Seagate May Benefit, but I'm Not Touching It

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This article is part of our Rising Star Portfolios series.

Last Friday, Seagate Technology's (Nasdaq: STX  ) shares rocketed 28% higher as news came out that its HDD manufacturing plants weren't hurt as badly as rival Western Digital's (NYSE: WDC  ) plants were from the monsoon flooding devastating Thailand right now. My heart goes out to the victims of the disaster, and I hope they will be able to put their lives back together as soon as possible.

My Rising Star portfolio, Messed-Up Expectations, owns shares of Western Digital -- in fact, it recently purchased more shares during the market downturn of August and September -- so, as you can imagine, I'm concerned about the situation.

Global supply of HDDs is going to be hit hard -- about 40% of all HDDs manufactured come from Thailand -- and computer manufacturers are worried. Apple (Nasdaq: AAPL  ) CEO Tim Cook said in last week's earnings call, "I'm virtually certain there will be an overall industry shortage of disk drives." However, because Seagate's Thai facilities have escaped relatively unscathed, analysts are predicting that Seagate will be able to pick up market share, maybe reaching 50%, by supplying drives while Western Digital is hurting.

Having read through the news and analyst comments, and having spent some time thinking about the situation, here is where I stand.

Flooding effect
Western Digital's manufacturing capability will be constrained until it can reopen the factories it closed, and clean and test (or replace) the equipment that was damaged in the flooding. Advantage: Seagate, because it didn't close any factories. However, there are broader issues.

First, flooding has also affected the makers of the components of the hard drives. Those suppliers are hurt and they sell to more than just Western Digital. If those guys are down for a long time, Seagate will be hurt as well.

Second, the flooding has quite possibly damaged or destroyed a fair amount of infrastructure in the country, such as roads. If the manufacturers cannot move product from the factories (regardless if they're damaged by the floods or not) to shipping points and on to customers, then the industry as a whole is hurt.

Market share moves
As I mentioned, several analysts see the situation as a bonus to Seagate. However, the situation is very fluid with more variables than just who had to close factories. Seagate is likely to gain market share in the short term, but over the long term the picture is murkier. Once Western Digital gets back on its feet, it will be aggressively going after any market share it manages to lose.

I like the comments and focus of John Coyne, Western Digital's CEO. He said during the company's earnings call late last week, "It's a very serious situation, but it's short-term in nature and we will recover from it." That's quite a statement given that it will probably take most of a year for WDC and the industry to recover. I like the kind of long-term thinking that comment implies and I'll gladly hitch my wagon to a company with a CEO who thinks like that.

What I'm a bit more concerned about is what the manufacturers of solid-state drives (SSDs) will do. This could be their opportunity to step up and fill the gap. Samsung and SanDisk (Nasdaq: SNDK  ) are two to keep an eye on, here.

Will I be buying Seagate?
Given the prospects for market-share gain by Seagate, should I buy shares? In a word, no. There are several reasons for this, all of them fundamental in nature:

  1. Western Digital has the stronger balance sheet, with $3.4 billion in net cash vs. Seagate's net debt of $584 million (I know, not too terrible).
  2. Western Digital has no problems covering its interest payments, with a trailing interest coverage ratio of over 80. Seagate's ratio is a much more worrisome 3.5.
  3. Western Digital appears to manage its operations better than Seagate. One data point is the cash conversion cycle, with it sitting at (0.1) day for Western Digital vs. 10.9 days for Seagate.
  4. The debt-to-equity ratio at Western Digital is a minuscule 4.6%, compared with 144% at Seagate.

I have several more reasons outlined on my discussion board.

Now, I could buy Seagate anyway, hoping it will fare better than Western Digital through this crisis and benefit in any share-price rise, but after Friday's jump a lot of that's already priced in. Plus, there's still the very real risk that Seagate will end up being hurt just as badly as Western Digital if component supplier constraints and/or infrastructure issues in Thailand come to pass. Even the analysts upgrading Seagate (e.g., Jayson Noland of Baird) say that Seagate is "speculative" given the uncertainties remaining in Thailand. With higher expectations come higher losses if and when those expectations are not met. In other words, there's less room for error in Seagate's stock at its current price.

