March 19, 2012 - 9:23pm EST by
2012 2013
Price: 26.44 EPS $0.00 $0.00
Shares Out. (in M): 486 P/E 0.0x 0.0x
Market Cap (in $M): 12,636 P/FCF 0.0x 0.0x
Net Debt (in $M): 693 EBIT 0 0
TEV ($): 13,329 TEV/EBIT 0.0x 0.0x

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  • Technology
  • Hardware
  • Industry Consolidation
  • margin expansion


While there has been a recent discussion on Seagate on a previous post, the risk/reward on the stock is still extremely compelling, especially given an unwarranted recent sell-off over the last week, making the entry price very good, given the valuation. Given better control of margins from consolidation and a massive equity shrink from Thailand related over-earnings STX is still a buy and worth the mid $40s despite the run from $10.  



The stock hit a low of $10 in late 2011 given general market volatility, missed guidance by the company (based on yield problems in certain new products and higher rare earth costs). From there it rallied to the current $26 based mostly on the Thailand flood. With its chief competitor Western Digital rendered impotent from the floods, STX was able to produce most of its typical volume at significantly higher ASPs (and fixed component costs), resulting in gross margin expansion from 19% pre-floods to its current guidance of 33% in CY2012. What makes the stock so compelling now despite the run is that management is using its windfall from Thailand to massively shrink the equity base and significantly increasing core EPS in the business. On top of that, a structural change has occurred because of consolidation by Seagate and Western Digital which turns the industry into an oligopoly to reduce margin volatility on a quarterly basis.


CY2012 Earnings

The company has guided to 60m units, at least $4.3bln in revenue, 33%+ gross margins, $405m in opex and FD S/O of 465m in the March quarter. They expected $20bln in revenue for the CY12, a benign pricing environment and a basic share count of 350m at the end of the year vs. the current FD S/O of around 486m.


The company’s guidance implies that they can sell 60m units at a $72 ASP. At $48 in COS/unit (higher than $44 pre-Thailand because of component shortages, I estimate a 33% gross margin. Based on $405m in opex, $56m in interest expense and a 5% tax rate, STX can deliver $1.97 in EPS in CQ1 2012. Assuming volumes ramp as component shortages lessen in CQ2-CQ4 2012 and stable $71-72 ASPs, 33% gross margins and similar taxes, opex and interest expense, the company can do $2.63 in EPS in CQ2, $3.10 in CQ3 and $3.36 in CQ4. Given that they are paying a $0.25/share dividend each quarter and D&A and capex are about the same, if the company uses all FCF ex the dividend to buy back stock in the $26-mid $30s range, they can shrink the equity base to their targeted 350m basic shares of 370m FD shares by the end of CY2012.


Management’s massive equity shrink offers them the ability to drive core earnings higher over the long run. Since Thailand is one-time, investors will look to value STX based on core earnings. If we assume annual volumes decline to 275m units and pre-flood ASPs are $56, the company can do $15.4bln in revenue. At 25% gross margins and $1,620 in opex, $224m in interest expense and a 5% tax rate, normalized earnings for the company is about $5.15. At a 7x multiple on normalized earnings, we get to a value of $36/share or 37% upside.


However, as the company continues to massively shrink the equity base with 90% of FCF (using 10% for the dividend), assuming that by CQ1 and CQ2 2013, ASPs drop back to $56 and all benefits from Thailand are gone and the company can continue to shrink its equity base by the same amount, I estimate FY2014 earnings rise to $6.31/share on the exact same revenue/margin/opex assumptions, in which case the stock is worth in the low $40s or 60+% upside.


Why did the stock sell off this week?

The stock recently sold off because during the floods, STX entered into long term agreements with some customers to sell in CY12 at its current ASP of $72. In Dell’s 10K, they alluded to the LTAs but said the ASP would be a market ASP. However, while this was the verbiage taken directly from the agreements, the ‘market’ rate is the rate that STX set when entering into the agreement. STX does not expect its ASPs to come down in CY12, hence they believe they will achieve their 2012 guidance and the massive equity shrink discussed above.


The stock also sold off because LSI said that HDD capacity is coming onto the market at a faster rate than they had originally anticipated. However, LSI last commented on capacity from the floods before STX/WDC/Nidec. LSI’s original guidance was below the HDD makers and Nidec but is revising their guidance to what these three manufacturers said last month. Thus, LSI’s comments in no way show that capacity is increasing at a faster rate than STX/WDC/Nidec originally said. As such, we can be further convinced that the pricing environment for STX should be flat through 2012.


Longer Term Value

In the longer run, while some believe that SSD risk exists and they will potentially replace HDDs given that they are faster. SSDs still cost 10x the cost of HDDs. That said, STX has been pioneering hybrid SSD/HDD drives for consumer devices that have the benefits of the SSD combined with the cost of the HDD. They will be selling these in Ultrabooks in the latter half of 2012. Windows 8 is optimized for hybrid drives and STX has a lead in the technology.


Industry Consolidation

Both the STX acquisition of Samsung’s HDD business and WDC’s acquisition of Hitachi’s HDD business recently closed, resulting in consolidation into a duopoly. The value to a duopoly in the HDD industry is that pricing and gross margins are a function of supply/demand and filling additional manufacturing capacity. In a duopoly, both companies will have a better sense of overall market demand and will not overbuild additional capacity or buy too many components as they have in the past. Bottom line, purchasing and expansion will be more precise than it has been in the past which should lead to better profitability for both companies. Also, the NAND/Flash supply agreements will help STX since they are not vertically integrated in NAND/Flash so they will have a constant supply of raw materials. The deal was extremely accretive to STX since it incurred very little incremental opex and came at a perfect time for the company to ramp capacity at much higher ASPs because of the flood, which they’ve used to massively shrink the equity base.


Given better control of margins from consolidation and a massive equity shrink from Thailand related over-earnings STX is still a buy and worth the mid $40s despite the run from $10.  


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