April 02, 2011 - 1:13pm EST by
2011 2012
Price: 14.98 EPS $0.00 $1.71
Shares Out. (in M): 461 P/E 0.0x 8.8x
Market Cap (in $M): 6,909 P/FCF 0.0x 10.0x
Net Debt (in $M): 153 EBIT 0 813
TEV ($): 7,061 TEV/EBIT 0.0x 8.7x

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Seagate Technology (NYSE:STX) is a leading hard disk drive ("HDD") manufacturer, with approximately 30% of the global HDD market.  HDDs are used by PCs, servers, mobile devices, and other electronic devices that use and store data.  The Company manufactures and distributes HDDs to customers in the PC, enterprise, mobile and external drive end markets (STX' business is weighted the higher ASP / margin enterprise devices).  STX is headquartered in California, although the holding company is domiciled in Ireland, and a large percentage of the manufacturing is done in Thailand, Singapore and Malaysia.  The Company's business is relatively straightforward, and I'm happy to elaborate in the Q&A if needed.


The stock has come under pressure of late, due to three primary concerns:

  • Near-term seasonal / cyclical issues
  • Medium-term product transition
  • Long-term threat from SSDs

While the stock has rebounded from recent lows, I see meaningful upside to the high teens throughout 2011.  Near-term upside exists from improved pricing, a key investor concern which has plagued the industry throughout previous downturns (the WDC / HGST deal is a major positive for the industry).  This is a key positive, which has not yet been adequately reflected in street models (or the stock).  When coupled with the Company's share buyback program, I think we can see high teens relatively soon.  Longer-term, I see (i) sustainable margins due to a shift in industry structure, and (ii) a longer "tail" to the STX' business than the street is pricing in.  The HDD industry in aggregate may not be able to support double digit growth rates, but STX' business is unlikely to disappear, given (i) their strong presence in enterprise drives, (ii) potential upside from hybrid drives, and (iii) longer-term PC demand driven by growth in emerging markets.  I see downside as relatively manageable, given (i) poor sector sentiment, (ii) share buybacks and financial flexibility and (iii) attractive valuation.


Key Risks

  • Near-term seasonal / cyclical issues - PC & HDD production is inherently seasonal, with a typical trough in Q1.  Given a relatively predictable pattern, you would not expect an adverse stock price reaction, however, recent events have been somewhat exceptional:
    • Calendar Q4 PC production was weaker than expected (see HPQ results, MRVL & LSI commentary, etc.)
    • Intel Sandy Ridge issues
    • WDC's commentary around 6 - 8mm excess drives (which has proven largely unfounded)
    • These are all legitimate concerns, but are "behind" the stock.  Several of the above issues are one-time in nature, and may push demand into late CQ1 or CQ2.  STX mentioned the potential for "stronger than usual" sequential growth in CQ2 at a recent conference (pre Japan); a clear positive relative to investor expectations.  Original Distribution Managers (ODMs) have noted meaningful improvements in order volumes over the past several weeks.  I've also heard that both WDC and STX very recently raised pricing for the 3.5" drives, a clear positive.
  • Medium-term product transition - The HDD industry is expected to transition towards 500 GB 'single platter' HDDs in late 2011.  Investors have become concerned that this complex transition may experience delays, which could postpone potential margin improvements.
    • I have spoken with several supply chain participants on this, each with a unique take.  Both STX & WDC note meaningful upside in the back half of 2011 / early 2012 from this transition.  Even if the product transition is unsuccessful, core HDDs are unlikely to see meaningful pricing pressure (given supply chain constraints and rationalized competitive dynamics from the WDC merger).
  • Long-term threat from SSDs - NAND Flash technology (used in Sold State Drives, "SSDs") offers superior performance when compared with HDD technology.  SSDs lack moving parts, have higher IOPs (input output per second), offer other great features ("always on") and offer greater energy efficiency.  No doubt this is the largest concern for investors in the space.  Tablets are powered by SSDs, and tablets are likely to cannibalize PC demand.
    • The above commentary is certainly powerful and generally true, with some caveats.  Consider the relative price points for storage; 160GB SSD for ~$400 versus a 160GB HDD for <$40.  The fact is, NAND technology is extremely expensive, and while prices will come down as the market expands, these will not come close to reaching parity over the near / medium-term.  NAND producers have not invested a sufficient amount of capital to make NAND affordable, and the NAND market may not be large enough in the medium-term to justify further large-scale NAND investments.
      • From a pricing parity perspective, HDDs have been falling ~8% annually, and while this may improve given a rationalized market, SSDs still face a moving target.  Further complicating the pricing discussion is the recent earthquake in Japan, which impacted Toshiba, one of the largest NAND producers.  NAND pries shot up in the weeks following the earthquake, and have since normalized, but more importantly, supply chain disruptions may limit SSD price declines in 2011.
    • 15mm tablets (12mm iPads) were sold in 2010, and the street consensus seems to suggest ~60mm will be sold in 2011.  Producers are rolling out ~70 different models in 2011, each with different price points and features.  I see two issues here:
      • The potential for a tablet "bust" is not unreasonable, with real downside for the category.  We're certainly likely to see a few great products (iPad 2, XOOM) but we'll also see many duds.  There are many "me-too" tablets, and the coming onslaught may overwhelm consumers (recall the iPod / Zune experience from almost a decade ago).
      • Leaving aside the potential for category downside, tablets are likely to cannibalize some laptop demand, particularly at the low-end (e.g. netbooks).  The global PC market sold 345mm units in 2010, of which notebooks were 220mm (netbooks, a sub-category within notebooks, were 33mm).  So while the netbook market is getting killed, the relative size (and importance) of this segment must be considered.  If we assume 60mm tablets are sold, with a 35% cannibalization rate, we'd see a reduction in 21mm PCs, or 6% of the overall PC market.  Despite all of these negative events, the PC market is still likely to post mid-single digit growth in 2011, with longer-term tailwinds from low PC penetration rates in emerging markets.
    • SSDs are likely to overtake HDDs, even in laptop production.
      • I believe this to be a more credible argument, but still see issues.  Consider the relative pricing of SSDs versus HDDs, and you'll see that we're not even close.  The new MacBook Pro is flash powered, yes, but this computer also retails for ~$1,400.  Apple has been the driving force for NAND Flash, and even they could not make this work for the MacBook Air (which is HDD-powered, with a much higher-end NAND option).  HDDs represent exceptional value for storage, and NAND technology is too expensive to work in most applications.
      • Furthermore, the SSD / HDD argument may not be completely binary.  While still in the nascent stages of commercial development, hybrid drives offer a meaningful opportunity for HDD operators.  Hybrid dries, which combine the functionality of SSD with HDD, provide ~90% of the SSD functionality at a fraction of the price.  STX sees 80% of their longer-term business driven from hybrids (currently <5%).  Longer-term, perhaps pure SSDs become much more affordable, but over the medium-term, hybrid disks are a legitimate option.