Will I sell Western Digital?
Probably not. The comments by Coyne really impressed me. He gets that businesses are long-term things. Plus, the expected merger with Hitachi's (NYSE: HIT  ) GST division will help the company in the long term. Its factories in Thailand are outside of the flooded area, so if the merger goes through fairly soon, the short-term effect to Western Digital would be lessened to some extent.

Final thoughts
Well, one thing that this disaster has caused to happen is the total removal of the HDD inventory glut that had analysts so worried a mere six to nine months ago. Prices are likely to go up, too, at least in the short term as supply tightens up.

I'm comfortable with the MUE portfolio's position in Western Digital, sitting at a 4% level of investable capital. I might consider increasing it, depending on how management handles the situation in Thailand, how they communicate that to shareholders, and the stock price.

Come and discuss this and other investments on my Messed-Up Expectations discussion board, or follow me on Twitter.

The data-storage needs of the world keep on growing, which benefits both Seagate and Western Digital. But the real winner of that trend is the one that benefits from the new technology revolution. Download a special free report that reveals its name.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).

Fool analyst Jim Mueller owns shares of Apple. He's an analyst for the Motley Fool Stock Advisor newsletter service. The Motley Fool owns shares of Apple and Western Digital. Motley Fool newsletter services have recommended buying shares of Apple and creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool's disclosure policy is never messed up.

Read/Post Comments (7) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 24, 2011, at 7:13 PM, MotleyFoolSux69 wrote:

    I'm really glad I don't follow any of your advise; you obviously don't know what you're talking about.

  • Report this Comment On October 24, 2011, at 7:15 PM, terryongarland wrote:

    STX- from someone who just returned from Thailand, notes that the flooding is not over, and the STX facility will be almost surely engulphed by next week

  • Report this Comment On October 24, 2011, at 11:00 PM, willypt wrote:

    Every so often I think about buying some foolish advice. Thanks for saving me that money! This is clearly a ploy to keep your WD stock from sinking. STX has 60% of production outside of Thailand and just got approval to buy Hitachi Seems like that's more capacity that's in Korea. Good luck with your WD stock, it's under water.

    Some more data to ponder: WD has lost all 2 1/2 capacity and it will take months just to re-qualify their clean rooms. I think with a small price adder Seagate can hire a helicopter to move parts and product if needed.

    Good luck Fool you lose!

  • Report this Comment On October 24, 2011, at 11:54 PM, josephjpeters wrote:

    What about SSD manufacturer OCZ? Their new Octane is going to be $1.10-$1.30/GB and super fast.

  • Report this Comment On October 25, 2011, at 12:03 AM, priceg2 wrote:

    Correction to the above post: STX just received the ok last week from the EU to buy Samsung's HDD division assets. WD is "in process" to buy HGST.

    No correction to the impact of the Thailand flooding: this may be the single biggest event to hit the HDD industry in 10+ years. While WD and STX each had varying levels of impact from the flooding as of last week, see the transcripts from the earnings calls, the HDD supply base that is in Thailand was also hit. It will be a messy clean up once the water recedes - and in some areas, the water has still not subsided.

  • Report this Comment On October 25, 2011, at 12:07 AM, Gyre07 wrote:

    I know quality of product is sometimes subjective but I've got personal experience with this stuff. I've been building computers for years. Nothing but bad luck with WD drives, while I've had nothing but good luck with Seagate drives. It's been very consistent. As an investor, if the quality is superior and the price is the same I'm buying quality regardless of floods in Thailand. This will do nothing but boost Seagate's bottom line regardless of how much longer than WD they can keep retailers supplied.

  • Report this Comment On October 25, 2011, at 10:20 AM, daustin97222 wrote:

    It's my view that higher prices and constrained supply will benefit all vendors in this space (those who can still supply drives). However, it will also close part of the gap between HDD and SSD pricing. FWIW, our company here (a gigantic high-tech firm you all know) has contacted the server vendors and they are not concerned about supply constraints as fallout from this.

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