valuation levels. They can pay about 7-8x EPS, giving existing shareholders a nice return (even after the recent run-up), and still generate a solid return themselves. We know Seagate and Chairman/CEO Steve Luczo has taken Seagate private once before in an attempt to unlock shareholder value, back in 2000. We also know that Seagate was rumored to have participated in failed talks to again take the company private in 2010. Today, the Company is performing better than ever. Cash flow is extremely strong, giving the Company many options for its uses. If they continue to buy back shares at the pace they are currently, one of two things will happen. The stock will either soar to $50+ per share or the Company will get bought out in a LBO transaction. Either one will be a win for shareholders.

Disclosure: I am long STX.