Why It's Time to Bail on Seagate

For all of the talk of the death of the personal computer and its potential disastrous effects on PC-dependent companies, it's remarkable that Seagate Technology (NASDAQ: STX  ) is performing as well as it has. For that matter, the same can be said of Western Digital (NASDAQ: WDC  ) . But can it continue?

To that end, Seagate seems the most interesting. I think this is why David Einhorn drastically reduced his shares in the stock by almost 5%, which represented his largest percentage reduction. While it could be just simple profit taking, Einhorn also understands that what Seagate faces is real. While the fundamentals in this company are indeed solid, increased demand for solid state drives, or SSD, is taking a toll on Seagate's core hard disk drive business, or HDD. And placing a bet here on Seagate assumes that there will be a reversal at some point. Seagate's second-quarter results suggest that's not likely to happen.

Mixed results due to mix shifts
Relative to expectations, the results weren't that bad. Revenue climbed 15% year over year, helped by a 24% jump in hard disk drive units. But revenue fell 2% sequentially. As expected, prices continue to be an issue and are still in decline. Average selling prices, or ASPs, fell 7% year over year and 3% sequentially. But the company did surprise investors as client, non-computer segments and enterprise each posted double-digit growth.

Similar to its impact on revenue, ASPs also hurt profitability. The company struggled with its product mix. Margins weren't strong, but arrived in-line with expectations. The company posted 4% year-over-year drop in gross margins, while shedding 1.5% sequentially. Similarly, there was a 8% decline in operating income, which fell 13% from the first-quarter.

Is it really here finally? What do we do now?
It's looking more and more that the market is beginning to shift. Although this has been anticipated for some time, the evidence has not shown up until now. There's no more denying that HDD demand is in decline. But that not to say there's still not a market for Seagate. But there's also a urgency for this company to find new end-markets. And anything short of this could mean a slow death. And that's the key factor here -- the word "slow."

Investors have to decide how much time this company has. And how much confidence there is that management can use capital reinvestments to mitigate further share erosion. What's more, it has to coincide with a transition to SSD. And unfortunately, it's not a situation of competitive outperformance where Western Digital is any better. The market is shifting, and neither company appears adequately prepared. Seagate has to hope that the big talk of "big data" can prolong its relevance in enterprise storage.

I've spoken recently about the strengths of storage kings EMC (NYSE: EMC  ) and NetApp (NASDAQ: NTAP  ) . While tablets and smartphones are indeed eating away at the PC market, I don't see a scenario where either EMC or NetApp will cease needing HDDs.  And although a case can be made that Seagate should be sold to either one of them, what would they gain? Besides, the highly anticipated PC-boom that was expected following the release of Microsoft's Windows 8 has not happened. Chances are, it won't in the future. And since then, there's been a chain reaction.

Dell has decided to go private, Hewlett-Packard has formed a partnership with Google to lessen its Windows dependency. In other words, the PC-death effect has finally arrived. It is now clear that Seagate and perhaps even Western Digital need to change their business models if they care to survive.

What of the stock
The stock is far from expensive. But there's no compelling reason to buy here. What would be the catalyst for revenue growth going forward? Not only does Seagate have to fight to secure market position, staring down the likes of Western Digital, but it must also has to spend to transition its business from HDD to the new SDD standard. It can't rely solely on enterprise storage for its revenue. Likewise, as the gaming industry continues to grow, SSD is rapidly evolving into those devices as well. It may just be the case that investors should follow Einhorn's lead.

While Seagate Technology pays a significant and growing dividend and seems able to generate the cash flow to support it, a global slowdown in demand for digital memory storage has begun to put pressure on margins. Is Seagate worthy of your investment consideration? The Motley Fool answers this question and more in our most in-depth Seagate research available for smart investors like you. Thousands have already claimed their own premium ticker coverage, and you can gain instant access to your own by clicking here now.

Read/Post Comments (7) | Recommend This Article (2)

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  • Report this Comment On February 27, 2013, at 3:04 PM, havoc007 wrote:

    Please! Stop the insanity. This article is complete lunacy.

