HUTCHINSON TECHNOLOGY INC HTCH
May 17, 2010 - 6:23pm EST by
cbubba1090
2010 2011
Price: 5.59 EPS NM $0.00
Shares Out. (in M): 23 P/E 0.0x 0.0x
Market Cap (in $M): 130 P/FCF 0.0x 0.0x
Net Debt (in $M): 30 EBIT 0 0
TEV ($): 160 TEV/EBIT 0.0x 0.0x

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Description

Preamble This Reactivation Idea revisits what was by far the worst performing of the three ideas that I contributed to VIC. As uncomfortable as it might seem to revisit a “Did I really write that?” recommendation, it simply has to be done. The passage of 26 months has meaningfully evolved the underlying business fundamentals, and mostly to the good. The same can be said for my understanding of those fundamentals. Most importantly, a recent setback has put the stock back on the “left for dead” pile, at a price that in my estimation provides substantial near term as well as long term appreciation potential. After briefly recapping what caused this stock to trade off the map, I will detail a very old school value case for why the intrinsic value of HT might be significantly (perhaps by 100%+) greater than its recent book value of $13.20. A case can be made for appreciation potential significantly beyond that, though not in a way that can be put to numbers based on present business conditions. My expectation is that over the next several quarters, conditions will evolve to a degree where it will become possible to discern whether the appreciation potential is on the order of “a triple or so”, or something much greater.

The Initial Premise In early 2008, HT seemed poised to enjoy a season of strong earnings growth. It had been investing heavily ($550MM+ over the preceding three years) in its main business, suspension assemblies (SA) for hard disk drives (HDD), primarily in preparation for a design step change. (This is described in some detail in the 3/8/08 Idea, and can also be explored at www.htch.com.) It also had just started marketing its recently approved InSpectra™ device, which by providing a noninvasive real-time measure of tissue oxygenation held significant potential as well. The HDD supply chain within which HT had grown to be a technological leader seemed to be in the late stages of meaningful consolidation and so had the potential to become a much saner (how about less insane?) place. Since at least FY 06, earnings had been weighed down by the expense of preparing to transition to TSA+ (using an “additive” process to make the flexure, the circuitry wherein data flows between the read head and the rest of the drive, rather than the “subtractive” process which HT pioneered over a decade previously). They were also impacted by collateral damage from competitors going out of business, including one large customer shifting business away from HT to try and prop one of them up. Once Magnecomp was acquired by TDK in November 2007, the SA industry was down to just three rather prudent seeming and deep-pocketed suppliers (the other being Japanese spring maker NHK). There was also this phenomenon which has come to be called Web 2.0, off-the-charts growth in the rate at which enterprises and households generate, share and replicate data, a great deal of which has to be stored somewhere. 

Disaster Diagnosis

They all seem like good ideas at the time. Who knew, on March 8, 2008, that the collapse of the once estimable Bear Stearns was only a few days away? Or that as dramatic that was, it was but a fleeting foretaste of what would be visited upon investors over the next 250 or so trading days. That HTCH ended up on the long list of stocks that would have a “near death experience” should not be surprising, considering just how compressed the valuations of many, far more “bullet-proof” enterprises got before that unpleasant season had run its course. As we all witnessed, up close and personal if we were long much of anything, Financial Panic pushed an overdue recession into what seemed like a global economy freezing in its tracks while everyone waited for some sign that it would not just keep on getting worse. In the HDD world, the evaporation of end market demand was exacerbated by a clamor for liquidity (i.e., Inventories bad! Cash good!). This would have been acutely painful for a high volume, high fixed cost manufacturer like HT even if they had not just finished a massive capital spending program. The company shipped 553MM units in FY 09 (only 107MM in Q2), down from 865MM in FY 07. Industry demand started to recover in Q3, but the effect of this was muted when as a part of its turnaround plan, Seagate decided that it would shift its suspension business to the other two suppliers. This was 19% of HT’s shipments at Q2 09. (Shipments to Seagate were 11% of the total in Q2 10, and it appears that HT’s supremacy in SA for enterprise drives, plus robust recovery, is going to keep Seagate in the mix for the foreseeable future.) 

The events of 2008 also impacted HT in at least a couple of other ways. Those of us who owned cash rich tech companies became all too familiar with something called Auction Rate Securities. HT had about $100MM of them, which loomed large in the face of operating losses and a $140MM debt issue coming due in March 2010. What only a few years earlier was a seemingly “bullet-proof”, net cash enterprise now at least appeared to have a serious solvency risk. It also mattered that the Crisis induced fiscal constraints on health care providers, which linger to this date. This means that the process of getting InSpectra™ through the approval process at each hospital has turned out to be even more torturously protracted than we expected. 