Other Items

  • WDC / HGST - Western Digital's recent announcement to purchase HGST is a major positive for the industry, in terms of rationalization.  The pro forma industry will be more disciplined with respect to production and pricing, given four "functional" players.  From what I can gather, HGST was the likely culprit in the pricing wars, and this will obviously be changed under WDC (who will have ~50% of the industry).
    • More importantly, STX is a likely share winner as OEMs re-allocate their supplier spend.  This has happened in several HDD mergers (including Seagate / Maxtor), and I see no reason to think this would not happen here.
    • The major downside risk for STX relates to the enterprise division, where STX' high market share (~60%) leads to less pricing pressure and higher gross margins.  ASPs in this segment are higher, as are gross margins.  WDC has historically had very little success in enterprise, although they view the HGST purchase as a remedy.  This will be a key area to monitor, but customer attrition in the enterprise segment has been low, and characterized by long-term, stickier relationships.
  • Japan - Japan is a major electronics component supplier, and certain devices will experience meaningful outages as a result of the tragic earthquake and tsunami.  Fortunately, the HDD industry has limited exposure, and if anything, may actually benefit from these events.  Recall the aforementioned note on Toshiba, a key supplier of NAND, who has experienced outages.  NAND outages and delays in price decreases are a good thing for the HDD industry, even if only temporary.  Some HDD components (e.g. read-write heads) have experienced delays, but overall the situation is quite manageable.  Japan represents ~5% of PC demand, a number which has been relatively flat over the past several years.
  • Buybacks - STX approved a $2bn buyback in 2010, and had $1.7bn outstanding as of fiscal Q1.  The Company has been active in the market, repurchasing shares (they post details on the website due to Irish law).  Buybacks at these levels are likely to prove highly accretive for holders.
  • LBO - TPG bought Seagate in 2000, and took the Company public in 2002 at $12 per share.  Seagate came back into focus in October 2010, when the Company disclosed discussions with a private equity firm (Irish law requires such disclosures).  TPG supposedly brought in KKR as a partner, but KKR could not get to $18 per share.
    • I've talked with many people on this point, and have frankly come away with inconclusive notes.  Some people claim that STX whiffed on projections, while others claim the CEO would not sell at $18 per share.  In any case, two additional points are worth noting:
      • STX' response to the termination of LBO discussions was to issue debt and buyback stock, a bullish read-through.  STX' LBO profile has probably improved since October 2010, given the relative pricing strength and WDC / HGST merger.
      • The leveraged finance markets have improved markedly since October.  A transaction would be complex, especially given antitrust considerations, but likely possible.  Several leveraged finance professionals estimate ~$4 - $4.5bn of HY debt capacity for this company, implying attractive returns even near $20 per share.


