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:
- 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).
- 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.
- 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.
- 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.
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