“Near death” for HTCH would be $1.28 in early 2009. It would linger around $2 until mid-July, then ride along with the rest of Tech, hitting $11.51 at around yearend. It has since retraced a significant part of that move. The most significant reason (other than the obvious “trading” factors) for this has had to do with the transition to TSA+, the new flexure technology. HT has been making SA with the new additive flexures for a couple of years (in large part with purchased flexures) and producing a modest quantity (43MM, or 8% of FY 09 shipments) of flexures themselves. During H1 10, the company and its customers decided to step up the transition to TSA+. A necessary process change had a moderate impact on Q1 costs. This was followed by a volume ramp in Q2. It is hardly surprising that it was not trouble free, and there was enough of a production upset to cause customers to shift some volume to competitors. This “bump” paled in comparison to the transition to TSA (c. 1998) but it was enough to thoroughly trash the quarterly results. By the time of the earnings release on April 27, the manufacturing yield issues were deemed under control to a degree that management spoke confidently about regaining whatever market share was lost during the Q. The earnings release was also disappointing in that management lowered the FY 10 revenue expectation for the BioMeasurement division. While the installed base and sensor revenues continue to grow at a robust pace, fiscal constraints and uncertainty around health care reform have stretched out the sales process at many hospitals. 

Prognosis 

HT did not get to be the “more or less last man standing” in a difficult industry by being unable to respond to adverse surprise. In 2008 and 2009, the company moved aggressively to lower its cost structure and eliminate the prospect of solvency risks. They shuttered a plant in Sioux Falls, SD, reduced head count and took other steps which lowered annual cost base by about $175MM. Negotiated settlements effectively re-liquified the ARS portfolio. With D&A exceeding CE by $56MM in FY 09 (doable because so much capacity was installed at mid-decade), there was ample cash not only to fund restructuring expenses (mainly severance) but to reduce debt. A significant portion of the convert issue due 3/10, and a good chunk of 3.25% convert (very long term but puttable in 2013) were repurchased at meaningful discounts. As of 3/31/10, total borrowings of $226.8MM exceed cash and equivalents by only $30.1MM. The question of near term survivability has been taken off the table. That HTCH has an enterprise value of only $160MM and trades at less than half of BV suggests that whether or not it can ever prosper remains an open question. 

HTCH is “left for dead” despite the outstanding prospects of the markets it serves because so many of the assumptions that are elemental to estimating earnings can only be guessed at. Pricing has been onerous due to overcapacity (the competitors also added ahead of the expected growth that was interrupted in 2008) and the transition to the new flexure technology. (Apparently, at least one of the leading HDD makers insisted that another supplier go first, using flexures purchased from Nitto Denko. This new technology SA is cheaper to make, once volumes are covering the fixed costs of the new processes, and so likely to have a lower ASP. Once HT has ramped its TSA+ flexure capacity, it will have a distinct cost advantage rather than its recent disadvantage.) Looking ahead, the transition to TSA+ can be expected to push the average selling price (ASP) down. However, HDD product road maps indicate that SA will have to become more featured to cope with ever increasing areal density. In particular, there will be extensive use of dual stage actuators (DSA), a pair of piezo-motors that refine the position of the head. These will exert an upward influence on ASP over the next few years. Nonetheless, we are left guessing at something very basic (ASP) if we want to derive a valuation based on future earnings or cash flow. Volume projections are similarly encouraging but clouded. TAM is a function of global demand for HDD times the average number of heads per drive, less a manufacturing yield factor tied to the customers’ delicate task of affixing the head to the SA. Reasonable estimates for these exist, but then there is the matter of market share, where the rest of the market is in the hands of two very large, not very communicative Japanese companies. To the extent that things as basic as P and V can only be guessed at, prudent analysts will either take a pass, or find another way to get at a valuation.

Having lived with the situation for many years, I am personally comfortable with HT’s prospects, but I can certainly understand a potential investor wanting something a little more solid than “Trust me, I know what I’m talking about!”. To this end, I have a very compelling valuation measure in mind. However, the integrity of this measure depends on a basic assumption about the near term future of HDD demand. If you believe otherwise, don’t bother. My belief is that Web 2.0, a commercial response to the global-wide clamor for cheap and easy connectedness-on-one’s-own-terms, is real and durable. This phenomenon will keep the rate at which the need for HDD data storage grows (40%?) well ahead of the rate at which the areal density of HDD can increase. The barriers to entry are such that there will be no new entrants. The specter of competition from solid state drives (SSD) will continue but value will continue to be the dominant selection criterion, and the HDD will maintain its superior value proposition in the high volume applications for the foreseeable future (more on SSD to follow). I would also submit that for HT, the past several years of getting to TSA+ has been all cost and no benefit, including in terms of market share, but that tide is pretty much all the way out. It will be coming back in over the next couple of years in terms of both cost advantage and market share. Market share will also be helped by management’s recent decision to site some final assembly closer to the customers. A $15MM plant (for a building & improvements; the much more expensive equipment will be relocated from existing sites and warehouses) in Thailand will be ramping up over H2 10 and should be in volume production by CYE.

