SEAGATE TECHNOLOGY PLC STX S
November 21, 2016 - 3:38pm EST by
smokey
2016 2017
Price: 39.75 EPS 3.21 2.95
Shares Out. (in M): 295 P/E 12.4 13.5
Market Cap (in $M): 11,726 P/FCF 10.6 10.2
Net Debt (in $M): 2,603 EBIT 1,210 1,110
TEV ($): 14,329 TEV/EBIT 11.8 12.9
Borrow Cost: General Collateral

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  • Technology
  • Hardware
  • Flash storage

Description

   

 2.7x Gross, 1.7x Net

 6.4% Yield

Overview: Seagate is one of three players in the HDD industry along with Western Digital with ~44% share and Toshiba with ~18% share. The HDD industry faces a longer-term threat from SSDs, which offer faster speeds, better reliability (no mechanical parts) and lower power consumption. 

Over the last few years, the bear case for HDDs has focused on declining PC sales combined with increasing SSD attach rates (HDD displacement) into PCs. However, as this thesis has played out, and the HDD TAM has declined from 600MM units to 400MM units, PC HDDs which have lower ASPs and margins, have become less relevant to Seagate's income statement. 

Enterprise HDDs account for only 22% of units, but ~40% of revenue and approximately two-third of profitability. This is due to the fact that Enterprise HDDs have higher ASPs at $132 vs. ~$40 and double the gross margins of consumer HDDs (PC, gaming, etc.)  While much of the investor angst has focused on PC HDDs, the fulcrum issue for Seagate is the competitive landscape in Enterprise HDDs. 

Q1'17 Enterprise Profit Pool

 

  Revenue  % of Rev  Units  ASP   OPM   EBIT   % EBIT 
Enterprise    1,146.8 41%      8,700 $131.81 20%      229.4 62%
PC      671.3 24%     16,000 $41.96 7%        47.0 13%
Other      771.0 28%     22,600 $34.11 9%        69.4 19%
Source: Sales breakdown from Q1'17 Fact Sheet. Units from Trend Focus. Margins are est.

 

 

Enterprise HDDs

There are two main types of enterprise HDDs: mission critical drives used in servers and networked storage (10K and 15K drives) and high capacity nearline drives used primarily by hyperscalers like Amazon, Facebook, Google and Microsoft. 

Mission Critical 

Mission critical HDDs are used in servers and networked storage  under threat from SSD substation as this article does a good job of highlighting (http://bit.ly/2gvuUkx). Due to performance, power and density advantages, the majority of mission critical HDDs will be replaced by SSDs over the next few years. The only gating factor is how quickly EMC, NetApp, HP, etc. rewrite their legacy architectures  to take advantage of SSD. While 15K HDDs have borne the brunt of SSD substation and Seagate highlights that 15K is only 4% of revenue (higher % of EBIT), the clock is ticking on 10K segment as well.  Mission critical HDDs are ~25% of Seagate's EBIT and this profit pool is at significant risk. 

Nearline

Unlike the ex-growth mission critical market, the nearline market is growing, as hyperscalers  insatiable demand for cheap and deep storage continues to grow. All those Instagram photos, machine generated sensor data, and YouTube videos have to be stored somewhere, and that somewhere is nearline HDDs. Nearline HDDs are expected to grow at a high-single digit CAGR through 2020. However, Seagate's profits in nearline are under threat on two fronts -- competitive nearline offerings from Toshiba and Western Digital and potential cannibalization from quad-level cell (QLC) 3D NAND.

Nearline Competition

Toshiba has not had a competitive nearline offering, with it's highest capacity offering at 6TB vs. 8TB and 10TB offerings from Western Digital and Seagate. Having the highest capacity point is important to hyperscale, as this lowers power costs, increases density and lowers $ / GB. This adds up when you're running 1MM servers like Google. Toshiba now has a competitive 8TB offering with a 10TB on the roadmap for mid-2017. Toshiba's nearline share had been flat at ~6% for a number of quarters, but now that they have a competitive offering, I expect their share to move closer to their overall HDD share at 17%. Last quarter, Toshiba's nearline share was 8.1% and they grew nearline units 52% year-on-year. If this trend continues, it will be bad news for Seagate's nearline profit pool.

Nearline Share Q3'14 Q4'14 Q1'15 Q2'15 Q3'15 Q4'15 Q1'16 Q2'16 Q3'16
Seagate 47.8% 47.9% 47.5% 48.8% 43.4% 45.7% 47.0% 52.8% 51.3%
Western Digital 48.9% 47.7% 46.2% 45.2% 50.3% 48.3% 46.6% 40.6% 40.6%
Toshiba 3.3% 4.4% 6.4% 6.0% 6.3% 6.0% 6.4% 6.6% 8.1%


See page 22 of the following Toshiba presentation. https://www.toshiba.co.jp/about/ir/en/pr/pdf/tpr20160706_4e.pdf

 