Valuation & Capital Structure

  • I'll keep this short because in my opinion this is the easiest part of the investment thesis.  At $14.94, STX' market cap and enterprise value is $6.9bn and $7.1bn, respectively.  The Company is trading at 4.4x and 4.1x my 2012 and 2013 EBITDA estimates.  My EBITDA estimates are below street estimates, since I'm assuming lower industry growth rates (5% in 2012) and lower gross margins (19%).  STX has discussed a "target" gross margin range of 22 - 26%, and perhaps we can get there given the industry rationalization, but we don't need to get there to make the stock work.
    • While STX and WDC do face secular challenges, shares clearly account for these risks.  These are well-run, profitable companies that generate real free cash flow (even in 2009), which, in STX' case, is being returned to shareholders via buybacks. The below model outlines the assumptions and resulting output.
My target price is ~$19, based on 4.5x FYE 2012 EBITDA.  I believe private equity could bid $18 and make a 20% IRR (assuming $4.25bn of leverage capacity).  While we've seen some rumors suggesting STX may do a deal with Samsung, I believe a financial transaction is far more likely.
 Seagate Technology (NYSE:STX) 

 Price  $14.98

 Shares              453.0

 Options & Warrants                  8.2

 Market Cap              6,909

 Less Cash            (2,814) coupon maturity price YTM

 Plus Capital Leases                      1 0.00% Jan-00 NM NM

 Plus Senior Notes                 600 6.38% Oct-11 102.75% 0.8%

 Plus Senior Notes                 416 10.00% May-14 117.47% 3.9%

 Plus Senior Notes                 600 6.80% Oct-16 105.38% 5.6%

 Plus Senior Notes                 600 6.88% May-20 98.25% 7.1%

 Plus Senior Notes                 750 7.75% Dec-18 103.00% 7.2%

 TEV              7,061

 Key Stats 

 52 week high  $20.90

 52 week low  $9.84

 average daily volume                10.6

 average daily $$ traded              158.8

 YTD performance  (1%)

 LTM performance  (18%)

 float                 385

 short interest                  8.8

 short as % of float  2.3%

 days to cover  0.8 days

 Fiscal Year End  6/30/07A 6/30/08A 6/30/09A 6/30/10A 6/30/11E 6/30/12E 6/30/13E
 HDD Industry Units         457,710        542,830        519,690        632,790        654,214        686,925        721,271
 STX Units         159,266        182,480        163,840        193,150        194,503        204,228        214,439
 STX ASP  $71.34 $69.62 $59.87 $59.01 $54.95 $53.31 $50.64
 Revenue           11,362          12,704             9,809          11,398          10,689          10,886          10,859
 Gross Profit              2,328             3,244             1,459             3,215             2,111             2,068             2,063
 EBITDA              1,748             2,417                932             2,681             1,551             1,617             1,741
 EBIT                 769             1,460                 (82)             1,846                749                813                937
 EPS  $1.46 $2.68 ($0.38) $3.35 $1.16 $1.71 $2.38

 Cash Flow Build 

 EBITDA              1,748             2,417                932             2,681             1,551             1,617             1,741
 less capex               (906)              (930)              (633)              (639)              (910)              (700)              (700)
 less cash interest                  (25)                 (62)              (140)              (167)              (168)              (168)              (168)
 less cash taxes                  (19)                 (67)                 (40)                 (30)                 (46)                 (52)                 (62)
 less change in NWC               (743)                132              (126)                  95                 (86)                   (6)                     1
 Discretionary Free Cash Flow                   55             1,490                   (7)             1,940                341                692                813

 Growth & Margins 

 Volume Growth 
15% (10%) 18% 1% 5% 5%
 ASP Growth 
(2%) (14%) (1%) (7%) (3%) (5%)
 Revenue Growth 
12% (23%) 16% (6%) 2% (0%)
 Gross Margin  20% 26% 15% 28% 20% 19% 19%
 EBITDA Margin  15% 19% 10% 24% 15% 15% 16%
 EBITDA Growth 
38% (61%) 188% (42%) 4% 8%
 EBIT Margin  7% 11% (1%) 16% 7% 7% 9%

 Valuation Stats 

 TEV / Revenue 

0.6x 0.7x

4.4x 4.1x

8.7x 7.5x

8.8x 6.3x
 Free Cash Flow to Equity 

10% 12%

 Memo - Consensus EBITDA 

            1,891             2,092
 TEV / Consensus EBITDA 

3.7x 3.4x


-upward estimate revisions (pricing & gross margins)
- WDC transaction closes (longer-term rationalization
- continued share buybacks
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