Seagate: A Great Past, But Is There a Future?

Zarr is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

For many years, analysts have been predicting the eventual demise of hard-disk drive companies because of the increasing adoption of solid-state drives, or SSDs, eventually rendering hard-disk drives, or HDDs, obsolete.   

SSDs are faster, battery-saving, and are insensitive to vibrations, making them a better fit for mobile devices. Thus, the thinking goes, as more consumers shift from PCs to mobile, HDDs will eventually be phased out sooner rather than later. 

This helps explain why the two largest HDD companies in the world – Seagate Technology (NASDAQ: STX) and Western Digital (NASDAQ: WDC) – have been trading at relatively low valuations during the past few years despite solid track records.

Company         Seagate    
Date 2008 2009 2010 2011 2012
P/E (ttm) 8 0 4 15 4
P/FCF   7 27 5 18 4
P/S R  0.8  0.5 0.6 0.7 0.7
EV/REVENUE 0.8 0.6 0.6 0.7 0.8
EV/EBITDA  .5 0 3 5 3
Company Western Digital
 P/E (ttm)  9 13  12 
 P/FCF  10  10 
 P/S  1  0.8 0.7  0.9  0.6 
 EV/REVENUE  0.9 0.6  0.5  0.6  0.6 
 EV/EBITDA

Data from gurufocus.com

In this article, I’ll be focusing more on Seagate, whose stock price has gone up by around 85% in 1 year, and is currently trading near its 52-week high.

A quality company

Seagate is one of the dominant manufacturers of HDDs in the world. HDDs are devices that store digitally encoded data on rapidly rotating disks with magnetic surfaces. The company produces a broad range of these products for personal computing such as desktops and laptops; enterprise applications such as mainframes, servers, and workstations; and other end-user devices such as digital video recorders (DVRs), gaming consoles, portable external storage, and personal data backup systems. The company also provides storage services which include data protection and recovery solutions and online backup.

During the past decade, the hard drive industry had undergone a massive consolidation. Western Digital bought several companies including Komag, Silicon Systems, and Hitachi Global Storage Technologies. While Seagate acquired Maxtor Corporation -- the 3rd largest HDD company in the world at that time -- in 2006, Samsung's HDD business in 2011, and just recently in 2012, a controlling interest in LaCie, for more than $186 million. Today, these two companies control 80% of the global hard-drive market.

During this period, Seagate's performance, although quite variable, has been very good. Revenue has compounded by 9% per year, operating income by 24% per year, and earnings per share by 34% per year; while operating margin has been inconsistent ranging from 5% to 21%; but return on invested capital (ROIC) has been great ranging from 20% to 40% for most of the decade.

The company also generates a healthy amount of free cash flow yearly -- averaging $1.4 billion per year during the last 3 years -- which allowed it to return more than $5 billion to shareholders via dividends and stock repurchases during this period. 

Long-term headwinds

Despite Seagate's solid fundamentals and very good record of profitability, many investors remain worried about its long-term prospects, especially given the following developments in recent years.

Since Apple launched the iPad in 2010, tablet sales have continued to grow at an explosive rate. According to the International Data Corporation (IDC), tablet shipments grew by 142% this year compared to the previous year. On the other hand PC shipments have declined by 13.9% -- marking its worst drop-off since IDC began tracking these figures in 1994.

Moreover, IDC forecasts tablet sales to overtake PC sales by 2017, while the Yankee Group, an information technology market-research company, forecasts tablet sales to grow by 36% per year in the next five years

In fact, computer makers such as Dell (NASDAQ: DELL), the number-three PC vendor in the world by market share in 2012, and Hewlett-Packard (NYSE: HPQ), the number-one PC vendor, have seen their PC businesses decline this past year.

In the last 12 months, Dell's sales have declined by 5% and earnings per share by 70%. Meanwhile, Hewlett-Packard reported a 32% drop in sales in the second fiscal quarter compared to the same period the previous year due to slower PC and server uptake.

Meanwhile, Seagate, which derives around 30% of its revenue from Dell and Hewlett-Packard and 70% of units sold from desktops and notebooks in 2012, has seen its revenue drop by 17%, 2% and 4% in the last three quarters; operating income drop by 13%, 41%, 11%, and 16% and net income decrease by 12%, 43%, 15% and 15% in the last four quarters.

Revenue is down 21% year over year in the quarter ended in March, while operating income has been down 8% and 62%, and net income 13% and 64% year over year in the last two quarters.  In addition, total units shipped have been declining in the last four quarters -- (by millions) 61, 58, 58 and 56.

HDDs still reign supreme

However, despite these concerns, many also believe that the predictions about the HDD industry's eventual fall have been overblown. They point out to the continued healthy growth of HDD shipments the past couple of years as it remained the preferred digital storage medium of choice for most businesses and individuals.

Furthermore, there are several key reasons why demand for HDDs will continue to grow in the future:

  • SSDs are still at least 10 times more expensive per gigabyte than HDDs. Unless the cost of producing SSDs considerably drops soon, HDDs will still be the more cost-effective choice to store mass data.
  • The proliferation of content-rich devices such as tablets, smartphones, DVRs, game consoles , digital cameras and digital music players will drive the rapid growth of digital content requiring increasingly higher storage capacity.
  • Lastly, the shift to cloud computing and to mobile will drive the demand for high capacity storage even more. 

Foolish bottom line

Seagate is a very good company with a great track record, but like most technology companies, there is a lot of uncertainty in its future. It is currently trading at relatively low valuations due in part because of the uncertainty surrounding HDDs long term and also because of its recent spike in profitability.

In 2011, the global supply of HDDs decreased because of the damage caused by floods to HDD manufacturing facilities in Thailand where a majority of HDDs are made. This increased Seagate's sales and average selling price per unit in 2012 enabling the company to post a record operating margin of 21%, a lot higher than its historical operating margins of 5%-11% from the past 10 years. 

However, even if profitability normalizes soon, Seagate remains relatively cheap for a high-quality company. It virtually operates in a duopoly with Western Digital, giving it economies of scale and pricing power, which enable it to generate high levels of cash flow and return on capital. The big question is whether it can sustain its business model or if it can adapt to the new technology when the time comes.

I believe it can. The notion that SDDs will eventually replace HDDs is quite overblown. The growth of mobile devices and rich data content ensures the demand for mass storage will grow even more and it would be too costly to use SSDs to store all this data. Therefore, HDDs will remain the cost-effective choice for businesses and individuals for their storage needs in the next couple of years, at least. Thus, I think now is a good time to buy Seagate.

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Zarr Pacificador has no position in any stocks mentioned. The Motley Fool owns shares of Western Digital.. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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