FOOL ON THE HILL
4 Reasons Seagate Sinks

Remember disk-drive maker Seagate? The private equity investors that took the company private in 2000 have sold shares to the public again. While investors should be wary of initial public offerings, in general, this company's numbers provide specific warning.

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By Tom Jacobs (TMF Tom9)
December 12, 2002

Any IPO that raises $870 million is a standout these days. That was the take Tuesday when hard-disk maker Seagate Technology (NYSE: STX) floated 75.2 million shares at $12 each. The haul placed Seagate sixth among new public offerings of shares this year, according to IPOHome.com., and the 21st largest since 1990.

It's interesting that the news reports focus entirely -- and innaccurately -- on the size of the deal and company history. Most of us probably want to know whether Seagate, taken private by investors hoping to make it more efficient and sell again in the future for their profit, is more efficient and perhaps a turnaround with potential for individual investor profits.

I think not. There are at least four good reasons to eschew the shares. Remember that IPOs are financing events for a company and very, very rarely opportunities for you and me to "get in on a good thing." Those exceptions -- investments in Amazon (Nasdaq: AMZN), eBay (Nasdaq: EBAY), and others purchased during their first days of trading -- can be lucrative, but in the vast majority of cases, it's best to be skeptical at first and watch a company release a year or more's worth of SEC filings.

And Seagate's IPO is more a financing event for its investors than for the company. In November 2000, several private equity investment firms, led by Silver Lake Partners, formed New SAC. They contributed $875 million and borrowed another $809 million for New SAC to pay $1.684 billion for Seagate Delaware's rigid disk-drive and storage business. I didn't see the financial media reporting that, of the $870 million raised Tuesday, about 65% will go to the owners of New SAC-preferred and ordinary shares, while only 35% will go to company coffers. But that's in the fine print of its prospectus, SEC Form S-1.

Seagate's prospectus reveals the four good reasons not to invest.

1. Do the math
Clear, year-over-year comparisons are only available for the balance sheet, but not for the income or cash flow statements. That's because FY 2001 is a mongrel year, with numbers broken out for the 5/12 representing operations of the old public Seagate (July 1 through Nov. 22) and 7/12 representing the newly private Seagate (Nov. 23 to June 30). FY 2002 data covers the privatized company's operations only. To obtain some picture of trends, I combine the FY 2001 data to compare with 2002.

2. Beachfront condo
The company is incorporated under the laws of the Cayman Islands. Beware of companies headquartered in a lovely locale for legal or tax reasons and with operations elsewhere. We have enough trouble with companies operating in the public eye here. Not every firm is a Bermuda-based Tyco International (NYSE: TYC), but why take the chance?

3. Accounts receivable and inventory growing faster than sales
While sales increased a slight 2% in 2002 over 2001, reversing three years of annual declines, inventory bulged 8%, and accounts receivable (A/R) swelled 14%. Without evidence that sales are accelerating, this looks just plain lousy. Why invest more money in inventory you're not selling in an industry noted for rapid change and short product cycles?

Increases in A/R suggest a company extending payment terms with potential problems collecting, but it's helpful to look deeper. Many companies break out inventory into three elements -- raw materials, work-in-process, and finished goods -- in the notes to their financial statements. (For a great explanation of these inventory components and how to use them, enjoy Rex Moore's column, The Inventory Story). This helps us determine whether  inventory is up in all categories, only at the start (more raw materials needed to respond to new orders?), or at at the end (finished goods piling up with fewer new orders coming in?). Here are the year-over-year figures for Seagate:

Inventory Element  6/2001   6/2002  Change
Components         $63 mil. $54     (14.3%)  
Work-in-process     61       34     (44.3%)
Finished goods     198      259      30.8%

Sales            5,966    6,087      2.0%

The 30.8% increase in finished goods is scary! Unless the 2% year-over-year sales increase suddenly changes -- which is hard to imagine in the exciting, bustling world of disk-drive storage -- those finished goods will either be written off or sold for peanuts.

How's the competition?
Seagate competes with "captive" and "independent" rigid disk-drive makers and says it's gaining market share. Captives include Fujitsu, Hitachi (NYSE: HIT), IBM (NYSE: IBM), Samsung, and Toshiba, which manufacture the drives as part of other products they sell. Independent makers, like Seagate, produce the drives alone and sell to OEMs that incorporate them. Seagate's independent competitors Western Digital (NYSE: WDC) and Maxtor (NYSE: MXO), which said yesterday it would ax 5% of its employees, have mixed inventory and A/R numbers relative to sales. Only Seagate's A/R and inventory growth both exceed sales growth. 

Y-O-Y Change: Seagate  West. Dig'l Maxtor      
Revenue        2%         10%       40%    
Inventory      8%         -7%       74%
A/R           14%         71%       34%

Those 70%-plus increases at Western Digital and Maxtor should frighten investors at those companies, too, and all of these suggest an industry with disappointments coming.

4. Efficiency
The fourth reason appears when we look at the cash conversion cycle (CCC) and its elements for Seagate and competitors. The CCC tells how long it takes a company to turn a dollar paid to suppliers into a dollar of income. The lower the number, the better. For an easy-to-follow explanation of how to compute CCC and its components, check out Bill Mann's Show Me the Money! 

             Most Recent Year    Prior Year
Company      DSO DIO DPO CCC   DSO DIO DPO CCC
Seagate       36  28  60   5    33  23  37  19  
Western Dig'l 24  17  47  -7    37  14  59  -8
Maxtor        38  17  66 -11    37  20  63  -7

Key:
DSO -- days sales outstanding 
DIO -- days inventory outstanding
DPO -- days payables outstanding
CCC -- cash conversion cycle (DSO + DIO - DPO)

At first glance, Seagate has the worst of three decent cash conversion cycles. A negative number is excellent, meaning that a company's suppliers are funding its operations -- Dell Computer (Nasdaq: DELL) typically sports a negative CCC. But we need to look more closely. A large but steady DPO number might indicate a strong company whose suppliers know they will be paid and accept the time lag, but a jump in DPOs can signal financial weakness rather than the power to keep trade creditors at bay. Seagate is no Dell. A 60% jump in DPOs suggests trouble.

I don't need to go further than this to steer clear of this IPO -- a disk-drive maker incorporated in the Cayman Islands with accounts receivable and inventory out of control. And I bet we'll see disappointing numbers from Seagate in the coming quarters, with bad news for the stock price.

Have a most Foolish weekend! And please join the debate on our Fool on the Hill discussion board. 

Tom Jacobs (TMF Tom9) spends his nights putting plastic over draughty windows. Exciting! 
Join Tom in examining the fine print each month in The Motley Fool Select. Enjoy your 30-day free trial today! At press time, he owned no shares of companies mentioned in this column. To see his stock holdings, view his profile, and head right down the street to The Motley Fool's disclosure policy, available in chocolate, vanilla, bull, and bear.