    Now where does it state how many billion wdc/stx are making. wdc/stx are printing cash. They both own 90% of the storage market. Everyone knows what the cloud is. Every cellphone vendor (msft, google, samsung, apple, etc) now offers free cloud storage for the billion devices that get sold every year. 99.9% of that cloud storage uses hard drives that are made by wdc/stx. Those same billion mobile devices have cameras and video capabilities. That content will either get offloaded to a PC or to the cloud. Both require hard drives.

    This author is completely insane to infer SSD's are crimping HDD sales. Tablet sales may delay PC sales, but the fact remains, users will want to upload content to the cloud or they will offload the content to their home PC/Media center.

    Take a look at their EPS, dividend and margins. Historically margins used to be in the 17-20% range. Since a year ago when the industry consolidated from 5 to 3 hard drive companies, margins shot up to the current 27-29%. Seagate is on record as saying they intend to raise their dividend by 10% per year (currently at 4.5%). They are also committed to retire another 10% of their shares over the next year (recently bought back 20% of the float). Otherwise, they are on a trajectory to 'force' the share price higher. If the shares do not go up, then private equity will soon be knocking on the door.

  • Report this Comment On February 28, 2013, at 9:51 AM, summersnowflake wrote:

    Let me tell you why STX is a sell.

    1. Current gross margin is artificially high. People forgot that there was a huge flood in Thailand one year ago that wiped out 50% of HDD manufacturing capacity globally. OEMs had no choice the but to sign long-term (mostly one year) agreements with HDD makers, promising to buy one year worth of supply at ridiculously high price in order to get priority supply during the flood. This is equivalent to extortion but HDD makers got away with them. These agreements are expiring now. Look at historical P&L, HDD gross profits were normally in the teens. Just watch how HDD GP % will drop over the next few quarters.

    2. After the pros and cons are considered, cloud is NOT good for HDD. In the past, content used to be distributed, eg a movie is stored repeatedly in all the PCs. If 1000 people watch it, they download 1000 times and store locally. Now, they watch streaming. So poof ! 1000 copies turned into one in the server. Lots of duplication of demand will be wiped out.

    3. SSD is definitely encroaching into HDD space but starting not in PCs but rather in servers. If you understand storage technology, you'll know that tier 0 storage in data centers are now default SSD. Not so a few years ago. Tier 1 is going that way now. Their 0 and 1 are most profitable tiers for storage and now it has gone to SSD.

    4. Tablets are affecting PCs. PCs are not growing anymore. HDD needs PC to grow. Otherwise, supply growth will outstrip demand growth. The bigger problem is that after using tablets, they will realize 64GB is more than good enough, why buy those TB HDDs ? HDD capacity will become a don't-care when people buy PCs. That'll be a disaster for HDD companies.

  • Report this Comment On February 28, 2013, at 2:15 PM, havoc007 wrote:

    @author and summers,

    1. Current gross margin is artificially high. People forgot that there was a huge flood in Thailand one year ago that wiped out 50% of HDD manufacturing capacity globally.

    True, but you conveniently ignore the biggest reason HDD prices are holding the 27-30% gorss margins. THERE ARE EFFECTIVELY ONLY 2 DRIVE COMPANIES LEFT IN THE ENTIRE WORLD. Those 2 companies have not spent a dime on cap-ex. Thus, they are not fighting for market share and can enjoy reasonable margins. If EMC, NTAP, FIO can get 50% margins, so can a HDD maker. Do you know what a duopoly is? I'll give you a hint: Comcast and DirectTV. They consistently raise their rates by over 5% EVERY FN year. Do you know why? No competition and the cost of entry to the market is impossible. Sounds an awful lot like the HDD industry eh?

    Also, to counter. Concerning the long term agreements that you talk of, WDC doesnt have those in place, so how can they enjoy the 27-30% gross margins also? Wouldn't they take advantage of that? If they did, it would show up in lower GM's, but they dont. So that idea is a non-issue.