The underlying fundamental need (data storage) is well advertised. A recent IDC study projected a 9% CAGR for HDD growth 2009-13, from about 550MM units to about 800MM. Subsequent reports from throughout the PC supply chain suggest that this December estimate is probably conservative. 800MM HHD with an average of 2.8 heads per drive would require 2.64B SA, assuming 85% yield. (Hey, Sherlock! Here’s a clue as to earnings power: the market was 1.48B units in 2005, when HT’s SA operation posted a fully loaded $66MM operating profit, and there were more competitors.) We  can expect earnings to be clouded over the next few quarters. June is typically the slowest of the year, and only time will tell whether the effects of the ramp that hurt Q2 leaked into it as well. Modest start-up costs for Thailand (est. $3.5MM in Q3, $5MM Q4) will also weigh, and of course the operating losses of BioMeasurement continue (more on which follows). All of these “moving parts” should be moving quite favorably in FY 11.

Management has suggested that if recent demand persists, overcapacity in SA just might be a thing of the past a year or so from now. As there is no reason to suspect that either of the competitors has enjoyed the recent status quo (other than final assembly being closer to the customer, neither has any cost advantage v. HT) and so are probably not inclined to extend the season of overcapacity. At any rate, it appears that over the next several years, being the only integrated producer of SA with the “additive” flexure, technical leadership with features like DSA and a final assembly presence in Thailand should enable HT to grow its share of a growing, tightening market. Not only will this volume growth really help profitability, but it will come with very little incremental capital outlay, and that brings us to the value of HT.

Book Value is often a meaningless construct, and rarely if ever a perfect proxy for intrinsic value. However, in many cases it can be used as something of a benchmark. Consideration of the degree to which accounting standards might overstate or understate the value of what actually there can lead one to a ballpark sense of intrinsic value. When I look at HT’s balance sheet in the latest 10-K, two things jump out about what as of 3/31 was a $13.20 BV. The lesser of these is that the company has considerable NOLs completely buried under a valuation allowance. Not sure what this is worth, but it means that in a season of profit recovery the cash flow will be untouched by taxation more or less indefinitely. The larger issue is in property, plant & equipment. In the latest 10Q we see a net figure of $269MM. In the K we see that the gross figure is nearly $1B ($211MM in buildings, $744MM in equipment, $14MM CWIP). Of this, some $550MM was put in place 2005-07. The equipment tends to be rapidly depreciated, well short of its actual useful life, but is of more or less constant value as long as routine maintenance and upgrades accompany the periodic re-tooling. This is not like a burnt out old cement kiln or saw mill or a bunch of trucks that can run forever if you have good mechanics. It is high volume, touch-free production at tolerances as exacting as humanly possible. Much of that 2005-07 spend has been depreciated or written down (based on expected future cash flows during FY 09), but what does that really mean as to the value of this equipment, much of which, incidentally, could be re-tooled for other high-precision, mass produced microstructures? It is still there, either producing or capable of producing something that is very difficult to produce and that the world is going to need a whole lot more of. 

I suspect that the value of what HT spent $550MM (including $200MM+ on TSA+ capabilities) to put in place a few years ago is on the order of $550MM, or >$20/share. If the oversupply of SA somehow persists, this will prove wrong, but more likely, the economics of SA will be in much more favorable place in 2011 and beyond. But let’s try on a more conservative valuation anyway. Consider the November 2007 purchase of Magnecomp, an erstwhile competitor, by TDK, who based on the amount of money they have piled up over the years are clearly not  a bunch of dopes. As reported, a 74% interest went for $123MM, but the debt assumed put the value of the transaction well above $300MM. This was for capacity estimated at about 12MM units/week, or roughly half of what HT had in place before the Bump-In-the-Road that was 2008 put a lot of their equipment under wraps or into the warehouse. In contrast to HT’s consistent operating superiority (e.g., fastest prototyping, lowest part-to-part variation) a series of owners reputedly never quite got these operations running right. And this capacity apparently did not include flexures, which seem to entail more “black art” than the load beam and base plate that makes up the rest of a SA. So by this measure, is HTCH, an enterprise recently valued at about $170MM, worth two, three, four or more times the $300MM+ that TDK paid for a much smaller, much less capable entity? (It is certainly possible that TDK overpaid. But if a well informed player were willing to pay $300MM for a marginal piece of an industry, would an enterprise that would make them the dominant player of a duopoly not be worth considerably more than that?)

What About BioMeasurement?

