This Tech Company is Cheap and Hedge Funds are Buying
Mike is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Seagate Technology (NASDAQ: STX) is not in a sexy business. Most consumers don't care about the company making their hard drive; they just want to have a large number of GBs to store games, movies, and Justin Bieber songs. However, if the company making the hard drive is raking in the cash, in a duopoly, and trading at a great yield, investors should be interested. Some certainly are, such as the legendary hedge fund manager David Einhorn. Other hedge funds into Seagate are Litespeed Capital and Iridian Asset Management.
Growing Business in a Shrinking Industry
Due to a Seagate's sales growth, earnings have increased 750% year over year. Not bad, I guess. This is even with an issue regarding a high margin enterprise unit that killed the sales of 1.5 million hard drives in June. Yes, Seagate has made two acquisitions in the past year but LaCie was purchased after these earnings were reported and the Samsung hard drive unit was losing money when purchased.
The acquisitions in the past year created a duopoly in the hard drive market. Less competitors means more business and usually higher profit margins as pricing power increases. Given Seagate's decent moat through branding and technological innovation, when compared to competitors in the space, it already has a profit margin of 19%. The other guy in the duopoly is Western Digital (NASDAQ: WDC) and their profit margin is only about 13%. Plus, Seagate management is pushing Seagate into higher margin segments. First, with their movement into the enterprise space and, secondly, with their purchase of the premium hard drive manufacturer, LaCie.
One aspect catching the eye of many investors is the amount of operating cash flow heading back into shareholder's hands. In the first half of 2012, 85% of operating cash flow was paid out in dividends or share redemptions. Dividends have been increased more than once in the last 52 weeks and the dividend yield is currently at 4.20%. Management redeemed 19% of outstanding stock in the first half of 2012! Plus they plan to reduce outstanding stock by about 12% more by the end of 2012. This is what we want from a highly profitable company in a shrinking industry.
So, it's a great company heading in the right direction, but what are we paying for it? Not much. The stock is trading at a 4.7 PE right now. This low PE mixed with the company's high ROIC puts Seagate in the top 30 on Joel Greenblatt's Magic Formula. The PE is lower than Western Digital's PE which is at 6.2.
Currently, the book value per share is about $8.80 compared to the $30.50 stock price but after the share redemptions in the second half of 2012, the book value per share should be about 12% higher at $9.85. Is the business worth the $21 over the future book value per share? If the industry was expected to grow or remain flat, the answer would definitely be yes. However, things aren't looking so peachy in the industry.
First of all, your typical consumer PCs are on the decline and 74% of Seagate's sales are to consumer PC manufacturers. Consumers have less use for PCs these days with tablets and smartphones/pocket computers. Seagate isn't getting any of those markets. On top of this, Apple (NASDAQ: AAPL) is taking a lot of the consumer laptop market and Apple has no desire to install outside hard drives into their systems these days. Apple did include Seagate hard drives in the iMacs a few years ago but not anymore. According to PC Mag, HP (NYSE: HPQ) did take back top spot from Apple in Q1 but who knows if it will last. HP shipped millions of PC units to customers and many of these PCs retained Seagate hard drives.
Seagate is making moves to lower their risks though. They are trying to move more into the enterprise space where margins are better and demand is steady. Also, Seagate has a cloud backup and recovery service that is small but growing. Given their storage expertise, they could do well in the backup services arena.
There are also ways the investor can mitigate risks of a declining market. An investor could hedge his/her bets by shorting the consumer PC market. So then Seagate only has to perform well compared to the consumer PC market.
You could follow Einhorn's lead and beat on more than one horse in the race. Guess what stock is that surpassing Seagate in his portfolio...Apple. He is betting on the super cheap hard drive manufacturer and the company that is leading the fight against the old PCs. Will the market reward him for mixing the sexy with the unsexy? It has so far.
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mthiessen owns shares of Seagate Technology. mthiessen runs a partnership that invests in public and private companies. The Motley Fool owns shares of Apple and Western Digital. Motley Fool newsletter services recommend Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.