Additionally, Western Digital should regain lost-share from Western Digital as their 10TB helium platform ramps. Western Digital launched their first generation 6TB helium platform in Q4'13 and their 10TB platform is their third generation on helium. Helium HDDs are filled with helium and sealed vs. conventional on-air HDDs.  Due to reduced drag, thinner platters and lower flutter, helium HDDs use less power and cooling, resulting in a 12-17% TCO savings for hyperscale providers vs. on-air HDDs. Seagate was behind the curve on helium HDDs and lost significant share to WD in nearline in H2'15 as hyperscalers favored WDs 8TB helium offering. However, in Q2'16 Seagate came out with an 8TB offering that used one less disk and two less heads than WDs 8TB offering, resulting in a $30 / drive bill-of-material savings. This allowed Seagate to be aggressive on price and regain its lost nearline share and then some. Instead of copying Seagate's 8TB design, WD decided to forge ahead on it's 10TB offering, which is ramping now. Seagate loses it's bill-of-material advantage on 10TB and based on commentary from Nidec and Showa Denko,  Seagate is having problems with it's first generation 10TB helium offering. I expect the same phenomenon that occurred in H2'15 to happen again and Seagate will lose significant share to WD on 10TB as they lose their bill-of-material advantage.

 

The narrative that Seagate is pushing is that 10TB is a tweener platform, as is only a 25% increase in density from 8TB to 10TB. However, as the chart below shows, hyperscalers adopt these platforms quickly and while 8TB to 10TB isn't a huge jump, you get a significant boost from decommissioning 3-4 year old 3TB and 4TB  drives and replacing with 10TB. 

See page 28 of the following Western Digital presentation. https://www.emcworldonline.com/2015/connect/fileDownload/session/DA1CB32A7B9AC293B2DBE23898769766/hgst.01_Gallagher-HGST.01.pdf

 

QLC NAND Competition

 

The majority of 3D NAND production is expected to remain three-bits per cell. However, qual-level cell NAND could begin to ramp in 2017 which would be increasingly competitive with nearline HDDs. Toshiba / Western Digital are sampling QLC 3D NAND now and expect to ship QLC SSDs in the near future.  While QLC NAND would have lower endurance than traditional TLC NAND, it would also come at a lower cost and have much lower power consumption than HDDs. Jay Parikh made a request of the NAND industry for such write-once-read-many (WORM) flash back in 2013 and it looks like this may become a reality in 2017. The article below does a good job of summarizing.

https://www.wired.com/2013/01/facebook-cold-storage/

 

Parikh and company could move those older photos to the sort of flash memory devices that are now invading other parts of the computer data center — devices that consumes far less power than hard disks — but these carry relatively high price tags. Today’s super-speedy flash devices are a great to store information that’s accessed all the time, but they’re too expensive for the kind of “cold storage” Facebook needs for old photos.

 

So Parikh wants someone to build him some flash storage that’s cheaper. Basically, today’s flash is built to maximize the number of reads and writes you can make — the medium tends to degrade as you read and write — but he wants a version that specifically designed for data that’s accessed only occasionally.

 

“We want something with a low write-endurance,” he told us on Wednesday. “We want to get to something with a much, much lower unit cost per gigabyte.” This will also reduce the company’s power consumption, and according to Parikh, it will give his engineers more flexibility when it comes to writing software. “You play all sorts of neat software tricks in terms of how you optimize it.” When you’re reading and writing data on spinning hard drive platters — and you want to keep speeds up — there are tight restrictions on how you can do so.

 

On stage, during his speech, Parikh likened storage devices to cars. Right now, he said, it was as if his only options were a minivan and a high-end sports car. What he really wants is a third option — something more like a Prius. “We want is a continuum of options,” he said. “Today, the spectrum is very coarse. There’s tape on one end. There’s flash on the other end. And spinning disks in the middle. And that’s it.”

 

QLC 3D NAND SSDs are expected to attain >100TB capacities and were compared against  the  current  8TB  nearline  /  high-capacity  enterprise  SSDs  in  the  market  (e.g.,  a  12  x  8TB  nearline  HDD deployment versus a single 100TB QLC SSD using 0.1 watts of power versus 96 watts for the HDD deployment). QLC SSDs will also have much lower cost than TLC SSDs with a cost of $0.09 / GB vs. $0.05 for nearline HDDs . With power and cooling comprising 30% of a hyperscalers datacenter TCO, the power savings from QLC SSD would more than make up for the increase in $/GB

 

Price Target

Priced for perfection at 11x  forward EPS with increasing competition in enterprise HDDs.

 

Downside: 11.0x bull case EPS of $4.00 or $44 representing 22% downside

Base: 8.0x midcycle EPS of $2.62 or $23.50 representing 41% upside

Bull: 10x downside EPS of $1.85 or $18.50 representing 54% downside

 

 

 

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Catalysts include: 
- Increasing Competition from Toshiba and Western Digital in nearline HDDs

- QLC flash ramp

- Continued erosion of mission critical enterprise HDD profit pool

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