Considering the magnitude of this apparent value discrepancy, at this point in time the BioMeasurement division does not in my estimation figure into whether or not one should own HTCH. This is despite its stubbornly high operating losses ($5.3 in Q2), which I consider bearable pain in light of both SA’s near term prospects and its own longer term prospects. We can be reasonably assured that the operating losses will shrink over time, but as yet we simply cannot know the rate it which it will happen. These losses reflect an arduous process, but once a monitor is installed at a hospital, the protocol has been defined and the (actually quite simple) training has taken place, each one of them becomes an annuity in the form of a steady stream of $150 disposable sensors.  

As I understand it, the value proposition of InSpectra™ is based in its ability to provide something of a leading indicator of that set of autonomic bodily responses we know (approximately) as shock. Akin to the way that perceived threats trigger autonomic responses that either enhance (“eustress” putting us in “the zone”) or diminish (the “choking” response) our ability to fight or flee, our bodies have a way of perceiving what they take to be irreversible damage. This seems to be a way of smoothing the path when we (unconsciously) know that we’re toast, making what up until very recently was inevitable death as comfortable as possible. Once these responses, which by the way include a breakdown of intracellular function, kick in and commence what looks to me like a rather gruesome cascade of what physicians call complications, the costs of effecting a recovery seems to grow exponentially as the minutes pass. By detecting vasoconstriction in the extremities, non-invasively and in real time, InSpectra™ enables more rapid and in many cases more appropriate and effective clinical responses. Even a cursory look at the avoided expenses suggests a compelling value proposition. For example, monitoring StO2 seems to provide a way to prevent the overuse of blood transfusion in resuscitation. The avoided cost of just one unit of blood, one too many of which can aggravate the patient’s condition, exceeds the cost of the sensor. (Google up Shock, or MODS, or sepsis to learn more about why proactivity toward shock responses might be so valuable.)  

InSpectra™ appears to have huge potential wherever there is blood loss related to trauma or surgery, sepsis, in many cases that call for a central venous catheter, and for dialysis, among others. It has been selected by over 120 hospitals in the US and Europe, including some that are leaders in their field, and has garnered some meaningful champions in the medical community. The clinical evidence has piled up as well, as can be seen at  studies available at www.htibiomeasurement.com. Still, adoption of new medical technologies is invariably cautious at first. That tipping point, before which an institution asks, “Why should we take a chance on this?” and after which it asks, “Why haven’t we gotten on board with everyone else?” is still out there in the future. Once that tipping point becomes apparent, HTCH would likely be a Buy and not a Sell at $20.

But What About SSD? I would conclude with a thought on this nettlesome issue based on my lifelong experiences. A leading knock on the whole HDD industry is the threat of emergent technology in the form of NAND flash memory. (Other forms are out there as well.) I have been hearing about how flash is going to supplant HDD “any day now” since at least 2004 (prior to which I was focussed elsewhere). Somehow, this day of reckoning keeps moving out in time, like a mirage on a desert highway. This is because HDD is one of those industries where only the strong, those capable of delivering a constantly improving value proposition, survived. Solid state memory definitely has a future, be we delude ourselves trying to guess the rate at which it can supplant such a resourceful and combative incumbent.

In point of fact, flash memory has actually been very good for HDD demand. It reminds me of how early in my working life, we heard about how various technologies were going to lead us to the “paperless office” (remember the Wang word processor?). Instead, technological advances made publication so cheap and easy that it kept paper usage growing (insanely so, it seemed at times) for another 20+ years. Many years later, around the height of the Tech Bubble, I found myself doing battle with the notion that telecommunications was going to do away with the need for air travel. Sure enough, some travel has been rendered unnecessary, but this has been more than offset by the extent to which cheap telecom has fostered a spreading out of personal and commercial relationships that produce a whole lot more occasions for travel (not to mention how that plethora of visual media exposes us to all kinds of things “out there” that we simply have to go and see.) While the “tipping point” on paper usage seems to have finally set in, this instance of what was purported to be a substitute turning out to be a net stimulus shows no signs of abating. So when I look at flash memory, I see a gazillion cheap and easy to operate hand held devices out generating data that if it lasts more than a day or so will probably be stored on one or more hard disks somewhere else. The pack rat instinct is alive and well when it comes to things digital. There is all but certainly a tipping point out there in time beyond which solid state memory substitutes for more than it stimulates the need for HDD (at which point HDD will become a decent, cash cow business for an appropriate owner or two, a fitfully declining market like optical media or magnetic tape have become in recent years). But it sure doesn’t look like it is going to happen during the TSA+ product cycle that I see carrying HTCH much higher over the next couple of years, at which point we should know whether or not InSpectra™ is the fuel that boosts the next stage of the rocket. 

(F.D.: Long HTCH & STX; Short WDC Puts)

 

Catalyst

A recently disruptive ramp-to-volume of a new manufacturing technology will give HTCH a  more or less permanent cost advantage in growing and tightening market. The earnings power implications of this should become a lot more clear before CYE. 

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