    2. After the pros and cons are considered, cloud is NOT good for HDD.

    WRONG! Cloud is extremely good for HDD makers. Did you know that the GM's for Cloud drives are about 15-20% higher than drives sold into PC's? The quality of EPS goes through the roof with more Cloud drives. The Cloud is also controlled by governments and major privacy issues limit its appeal for personal storage. Thus, with mobile devices, people will either upload OR offload the content to an external USB drive. p.s. Margins for backup hard drives are much high than for PC drives. Thus, once again, the Cloud creates even more upside to the quality of EPS for the drive makers.

    3. SSD is definitely encroaching into HDD space but starting not in PCs but rather in servers.

    Quick! Name the 2 largest FLASH manufacturers in the world (FLASH is a component that goes into SSD's). Who would that be? Want a hint? OK, its Samsung and Hitatchi. OK, those 2 companies just sold their hard drive businesses to STX & WDC respectfully. Those deals also have arrangements to allow WDC & STX to have access to the FLASH the companies produce. So, it looks like the 2 largest drive companies in the world have teamed up with the 2 largest FLASH companies in the world. Thus, one can reasonably assume they will own the SSD industry. Want proof? OCZ's ceo stated they could not procure FLASH in quantities because they were not big enough. STEC is hemorrhaging money. FIO only has 3 major customers and is slashing revenue guidance. None of the major SSD companies are making any money. Yet, WDC & STX are rolling in it.

    4. Tablets are affecting PCs. PCs are not growing anymore. HDD needs PC to grow.

    HDD makers don't need anything to grow. They only need to keep doing what their doing. Maintain 27-30% margins. Print money like a bank. Buy back massive amounts of shares and keep increasing its dividend.

    4.) The bigger problem is that after using tablets, they will realize 64GB is more than good enough, why buy those TB HDDs ?

    WRONG. Why is it that every owner of a mobile device wants a micro card slot? To expand storage! Why is it that all the mobile device makers offer Cloud storage? Because their customers want more storage. Why does Apple charge a massive $100 for an extra 32GB of FLASH? Because their customers want more storage.

    If you think the SSD industry is a great area to invest in (Lose boatloads of money, cant compete on scale nor distribution, etc,.) go right ahead. I'll invest my money in companies that make money. Thank you.

  • Report this Comment On February 28, 2013, at 6:58 PM, gargabe wrote:

    More Garbagggggggggge

  • Report this Comment On March 01, 2013, at 2:14 AM, mattdavidian wrote:

    The increased amount of streaming video content does not mean that one copy of a movie is stored in the cloud for all to access. As an example, a company like NetFlix uses a content distribution network that puts the content closer to their customers for best performance and lower costs. That means storing many copies of the same content on many servers. They are pushing their own Open Connect CDN (as opposed to third party CDNs), and promoting the Super HD picture that it provides (higher bitrate than their existing HD streams, better picture, larger streaming files) to their customers.

    The Open Connect appliance uses 36 3TB SATA drives for 100Tb of storage, and two SSD drives provide 1 Tb of storage. Multiple appliances may be deployed, depending on how much NetFlix traffic an ISP needs to handle.

    That is just one type of "cloud" server. Others may or may not rely on more SSD storage.

    I would also debate the notion that "in the past" 1000's of people would download movies and need storage for those movies, obviated by increased streaming. Increased streaming may be reducing downloads a little bit, but the big driver of downloadable video content is almost certainly BitTorrent. It is not 1000's of people, but at least tens of millions. There are some companies that offer legal downloadable video for sale (like Amazon) but the storage requirements for downloadable video are almost certainly still being driven more by BitTorrent than legal sources.

  • Report this Comment On March 01, 2013, at 2:17 AM, mattdavidian wrote:

    Oh yes, the HDDs in the Open Connect appliance do come from either WDC (HGST) or STX.

  • Report this Comment On March 01, 2013, at 7:43 AM, assisgnmeaname wrote:

    A new low for the Fool. How about an editor? Anyways, often a good contra-indicator...I'll buy STX. PS - Einhorn decreased STX (probably up around $38) but increased (or initiated) WDC; not exactly a vote of no confidence in the space...more like getting both sides of a duopoly...(no Coke, Pepsi).

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